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. Last Updated: 07/27/2016

Drivers vs. Highway in Economic Crackup




DAVOS, Switzerland -- Among the movers and shakers gathered for the World Economic Forum, a striking metaphor is helping to frame the debate over the global financial crisis that began in Asia, toppled Russia and spread to Brazil. That of a slick stretch of highway that has been the scene of a half-dozen recent auto accidents. So is it careless driving - or the highway itself?


Substitute freewheeling worldwide capital flows and unrestricted lending for the slippery, fast-moving highway. Make South Korea, Thailand, Indonesia, Russia and Brazil stand-ins for the drivers and their cars. The accidents are the panics and recessions - the crackups - that have devastated each of these countries. And the question now so widely debated is simple enough: Are the countries mostly to blame or the unrestricted capital flows, or both?


After the first accidents, the countries came in for almost all the blame. It was because of crony capitalism, bad banking and overleveraged real estate investments, many experts said. Fix the sloppy financial practices and also make enough bailout money available when a country gets into trouble - basically the current strategy of the International Monetary Fund for Brazil - and the accidents will be mere fender benders.


But spectacular wrecks have occurred with alarming frequency and severity in the last 18 months, and some who had mostly blamed the countries have begun to argue that the system needs serious fixing, too.


The Clinton administration had placed most of the blame on the countries, and still does. But its view, like that of the IMF, is starting to reflect a more nuanced appraisal - one that is beginning to grudgingly allow for countries to control capital flows across their borders.


At the top of many lists for fixing the system are proposals to limit the flow of short-term foreign loans to developing countries - loans that often contributed to more rapid growth but which piled up in huge amounts in Asia, Russia and Brazil. Then, at the first hint of trouble, much of the money fled, precipitating and worsening a full-scale financial collapse.


But other system-wide suggestions are winning favor as well: pursing flexible exchange rates, for example, to avoid sudden, frightening devaluations; or standstill provisions in lending agreements that would temporarily prevent a foreign lender from withdrawing loans from a South Korea or a Russia in the midst of a crisis.


Either move would put more of the burden on international banks and lenders to evaluate risks - and suffer more of the consequences later if things go bad.


"The banks don't like this; they value liquidity of lending," said Barry Eichengreen, an international economist at the University of California at Berkeley. "But if they had a provision in their loan agreements that they cannot pull out their money right away when a crisis is developing, maybe they would not lend the money in the first place."


Some experts now favor rules that prevent not only foreign lenders but wealthy nationals - Brazilians, for example - from canceling their short-term loans and investments, then converting this money from local currencies into dollars and taking the dollars out of the country.


Wealthy Brazilians, many of them already moving chunks of capital abroad, hold more than $150 billion in their government's debt and rushing this money out of the country would quickly exhaust Brazil's dollar reserves.


"My view is that basically all short-term debt constitutes potential capital flight," said Paul Krugman, an economist at the Massachusetts Institute of Technology. "Brazil is at risk not only from foreign lenders, but from anyone who can take money out of the country."


Perhaps some of these measures would make the highway safer for ordinary drivers. But before the dangerous stretch of road is rebuilt in hopes of preventing future accidents, the smashed cars of the last 18 months have to be repaired and put back in operation. There is little agreement on how to do that. Rather there are two diametrically opposite approaches.


"The mainstream view would still be that the key solutions to crises remain policy adjustments within the countries themselves," said William Cline, chief economist at the Institute for International Finance, which represents lenders. "Once you restore confidence in a country's financial system, then you can get its economy growing again."


The chief tools in this approach are sharply higher interest rates and cutbacks in public spending. But the high rates and spending cutbacks invariably produce recessions.


The Clinton administration argues that once confidence in a financial system is restored, interest rates can then come down, as they have in South Korea and Thailand, and nations can begin the long climb out of recession. But even Thailand and South Korea are still on the side of the road, their economies spinning their wheels.


Like the East Asian countries, Brazil, the latest victim of a financial panic, is hewing to policies that are plunging that country into recession. And as the hobbling of giant Brazil slows economic activity everywhere in Latin America, the odds rise that even the United States and Europe could be caught in the spreading global crisis.


The contrasting view is argued most vehemently by Jeffrey Sachs, a Harvard economist who once advised the government of former Russian Prime Minister Yegor Gaidar. Sachs insists that high interest rates and austerity measures are bringing disaster to many emerging markets. He would keep interest rates down to encourage economic activity and let exchange rates find their own level. A growing economy is more likely to restore investor confidence, he says, than a recessionary one burdened by high interest rates.


"The Treasury and the IMF have driven a large part of the developing world into recession," said Sachs, who directs Harvard's Institute for International Development. "And the Brazil case makes absolutely clear that the first step is not to defend overvalued currencies. The punishing cost of this is overwhelmingly high. This is a lesson that the IMF and the Treasury have continued to ignore. I don't understand why."