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No 1- 2001 February 2001

WORLD ECONOMIC TRENDS

Rudi DornbuschMassachusetts Institute of Technology

EXECUTIVE SUMMARYECONOMIC OUTLOOKESSAYS: Just a Banana, Living Standards Compared, Winning at CorporateGovernance, Crisis Primer, Fewer Monies, Better Monies.APPENDIX: DATA AND FORECASTS===============================================================

Executive Summary

The most critical issue of the day is US economic performance: is this a recession or justa banana? How effective are monetary and fiscal policy in getting the economy into anupswing? What are the risks of a downward spiral? There are plenty of reasons to beoptimistic. Every time in the past 50 years monetary and fiscal policy have worked,including in decidedly difficult situations such as the early 80s deep recession. Thus,even if the present situation should technically be a recession-- two consecutive negativequarters-- and worse quite a bit of a recession, there is no serious question of an upswing.Moreover, that there is a recession today is far from decided. Indeed, a zero quarterfollowed by a mildly positive quarter is the central scenario. Going further out, asubstantial upswing in the second half of the year, driven by monetary and fiscal policy,seems likely. No hard landing in sight! The consensus outlook is consistent with thatstory. It is also a plausible if mildly optimistic rendition of European growth prospects.This is the year where Europe will outperform the US. But this comes with two caveats:not by much and not for long .

Table 1 Consensus Forecast

Growth2000 2001

Inflation2000 2001

Ind. CountriesUSEurolandJapan

3.8 2.65.0 1.83.4 2.61.7 1.4

2.3 1.93.4 2.52.3 1.90.7 -0.4

Source: The Economist

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On the side of Japan, optimism is not appropriate. The fact of a slowdown is recognizedbut the question is whether it won't go further. External growth won't help much,investment has slowed down sharply, fiscal spending is politically unpopular, monetarypolicy has nowhere to go. All this risks adding to a story that hangs entirely on theconsumer and on that front there is no reason for optimism. Unlike in the US, policyinstruments are not available to respond to a renewed deep slowdown or recession. Giventhe very bad shape of balance sheets, that presents a dangerous situation for worldfinance.

Emerging markets in Asia are exposed to the Us high-tech slowdown, domestic politicaltroubles and balance sheet issues everywhere. There is no crisis situation, outsidepossibly Indonesia, but there is no upside story either. In Latin America the Us slowdownshows a shadow too, but interest rate cuts help as did the IMF rescue of Mexico. Asmarkets look to a US upside, pressure on Latin America will again lessen. In EasternEurope the framework is convergence even though the toads is still long and thepreconditions, for example in Poland, are far from met.

==============================================================ECONOMIC OUTLOOK

For industrial countries, and hence the world, 2001 is a poor year – no crisis conditions orworld recession but a slowdown. That is most acutely the case in the US, followed byJapan with risks of getting worse, and lest in Europe. But around the corner are a USupswing, some European upswing and a big question mark about the Japanese outlookfor 2001 and beyond. On balance, for a US shift from boom to normalization, this is quitegood news – no bust, no recession, and no world growth drama. This is in fact a first. Inhindsight, the landing will look quite soft but it will take a moment to get there.

United States

At the bottom of every slowdown, growth recession or outright recession, the signals arealways mixed: last reports of consumer confidence are disappointing, unemployment isrising, bankruptcies and credit problems are rising. But there are also signs of upswingfrom policy measures to more optimistic readings from purchasing managers or retailsales. The US is about there. It may well take another months or two, or even three todeclare victory. But that the slump ends in the first half of the year is a foregoneconclusion. The questions are whether this is in fact a recession—two negative quartershowever small the negative number—or just one or none. And the more importantquestion relates to the upswing: anemic, strong or too much. Anemic is possible ifmonetary policy already is done with and then fiscal policy comes late and small. Toomuch if the reverse occurs, more from the Fed and then a blast from the congress in theform of tax cuts.

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Table 2 US Growth Outlook

2001 2002

ConsensusGoldmanJPMorganDRIMorgan StanleyMerrill Lynch

1.82.01.62.51.12.8

n.a.n.a.3.34.34.73.6

The range of current forecasts shows the uncertainty about just what is happening now.Even those forecasts that allow for a recession in the first 2 quarters end the year with apositive number and all show strong growth for 2002. The point is, this is not a good yearbut it is not a big deal either. Remember, the US needed a slowdown and that is what theeconomy is experiencing just now.

The risks of a downward spiral are not serious. The Fed’s determined and substantial ratecutting has stood in thew way of any cumulative development of fear, a credit marketgetting wound up in knots and spreading illiquidity, a stock market melting down. Allthose things were stopped with the first rate cut in January and the second one confirmedthe Fed's commitment to limiting the damage, yes the Fed will do so. The test whether theFed can limit the damage is also in, asset markets are stable and large credit spreads arecoming off, credit rationing is easing.

Fed policy works in four ways: effects on wealth, via asset markets, and hence onspending and the dollar. This is by rule of thumb some 5 cents on the dollar for equitymarket gains and it applies also, of course, to real estate and bonds. The second channelis credit rationing which tightens with rate hikes and eases with a rate cut. And lastlythere is the longer-term cost of capital channel. And lastly there is the impact on thedollar (assuming abroad there are no cuts).

The combined effects, after about 6 quarters, amounts to a 1:1 effect on growth: apercentage point cut from the Fed yields a percentage point increase in growth; the fulleffects build up over time and they do take their time coming. In the end durables,housing, fixed investment, inventories, trade all adjust and contribute to growth and thatgrowth in turn yields induced spending effects. Monetary policy works.

The question now is how much else to expect from the Fed. Two issues are critical. First,has the Us near-bottomed out and is an upswing however mild already underway or isthere more bad news and a further downward adjustment of production and spending.Second, what is to be expected from fiscal policy? If the economy is near bottom alreadyand expectations for fiscal expansion are significant – front-loaded and retroactive cutswith a focus on low and middle-income households, then the Fed is done. By contrast, ifthe tax cut is slow in coming and is getting scaled back and significantly deferred while

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the economy is looking shaky, then the Fed will come with more and possibly muchmore. At this point the guess might be 50:50 for two scenarios: 50 more basis points anda neutral bias or 25 or zero basis point cut and a negative bias. The reading on fiscalpolicy will be all-important. The President has already asked for a retroactive tax cut.That will be favored by Democrats and helps a more rapid recovery.

There are too risks to the benign US scenario: One is that because of a dent overhang—corporate and personal—the recovery will turn out to be anemic. If that should be thecase, ongoing corrections from the Fed can be expected. The other scenario is moretroublesome. What if the recovery is overdone? At present the US is still at fullemployment, or just about, and labor market are only starting to ease. True productivitygrowth has run ahead of output growth for two quarters and surely this one too, butunemployment has not risen much. An overly strong fiscal stimulus risks putting theeconomy in the fall just back to where overheating is a concern. That is far from excludedand is surely a reason for restraint on the part of the Fed.

There is also the question of how affordable the tax cuts are. The most recent report ofthe Congressional Budget Office leaves little doubt about affordability. On currentpolicy, the public debt is scheduled to disappear in the next decade. Slower growth doeschange that scenario somewhat, but so do lower interest rates. Budget projections arealways somewhat heroic and sensitive to macro developments. But the fact remains thatthe situation is extraordinarily strong and surely supports the case for immediate tax cuts.

Table 3 US CBO Forecasts (% of GDP except as noted)

2000 2005 2010 2002-2011 Surplus(Billion $)

Budget Surplus

Public Debt

2.7

30.5

3.4

13.5

4.9

5.5

5,610

It is not correct to argue that recovery should be left to the Fed, carrying the benefit oflower interest rates and increased debt retirement. Fed policy works with a long lag andthere is absolutely no reason for the economy to linger growth-less for much of the year.Tax cuts now, retroactive, is entirely appropriate. Not overdoing them is also entirelyright so as to avoid a situation where the Fed is forced to shift toward rate hikes later inthe year.

