We understood that countries could fight recessions by printing money. That's
one of the great lessons of the '30s. But it turns out that when you have these
wide open international capital markets, when a country tries to print money to
fight a recession, money starts pouring out of the country. The currency
plunges in value. The country's obliged to reverse those policies and do a
U-turn in order to stop that hyper-devaluation from taking place. So in trying
to get rid of some of the inefficiencies of this over regulated system that we
had 20 years ago, it turns out that we've also created a system where some of
the old remedies to problems don't work.|
Part of the result of this is ... a big argument about whether or not we
should slow down this march to absolutely free capital markets that the U.S.
government has been pushing ...
Well, sure. The things that people would have said two or three years ago about
what a terrible thing an over regulated banking system is, how inefficient it
is, about capital controls and how they distort incentives and create
opportunities for corruption--all those things are true.But it also turns out now that free markets are, as John Maynard Keynes would
have told you, sometimes desperately unstable. If you look at someplace like
Indonesia, one 15% decline in GDP offsets a whole lot of efficiency gains in
the past. So a lot of the old issues have been reopened. It's not easy to be a
free marketer with a free conscience right now, unless you are completely
blinkered, unless you just don't look at what's been happening in the world
Talk about exchange rates ... Why are they important to governments, to the
Each country has its own money ... that money trades on a market against other
monies. So there's an exchange market where people trade bahts for dollars.
There's a price of dollars and bahts or price of bahts and dollars; it doesn't
matter. Either way, between them is the exchange rate, which is determined by
supply and demand like any other price.
The only thing is that the supply and demand for bahts and dollars in this
market is mostly determined by investment decisions. People buy bahts because
they think Thailand is a good place to put their money. Thai residents buy
dollars because they think that Thailand is not such a good place to put their
money. So it goes back and forth.
Now, if you're a big country like the United States, which doesn't do a lot of
foreign trade relative to our income, which is just sort of big enough to ride
out whatever happens, we don't care much. The news says that the Japanese yen
has gone from 140 to 110 to the U.S. dollar. The average American citizen
doesn't say, "Oh, my God. The dollar is losing value in yen." But if you're a
small country like Thailand, it matters a lot.First of all, a lot of what you buy is imported, and the prices of those
imports tend to be set in dollars rather than in bahts. So if the baht drops
against the dollar, then your input prices surge. Even more important, this
turned out to be crucial, a lot of the borrowing that Thai businesses do is not
loans in bahts. A bank in New York doesn't want to make a loan that's defined
in bahts. It's defined in dollars or in yens.
So when the baht drops, all of a sudden, the money that you borrowed, that
looked like a tolerable amount of debt before, has suddenly increased. If the
baht devalues by 50%, suddenly the baht value of those yen or dollar loans is
50% more than it was. Now you can be in very deep financial trouble. So small
countries with a lot of foreign debt like Thailand or Mexico or Brazil find
themselves very worried about the value of their currency on the foreign
Talk about the difference between fixed rates and floating rates.
There are a couple of ways you can manage this thing. You're a country. You
have your own money. What do you do? One answer is, you do what the United
States does, which is you say, "Okay. We're going to manage our money based on
domestic considerations. If the economy's in a recession, we're going to print
more money. If the economy's overheating, we're going to pull money back. We're
going to let the foreign exchange rate do whatever it does." That's a market.
It's like any other market. Supply and demand will let it go up and down.
The U.S. gets away with this. It works fine. Even smaller advanced countries
get away with this. Australia does that, and they don't seem to have problems.
But the alternative, if you're worried about that, if you think that we can't
take the risk of having this price move too much, we can't have the risk of
having the dollar debt of our companies blow up in value, or a burst of
inflation or whatever, then instead you say, "Actually, no, we're not going to
do that. We're going to make our monetary policy keyed on keeping the exchange
rate fixed. We're going to declare a commitment to keep ... one peso to one
dollar. Whatever we need to do, if it looks like people want to change pesos
for dollars, instead of letting the peso drop in value, we're just going to
reduce the supply of pesos, make them scarcer, keep the price up." That's a
fixed exchange rate.
