Published January 26, 1998
The Weekly Standard, January 26, 1998
OUR GREAT DIFFICULTY IN UNDERSTANDING the Asian financial bubble and its implications for the United States is not that we have too few explanations, but far too many. The crisis has been blamed, variously, on greedy speculators (by an Asian head of state), on the failure of Asian governments to appreciate the important social function of greedy speculators (George Soros), on the folly of pegging exchange rates (monetarists), on the folly of not defending pegged exchange rates to the last ditch (supplysiders), on not deregulating Asia’s financial institutions quickly enough (conservative economists), on deregulating Asia’s financial institutions too quickly (liberal economists), on IMF bailouts (libertarians), on failure to follow IMF advice (the IMF), on Clinton administration myopia (GOP presidential hopefuls), and on the failure of countries like Japan to follow the Clinton administration’s farsighted advice (the Clinton administration)—and this list omits technical arguments too stupefying to summarize.
The appeal of each of these partial explanations is that it boils down a complicated situation into a simple drama, whose tragic outcome can be traced to a flaw in one or more players. And there are kernels of truth in many of these theories. What doesn’t make sense is the tremendous series of coincidences. Why did so many of the tragedians apparently fly off the handle all at once? And why these particular tragedians? After all, government policies in the Asian Tigers have been, on the whole, much more market-oriented than in Latin America or Eastern Europe. Also, most of the explanations amount to advice to various players as to how to deal more deftly with speculative bubbles and their aftermath. But where did all the bubbles come from?
I’d like to suggest that, if the crisis is to be considered a drama, it is less a Greek tragedy—a story in which abnormal people mess up a normal situation—than a story in which a number of relatively normal people are thrown into a thoroughly abnormal situation, more like a fairy tale (or nightmare).
For an understanding of Asia’s predicament and its disturbing implications for the United States, the first step is to grasp the Through-the-Looking-Glass nature of our international monetary system. This peculiar system is based on the U.S. dollar—at least for all the countries involved in the present crisis. To appreciate what it means that the dollar is the “reserve currency” for the world, imagine that all the people you met not only would accept your personal checks, but actually carried your uncashed checks around in their wallets to use instead of money. This would have two effects on your personal finances. First, you’d no longer need to carry any cash, just your checkbook. Second, when you received your bank statement every month, you’d find a lot more money in your checking account than you had actually saved. The extra money would equal the value of the uncashed checks floating around. Under this arrangement, your personal purchases and investments would no longer be limited by your savings, only by other people’s willingness to hold your checks.
This is what being a reserve currency means for the United States. The fact that other nations’ central banks hold dollars to back their currencies means that our country doesn’t need to hold much, if any, foreign money in reserve; it also ensures that the United States makes more investments and purchases of goods and services abroad than are made in the United States—the difference equaling the amount of dollar reserves acquired by foreign central banks.
Some Americans consider this a neat arrangement; what they overlook is that it gives foreign governments partial control of the U.S. “checking account.” What the dollar-reserve-currency system does, in effect, is turn participating foreign central banks into so many Federal Reserve Banks of Tokyo, Seoul, and Bangkok. These banks conduct open market operations, buying and selling U.S. Treasury securities in the New York money market, exactly as the U.S. Reserve Banks do (in fact, the New York Fed acts as their agent). The only difference is that the foreign currencies issued in this way—unlike those issued by the Reserve Banks of Chicago, Richmond, and San Francisco—may not be permanently fixed in dollar value.
This creates at least two policy headaches for the United States. First, monetary policy in the United States is determined not by the Federal Reserve alone, but by all the central banks in the world that buy or sell dollar assets. Second— and this headache is more remote but potentially dire—there is always the chance that too many “checks,” or foreign dollar reserves, will be cashed at once. When foreign dollar reserves are sold, the same amount of U.S.- owned goods or securities must be sold at once, at whatever price they will fetch. If the amount is large enough, it causes a U.S. recession. That’s what happened between 1929 and 1932, when virtually all dollar and sterling reserves were liquidated by central banks, triggering deflation and depression.
The postwar Bretton Woods system was intended to prevent such a crisis. After 1971 and until just recently, the U.S. Federal Reserve still set the pace for monetary policy, despite the end of fixed exchange rates. When the Fed lowered interest rates, the dollar sank, inducing foreign central banks to ease also. When the Fed hiked rates, the dollar rose, inducing foreign central banks to tighten. But because it no longer controls all central-bank activities, the Fed is often astonished at the magnitude of the response to its policies—the severity of the inflation in the 1970s, for example, and the depth of the recessions in 1974, 1982, and 1990. But at least the timing used to be pretty regular. Now, the Asian crisis has revealed a new twist for the United States. By 1992, the total holdings of U.S. Treasury securities by foreign central banks began to exceed those of the U.S. Federal Reserve. And by 1995, the holdings of some individual foreign central banks were large enough to rival the importance of the Fed.