Much is said about the Fed being responsible for the asset bubble and the asset collapse,NASDAQ and beyond. Much is said about the moral hazard of Fed action to revive theeconomy with the side effect of creating confidence and support for asset prices. Whatexactly does all this mean? Was growth excessive in 1996-2000? Record growth rates ofproductivity suggest that this was not simply demand expansion by mismanaged credit.

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The Fed slowdown was timely, before inflation became a problem, and it is at work justas prescribed and for the first time really in postwar history. Should the Fed now stand byand let the economy take its course, whatever that might be? Surely that is profoundlyimmature thinking. Yes, asset markets will take relief from Fed reflating of the economyand validating debt positions with lower interest rates and higher growth. But what iswrong with that as long as inflation is not the issue? The argument that all this merelypostpones the day of reckoning is a bot too doomy to be taken seriously. Lets jump fromthat bridge when we get there.

Stories f US hard landing, rising interest rates with collapsing stocks and a melting dollar,keep losing ground. They lost ground last year when the NASDAQ decline did not bringthe end of the world; they died a bit more in January when the fed called off doom andgloom. They will yield even more when the US upswing becomes apparent in the nextfew months. All this serves to support asset prices and the dollar.

The prospect of a major dollar fall is just not on the horizon. Against Japan it won’thappen because the question mark is far more on the Japanese than the US side. AgainstEurope there is a tendency to see questions here and answers there. But that also won’tlast: the upswing here will restore growth of 3 percent or so per year and Europe isunlikely to do better if that much. For the time being, a strong dollar and a large USexternal balance are here to stay simply because there are no alternative candidates formassive capital inflows.

The remaining major issue for the coming few years is US productivity growth. For themoment, even through two slow quarters in 2000, it is holding up well. The question iswhat is happening just now and how will it fare in the recovery.

Table 4 US Output and Productivity Growth (annualized, %)

1996-2000 2000 2000:III 2000:IV

GrowthProductivity

4.32.8

5.14.3

2.23.0

1.42.4

The assumption that productivity growth is predominantly cyclical, and therefore nowmust vanish, has certainly not been borne out in the slowdown of late 2000. More is to beseen.

Euroland

There is not much question about what is coming in Euroland. Growth is at about thepace of potential output – some 2,5 percent—in 2001 and, with a world upswing,somewhat better in the following year. There is little risk of doing worse and there is littlechance of doing much better. Europe has a lot of inertia; its rich and it has little of the

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exuberance-despair potential of the US. Hence growth fluctuations in this relativelyclosed economy will be minor.

Table 5 Euroland Growth Outlook

2001 2002

ConsensusJPMorganMorgan StanleyDeutsche BankGoldman SachsDIW

2.62.42.32.52.62.8

n.a.3.03.32.92.82.7

What is apparent at the Euroland level is also clear for major partner countries and for theUK: a poorer but not bad year in 2001, a marginally better year in 2002. But except in theUK, 2002 is not quite as good as 2000, a top year of the decade.

Table 6 European Prospects2000 2001 2002

GermanyFranceItalyUK

3.13.12.62.4

2.42.62.22.5

2.73.02.73.1

Note: Averages of Goldman, DBank, Merrill, MorganStanley, JPMorgan, DIW country forecasts

The negatives in European growth continue to be these:• The petering out of Euro depression effects and the gradual negative impact of the

reversal.• The gradual development of the impact of significantly increased interest rates, with

cuts likely minor and delayed.• The oil shock of 2000 with its impact on real incomes.• The sharp reduction of growth in the world associated with the Us and Japanese

slowdown.

Even though Europe (like the US and Japan) is a relatively closed economy, the externalfactors do account for some growth reduction as does the tightening of money. All this issure to bring growth down about three-quarters of a percent from 2000 performance. The

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offset is predominantly fiscal expansion, as in Germany, via tax cuts. That is real andaccounts for something to hold against the slowdown factors. The balance is less growth.

Surely the ECB will cut rates, but this does not come easily. Inflation is still highalthough now Euro appreciation and energy start helping. But with an inflation target of 0to 2 percent, running above the target or near the top is not good, not good enough, for anew money. The forthcoming introduction of the euro, and the certain recovery of the Usalso focus the mind on not putting the Euro back on thin ice and open up a carry trade.All that to say that the ECB will have none of the rate cutting enthusiasm in evidence atthe Fed. And that is appropriate because Europe is not, unlike the US, growing far belowpotential. Like the US, but because of a bad supply side, Europe does not have a greatoutput gap and hence monetary policy must be prudent even if at the price of notenjoying a boom.

Over time a substantial amount of good is happening in Europe: new economy is takinghold, gradual reform – in the somewhat experimental and competitive atmosphere forcedby countries like Ireland and the Netherlands—is moving forward. Not everything isforward, of course, but over time Europe is accumulating a better image.

Of the Euro challenges lying ahead, the greatest is surely the question of UK entry. It isclear now that the UK has relatively little in common with the Us performance of the pastfew years: productivity growth is not significant all deregulation and relatively marketfriendly attitudes notwithstanding. Something is missing. Could it be greed? As Europeimproves, the UK might find that it needs Europe quite a bit and finds it hard to make thecase of an unaffordable union. In the meantime it is becoming a central anduncomfortable and untimely theme in the forthcoming election contest, much to thechagrin of Mr. Blair. All things considered, he is much more likely to sacrifice Europethan a second term.

JapanGrowth forecasts for Japan are all over the map. That means one thing: there is no singlecoherent story and much of what is predicted is more an assumption than a forecast. Theingredients are quite clear: world slowdown is a negative, more so with its concentrationin the US and in high tech. The collapse of US high tech investment has a counterpart inJapan and that was the central growth engine; it has ground to a halt.

Table 7 Japan Forecasts

2001 2002

ConsensusMerrill LynchMorgan StanleyJPMorgan

1.41.40.30.8

n.a.1.01.92.3

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With exports and investment not playing their role, the focus turns to government policiesor the consumer. The consumer remains on the defensive: large wealth losses and the fallout of restructuring depress consumer confidence. Hence a consumption-led growth spurtis not going to happen. Nor is the government the source of good news. The public isskeptical of public works and deficits and officials assume that tax cuts would be saved.That takes out fiscal policy.

It remains to discuss the possibility that the central bank shifts policy toward anaggressive magnetization and Yen depreciation. So far the answer continues to be NOand it is likely to remain that way unless Japan actually slips into recession. So what isthe bottom line? Unless there is a re3covery in investment, sometime in the second halfof the year along with US recovery, Japan will be a sort of 1 percent growth economy.Too much to be an acute crisis country and too little to be an important partner for worldgrowth.

Slow growth, with ongoing deficits and adverse demographic trends of course implies agrowing public sector balance sheet problem. While corporations have been busy, andsuccessful, at restructuring, the same is not true in finance. Banks and Life Insurancecompanies are a great threat to financial stability just as the government.

What would change Japan? The answer today is no longer fiscal expansion – the Rubin-Summers strategy. The new answer is supply side economics. Of course, for the LDP thatis taboo.

With a poor growth outlook, or at the least a very fragile one and no important upside, aweakening of the Yen must be a forgone conclusion. The low 120s are comfortable –some export stimulus and no trade conflict on the other side.

Emerging Markets

The US slowdown, the high tech collapse, and the rate cuts bring mixed effects toemerging market growth and stability prospects. Latin America is exposed on the side ofinterest rates and credit risks because debts and deficits are large and trade integration issignificant; Asia is exposed via trade, more so in high tech, and via capital markets.Eastern Europe is mostly on the sidelines, with EU enlargement as the dominant issue indetermining prospects. No crisis in sight, not in Argentina, in Mexico, not any time soonin Turkey, not even yet in South Africa. Most countries have had their crisis and it takes awhile to get ready for another one. That does not mean stellar performance or low riskspreads or no disappointments on exchange rates, but it does mean no big time meltdown.

