Financial Hypocrisy

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This year marks the 10th anniversary of the East Asia crisis, which began in Thailand on July 2, 1997, and spread to Indonesia in October and to South Korea in December. Eventually, it became a global financial crisis, embroiling Russia and Latin American countries, such as Brazil, and unleashing forces that played out over the ensuing years.

Argentina in 2001 may be counted as among its victims. There were many other innocent victims, including countries that had not even engaged in the international capital flows that were at the root of the crisis. Indeed, Laos was among the countries that were affected the worst. Though every crisis eventually ends, no one knew at the time how broad, deep and long the ensuing recessions and depressions would be. It was the worst global crisis since the Great Depression.

As the World Bank's chief economist and senior vice president, I was in the middle of the conflagration and the debates about its causes and the appropriate policy responses. This summer and fall I revisited many of the affected countries, including Malaysia, Laos, Thailand, and Indonesia. It is heartwarming to see their recoveries. These countries are now growing at annual rates of 5 percent, 6 percent and in some cases even higher -- not quite as fast as in the days of the East Asia miracle but far more rapidly than many thought possible in the aftermath of the crisis.

Many countries changed their policies, but in directions markedly different from the reforms that the International Monetary Fund had urged. The poor were among those who bore the biggest burden of the crisis as wages plummeted and unemployment soared. As countries emerged, many placed a new emphasis on "harmony," in an effort to redress the growing divide between rich and poor, urban and rural. They gave greater weight to investments in people, launching innovative initiatives to bring health care and access to finance to more of their citizens and creating social funds to help develop local communities.

Looking back at the crisis a decade later, we can see more clearly how wrong the diagnosis, prescription and prognosis of the IMF and United States Treasury were. The fundamental problem was premature capital-market liberalization. It is therefore ironic to see the U.S. treasury secretary once again pushing for capital-market liberalization in India -- one of the two major developing countries (along with China) to emerge unscathed from the 1997 crisis.

It is no accident that these countries that had not fully liberalized their capital markets have done so well. Subsequent research by the IMF has confirmed what every serious study had shown: capital-market liberalization brings instability, but not necessarily growth. India and China have, by the same token, been the fastest-growing economies.

Of course Wall Street, whose interests the U.S. Treasury represents, profits from capital-market liberalization: It makes money as capital flows in, as it flows out and in the restructuring that occurs in the resulting havoc. In South Korea, the IMF urged the sale of the country's banks to U.S. investors, even though Koreans had managed their own economy impressively for four decades with higher growth, more stability and without the systemic scandals that have marked U.S. financial markets.

In some cases U.S. firms bought the banks, held on to them until South Korea recovered, and then they resold them, reaping billions in capital gains. In its rush to have Westerners buy the banks, the IMF forgot one detail -- to ensure that South Korea could recapture at least a fraction of those gains through taxation. Whether U.S. investors had greater expertise in banking in emerging markets may be debatable; that they had greater expertise in tax avoidance is not.

The contrast between the IMF and U.S. Treasury advice to East Asia and what has happened in the current subprime debacle is glaring. East Asian countries were told to raise their interest rates, in some cases to 25 percent, 40 percent, or higher, causing a rash of defaults. In the current crisis, the U.S. Federal Reserve and the European Central Bank cut interest rates.

The countries caught up in the East Asia crisis were lectured on the need for greater transparency and better regulation. But lack of transparency played a central role in this past summer's credit crunch; toxic mortgages were sliced and diced, spread around the world, packaged with better products, and hidden away as collateral, so no one could be sure who was holding what. And there is now a chorus of caution about new regulations, which supposedly might hamper financial markets, including their exploitation of uninformed borrowers, which lay at the root of the problem. Finally, despite all the warnings about moral hazard, Western banks have been partly bailed out of their bad investments.

Following the 1997 crisis there was a consensus that fundamental reform of the global financial architecture was needed. But, while the current system may lead to unnecessary instability and impose huge costs on developing countries, it serves some interests well. It is not surprising, then, that 10 years later, there has been no fundamental reform. Nor, therefore, is it surprising that the world is once again facing a period of global financial instability, with uncertain outcomes for the world's economies.



Joseph E. Stiglitz, a Nobel laureate in economics and former chairman of the Council of Economic Advisers to U.S. President Bill Clinton, is professor of economics at Columbia University. This comment appears © Project Syndicate.