For the last 150 years, people have gone back and forth between the merits of
those two systems. Basically, each system has got big problems. After some
length of time with one system, you start to say, "Gee, maybe life would be
easier if we had the other system." And you switch. Then after a while, you
switch again, and back and forth.
In general, is it possible to say which of the two, countries prefer?
It varies a lot, depending on who you are. Basically, big countries like the
United States, and to a lesser extent Japan, basically find that foreign trade,
foreign investment, is not important enough for domestic policies to become
hostage to the exchange rate. That would be the tail wagging the dog, and
they're not prepared to do that. They may talk about stabilizing the exchange
rate, but when push comes to shove, the domestic economy rules.
The smaller the country, the more it tends to be committed to keeping the
exchange rate stable. The problem is particularly in a small country with bad
history, Argentina--small country, terrible history of hyper-inflation. Their
problem is always to convince people that pesos are real money. There's always
the risk that people will go back to the old habit of thinking of pesos as
being basically worthless pieces of paper and "I prefer to have dollars, thank
So they end up being prepared to sacrifice a lot to keep a peso stable, to keep
a peso worth a dollar, so that people continue to regard those pesos as real
money. It's an agonizing choice. And whenever the choice is made one way or the
other, there are many recriminations, because inevitably something goes wrong.
There don't seem to be any easy answers here ...
In general, don't investors wish that for the amount of dollars they put
into a country, they know that they will get that amount or more back
Yes, but not doing so kills the domestic economy. The one thing you can say is
that ... the markets prefer that whatever you do, you make a firm choice. Go to
the church of your choice, but go, goddamn it. The worst of both worlds seems
to be fixing the exchange rate, but not convincingly. If you have a fixed
exchange rate, but people suspect that you really aren't going to stay there,
then all hell breaks loose at the least provocation.
There are countries that have completely floating rates, and the market seemed
happy with them. When their currency drops, the market says, "Oh, good, that's
a buying opportunity," and it stabilizes. That's the case with Australia.
That's the case of what happened when Britain let its exchange rate drop in
1992, after promising up and down that it never would. Everyone was relieved.
It was good news.
There are other countries, mostly Third World countries, that the market
decides are not reliable. If they promise to fix their exchange rate and then
change their mind, the market treats it as a betrayal, the currency loses half
its value, and a terrible recession results. It's a very difficult world. It's
not fun to be a finance minister in this world. Whatever you do, it turns out
that the market is very likely to say that was exactly the wrong policy.
What kinds of trouble does a small country potentially create for themselves
by guaranteeing a fixed rate?
Well, suppose conditions change. You're a prosperous economy one year. Then
something happens. The price of your primary export falls, or there's some sort
of financial disturbance in the world. Investment drops, and money starts to
flow out of your country.
If you've guaranteed a fixed exchange rate, you have no alternative when people
take those pesos and want to turn them into dollars. You have to supply the
dollars and reduce the supply of pesos. That means people pull their money out
of your banks, which means the banks have less money to lend, which means that
there's a further contraction of credit, which means the deposit falls still
more. You're setting yourself up for a nasty recession, maybe even a banking
crisis, a run on your whole banking system. If you are truly committed to that
fixed exchange rate, there's nothing you can do ... Under the ordinary rules of
the game, there is nothing they can do. They just have to sit there and hope
that it's not a complete catastrophe.
Currency crises...if a country thought its currency was overvalued,
that was creating a problem--its exports were too expensive. If they decided to devalue
or let their currency float, the markets run out because of that too.
Yes, the '90s have been a bonus year for currency crises and a bonus decade for
currency crises. We've had more of them than in any decade since the '30s. It
started with good news. In 1992, Britain and Sweden dropped out of their
exchange rate commitments and nothing terrible happened. We all thought, "Okay,
there's a financial crises. Government officials get to look foolish, but
nothing really terrible happens." But since the middle of this decade, every
time a Third World country has tried to let its exchange rate go, has decided
that rescuing the banking system or fighting a recession was more important
than some exchange rate commitment, the result has been a catastrophic
Mexico, at the end of '94, devalued by 15%. Nothing unreasonable about that.