The accompanying Table shows averages of the current forecasts from variousinvestment banks. The message is this: 2001, with the US slowdown and asset marketstress, shows somewhat less growth than the boom year 2000. This is the case except inArgentina where a weak and indecisive government, following on a disappointing secondterm of Menem, put the country on the verge of default. IMF money has resolved for themoment the Argentine situation. But that leaves the question whether more debt is the

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right answer. In fact, it is not. Argentina needs to work very hard to create reform andconfidence and there is little prospect that the current president and his team arecommitted to the hard and unpopular task, more so with elections on the horizon.

Table 8 Latin American Outlook

2000 2001 2002

ArgentinaBrazilChileColombiaMexicoPeruVenezuela

0.04.25.63.07.23.73.1

2.23.44.92.93.52.03.9

3.34.35.43.45.23.83.1

Brazil looks good; Brazil is always lucky; there is enough fiscal stability thanks to theformidable work of the central bank in bringing down interest rates. The US slowdownmakes a bit of a debt but growth is good and expected to pick up.

Mexico is more of a problem case. The President is formidably popular (much likeCardoso when first elected in Brazil) and expectations are far more optimistic than he canpossibly deliver. There is a genuine risk that with no control of Congress, things will gothe Brazilian way; the currency is overvalued, growth is down, real interest rates are highand this circle won’t be broken y a little miracle coming on conveniently. President Fox’sdecision not to have a currency board discards unwisely the easiest route to an easiermacroeconomic scenario. The growth pickup predicted for 2002 is more likely because ofthe US upswing, but much less likely on account of the real exchange rate and thecontinuing high real interest rate.

Asia’s recovery into 2000, with a US boom and some Japanese growth, was very strong.But by now all the negatives are coming into play. Lack of deep reform, lack of Japanesegrowth, US and high tech slowdown, big balance sheet problems, bad politics almosteverywhere, The growth numbers are still impressive compared to Latin America, butthey always have been that. Except in India and China, however, there is more troubleand more chance of disappointment. In Indonesia a full-blown political crisis is waiting tohappen and, if and when it does, there is a macro blow-up coming with it.

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Table 9 Asian Outlook

2000 2001 2002

ChinaHong KongIndiaIndonesiaMalaysiaPhilippinesKoreaSingaporeTaiwanThailand

8.010.26.14.58.73.99.29.96.24.3

7.54.06.33.14.52.54.15.44.23.1

7.54.36.83.95.83.75.66.25.14.4

EU enlargement, formidable as the task will be, is now in the works. Convergence is thedominant theme for policy thinking and for asset markets. The discipline is welcomeeven though more reform, less welfare state are more important priorities than apercentage point on the inflation rate or on the budget. It is interesting to note thecontinuing disappointing performance of the Czech Republic, initially the starperformer—and the good showing of Hungary, the more Bohemian player. In Poland alot of work needs to be done to get inflation down without too much real appreciation.Poland is much further away from convergence although it is the most importantenlargement partner.

Table 10 Eastern Europe & Israel

2000 2001 2002

CzechHungaryPolandRussiaIsrael

2.75.34.52.05.4

3.24.93.94.23.0

3.35.25.04.05.0

Russia continues with growth, serious budget efforts, large current account surpluses andso far no foreign exchange experiments. Putin is pursuing power and the only way he cansucceed is by delivering growth and financial stability. Russia will continues to do welleven with somewhat lower oil prices.

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Table 11 Turkey and S.Africa

2000 2001 2002

S.AfricaTurkey

3.06.0

3.31.8

3.64.1

Turkey has stepped back from the cliff thanks to just-in-time IMF support. An IMFprogram that was in question because of a boom that undermined the disinflation strategynow looks much sounder; the boom is sure to be gone due to record interest rates andcredit rationing. The pressure is on to accelerate and deepen reform, to push privatization,to stop dancing on the cliff. Turkey was within inches of a meltdown, or capital controls,and that should focus the mind of policy makers. If that fails to happen, slipping back intocrisis mode is very easy indeed and this time round harder to head off.

==============================================================ESSAYS

JUST A BANANA

“Reports of my demise are greatly exaggerated”, Mark twain once quipped and the samecan be said of the expectation of a hard landing in the US. Don’t hold your breath, it’sjust a banana. Yes, exuberance is gone and, from high tech to financial markets, thingshave gotten a bit tough but it is just that, not even a recession and most definitely not theend of the world.

The most recent Gallup poll reports that Americans feel perhaps not exuberant anymorebut surely comfortable. In response to the broad question are you satisfied with thequality of life in the US at this time, 33 percent were very satisfied and another 56percent somewhat satisfied. The economic conditions in the country were found good orexcellent by 67 percent of the respondents, 63 percent judged that they would be betteroff a year hence, and 73 percent reported that they were not worried about losing theirjob. They are right; unemployment will at most rise to 5 percent and 6 month from nowthe economy will already be out of the doldrums.

After 5 years of a 4% plus growth boom, the US economy has now slowed to just aboutzero. The impetus was, as always, the federal Reserve. No expansion in the US just ranout of steam and just fizzled out; they all were brought down by the Fed. And for thesame reason, fear of inflation. This one was different though: the Fed acted whileinflation was still very low and the Fed acted early, preemptively. As a result the cure forinflation can afford to be much milder—a moderate rise in unemployment and a briefgrowth pause rather than full blown recession and a massive increase in joblessness. Sofar the game plan is fully on schedule. True, the disappearance of growth is a bit abrupt

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and more drastic than a soft landing, the carnage in high tech is pretty awful and for amoment there was a spot of fear. But all that is quickly giving way to asking what comesnext. And the answer, obviously, is recovery and expansion. Inflation is in check and it istime to work on the upswing.

There is nothing fundamentally wrong with the US economy, nothing at least to which arecession would be the answer. Overheating and the risk of inflation were the issue andthat now has been attended to by two slow quarters already and perhaps two more tocome. Its time therefore to think where the upswing will come from. The answer ofcourse, as in every past downturn, is monetary and fiscal policy. With inflation abated,monetary policy is free to reduce the Coty of capital and renew the spending spree as wellas financial stability. Fiscal policy is more than free as record surpluses cry out for taxcuts. And yes, 71 percent of Gallup poll respondents feel they pay too much in taxes; theycan’t wait for their rebate checks, they are all set to go shopping. Monetary and fiscalpolicy work in America; they have gotten us out of every recession, they certainly canovercome this growth pause. Six months from now, the economy will be up and running.

Of course there are risks to this rosy scenario. Downward adjustment in profitexpectations for corporations and hence for stocks is not overt, downward adjustment ofconsumer confidence may go one more notch. But that is unlikely to be the trouble area.More likely the problem is this: too vigorous an upswing. The fed is under pressure tomake good and take the economy out of a growth slump that turned out to be rather big;the Treasury is under pressure to produce tax cuts that have bipartisan support whichmeans money into the pockets of people who go out and spend, here and now. With somuch pressure, how can we be sure that policy makers are not stepping on the acceleratorjust a bit too hard? That is the real problem of the US today—too little is the way to ameltdown, too much is a rocket that lands way beyond full employment. The problem ismade by the long lag with which monetary policy works – nine month or so—whichmeans that the Fed front-loads its action before it gets to see what the Treasury does. Andthe treasury will act under the pressure of current slack, before the Fed dope takes effect.That has the makings of overdoing things. Don’t forget, the US economy is today at fullemployment and any boost to growth beyond 3 percent or so is overdone.

Some observers will feel that this whole discussion misses the point: how cam the USkeep spending itself out of trouble with tax cuts encouraging households to spend evenmore and interest cuts underwriting still aggressively priced stocks; in other words, ahouse of cards overdue fort collapse. Don’t wait for collapse, not in stocks, not inconfidence, not in credit. The US economy is fundamentally sound: everybody works,there is plenty of cost cutting and innovation, and there is plenty of investor support. Andthat includes support from outside because surely nobody can imagine for a moment thatJapan or Europe offers a more dynamic economy with better potential. But imagine thisis all wrong and a collapse does happen? Careful with Schadenfreude. If the US problemis not a banana but an abyss, the whole world will go that way; everybody has a greatinterest in the US turning around, sound and soon.