In 1995, the Bank of Japan began to act like a regional Federal Reserve Bank that had declared independence. After the Federal Reserve started hiking interest rates in 1994 and sharply curtailing its own purchases of Treasury bills (incidentally triggering the Mexican peso crisis and a sharp U.S. slowdown in 1995), the Bank of Japan not only didn’t join in; in an effort to restart its economy with a cheaper yen, it began actually buying Treasuries, ultimately over $100 billion worth. To Japanese banks, however, the rest of Asia looked like a better bet than Japan itself. Monetary authorities in mainland China, meanwhile, purchased another $80 billion of Treasury bills; Hong Kong and Singapore about $22 billion each; Korea, Malaysia, Thailand, Indonesia, and the Philippines scraped together another $30 billion or so. All told, these Asian countries account for virtually the whole $260 billion increase in the world’s foreign dollar reserves between the end of 1994 and early 1997. The flow of dollars back and forth between New York and the Far East, and the Asian bubble, continued more than two years after the similar bubble had collapsed in Latin America.
This dollar buying enlarged the already growing Asian bubble. When Americans invest abroad, the foreign country receives the dollars that finance the investment—but its central bank promptly turns around and invests them right back in the United States. Mostly, it invests in Treasury bills held in custody at the Federal Reserve Bank of New York. The original investor’s money is effectively cloned: ostensibly lent at one and the same time both to foreigners and to the U.S. government. But one thing doesn’t change with this transaction: There is no more real wealth than before, and somewhere in the world, the price of something will go up without the prices of other things going down. The dollars may bid up stock prices in the United States, as in the 1920s; they may bid up commodity prices on the world market, as in the 1980s; or they may bid up real-estate prices in Tokyo or Hong Kong. But the process leaves the same amount of money sloshing around New York as before.
As foreign stock-market or real-estate prices start going up, it seems attractive to borrow still more dollars and invest more; so more loans are made and more dollars go abroad, only to wind up right back in New York. In the process, the assets of the foreign country become more and more expensive, which typically results in a growing trade deficit in goods and services; but the flow of investment can be kept going as long as the expectation persists that the items rising in price will become more expensive still.
Judging the turning point is a fine art. (George Soros’s response to the head of state who accused him of assaulting the currency in question was that he, Soros, was on the wrong side of the market at the time.) But once investment funds start flowing out faster than in, the local central bank is forced to make a choice: either slam on the monetary brakes until prices deflate back to their starting point, or devalue the currency, which accomplishes the same thing in terms of foreign, though not domestic, currency.
Whether the country manages to keep its currency fixed to the dollar at this point becomes secondary: Either way, the country’s economy will go through the wringer. There have always been speculative investors greedy or shrewd, foreign businessmen making fortunes or going bust, foreign policymakers corrupt or virtuous, and American and international bureaucrats adept or inept. But what the Asian crisis demonstrates is that the reserve-currency system vastly magnifies and prolongs the impact of their mistakes.
HOW WILL THE CRISIS PLAY ITSELF OUT, and what will be its effect on the U.S. economy? Conventional wisdom, adding up Asia’s share in U.S. trade, says that the impact will be negative but limited. Maybe, but the outcome actually depends on certain unknowns. Since the Asian currency crises began in mid-1997, foreign central banks have sold about $50 billion worth of U.S. Treasuries. This has tightened monetary conditions at a time when the Fed is trying to keep things on an even keel. How much further the process goes depends not only on the Fed, but on those foreign central bankers who still have the most policy discretion.
Think about the Bank of Japan, which started the ball rolling. After nearly doubling its chest of dollars, the Japanese government confronts a loss of confi- dence in its currency. It is also up against the political problem of how to finance a bailout of its banking system costing $80 billion or more, in the face of strong objections to using taxpayers’ money and without causing a collapse of the yen. The temptation will be strong to sell some of the $100-plus billion in dollars acquired since 1994. The Bank of Japan started doing this in December.
The second question-mark is China, whose dollar holdings have more than doubled to nearly $140 billion (not counting the $70 billion held by Hong Kong, now under mainland control). China’s currency has weathered the storm so far, partly because the yuan was already devalued in 1994. But the Chinese economy is being hit heavily by the current crisis, and the leaders in Beijing don’t seem to feel they owe Washington any favors.
A third though smaller question-mark is Latin America. In Mexico, for example, both the economy and foreign reserves have recovered in dollar terms roughly to levels they attained before the 1994-95 peso crisis. But in the process, Mexico has started to flash warning signals of the same sort as before the last crisis. The devaluation made Mexican goods cheaper for a brief period, but inflation has reversed that change. As a result, the current account balance, which shifted sharply from a large deficit to a small surplus, is likely to head back into deficit.
The U.S. economy is in better shape to weather a monetary storm than at any time since the mid-1960s, when a surge of growth in industrial capacity like the one we’re seeing now meant that the monetary crunch of 1966-67 produced only a “growth recession”—a slowdown but not a decline in output. Even so, despite all the talk of a “new economy,” the business cycle has not been tamed any more than it was by the much-ballyhooed “new economics” of the 1960s. A large enough cashing in of America’s “checks”—say, the sale of $100 billion worth of Treasuries by Japan and China—would suffice to cause not just a U.S. slowdown but a recession. Stay tuned.