Lots of people thought they needed that. The reaction of the markets was, "Oh,
my God, they're still a Third World country. They're still Mexico." Within a
couple of month the peso has lost half its value.
Thailand devalued in the summer of '97. Again, that was perfectly reasonable. A
lot of calculations suggested that was a reasonable thing to do. This was a
country with a spectacular record of economic growth. It didn't matter. But as
soon as it happened, people said, "Oh, my God, the Asian miracle was a myth.
So in this world of hyper-mobile capital, the market seemed sort of manic
depressive about Third World countries. One day, "They're emerging markets and
they're the hope of the future." The next day, "They're bums and they always
were. It's crony capitalism." Countries are desperately afraid to do anything.
They feel that it doesn't matter what the economics are. As long as they have a
commitment or they're perceived to have a commitment to the exchange rate, to
break that for whatever reason is to open the flood gates.
Instead of taking the steps that might pull them out of recession, they're
afraid that if they take those steps, more money rushes out.
So they're trapped.
Yes. Hong Kong, at this moment, is an economy where there's deflation. The
unemployment rate is the highest its been in a generation. Everybody can see
that they have, at best, years and years of grinding slow adjustment as wages
are squeezed down. Perfect case, according to the textbook, for devaluation.
All their neighbors have devalued. Why not devalue the Hong Kong dollar to
The answer is that everybody believes that if Hong Kong were to go off its
current peg, that would destroy the credibility of their administration. And
because everybody believes it, it's true. It doesn't matter whether you believe
it, as long as you believe that every other investor believes it, then it would
be catastrophic. They are stuck. They are as stuck as an economy that was by
law committed to the gold standard in 1907 ...
You've called a lot of what we're talking about a confidence game. Tell me
what you mean by that.
The perfect case is Brazil. Brazil has a budget deficit ... that is not the
worst budget deficit in the world, but it's serious ... It doesn't seem like
something that has to be done now, but the markets have fixated on Brazil's
budget deficit and think that it must be reduced instantly. So it becomes
urgent to reduce it to satisfy the market. It's not because of the fundamental
economics. Of course, if you slash government spending and raise taxes, that
causes a recession. You might say, "Well, let's lower interest rates to not
have the recession." But they don't dare do that, because if they did that, the
currency would fall and that would unleash a sudden loss of confidence.
They end up having to do everything, not because, if you sat down and work
through the underlying economic situation, it's necessary, but because they
believe that the market believes that these are the right things to do. And the
market believes that these things are the right things to do because each
market participant thinks the other market participant thinks these are the
right things to do. They end up entirely in a game of psychology ...
Isn't it also the case that the IMF and the U.S. Treasury is telling Brazil
that this is what everyone believes?
The saddest thing for me personally is that we have the smartest, best
economists in the highest level positions ever in the history of the world. The
top people at U.S. Treasury, top people at the International Monetary Fund are
fabulously good economists, who are, by the logic of the situation, forced
pretty much to toss aside the textbook and cater to the prejudices of the
They knew when talking to Brazil, they understood that everything they were
telling Brazil to do was practically a checklist of how can I generate a
terrible recession in this country. But they felt, with fairly good reason,
that they had to do these things, because the markets were demanding them. The
markets were demanding them, not because they had that much to do with the
fundamentals in Brazil, as because the markets believed there would be a panic
if these things weren't done, and the markets were right, because the markets
would themselves generate that panic.
So what's happened, in a way, it doesn't matter how much economics you know, it
doesn't matter how thoroughly you understand the fundamentals of the situation.
Everybody ends up having to cater to the need to have market confidence. That's
the story of the last two years.
How did we get into that situation? When did the U.S. Treasury decide that
the markets were going to direct its policies?