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LIVING STANDARDS COMPARED

Occasionally we are lucky and some organization goes to the effort of putting together acomparable set of data on incomes, prices, taxes and everything involved in coming upwith a single number -- internationally comparable measures of living standards. Theaccompanying table shows just that. A survey of after-tax incomes of 12 professions(from cooks to engineers, clerks and bus drivers to teachers) and a basket of 111 goodsand services (from cars to dry cleaning, from apartment rental to food and clothes) comesup with the summary of after tax purchasing power of income.

Yes, incomes are high in the richest countries -- easily 5 or 6 times the salaries in Brazilso that they seem positively astronomical. But so are prices. What matters then is thecombination, the purchasing power of after tax incomes. In these terms, people in NY orZurich are at two and a half times the level of real income in the same professionscompared to Sao Paulo. On this measure, no surprise, living standards are highest in therich countries: America and Switzerland lead, far ahead of Japan and Germany and veryfar ahead of France or the UK.

Table 12 Living Standards Compared(NY=100, Source: UBS)Sao PauloBuenos AiresSantiagoMexico City

MadridParis, LondonLisbonSeoulWarsawShanghai

38.250.040.222.2

79.975.755.348.520.610.9

For emerging markets, the numbers carry a few surprises: Sao Paulo and Santiago reportapproximately the same living standard. Why a surprise? One might have thought that 15years of strong growth, reform-driven, had put Chile further ahead. And then there isBuenos Aires versus Sao Paulo, a full 30 percent gap. Argentina continues to be the richcountry in Latin America, but can Argentines really afford their position? Lack ofgrowth, as well as high unemployment, suggest that the living standards enjoyed todayare increasingly out of line with reality. And then there is the formidable differencebetween Sao Paulo and Mexico City, the two great metropolises of Latin America. SaoPaulo living standards are double those in Mexico City-- Mexicans are really poor!

More surprises-- Warsaw in Poland, on the border of extremely rich Germany, has thesame appalling poverty as Mexico and that is even true a decade after the end of

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communism. Asian super-tiger Korea is behind Argentina. Lisbon, in the Europeancommunity, does not do much better than Argentina. Madrid is different; Spain hasmoved in the past two decades quite formidably. Who would have thought that earners inMadrid are already ahead of their counterparts in London and Paris?

How exact are these numbers in capturing precisely the living standard of a mechanic ora teacher in Sao Paulo versus Lisbon or Shanghai? Of course they are only approximate--there are such issues as the quality and availability of public health and education whichdo differ across countries and are decidedly part of the standard of living. Clearly, amechanic in Zurich will get better schools for his children and will find better health carein public hospitals than his counterpart in Brazil. However, it would be surprising if theywere much out of line with the reported differentials. But there is another dimension inwhich differentials may be radical. In Mexico City or Sao Paulo people spend their livesin traffic jams; in New York or Santiago they do not do quite as poorly in that dimension.

Changes in living standards happen very slowly, particularly on the way up. Who will bethe gainers and losers in the next decade? Over the past two decades, economic progressin Brazil and much of Latin America has been very slow and it has been extremely fast inChina. Over the next decade Shanghai will continue to do very well-- skills andproductivity are rising, foreign investment is piling in, competitiveness is formidable andcrises are unlikely. And Argentina is certain to go the other direction, continuing relativedecline of already a century -- finance is strained, investment is lacking, there is just nodriver of prosperity at work.

Enlargement of the European Union to the east will benefit Warsaw, just as inclusion inthe EU helped Spain and Portugal in the past two decades. That effect through NAFTAshould work for Mexico just as much and, in the north where integration with the US isdeep, it does in fact. But Mexico City is left out, swamped as it is by endless immigrationfrom the impoverished south. No gains here! How about the race between Sao Paulo andSantiago? No question at all, Santiago is steadily moving ahead: growth is high, humancapital formation is significant, no crises worth talking about. All that pushes Santiagoincreasingly toward European living standards; it will take a decade or two to get toLisbon levels but Santiago will get there. For Sao Paulo, that question is more open: twostrong decades of growth would do miracles for prosperity, but two decades of growthare hard to get in a country that is managed from hand to mouth.

WINNING AT CORPORATE GOVERNANCE

NASDAQ crashes and US slowdown notwithstanding, the New Economy is surely notgone. It remains the cornerstone of hopes for much better performance in Europe andJapan in the years ahead. But where exactly the heart and soul of New economy liesdiffers from one observer to the next – more competition in labor markets, better taxstructures, deregulation, and the list goes on. One driver that must not be underrated iscorporate governance. If corporate management creates productive and flexible structuresfocused on wealth creation, companies will find it easy to adjust and explore new sourcesof productivity and cost control; if decentralization and risk taking are part of the

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mission, innovation in products and processes is not far away. If, on the contrary,corporate management behaves like administrators of wealth, the companies will soonlook like museums.

Economic performance, who is surprised, is largely the mirror image of individualcompanies. No surprise, countries with a hefty lot of great companies will show greatperformance. So where in the world are the great companies? A survey reported in theFinancial Times is instructive: It shows how a large sample of executives worldwide seethe situation.

Table 13 Where Are The 50 Most RespectedCompanies (Source: FT)

Today In 5 Years

USEuropeJapan

33134

31163

No surprise, more than half of the great companies are in the US. This is not a foregoneconclusion—Europe has roughly the same economic size as the US but it has much fewerof the winning teams. Japan is much smaller than the US or Europe, but their scoring ongreat companies way underperforms even their share of G7 income or wealth. The picturecould not be clearer – the US economy performs stunningly, in line with its corporatesector, Europe is behind by a distance, Japan does not make it.

Note next that asked about the winning league five years from now, there is movementhere: Europe is catching up, Japan is losing ground even further, the US too has to givesome. That is a very interesting picture because it mirrors very much the perception thereis a maturing (a code word for losing the edge) in the US and a catch up in Europe wherethe new culture is taking hold. The survey also reflects appropriately the reality of veryfew Japanese firms accomplishing the difficult restructuring toward a modern world classstructure of governance. A world class Sony stays, an NTT ( DoCoMo is the keywordhere) comes on but old and tired Honda and Matsushita are moving to B-League.

Some of the dynamics over the next five years reflect head-on competition and a view ofthe winner. The most interesting example is Boeing versus Airbus. In the current rankingboth are there, close and near the bottom. But go five years out and Airbus is up andBoeing is gone! What lies behind the move is the fact that Airbus has looked ahead,invested and is bringing on a new jumbo that simply will make Boeing’s existing productline look outdated and inefficient. What happened? Boeing fell asleep on its glory andmoney and forgot that this is a tough and competitive world.

When thinking about economic performance potential we often tend to look to the qualityof the labor force, willingness to work and the level of education. In that perspective,

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Europe and Japan could certainly trounce the US with far superior education andJapanese willingness to work would make Europeans look outright lazy. In fact, it turnsout that all the effort and all the education are not really that important. Far moresignificant is the economic environment in which people work--a market economy versussome form of socialism--and the organization of the business in which they participate.

The best model of corporate governance to produce lasting and strong economicperformance remains to be found. In the 1980s respect for the long run view of theJapanese model ran high; a look at the resulting balance sheets has put that idea on theshelf. And then there was the flirtation with the German model of business-bankingintegration, which brings the capital market in-house. That has lost attraction when itbecame clear that the cozy board relations resulted in attitudes all too tolerant of pooreconomic rates of return. The US model is in: decentralization, lean on middlemanagement, tough on the CEO, don’t take no for an answer, don’t ever, ever sayimpossible. Very Darwinian, there is no question about that. That won’t be the lastanswer, but for the time being it will drive the restructuring of companies and ofmanagers’ minds.

