November 29, 1998
"In The Long Run, Insane Markets Will Return to Reality"
San Jose Mercury News
By Timothy Taylor
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EVEN IF the recent sense of unprecedented peril in the world economy was overdone,
it has provided some useful lessons and raised some perplexing questions.
Not long ago, it was argued that Japan and east Asia had created a better form
One key element was government support of important industries. Another was
a financial system which limited the investment options of households, more-or-less
forcing them to channel their savings into banks. In turn, the banks served as
a patient source of long-term capital to business.
While this system clearly helped some Asian industries to grow quickly, its
tradeoffs are now apparent.
By favoring some high-profile companies, and helping them charge high prices
and garner investment capital, governments made consumers and other companies
pay the price. The result was often a two-tiered economy. At the top level were
steroid-fed world-class exporting and manufacturing firms. But the same economy
could have a flabby service sector and restricted standard of living. Even worse,
the government support of industry often shaded into intrusive regulation, cronyism
and outright corruption.
Moreover, it turned out that the renowned patience of banks in Japan and east
Asia wasn't due to a thoughtful long-term perspective on investing. Instead, they
only appeared patient because they had gotten so lazy in those fast-growing economies
that they were barely paying attention to risk.
Japan's banking system has racked up bad loans that may total $600 billion
or more -- four times the size of the U.S. savings and loan crisis. Banks across
east Asia may be in even worse shape; some estimates are that a quarter of all
their loans will never be repaid.
In good economic times, a virtuous circle of strong business confidence, high
investment rates, and rapid growth could overcome cronyism and inattentive banks.
But now the pendulum has swung, and the negative effects of low confidence, low
investment, sick banks and flabby firms are self-reinforcing, too -- but this
time in a negative cycle.
Of course, global capital markets can benefit nations by providing capital for
additional investment; in fact, the net inflow of foreign capital has been vital
to sustaining the boom in U.S. investment spending these last few years. Poor
economies also can benefit from an inflow of foreign investment capital, and from
the outside management expertise that often comes with the money. But global capital
markets also seem prone to overreaction.
Imagine that when someone is hungry, you dump a vat of spaghetti on his head.
When he is full, you put him on bread and water for a year. International capital
markets seem to have roughly this level of subtlety.
Sure, the economy of Indonesia was probably riding a little high last year,
and due for a correction. But the outflow of international capital was so strong
that it all but collapsed the currency, the stock market and the banks. Indonesia's
gross domestic product has contracted by 17 percent in the last year, while inflation
has hit 82 percent, which seems like an overreaction.
Certainly Russia's economy is in cruddy shape. But having its stock market
fall 94 percent in 1998 still seems like an overreaction to what has happened
there in the last year. And Brazil has economic weaknesses, but they don't seem
so severe as to justify an outflow of international capital that has led to a
6 percent fall in industrial production in the last year.
The declines in bloodless economic statistics like GDP and stock prices and
industrial production have harsh effects on real people. The average standard
of living in countries like Indonesia, Russia, and Brazil was only 15-20 percent
of the U.S. level before the economic troubles hit, which doesn't leave much safety
margin against dire poverty.
The behavior of U.S. stock markets this summer raises a similar point about
the volatility of financial markets. In fact there were economic reasons for stocks
to fall somewhat earlier in the summer and to rise after the Fed cut interest
rates more recently. But those reasons don't seem large enough to justify losing
one-fifth of the entire value of the U.S. stock market and then restoring it,
all within a few months.
An old, intractable question arises here concerning the relationship between
the real economy, in which people work, companies make products, innovations are
made, and so on, and the financial economy, the world of stocks and exchange rates.
Over the long run, the financial economy will on average reflect the real economy.
But over the short and even the medium run, the financial economy can be driven
by fads and speculation.
As we have seen this year, financial markets can flip-flop from irrational
exuberance to equally irrational despair, and back again, almost overnight.
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