I think [they] sort of slid into it. A lot of it is the story of Mexico. At the
end of '94, Mexico ran out of foreign exchange, hit the wall, devalued. They
botched it. It's a long story, but there was a terrible plunge in the Mexican
peso, and policy had to be made on the fly. The IMF and the U.S. Treasury put
together a plan which, I think you have to say, was improvised. They were
What the plan was, the Mexicans were supposed to do lots of things that were
tough--raise interest rates to 75%, cut spending, raise taxes--tough stuff
which might convince the markets that they were serious, might regain the
confidence they'd lost a few months earlier. The U.S. and the IMF and other
sources would rush them emergency cash to back up the procedure. And it
In retrospect, you have to say we're not quite sure why it worked. It wasn't as
if it was a well thought out plan. It was an emergency response. They saw the
ball whizzing past them. They reached out and they managed to grab it. But
having seen that work, the natural thing to say was, "Well, that's the way we're
going to deal with every crisis. We're going to focus everything on regaining
the confidence of the markets." And that's what they did in Asia.
Unfortunately, it didn't work as well as it did in Mexico. Basically, we got
suckered in by the success of the Mexican rescue into
playing this confidence game every time a crisis occurs.
There are others who take a less benign view of the lessons of Mexico ...
that the markets learned they could take whatever risks they wanted to, and
they would always get bailed out ...
Well, this is the issue of moral hazard. Do people say they can go out and take
risks because someone will bail them out? There's a lot of moral hazard out
there, though I think you can be excessively literal about it.
Certainly people, to some extent, investors, George Soros or whatever, believe
that in many cases, there will actually be dollars from the IMF or the U.S.
Treasury or the Japanese that will bail out their investments if they go bad.
But I think it's something broader, which is that Mexico gave us a false sense
that we knew what we were doing.
Now, people got the incorrect belief that Bob Rubin and Alan Greenspan really
had this thing under control, and all future crises would be comfortably
managed the way Mexico was. The truth is, Greenspan and Rubin and the
people who work for them are smart people, but like everybody in the situation,
are mostly groping. They got very lucky in '95, and it was a mistake on
everybody's part to assume they would always be so lucky in the future.
You have been very critical of the response to the crisis in Asia, once it
got going ...
Actually, I'm one of the people who was less critical. Among the people who are
critical, I'm one of the softies, because I can very easily imagine I would
have done the same thing as the people at the IMF and Treasury did, at least in
the first few months. The more we look back at it, the more we can see that
they really missed a lot. There were a lot of mistakes. The important thing now
is to try not to keep on making those mistakes.
A lot of what happened was that because this was viewed as a confidence issue,
the responses were totally focused on building confidence at the domestic
economy. Countries were told to raise taxes and slash spending in the face of a
recession because that was supposed to be a confidence building measure. It
turns out, it intensified the recession.
Countries were told to completely steer away from anything that might limit the
outflow of capital from their countries, because the threat of such measures
would reduce confidence. But it turns out, the money went streaming out
If there was something I would really single out for criticism, it is that
Washington took the crisis as a signal that now is the time to push for
wholesale reforms in the country, that they've got a banking and financial
crisis. Good. Let's tell the president to eliminate the clove monopoly. While
the clove monopoly was a terrible thing, it had no relevance here. What it did
was to create an adversarial atmosphere between the country and Washington that
did a lot to feed the downward spiral of confidence.
If I get really critical, it's about things like the Brazilian plan. This is
now a year and some months after the first wave of crisis, and we've learned
something now. Yet, we go into Brazil with exactly the same set of
recommendations as before. It's a plan with no end game. There was no way out.
It was telling the Brazilians, "Suffer, raise your interest rates, slash your
budget, endure the recession," and there was no sort of clause that followed.
That, I think, was a lot less forgivable than what went before.
It doesn't sound like you have much confidence that Washington has learned
Well, I think they are groping. But, in a way ... they have the same problem
that the Mexicans had at the end of 1994, which is, that to reverse their
earlier assurances would itself be enormously devastating to confidence. Take
an extreme case. Suppose that the U.S. Treasury Department became
intellectually convinced that Prime Minister Mahathir is right in Malaysia to
impose capital controls--they're not, but suppose that they were. They could
never admit that. To say that, would itself unleash cataclysmic events, because
it would be saying Washington doesn't know what it's doing. I think anybody
who's been at all in public life knows that you never, ever admit a mistake. In
this case, I believe we're all somewhat trapped by our history here.
