Asia Needs Capital Controls

He asks rhetorically: "Is this not what most likely happened when, out of panic, investors fled from what they perceived as weakened Asian economies, weakening them when they were originally strong?" No, this is not what most likely happened. Blaming investors for the fall of the Thai bhat or the Indonesian rupiah is like blaming umbrella-carriers for the fall of rain. Capital flows can of course be volatile, but attribut ing a shift in the behavior of independent and calculating investors to a .self-validating "panic" or "mania" is at best an explanation of last resort. A large speculative attack on a central bank to get foreign currency before the fixed exchange rate collapses-like an 4 old-fashioned run on a deposit bank to get cash before it is gone-could in principle be self-validating, because a central bank with fractional reserves will eventually run out of foreign currency reserves and be forced to devalue.

But in practice the speculative attacks we witness are not of this self-validating sort. Just as the historical evidence indicates that nineteenth-century runs on deposit banks were generally triggered by bad news indicat ing the likely insolvency of those specific banks, speculative attacks on fixed exchange rates are generally triggered by bad news about economic fundamentals. The idea that unrestricted financial markets are prone to manias or bubbles is founded on historical myth, as my colleague George Selgin has shown by re-examining the historical episodes·cited by Kindleberger and others as supposed examples of bank-lending manias (Journal of Financial Services Research, August 1992). At its root, the fall of their currencies' exchange values, and the subsequent reversal of capital flows to Thailand, Indonesia, the Philippines, and Malaysia, were votes of no confidence in the exchange-rate and monetary policies of their governments. It is of course a challenge to explain the exact timing and size of the dramatic shifts observed. But if some sort of pure self-validating mania or panic had been afoot in the region, it would be hard to explain why Hong Kong, Singapore, and Tai wan were spared devaluations.

The countries that crashed were basically those where expansionary monetary policy was on a collision course with the supposed commitment to a fixed exchange rate against the U.S. dollar. As basic exchange-rate theory tells us, a fixed exchange rate between the local currency and the dollar cannot be main tained unless the creation of local money is limited to the amounts consistent with hold ing the local inflation rate down to the U.S. dollar inflation rate.

To generalize rather sweepingly, large amounts of capital had flowed in during the 1990s because, if the exchange, rates really did remain fixed, high real returns were avail able from nominal interest rates well above u.s. dollar rates. Local commercial banks became loaded with poor-quality loans, in some degree because of government interven tion or corruption in allocating loans, and in some degree because of excessively risky lending encouraged by implicit government guarantees to the banks. The nonperforming loans of Indonesia's banks, for example, reached more than a quarter of total loans before 1996. International investors finally lost faith because it became clear that the cen tral banks, when forced to choose, would print money to keep the banks afloat rather than exercise the monetary restraint necessary to maintain the fixed exchange rate. The succession of crises in several south east Asian countries, beginning with Thai land, has led many commentators to speak of a "contagion" by which crisis spreads from one country to another. The solution suppos edly lies in global crisis management by the IMP. But as Anna 1. Schwartz has noted in the Cato Journal (Winter 1998), "it was not con tagion from Thailand, however, that made the countries vulnerable to a financial crisis. They were vulnerable because of their home-grown economic problems. Capital flight from coun tries with similar unsustainable policies is not evidence of contagion."

Capital flight imposes a very useful, if sometimes harsh, discipline. As former Citi corp CEO Walter Wriston notes (in an inter view with Wired), the flow of short-term capital "functions as a plebiscite" on a gov ernment's economic policy. When a change in policy is observed, "by the end of the day, the market will have conducted a referendum reflecting the collective wisdom of people all around the world on what they think of [the new] economic policies. If your economic policies are lousy, the market will punish you 5 instantly." Wriston adds: "I'm in favor of this kind of economic democracy. There's nothing you can do to change it, except do right." Governments, of course, deeply resent the discipline that the market imposes. In an interview with Business Week earlier this year, Malaysian Prime Minister Mahathir Mohamad blamed the fall of the ringgit on the "herd" mentality of currency traders, likening them to "buffaloes." Even more notoriously, he intimates that "since most of the currency traders are Jewish, and it affects Muslim countries in East Asia, people will think this is a Jewish conspiracy." The Prime Minister imagines that the traders, acting with one mind, can "devalue our currency at will," and that doing so is a riskless get-rich-quick scheme: "When you devalue currency and you short-sell, you make a lot of money. You just push figures on a computer screen, and you make a billion dollars." One marvels that a conspiracy of traders would have waited until 1997 to grab this windfall.

In September, Mahathir announced new restrictions on the convertibility of the ringgit. Among other measures, Malaysian citizens may not take more than small amounts of cash out of the country when they travel abroad. Restrictions of that sort are a nuisance. Still more damaging to prosperity are the restric tions many developing nations impose on large financial outflows. Such capital controls are a cruelly effective investment repellent. No investor wants to bring wealth into an economy where it might become trapped. It is sad enough when a politician engages in scapegoating and uses it as an excuse to restrict his citizens' freedom to trade in finan cial contracts. The shame is compounded when a well-meaning economist counte nances the herd-mentality view of foreign exchange markets and derives from it a coun sel of hesitation in lifting capital controls. -LAWRENCE H. WHITE Department of Economics University of Georgia To Each His Due by Tom Bethell W e lead lives that are so immersed in pri vate property that we easily take its benefits for granted. Some everyday situa tions give us the opportunity to examine aspects of life without it, however. They per mit us to see the great transformation that takes place when a communal arrangement is privatized: efficiency is enhanced, and, far more important, justice itself is routinized.