All this leaves the question whether it makes sense changing the corporate culture every10 or 20 years. The pragmatic answer, inevitably, is that it takes very different models tohandle a very stable and stationary world as opposed to one where deregulation andtechnology produce dramatic change. The US model is good for rapid and pervasivechange and that is what lies ahead for the world. Welcome to the program.

FEWER MONIES, BETTER MONIES

so much of barbarism, however, still remains in the transactions of most civilizednations, that almost all independent countries choose to assert their nationality byhaving, to their own inconvenience and that of their neighbors, a peculiar currency oftheir own." (John Stuart Mill, (1894))A century ago, being a civilized country surely meant being on the gold standard;gradually countries had converged to the internationalist solution, overcoming theirnationalist experiences with peculiar coinage, paper, silver or whatever unusual andsegmenting arrangement. And if countries were not outright on gold, at least they were onsterling or the dollar. After World War I disrupted a financially integrated world, the veryfirst priority was to get back there. All that fell apart in the Great Depression with capitalcontrols, competitive devaluation and discretionary central banking.

It has taken 50 years to explore all possibilities offered by money without rules and theharvest has been disappointing. But following the great inflation of the 1970s andextreme monetary experiences in many developing countries, the past 20 years havebrought a fundamental transformation to monetary management. Independent centralbanks with transparency and some inflation target, more or less explicit, are nowstandard. In many emerging economies we also now observe independence of central

17

banks and, where rates are flexible, some variant of an inflation-targeting policyapproach.

At the same time, monetary integration is a live theme. In Europe this has become a factwith the creation of the European Monetary Union. That should grow with the increasingincorporation of countries in the east into the European Union, a handful as early as 2004and quite a few on the waiting list beyond. Indeed, membership in the European Unioncomes automatically with membership in the monetary union and some form ofrepresentation at the European Central Bank. But even though membership in theEuropean Union is clearly on the horizon, the larger candidate countries so far remainattached to discretionary exchange rate regimes, forsaking the readily available optionand benefits of unilaterally adopting the euro.

In the Americas, progress on monetary integration is far more haphazard: Argentina andEcuador have chosen a unilateral currency board solution in their peg to the dollar. Therewas a fleeting US Congressional interest in support for dollarization strategies in theAmericas, and there was some talk in Central America, but that is mostly it. Academicsupport is mixed but far from indifferent.

Well-governed countries in the monetary area, such as Mexico, Brazil and Chile, seemcontent with their national solution of managed flexibility cum inflation targeting. Europeand the Americas, accordingly, seem to be going different ways. The extent of politicalintegration is not the central reason; central bank independence makes politicalintegration an uninteresting issue in this context. It rather seems that a national currency,as opposed to a hard dollar peg, is seen as an unquestioned plus. If that is for anything butnationalistic reasons, it is worth finding out where the merit lies. Perhaps, however, weare just encountering one of those deep-seated prejudices against rules and the belief thatdiscretion must be maintained, whatever its price.

In Asia, the discussion of monetary arrangements is picking up at the behest of Japan.Noting the European developments and some discussion of dollarization in LatinAmerica, and the fragmentation of the region in response to the Asian crisis, Japan isexploring what kind of monetary arrangements might make sense. First discussions,however tentative, are underway with Korea. As a concept, this goes far beyond thediscussion of an Asian IMF or the establishment of central bank swap lines that arealready in place.

Traditional arguments

Five arguments make up the case against currency board arrangements. They are,respectively, sovereignty, the loss of seigniorage, the loss of monetary policy, the loss ofa lender of last resort and fiscal preparedness. On the surface, each argument ispersuasive; on closer scrutiny none really is. Sovereignty is beyond discussion; when itcomes to the quality of money the argument does not come up; when it comes to nationalpride it should not come up in most countries.

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The loss of seigniorage is, of course, a critical issue for public finance. The inability topursue an optimal inflation strategy to extract maximum revenue (as a function of theinflation sensitivity of money demand and the growth rate) limits public sector revenueand forces either spending cuts or recourse to possibly more distortionary forms oftaxation. This argument is more appropriate for full dollarization, but even in the case ofa currency board it does apply with the only mitigation that interest is earned on foreignexchange reserves. This limits the seigniorage issue to the spread between a country'sborrowing and lending rates times reserves -- we can imagine reserves being borrowed tosupport the currency on a long term basis but invested short term. The spread is a realityand the seigniorage issue accordingly is real. But there is an important offset to the lossof seigniorage from the reduction in public debt service costs that result from reducedinterest rates -- more on this below-- and this factor is surely far more significant than the1 percent or so of GDP in seigniorage loss. Of course, any kind of stability-orientedmonetary policy will yield some bonus but currency boards and dollarization presumablycommand the highest bonus.

The loss of monetary policy is, on the surface, very obvious: if money creation is tightlyand mechanically linked to reserve flows, the external balance, not the local central bank,determines interest rates. But there is surely an illusion here: what central bank in, say,Latin America can cut interest rates below New York or what central bank in EasternEurope can go below Frankfurt? Their fondest hope is to get down to these levels and thesafest way to get there is to foreswear all and any kind of independence. In principle,there might be some scope for deeply undervalued currencies, expected to appreciate, toachieve lower nominal interest rates than New York. Achieving such levels ofundervaluation is unseen in the region except in the immediate aftermath of a collapse atwhich time inflation fears typically abound. The monetary policy issue, therefore, is apoint with little practical relevance.1

The loss of the lender of last resort function is intriguing. It is based on the assumptionthat the central bank, not the Treasury or the world capital market, is the appropriatelender. There is surely nothing encouraging about the scene of money printing to savebanks that are facing an external drain -- the brief Turkish experience of December 2000with this strategy starkly reminds us that this is an express train to currency collapse. Inthat situation, the central bank poured money into failing banks even as that moneypoured out of the country, cutting central bank reserves at the pace of a billion a day andmore. At most then, the lender of last resort issue has to do with substituting good credit(not money) for bad credit. That is intrinsically a treasury function; if the treasury cannotbe a source of good credit, then the good part of the banking system, if any, or the rest ofthe world steps in. It may be the case that there is no good credit available and that, as aresult, bank closure is inevitable; much better to recognize this than to conceal the fact ina process of money creation that blows up the currency and the good banks, too. Lenderof last resort, more often than not, is failed or failing banking policy.

1 The point is relevant for Switzerland in joining the EMU because Swiss inflation and interest rates are farlower than those in the European Union.

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A surprising argument in questioning currency boards is fiscal preparedness. Of course,at an elementary level there is a point here: the central bank must be cut off from thetreasury, all back doors must be closed. It is hard to see how a discretionary monetary andexchange rate policy can accommodate a lack of good fiscal situation better than a fixedrate. At the most extreme level this may just be an argument about the government beingunable to do without seigniorage revenue. As argued above, the savings on debt servicefrom lower interest rates under a currency board amply compensates and takes awaymuch of the sting of this argument. But if it is not that, there is no argument. To believethat inflation and devaluation are constructive solutions to a fiscal problem iscontradicted by much of financial history. Indeed, from a political economy point of viewone might argue that the favorable political and growth effects following upon a shift to acurrency board might offer a quite unique opportunity to implement important fiscalreform.

The Exchange Rate Issue

The most serious and contentious point about a currency board is the abandonment of theexchange rate. This objection comes in two ways. First, in response to an unfavorabledisturbance, a flexible exchange rate offers an easier way of adjusting relative pricelevels, and hence competitiveness, than general deflation. Second, a fixed rate sets up aone-way option that is bound to be a target for speculative attacks.

Consider first the loss of easy relative price flexibility. This argument is overdone in anumber of ways. First and most important, most disturbances are temporary rather thanpermanent. As a result they should for the most part be financed rather than adjusted to.But before we even get to that discussion, there is, of course, the question of whetherexchange rates are, in fact, a short run stabilization tool. With low short-run elasticities itis entirely possible that rate movements could destabilize the current account andemployment. That view is more relevant the more the discussion focuses on temporarydisturbances as the target of rate movements.