Meanwhile, we have recessions and threatened depressions in many parts of
the globe. Doesn't someone have to admit a mistake somewhere along the
If you look ahead, what will actually happen is that countries will craft their
own responses. They will never be initiated from Washington, but they might be
acquiesced in by Washington. Malaysia is an extreme case. They've gone to
draconian capital controls. They've almost really gone too far and will back
But other countries will do things like institute measures to discourage
companies from borrowing in dollars. That's clearly one of the core issues in
this crisis. People in Washington will say, "Oh, that's a terrible thing;
that's interfering with free markets." But they won't actually take any
sanctions against countries that do it. So what I imagine will happen, assuming
that things don't fall apart before, the way out will be through a process of
steady deviations from the Washington consensus, which Washington itself
accepts without actually encouraging ...
You also wrote that the response to the Asian crisis was essentially a
betrayal of a deal made a couple of generations back.
Yes. That's the core. There are economists and there are economic commentators
who are free markets 100%. The market solves all the problems. But most
sensible people are aware that there are things like recessions, that the 1930s
did happen. The deal that we as economists made, the deal that governments of
advanced countries was, "We will take care of those. We will have monetary
policy. We will have fiscal policy. We will fight recessions. The 1930s
experiences are not going to occur. And given that, we can have free markets in
the economy at large. You don't have to have socialism, because we can
stabilize." That's the Keynesian deal. We can stabilize the economy. We can
prevent depressions. And that means that we can continue to have a free market
Everybody wins a bit from the free market.
That's right. There's a lot to be said for that. The free markets are very,
very good things. Attempts to better on them usually fail ... that's what's so
disturbing about the world in the last couple of years, is that that deal has
fallen apart. We have many countries that are now suffering from severe
recessions, that are heading with eyes wide open into recessions, because they
feel that there's nothing else they can do. They can no longer fight it. In
that case, the deal is off ...
One economist has said that this rolling crisis that began in Asia is
the greatest manmade disaster since the '30s.
That's right. That shouldn't even be a controversial remark. We've
had the two worst economic crises since the '30s. We had the first and second
oil crisis, and what those were about, we can debate. But the thing is, if
you're going to suddenly restrict the world's supply of oil, a global economic
crisis is comprehensible.
Nothing went wrong this time. There's no shortage of
raw materials ... basically, we just had technical issues that went wrong. Yet,
we've had a human catastrophe that's taken up about half a billion people and
thrown them back into severe poverty, and we don't know quite where it
How has something that was just a couple of technical issues that needed
some correction, turned into this disaster?
The thing that maybe is one of the greatest mysteries of macroeconomics is that
small causes can sometimes have enormous effects. If you take what I believe to
be the case--we're talking, in the case of the Asian economies or for
Latin Americans, about a technical interaction between foreign currency,
denominated debt, plunging exchange rate, capital flight--none of these
actually are a very difficult issue to deal with, if you got to it soon enough.
None of them is a fundamental statement about the weaknesses of the economy.
Nonetheless, devastating impacts.
Economists like me now believe that the Great
Depression in the United States was entirely preventable. At the time, people
said, "Ah, it's the excesses of the 1920s." Or people said, "Look, this is the
death throes of capitalism." We now think that if only the Federal Reserve had
printed more money early in the process and had rushed cash to those banks that
were threatening to close in 1930 and 1931, none of it would have happened.
Small causes, a little mishandling at a crucial moment, produced a devastating
What is the biggest question in your mind today?
Oh, the biggest question is what about the big advanced countries? This is an
enormous human tragedy. But so far, it's only affected people who didn't have
that much money to begin with. So in dollars and cents terms, it doesn't really
matter that much. The question is: Can this thing spread to us? By us, I mean,
basically, all of the rich, stable, democratic
countries of the first world.
