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Governments variously push fiscal and monetary buttons to sway the vigor of economies. Successes are often short-lived, as altered dynamics take on a life of their own.
Both deflation and inflation are devilish demons to stop once they get a head of steam, as market economies are largely driven by mass expectation. As the government does not control production its credibility in economic counsel is invariably taken with more than a grain of salt.
Shocks to the system aimed at changing expectations are difficult to engineer, and they seldom go as expected.
The 1997 East Asian Crisis
The rise of the yen in the early 1990s was halted via American intervention, in the Reverse Plaza Accord of 1995. With the Japanese economy on its back, the US was concerned that the Japanese would stop buying the bonds that cheaply financed US government debt. The Reverse Plaza Accord in effect subsidized American consumers’ purchases of Japanese and German manufactured goods.
Reversing the dollar-yen exchange rate was accomplished by lowering Japanese interest rates with respect to those in the US. It also involved the Japanese gorging on US Treasury bonds, and the buying of dollars by Germany and the US government itself.
Driving up the dollar let the US maintain its stance of monetary ease without incurring inflation, since the artificially low price of imported goods counteracted the price-raising effect of more money sloshing around.
But liquidity has to go somewhere. Where it went was into the US stock market (blowing the dot-com bubble), and into asset markets in east Asian countries, whose currencies were tied to the dollar (Hong Kong, Indonesia, Malaysia, Philippines, South Korea, Thailand).
These flows had perverse effects. Though the manufacturing profitability of American and east Asian producers was undermined by the rising exchange rate, asset prices were still artificially pushed up, as Japanese and European investors earned profits from both exchange rate movements and the rise of the American and east Asian stock markets in terms of the native currencies of those markets.
The deterioration of competitiveness in east Asian countries could have been countered by giving up pegging their currencies to the dollar and letting them float. This would have allowed the exchange rate to fall and reflect their actual market price. But none did. They instead held tightly to the dollar peg, for what seemed good reasons.
The stable exchange rate had been an important boon to in the past, particularly in attracting foreign capital. These countries needed a continuous inflow of foreign funds to finance their mounting current-account (trade) deficits, which existed in spite of the export boom. Foreign creditors and investors had to be paid, and high-priced imports were still coming in.
Pegging to the dollar propped up the exchange rate, which gave these countries the most money that could be had for their national currency; something which politicians looked upon quite favorably. In contrast, a floating exchange rate seemed risky.
The policy of maintaining a large interest-rate differential between the US and Japanese gave rise to the profitable “carry trade”: investors borrowed yen at low rates, which they then invested for a higher yield in the US.
As long as the Reverse Plaza Accord held, investors had a nearly guaranteed profit by borrowing yen in Japan to invest in US financial assets denominated in dollars. Such an arrangement could not help but artificially pump up the price of US financial assets.
In East Asia, governments had their central banks relax monetary policy so as to let their currency exchange rate dip within the set fluctuation range. This move promoted exports and reinforced the credit boom that was well underway. It also generated a speculative bubble that was bound to burst, which it quickly did.
The perils inherent in the Reverse Plaza Accord first appeared in East Asia in early 1997, as companies struggled to profitably export with a stronger currency. To try to stay afloat, many firms stopped servicing their debts.
Stock and real estate prices dropped. Bankruptcies and bad bank debts quickly followed.
International investment funds began an exodus, drying up liquidity. Stock markets plummeted. Currency speculation quickly set in.
To stop capital flight, central banks raised interest rates. This further pinched the real economy, as credit became increasingly difficult to get. Stock and real estate prices fell further.
This led to panicked capital flight. In 1996, the east Asian region had a net inflow of US $93 billion. In 1997 $12 billion was sucked out.
Debtors in the region – banks and companies – had to repay their obligations in foreign denominations (mostly US dollars). To do so, they had to acquire hard foreign currency via exchange in local currency, which had undergone a drastic devaluation.
From July 1997, central banks, one after another, gave up the battle to defend their dollar-pegged exchange rate. Currencies were set afloat, and immediately sank in devaluation.
The situation worsened well into 1998. The crisis was furthered by the International Monetary Fund (IMF).
The IMF created a series of bailouts for the banks which had lent to the afflicted countries, but in doing so it demanded debilitating measures from the troubled nations. While the bridging loans that the IMF provided went directly into the coffers of the international creditor banks, the high interest rates and drastic cuts in public expenditures insisted upon by the IMF choked the economies of countries supposedly being saved.
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The crisis spread to Russia. In the summer of 1998, the country defaulted on its sovereign debt, much of which was held by US investment banks.
International investors themselves created the crisis via capital flight and currency speculation against the Russian ruble. This pullback by financiers was in panicked reaction to what had happened in East Asia.
The Brazilian economy started to melt down shortly thereafter. There too the IMF made matters worse with its demands for instant probity, beginning with jacked-up interest rates.
During the East Asian crisis, it had seemed as if Latin America might actually benefit, as investment advisors had turned their gaze and were recommending opportunities in the “emerging markets” of this region. But Latin America was soon caught up in the maelstrom that had begun half a world away.
One facet lay in the real economy. As demand dramatically fell for raw materials in the wake of the Asian tigers falling ill, the Latin American countries that exported minerals and petroleum were hard hit.
Another facet was financial. Investors got the jitters about “emerging markets” altogether.
Capital flight started. Stock markets tumbled, as did exchange rates. Terms of trade deteriorated.
To attract capital, Latin American countries had to ramp interest rates, which in turn harmed those firms that made goods (as opposed to those who fiddled funds).
So, what started as a way for the US to keep cheaply financing its sovereign debt turned into a speculative bubble that blew ill for developing countries all over the world.
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Japan was of course harmed by the crisis in East Asia, as its exports fell and its banks accumulated more bad debts. Meanwhile, the Japanese government, itself deep in debt, tried a touch of fiscal rectitude which further weakened the economy. Raising taxes lowered domestic demand. Most damningly, deflation set in; the monetary nemesis which had prolonged the Great Depression.
Companies reduced wages, which set consumption falling, aggravating the stagnation. It was altogether a vicious circle which Japan has yet to step out of.