But the more substantial issue is to view the response to disturbances in a context ofintertemporal optimization, including an explicit role for capital markets. In a worldwhere there are international capital markets, cyclical disturbances at home or abroad ortemporary terms of trade fluctuations do not require offsetting movements in relativeprices so as to maintain current accounts balanced. On the contrary, from a perspective ofintertemporal optimization, partial adjustment of consumption or investment and currentaccount financing should be most of the buffer. But if current account adjustment is notpart of the script, is there the need for relative price adjustment? Of course, this overstatesthe point because there will typically be some adjustment of consumption or investmentand, as a result, some need for relative price changes to deal with full employment. Tosome extent this need is met by flexibility of wages and prices but that flexibility may beincomplete, more so in a new regime. That leaves a bit of an exchange rate issue, but italso puts it in a cost benefit perspective. In terms of the models used in new classicaleconomics, the exchange rate can be used as a "fooling device" to create unexpected

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changes in real factor rewards, but these will last only as long as expectations and wages-prices cannot adjust.

At the same time, the option to fool agents comes at a cost in the capital market. Ifrecourse to unexpected movements of the exchange rate is part of the regime the resultwill be a premium in interest rates and hence an increase in the cost of capital. That inturn translates into a loss of competitiveness which must be made up by lowerequilibrium real wages. (This discussion assumes that capital is mobile and labor is not.)The point of the discussion is to say that the devaluation option has limited scope in labormarkets, as new classical economics warns, and it surely has a cost in the capital market.Closing the circle suggests that a regime with the devaluation option translates into loweraverage equilibrium real wages compared to a hard peg.

For the case of permanent or highly persistent disturbances, the role of exchange ratesbecomes, of course, more prominent. Here it is an issue of adjustment rather thanfinancing. This adjustment of the relative prices would, of course, seem to be favored byexchange rate movements. But it is also true that price-wage adjustment can do much thesame. If they cannot, because of "rigidities,” it stands to reason that the exchange ratewill rarely do the job without some complication. That certainly has been the experienceof Latin America, where inflation-devaluation cycles have been the centerpiece of themonetary regime. If anything, exchange rates have been the dominant instrument ofdestabilization.

It takes a very special kind of money illusion that accepts real wage cuts from a large andperfectly obvious devaluation but cannot generate a fall in wages or prices. Perhaps itsays more about the monetary authorities' unwillingness to create the conditions fordeflation, but their willingness and ability to get by with real wage cutting bydepreciation and inflation. After all, the wage-price regime is not written in stone, butrather is mostly written by the central bank's systematic policy conduct.

The Gains

The gains from a currency board or dollarization come in the financial area and derivefrom a far enhanced credibility in the exchange rate and hence inflation performance. Thegains come in two forms. First and most obviously, there is a dramatic decline in interestrates with all attendant benefits. That gain is, of course, more important the moredebilitated a country is financially. who called it the gain "from (Giavazzi and Paganocalled this the gain from tying one's hands.") In the case of Greece or Italy becoming partof the EMU, that gain is quite striking, just as it has been in Argentina. In countries thatare not outright fragile, the gains are still significant, since in a modern financial setting acost of capital difference of a percentage point or two is decidedly relevant. But the gainsfrom abandoning national money are inversely proportional to its quality, past, currentand prospective.

As important are the transformation of the financial sector and the lengthening of agents'horizons. With low inflation and stable inflation, and a stable currency, economic

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horizons lengthen. The lengthening of horizons, in turn, is conducive to investment andrisk taking, which translate into growth and this closes a virtuous circle. Moreover, oncean economy moves out of crisis or state of siege mode, distortions and inefficienciesbecome far more apparent and can become the target of public policy. There is ampleevidence that inflation hurts growth, and high and unstable inflation does so with avengeance. Hence, a monetary regime that delivers and maintains low inflation, otherthings being equal, will help growth. While these points are quite obvious-- and werebehind the case for low inflation targets on the part of central banks in advancedeconomies-- on the periphery and notably in Latin America they are still to be reaped. Insum, doing away with inflation is a step toward pervasive and deep reform.

The Case of Argentina

Much of the current prejudice against currency boards comes from the Argentineexperience. Argentina is viewed as trapped by its currency board, unable to break out to amore competitive real exchange rate and with it to a resumption of growth. Events likeworld emerging market crises or a neighbor's crisis and currency collapse are viewed assituations that do require a devaluation response and the inability to respond in thatfashion condemns a country to no or at most poor growth.

It is, of course, a grave mistake to misread the Argentine experience with a currencyboard in this fashion. In the aftermath of the adoption of a currency board in 1991,Argentina has had one of the best growth performances in this century, some 5 percentannually, including even the setback of the Tequila crisis and the Brazilian collapse.Moreover, the political success of the currency board, and the wise use of it as a driver,made for a formidable restructuring of Argentina's public sector and the very distortedeconomy.

But the currency board did not change three fundamental facts. First, that Argentina has avery high level of debt and a very poor fiscal situation. The present crisis is above all afiscal crisis-- the question of whether Argentina can successfully roll its debt and attractfinancing for its current account deficit. That question is intimately linked to the secondissue: Argentina has invested little for the past 50 years and its economy, muchrestructuring notwithstanding, is highly obsolete and very closed. Third, Argentina has alegacy of labor relations that is not constructive. Unions continue to view the economicsituation as an end game and that, of course, stands in the way of an economicreconstruction or an investment boom. Unfortunately, beyond the first few years ofstabilization and reform, governments have readily fallen back into accepting thissituation.

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ARGENTINA: REAL GDP (Index 1968=100)

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22019

6819

6919

7019

7119

7219

7319

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7519

7619

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8419

8519

8619

8719

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8919

9019

9119

9219

9319

9419

9519

9619

9719

9819

9920

00

Would devaluation -- abandoning the currency board or the other version of devaluationfollowed by full dollarization-- change things materially? There would be a formidableshock to the banking system and with that an extra debt or wealth shock in a country thatalready has had a few too many. But there is also the question whether devaluation wouldsignificantly change growth. The share of trade in GDP is just 10 percent and much ofindustrial Argentina's output stands little chance in world markets because it is of poorquality or outright obsolete: That was the experience of Eastern Europe and Argentina isnot much different. As a result, devaluation may not do much and destroy the one verypositive factor at play now, confidence in the financial system. Rather, Argentina willhave to refocus its politics and its economy to the reality of having run out of credit, assetsales or other easy options.

The Case of Mexico

Jeffrey Frankel has argued that there is no one exchange rate regime right for eachcountry and each time. Against this agnosticism, consider Mexico: It has had unstableeconomic performance for all of 25 years. For awhile, with surprising regularity, thecurrency collapsed every six years, shortly after a new president took office. Invariably,the exchange rate has been used as an active tool to bring down inflation only to collapseagain and open yet another cycle.

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MEXICO: REAL EXCHANGE RATE (JPMorgan Index 1990=100)

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Jan-70 Jan-72 Jan-74 Jan-76 Jan-78 Jan-80 Jan-82 Jan-84 Jan-86 Jan-88 Jan-90 Jan-92 Jan-94 Jan-96 Jan-98 Jan-00

Far from being used as a stabilization device, the exchange rate has been the very focusof economic instability and dismal macroeconomic performance of only 2.7 percentaverage growth in the past 20 years, not much above the growth rate of population.NAFTA and a broad range of reforms carry the promise of a far stronger performanceand the newly independent central bank with its flexible rate might work in that direction,too. But it would be a mistake to believe that there is a well-established and unquestionedcommitment to sound money, understood and accepted by politicians and the public.

