Question

Summary on Asias Crash by Paul Krugman

Answer 1

Paul robin Krugman is an American ecnomist who is currently Distinguished Professor of Economics at the Graduate Center of the City University of New York, and a columnist for The New York Times.

Thinking about the Asian crisis

Most international economists, initially viewed Asia's economic travails through the lens of conventional currency-crisis theory. This theory focuses mainly, sometimes exclusively, on the exchange rate - other asset prices are left in the background.In the canonical "first-generation" crisis models (Krugman 1979; Flood and Garber 1984),, a government with persistent money-financed budget deficits was assumed to use a limited stock of reserves to peg its exchange rate; this policy would, of course, ultimately be unsustainable - and the attempts of investors to anticipate the inevitable collapse would generate a speculative attack on the currency when reserves fell to some critical level.In "second-generation" models (Obstfeld 1994, 1995) policy is less mechanical: a government chooses whether or not to defend a pegged exchange rate by making a tradeoff between short-run macroeconomic flexibility and longer-term credibility. The logic of crisis then arises from the fact that defending a parity is more expensive (e.g., requires higher interest rates) if the market believes that defense will ultimately fail; as a result, a speculative attack on a currency can develop either as a result of a predicted future deterioration in fundamentals, or purely through self-fulfilling prophecy.Despite the usefulness of these models in making sense of many historical crises, however, it has become increasingly clear that they miss important aspects of the unfolding crisis in Asia. Of course, every crisis is different - but the Asian crises seem to have differed from the standard story in several fundamental ways.

First, none of the fundamentals that drive "first-generation" crisis models seems to have been present in any of the afflicted Asian economies. On the eve of crisis all of the governments were more or less in fiscal balance; nor were they engaged in irresponsible credit creation or runaway monetary expansion. Their inflation rates, in particular, were quite low.

Second, although there had been some slowdown in growth in 1996, the Asian victims did not have substantial unemployment when the crisis began. There did not, in other words, seem to be the kind of incentive to abandon the fixed exchange rate to pursue a more expansionary monetary policy that is generally held to be the cause of the 1992 ERM crises in Europe. (And of course the aftermath of devaluation has involved dramatic economic contraction, not expansion).

Third, in all of the afflicted countries there was a boom-bust cycle in the asset markets that preceded the currency crisis: stock and land prices soared, then plunged (although after the crisis they plunged even more).

Finally, in all of the countries financial intermediaries seem to have been central players. In Thailand a crucial role was played by so-called "finance companies" - nonbank intermediaries that borrowed short-term money, often in dollars, then lent that money to speculative investors, largely but not only in real estate. In South Korea more conventional banks were involved, but they too borrowed extensively at short term and lent to finance what in retrospect were very speculative investments by highly leveraged corporations.

What all of this suggests is that the Asian crisis is best seen not as a problem brought on by fiscal deficits, as in "first-generation" models, nor as one brought on by macroeconomic temptation, as in "second-generation" models, but as one brought on by financial excess and then financial collapse. Indeed, to a first approximation currencies and exchange rates may have had little to do with it: the Asian story is really about a bubble in and subsequent collapse of asset values in general, with the currency crises more a symptom than a cause of this underlying real (in both senses of the word) malady.

The problem began with financial intermediaries - institutions whose liabilities were perceived as having an implicit government guarantee, but were essentially unregulated and therefore subject to severe moral hazard problems. The excessive risky lending of these institutions created inflation - not of goods but of asset prices. The overpricing of assets was sustained in part by a sort of circular process, in which the proliferation of risky lending drove up the prices of risky assets, making the financial condition of the intermediaries seem sounder than it was.

And then the bubble burst. The mechanism of crisis, Involved that same circular process in reverse: falling asset prices made the insolvency of intermediaries visible, forcing them to cease operations, leading to further asset deflation. This circularity, in turn, can explain both the remarkable severity of the crisis and the apparent vulnerability of the Asian economies to self-fulfilling crisis - which in turn helps us understand the phenomenon of contagion between economies with few visible economic links.