What Went Wrong?

Thursday, July 30, 1998

As an imperfect but believing member of a church that is founded on miracles, I can claim to believe in them. And as a holder of a number of Asian stocks and mutual funds, moreover, on occasion I find myself praying for them. But when the word miracle is invoked to explain the economic performance of a given country, I feel myself inwardly recoiling, like a Freemason who has inexplicably found himself at Lourdes.

As applied to this part of the world, miracles first gained currency four years ago in a remarkable book published by the World Bank called The East Asian Miracle. Its topic was the relationship among government, the private sector, and the market. And no doubt about it, the growth had been phenomenal: Since 1960 the eight countries in question—Japan, Singapore, Hong Kong, Malaysia, South Korea, Indonesia, Thailand, and Taiwan—had collectively experienced more than twice as much growth as the rest of East Asia, roughly three times as much as Latin America and South Asia, and five times as much as sub-Saharan Africa.


In Japan and Korea, banks did not evaluate risk and credit as did their counterparts in the West. They served instead as policy arms of their governments.


In the course of 387 pages the bank argued that this success was not as magical as it might appear and in fact that “in large measure” it was achieved by “getting the basics right.” Unfortunately for Asia, what stuck in people’s minds was not the straightforward explanation about fundamentals but the word miracle. This in turn led to all manner of extravagant claims about “Asian values” and the idea that Western concepts such as competition really didn’t apply. Today, with the major East Asian stock markets such as South Korea’s scraping eleven-year lows and having lost more than half their value in the last year, the haughtiness is gone. In its place is a pessimism that is arguably as unjustified as the excessive enthusiasm that preceded it.

THE TWO CRISES
In truth there are two crises in Asia today. The first, and more important, is a structural crisis that became apparent with the collapse of Thailand’s currency but in fact dates further back, to the collapse of Japan’s bubble economy in the early 1990s. In the seven years since that collapse Japan has dithered, treating it as simply another business cycle and coming up with spending package after spending package—more than $600 billion so far—in a futile attempt to jump-start growth. Given that many of Asia’s economies have adapted the Japanese model to their own needs, it should not be surprising that their own inefficiencies are now coming to the surface.

The other crisis, faced by countries such as Taiwan, Hong Kong, and Singapore, is related but far more prosaic. Their markets had been fueled by the same exuberance that had lifted their neighbors. But though their growth rates are being ratcheted down, their economies are generally far more open and more healthy than those of Korea and Japan, which will have to change not only their policies but their entire approach to economics.


Why did the planned economies of Asia succeed for so long? The answer is simple: Asian governments required the companies they supported to be competitive in overseas markets.


Although critics have been crawling out of the woodwork during the past year, until recently the Korean model was the darling of the development theorists. In my many years in Asia the phrase was always “Korean miracle.” Without doubt South Korea’s success in picking itself up from a devastating civil war to become the world’s eleventh-largest trading nation is a powerful story. But whenever one countered with the equally compelling story of Hong Kong, the word was not miracle but aberration. In my experience everyone wanted to hear about Korea, even though its income per capita was the lowest of the four tigers’ (Hong Kong, Singapore, Taiwan, South Korea); at $8,260, it still remains less than half that of Hong Kong. Yet whenever Hong Kong is cited as a model, the objection is raised that it is unique: it was a colony, it is near China, it had no defense to speak of, and so forth.

“GUIDED CAPITALISM”
My own guess is that the bias is entirely understandable. In Hong Kong, bureaucrats and planners had almost no role. But the Korean model operates on a completely different set of principles. It dates from 1961, when Park Chung Hee came to power in a military coup determined to raise his country from the ashes. Like most technocrats, Park associated wealth with heavy industry: steel factories, auto works, and so on, and he marshaled the country’s resources in that direction. There would be none of this trusting the marketplace to sort out winners and losers. The government knew what industries were needed; those that were favored received credit, and those that were deemed frivolous withered on the vine.

Like the Japanese model, the Korean model rested on three pillars: first, a bias toward the bigness that bureaucrats thought would guarantee economies of scale; second, the idea that banks would not evaluate risk and credit as their counterparts did in the West but would rather serve as policy arms of the government; and, third, that growth would be paid for by the public, by suppressing consumption. “Guided capitalism,” they called it, and though stubborn market types like me might in our tiresome way point out that it came with huge opportunity costs, it did work in the sense that the countries based on this model did develop.

So what accounted for the success of this planning, as opposed to the socialist varieties? The answer is simple. In contrast to other planned economies, Japan, Korea, Indonesia, Malaysia, et al. required that the supported companies be competitive in overseas markets. Instead of trying to preserve the foreign exchange balance by curbing imports, the tiger economies such as Korea did so by boosting exports, hence ensuring that their companies were more competitive.

The result was fabulous growth in exports plus a gleaming array of new factories. It was hard to argue against. In Hong Kong the typical entrepreneur has a five- to ten-man trading company in a grotty concrete building in Mongkok. In Korea, however, the visible signs of development were all modern looking: gleaming factories, modern skyscrapers, roads full of new cars, and so on. If Korea was more attractive to foreign theorists, this was in good part because it literally looked more attractive.

THEORY AND PRACTICE
In theory it worked like clockwork. As long as the consumers did not revolt, countries such as Japan and Korea were able to create internationally competitive economies on the back of suppressed earnings. But as the world economy became more complicated and the running of these economies more cumbersome, the system itself became a threat to competitiveness. On paper the advantage of cheap capital was that it could be channeled to companies where it was needed; in practice this meant that capital was often steered to the politically connected rather than the economically meritorious. As the world is now discovering, financial institutions that never used traditional criteria such as risk analysis found themselves saddled with an ever-greater number of nonperforming loans.

We still don’t know the real extent of this indebtedness. Indeed, global markets that winked at this system so long as the returns were coming in are now asking the tough questions and forcing the issue in a Japan that once thought itself immune from outside pressure. When Yamaichi Securities went bust last November, for example, it was largely because Moody’s had lowered its rating, which in turn made it impossible for Yamaichi to get the short-term credit that is the lifeblood of any financial institution.

Hong Kong, Singapore, and Taiwan have largely been spared these problems because they have not put all their eggs in the planning basket. The relative openness of the trading systems has brought a welcome discipline. It has also ensured gains in overall market efficiency. Indeed, although Taiwan started out on the Korean path and still competes in many of the same export markets, it has not allowed itself to become dominated by a few huge conglomerates. To the contrary, as Taiwan continues to liberalize, small and medium-sized firms are becoming ever more significant players in the overall economy.

In the end, it may be too harsh to say, as MIT’s Paul Krugman did—before this year’s meltdown—that the Asian miracle was at bottom the result only of increased inputs into the system, little different from the early spectacular gains of Soviet industry. There were virtues to the Asian way of doing things, primarily a belief in hard work and enterprise supported by public structures that had little concern for individual welfare, a virtue well worth keeping. It’s just time they applied it to companies as well as consumers.