ASIA:
What Caused the Crash?

By Charles Wolf Jr.

Those who championed the so-called Asian development model thought bureaucrats could make better economic decisions than the marketplace. They were . . . mistaken. Hoover fellow Charles Wolf Jr. explains what went wrong and how to fix it.

Asia's financial earthquake is the second biggest international surprise of the past decade. The first, and weightier, one was the demise of the Soviet Union. Like the 1991 Soviet shock, Asia's financial hemorrhaging has had many causes. The ensuing debate has largely focused on their relative importance.

The primary cause of the Asian crisis, however, has been largely obscured: namely, the legacy of the so-called Japanese development model and its perverse consequences. Subsequently relabeled the Asian development model as its variants were applied elsewhere in the region, this strategy of economic growth has been grandly extolled in the past two decades. Its strongest proponents included Eisuke Sakakibara, presently Japan's vice minister of finance, Malaysian prime minister Mahathir Mohamad, and such Western commentators as Karel van Wolferen, Chalmers Johnson, James Fallows, and Clyde Prestowitz. What we are now seeing in Asia's financial turbulence are the model's accumulated shortcomings.

This is not to deny the role of other proximate causes, including short-term borrowing by Asian banks and companies and their long-term lending or investing; the failure of the money center banks in Japan, the United States, and Germany, which provided the mounting short-term credit, to exercise due diligence; and foreign investors' unrealistic assumptions that Asian currencies' pegs to the U.S. dollar would be maintained. But these proximate causes are traceable to or abetted by the primary cause: widespread insulation from market forces.

The Asian Model

The Asian development model began with a conceptual framework largely built by American and Japanese academic economists. Central to it is the phenomenon of "market failure": the predictable inability of market mechanisms to achieve maximum efficiency and to encourage growth when confronting "economies of scale" and "path dependence." These conditions may lead to monopolies in the advanced economies and the extinction of competition in late-starters in the development process. If the objectively based decisions of the marketplace are recognized to have such predictable shortcomings, the argument has run, then subjectively based decisions by government agencies or key individuals could improve on market outcomes.

In the original version of the model, these subjective judgments were provided by Japan's Ministry of International Trade and Industry (MITI) and Ministry of Finance, in collaboration with targeted export industries believed to be associated with economies of scale. MITI and the Ministry of Finance tagged these "winners" to receive preferred access to capital, as well as protection in domestic markets through the use of tariffs or nontariff barriers to limit foreign competition.

In the Korean variant of the model, the subjective judgments as to who and what would receive preferences--often the same industries targeted by Japan--were exercised by the president, the industrial conglomerates (chaebols), and the banks associated with the chaebols. In the Indonesian variant, the subjective oracular sources have been President Suharto and his extended family and hangers-on, in conjunction with B. J. Habibie's self-styled technological community at the Ministry of Research and Technology.

To be sure, the Japanese model and its variants produced noteworthy accomplishments. Vast amounts of savings and investment were mobilized for and channeled to the anointed industries and firms. Although substantial resources were wasted in the process--for example, MITI's blunders in the case of steel, shipbuilding, and aircraft--the scale of resource commitments led to world-class performance in other cases, notably cars, consumer electronics, telecommunications equipment, and semiconductors in Japan; similar heavy industrial development in Korea; and light industry development in Indonesia.

What Went Wrong

But the negative effects of the Asian model were cumulatively enormous, including the following:

Wasted resources when bad decisions were made in utter disregard for market realities, such as Indonesia's large investments in a national car and in a domestic aircraft industry. These nonmarket failures account for the fact that Asia's economic growth has been mainly due to large inputs of capital and labor, with relatively limited improvement in productivity.

Structural imbalances due to overemphasis on export industries and neglect of the domestic economy. As a result, domestic production has been shortchanged and consumption standards held down in favor of aggressive pursuit of export markets.

Excess capacity has been built up in export industries through the arbitrary processes of "picking winners." Failure to take adequate account of demand saturation while production continued to expand has contributed to currency depreciation, falling prices, and sharply adverse changes in Asia's terms of trade.

A sense of hubris among the favored industries, firms, and individuals. When these entities confronted market tests that they could not meet, they and their foreign lenders expected to be bailed out with additional resources, often publicly funded or guaranteed. Whether the shortfall was in an old-line major banking house (Japan's Yamaichi Securities) or an established conglomerate (Korea's Halla group) or the start-up of questionable new ventures (Indonesia's Timor car), it was expected that some nonmarket (that is, government) preference would make up the difference.

The favoritism, exclusivity, and corruption of the Asian model's back-channel and nontransparent decision making have had a corrosive effect on the societies and polities of the region.

That market-mediated allocations of resources have shortcomings doesn't imply that the Asian model's subjectively mediated ones will not have still greater shortcomings. In fact, the legacy of the Japanese model and its Asian variants suggests that their associated shortcomings are enormously greater because they tend to be protected and concealed. Lacking the corrective, mediating responses that market mechanisms and incentives provide, the shortcomings accumulate until a systemic breakdown occurs.

If this lesson is heeded, Asia's recovery can be rapid and enduring; if it is not, recovery is more likely to be slow and fitful--and ultimately far more painful.

Charles Wolf Jr. is a senior research fellow at the Hoover Institution. He is also a senior economic adviser and corporate fellow in international economics at the RAND Corporation.