So far, mostly it hasn't, but there are some scary things out there. The
Japanese are fairly close to entering into a deflationary spiral. The United
States had one heck of a scare in the fall when the bond market froze. I
remember a Fed official in a private meeting, when people asked him what are we
going to do about this, [he] said, "Pray," which was not very encouraging. We
got out of that. We don't quite know how. So the scary question, the big
question is: How immune are the big advanced economies? I'd give you 10 to one
odds that it's not the 1930s over again for those economies. But those are not
the kinds of odds I'd like to be hearing.
Aren't we already seeing [people] in the oil industry, steel industry, in
this country beginning to feel the effects?
Yes. Clearly some groups are hurt, because they are dependent on those markets,
or one way or another are directly in the path of this storm. On the whole, the
United States' economy remains astonishingly prosperous in the face of what's
going on there. There's no necessary reason why that can't continue. But then,
there was no necessary reason for any of this to happen. So you've got to be
concerned. The great revelation here is that we don't know what we're doing as
well as we thought we did. That problems we thought were solved are not solved.
That economic analysts like me, economic managers like the people at Treasury,
hopefully know something, but don't know as much as we thought we did. That
means that problems that we thought were impossible may turn out to be quite
real in the modern world.
In your Foreign Affairs article, you talked about whether or not
governments would take enough steps to stimulate demand at this moment
If you look at two of the three great centers in the advanced world, Japan,
first and foremost, and then also Europe, you start to wonder, what are they
thinking? Look at Japan right now. It's an economy that's been shrinking for
the past two years. Prices are falling. Wages are falling, which never happens.
You say, "Well, they must be moving heaven and earth to get that economy moving
again." The answer is, they aren't. They're spending a lot of money on public
works, but they're not printing a lot of money. When the yen surged in value
for complicated market reasons, which is a terrible thing for an economy that's
on the verge of a deflationary spiral, the Japanese actually seem to be proud
So that's scary. That's making me wonder, is it really possible that here in
the modern world, there are people who don't understand even that much and are
prepared to take those kinds of risks with a big economy? If you look at
Europe, where they talk about price stability and are sitting there again on
the edge of deflation, you wonder, are they prepared to do what's necessary?
Meaning, spend money?
Well, in particular, print money. You print money, and you spend money. Print
money is the easier alternative and the preferred one, if you can do it. Again,
the Europeans start to talk about the virtues of the strong Euro, which is the
last thing they need right now. What worries me about Japan and Europe is the
people in charge seem to be like the old line about French generals, prepared
to fight the last war. They remember very well the inflation of the 1970s and
early 1980s. They remember the excesses of speculation in their markets during
the bubbly economy in Japan during the 1980s. Here, they are in a world which
is that world turned upside down, where the clear and present danger is
deflation, not inflation; where the problem is crashing asset prices, not
overvalued ones. They don't seem to be prepared to make the mental shift. And
when they do, it might be too late.
Add into that mix the U.S. economy running a budget surplus. Isn't that a
problem at this moment in time?
... Well, so far that's not a problem, because U.S. consumers are making up for
it. What happened is the U.S. government has gone from heavy dissaving to
substantial saving. But U.S. consumers decided to stop saving altogether at the
same time, so it hasn't created a problem.
I'm less worried about the U.S. I don't think that we are a contractionary
force in the world now, or are likely to be. And in Greenspan I trust--not
really, but the fact is, that the U.S., whatever criticisms you can make about
its policies and for the rest of the world, our domestic policies are more
flexible, more open minded, than that of anyplace else. That is one of our
great strengths ...
If Asia heads into depression and Europe is in a deflationary cycle, how
long do we think that we are protected?
Oh, we have to move fast. The world is not all that integrated. It is possible
to have prosperity in the U.S. while the rest of the world is in trouble. It's
possible in principle, but we'll have to move fast. If there is a slump that
spreads to the first world outside the U.S., then we have got to cut interest
rates, start spending that budget surplus ... The Great Depression would have
been easy to stop in 1930. It was very hard to get out of by 1935. The point
is, that the time to act would be quickly. I think Washington understands that.
Famous last words?