Mexico, quite obviously, is a candidate for a currency board arrangement. Its trade focuson the US, the increasing integration deriving from NAFTA, the long history of recurrentmonetary instability which now is being tested for the first time in a wide opendemocracy. All these are important reasons but there is more. Interest rates are high andfinancial development, including horizons, are held back; uncertainty about the exchangerate is pervasive because of its high level in real terms. The gains would seem to beformidable.

But there is also an argument from the other side, what does Mexico need an exchangerate for? An obvious answer might be fluctuating oil prices. But oil is entirely in thepublic sector and in the external balance, with negligible spillovers to the home economy.Therefore, temporary oil price fluctuations are a textbook case of financing the budgetand the external balance in the world capital markets rather than of adjustment: duringbooms there would be a surplus and debt reduction, during low oil price periods deficitswould be financed by the world markets.

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This would seem a far better strategy than bringing an exchange rate into play and with itthe risk of misuse-- which has been endemic-- and the extraordinary crises that destroythe financial system and real wages, over and over again. Here is an economy which,even if it has reformed, will gain further from deeper financial integration with the US.Mexico may well have reformed. If so, an unnecessary premium is being paid and isholding back growth and social performance.

The System

Currency boards or dollarization are strong measures that tend to be applied in quiteextreme circumstances, when everything else has failed. And even here, many see themas transition solutions to be set aside once normalization offers the leeway to return tomore flexible settings for monetary and exchange rate policy. This view does a disserviceto the institution. On the contrary, there is a whole range of economies that are doing allright, say Poland or Mexico, that would benefit from the immediate introduction ofcurrency boards to deepen economic integration and hence build much better growthprospects. Discretion does not have a good record and even if it is not putting the houseon fire for a moment, it is thoroughly out of line with open capital markets and theopening up of repressed finance.

Convergence on regional monies is a no-brainer; at the front end the burden is on theperiphery to recognize and collect the bonus. The benefits of good money and credit donot stop at the border. There comes a point where the center also must recognize thegains from system safety and create the presumption of a lender of last resort.Somewhere along the line, seigniorage sharing also becomes plausible. Like unilateraltrade liberalization, unilateral adoption of a currency board is in a country's interest. Butthere is further ground to be covered. The benefits can be enlarged on both sides if thecenter also contributes with risk management-- that large area between default and triple-A where the presumption of support yields low risk premiums which in turn assuresound credit performance-- and seigniorage sharing. There are moral hazard issues thatneed an answer, but that should not be the end of the discussion.

A PRIMER ON EMERGING MARKET CRISES

Over the past 20 years there has been an outpouring of emerging market crises and a vastaccumulation of commentary--descriptive, theoretical and applied--highlighting theorigins and mechanics of each crisis and of crises in general. And there is plenty ofanalysis on how to deal with crises both in terms of prevention and of cures. Is it possiblenow to distill from all this a simple set of propositions that summarizes the experienceand captures the chief lessons?

This paper attempts to set out a few propositions that summarize what is known andaccepted. The interest in doing so is to promote a set of presumptions about what isunsound practice, with a presumption that it cannot fail to engender, in time, a crisis.Moreover, crises are not just financial experiences, but rather involve large and lasting

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social costs and important redistribution of income and wealth. That makes it especiallyimportant to secure agreement on what constitutes bad practice and identify areas ofcontinuing controversy.

I. Slow vs. Fast, Bad Regimes vs. Big CollapsesA useful distinction can be drawn between old-style or slow motion crises focusing onthe financing of the current account in a financially repressed economy and the new-stylebalance sheet crises of a financially opened economy. The distinction is not only useful inhighlighting what is new, but also to have policy makers understand the great speed ofnew-style crises and their devastating cost compared to earlier experiences.

Old-style crises involve a cycle of overspending and real appreciation that worsensincreasingly the current account; while resources are ample and before real appreciationbites into growth the process is politically popular. In time resources become morelimited and unpleasant options such as demand restraint and trade restrictions have to bemounted but they cannot last. Ultimately devaluation comes and the process starts allover again. The "stabilization" may last if there is little accommodation; but if money ispassive and the increased external room is used for quick expansion the process is morenearly a regime of an inflation-devaluation spiral.

Exchange rate adjustments in an old-style setting have very little of a crisis aspect.Richard Cooper noted 30 years ago that it normally or invariably involves the fall of thefinance minister but not much more. The central issue, as Diaz Alejandro observed, is thefall of the real wages and the politics around it.2 Because finance is repressed, the buildup of vulnerable balance sheets is ruled out but speculative attacks are.

Example: One of the few old-style situations still in play is Egypt; occasionally a widelyanticipated moderate devaluation happens to relieve trickling reserve losses from currentaccount imbalances and suitcase capital flight.

An important part of the story, obscuring its simplicity, is the occasional arrival ofexternal resources (new access to the world capital market, the World Bank, etc.) whichopens up room for better growth without the early arrival of the external constraint. Butthese resources more often than not are debt and hence have in themselves an adverseeffect on the current account. Accordingly, unless there is significant productivitygrowth, trend real wages will have to decline in order to generate debt service.Alternatively, new resources or debt reduction must make room for keeping up realwages.

2 Carlos Diaz Alejandro, writing about the debt crisis of the early 1980s, keenly appreciated that financehad now become the key actor and aptly signaled this with the catchy title "We are not in Kansasanymore..". He would have needed yet another title to characterize the extraordinary increase in size andspeed of the finance factor in recent crises.

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A new-style crisis involves doubt about creditworthiness of the balance sheet of asignificant part of the economy--private or public--and the exchange rate. It mayoriginate with questions about either the balance sheet or the exchange rate, but whenthere is a question about one, the implied capital flight makes it immediately a questionabout both. In no time capital flight wipes out reserves and precipitates a currencycollapse. That process is only brought to an end by a resolution of the credit issues andthe commitment of monetary policy. External intervention has high leverage in resolvingcredit and credibility issues.

The capital account plays a key role in the run-up to the crisis and in its unfolding. Thereis too much credit on the way in and far too little once the crisis hits. The bankers’ adageis "it’s not speed that kills, it’s the sudden stop". Frank Taussig (1928) captured the pointwhen he wrote:

"The loans from creditor countries… begin with a moderate amount, then increase andproceed crescendo. They are likely to be made in exceptionally large amounts toward theculminating stage of a period of activity and speculative upswing, and during that stagebecome larger from month to month so long as the upswing continues. With the advent ofcrises, they are at once drawn down sharply, even cease entirely."

The central part of the new-style crisis is the focus on balance sheets and capital flight.Balance sheet issues are, of course, fundamentally linked to mismatches; even if therewere solvency they still create vulnerability related to liquidity problems. Exchange ratedepreciation, in a mismatch situation, works in an unstable fashion to increase theprospect of insolvency and hence the urgency of capital flight.

Because new-style crises involve the national balance sheet, they involve a far moredramatic impact on economic activity than mere current account disturbances; this farlarger impact arises both in terms of magnitude of the financial shock as well asdisorganization effects stemming from illiquidity or bankruptcy.

II. VulnerabilitiesThere are three central sources of vulnerability: a substantially misaligned exchange rateand balance sheet problems. Trouble in the balance sheet can come in one of two ways:existing big holes in the form of nonperforming loans or exposure. Nonperforming loansor vulnerable loans, not quite gone yet, speak for themselves, except to note immediatelythat they limit the room for higher interest rates and hence are a major problem for aninterest rate defense. The other problem is exposure in the form of mismatches. In anational balance sheet there can be two kind of mismatches: maturity mismatches leadingto liquidity issues and currency mismatches. In a situation where the willingness to holdassets on current terms is impaired, these misalignments or mismatches becomeexplosive. The willingness to hold assets can be impaired either because there s aquestion about the exchange rate or about the willingness and ability of debtors to meettheir liabilities.

