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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 of capitalism.

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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