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The exchange rate can be the starting point of a crisis when it is patently out of line. Thisis typically the case in exchange rate-based disinflation programs which succeed inbringing down inflation but do so at the cost of a significant real appreciation. Theresulting widening of the current account deficit and the disappearance of growth, fromappreciation and as a result of increased interest rates required to attract continuedfinancing, make it obvious that the program cannot last because it is not self correcting.At some point, see below for detail, a speculative attack occurs which cannot be met byhigh rates or reserve depletion. At that point currency depreciation interacts with balancesheet issues. The worse the balance sheets, the bigger the collapse.

The initial large real appreciation of an exchange rate is often justified by the argumentthat it reflects restructuring--induced dramatic rates of productivity growth generatingBalassa-Samuelson kind of inflation. The argument is invariably suspect because itshould not affect manufacturing price-based competitiveness measures and it is lesslikely to be the case in an environment where unemployment is high and rising and thecurrent account is deteriorating.

What are sustainable rates of real appreciation or of current account deficits and whatinvites a crisis? Because of such issues as lasting improvements in capital market access,persistent terms of trade improvements and productivity growth, emerging economies canexperience trend real appreciation; they certainly can expect to finance on an ongoingbasis some deficit/GDP ratio. It is safe to say, however, that a rapid -- say over two orthree years-- real appreciation amounting to 25 percent and more and an increase in thecurrent account deficit to exceed 4 percent of GDP, without prospect of correction, take acountry into the red zone.

Example: Mexico with its recurrent end of sexennial currency collapses is an examplewhere the exchange rate and the current account are in the foreground and where concernabout the possibility of a devaluation (or the fact of a small devaluation) triggers massivecapital flight. Because devaluation is postponed by shortening and dollarizing debt (theTesobonos issue, see below) the balance sheet issues triggered by the currencydepreciation are huge.

Consider next a balance sheet with substantial nonperforming loans. If interest rates arelowered, the currency comes under attack. If interest rates are raised, the loan portfoliogoes even further under water. This is a common situation leading up to a crisis.

Example: Thailand and Malaysia in 1997 had substantial nonperforming loans; inThailand they were in real estate and consumer finance, in Malaysia they included stockmarket loans that had financed a market boom. Protracted unwillingness to raisemandated lending rates brought about a "carry trade," the currency under pressure,created an offshore market and ultimately led to crisis.

A large budget deficit or a large short-term public debt are factors of vulnerability. Achange in the growth prospects undermines the sustainability of debt, as does an increasein world interest rates. These undermine the willingness to hold and add to the portfolios

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of lenders. The same is true for a perception that the willingness to service the debt isimpaired. The result is a flight from public debt and that flight, invariably, is into foreignassets. The resulting funding crisis translates into increased interest rates, which furtherworsen the fiscal situation and thus act in a destabilizing fashion.

Example: Brazil's crisis was centered on a large short-term debt part of which was dollar-linked; depreciation prospects put debt service into the express lane and actualdepreciation completed the picture.

Argentina in late 2000 is a case in point. A deteriorated growth outlook put in questionthe financing of budget deficits and the rollover of the public debt by external creditors.Interest rates shot up and the prospect of a massive capital flight was in the air. A massiveIMF infusion postponed the fiscal crisis until further notice.

If the exchange rate is fixed, reserves are being depleted and that process increasinglyadds currency risk to the equation. If the rate is flexible, depreciation ensues andincreasing depreciation is projected. That, in turn may spread risks to foreign exchange-denominated parts of the balance sheet and aggravate capital flight.

Banking problems are frequently part and possibly the initiating factor of a currencycrisis. When creditors of short-term inter-bank lines, or depositors, withdraw fromsuspect banks, the resulting flows tend to go offshore and hence translate into reservelosses and or depreciation. The situation is more likely to become a banking and foreignexchange crisis the worse the nonperforming loan situation, the larger the maturitymismatching in the balance sheet and the more significant the mismatching ofdenominations on the asset and liability side.

It is invariably important to look behind the balance sheet of the banking system to theunderlying exposure generated by the banks' loan customers. While the banks' balancesheets may look proper, the loan customers may have the mismatching on their books andhence will seek to shift it to the banking system if and when they run into trouble.

It is also important to recognize that a banking system's situation can change in a majorway in a very short time period. This easily happens in a situation where a concentrationof liabilities (say real estate loans) becomes bad or a spell of high interest rates causes ageneral deterioration of a loan portfolio that had been just a bit above marginal. If thebanking system's funding is short term, the makings of a crisis come on very fast.

Example: The Turkish crisis of December 2000 is a great example. In a situation of alarge number of bad banks (not the major part of the banking system though), awithdrawal of credit lines triggered a banking crisis; the central bank financed the run onthe banks by pumping in credit only to repurchase the liquidity in selling foreignexchange. Reserve depletion within days threatened the maintenance of an IMF-supported exchange-rate based stabilization program.

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The corporate sector, just as the banking system, has balance sheets that are vulnerable tomismatch issues both of maturity and denomination. The larger the corporate sector'sshort-term debt in the national balance sheet, the more vulnerable the country to afunding crisis which then becomes a currency crisis. Once again, when credit to aparticular sector is withdrawn, in emerging markets, that means a capital outflow and nota substitution into other assets. For that reason balance sheet problems become currencycrisis issues.

Example: Indonesia and Korea are examples where formidably bad balance sheets--hugedebt equity ratios and large foreign exchange exposure--were a major part of the crisissituation. Typically it takes weeks to even figure out just how large the external exposureis. Creditors will be reluctant to take haircuts; debtors are under no pressure to yield. Theprotracted debt problem overshadows post-crisis credit normalization.

Whenever capital flight emerges, the question of the exchange rate regime is immediate.Under fixed rates the question is how many reserves does the central bank have and whatis it willing to commit; under managed or flexible rates it means how far and fast will ratedepreciate. Either way the question is how urgent is it to bring money out? Once thatquestion emerges, very urgent is the answer. Reserves are almost never enough towithstand a balance sheet attack and often they are less than reported.

Vulnerability can, at least conceptually, be expressed in terms of a value at risk exercise;what are the relevant shocks, what are the exposure areas, how large a deterioration of thebalance sheet would result. Mismatches are the key triggers of extreme vulnerability. Andthe worse the risk in part of the balance sheet, the more likely that it will spread to all ofit if only because, in case of doubt, creditors want recovery and asset holders hold offlending.Example: The Asian economies which experienced crises had bad corporate financialstructures (high debt, high foreign exchange debt) relative to equity and a high ratio ofshort-term external liabilities to reserves. The combination made for fireworks.

Table14 Critical Indicators: 1996 (%)

Corporate Debt/Equity Short-term ExternalDebt/Reserves

IndonesiaKoreaMalaysiaPhilippinesThailand

310518150160250

1771934180100

Source: World Bank

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III. Timing

There is no hard rule about the timing of crises. It is surprising how long basicallyunsustainable situations can be given extra lives, notably if an election is in sight. Withan election on the horizon, creditors are willing to believe that much or anything will bedone to hold off a crisis or a corrective devaluation. Governments will do anything,including high interest rates or preferably a shortening of maturities and re-denominationinto foreign exchange of claims. As a result, crises happen after elections, not before.This is akin to the myopic political business cycle but no less real. It is clear that the morethe crisis is postponed, the worse the balance sheet and the larger the fallout once it doeshappen.

Example: Mexico always postpones crises until after the election; so did Brazil andKorea. So did Russia. The post-election discovery of a Taiwan banking problem, andcrisis, is another instance.

(2) Bad balance sheets -- as opposed to significant overvaluation, escalating currentaccount deficits or vanishing growth-- in principle can last almost forever provided netinflows cover up the hole and transparency is absent ("clear water, no fish" as theChinese saying goes). As a result, the proverbial straw that broke the camel's back storycan easily be the trigger. A relatively minor event might break a precarious refinancingscheme, or a suspicion arising anywhere else in the world might cause creditors to kickthe tires somewhere else. Importantly, changes in the relative attractiveness of domesticand foreign assets or a change in the growth scenario can bring suddenly the test of thebalance sheet and with it the move to crisis. If the balance sheet is bad enough, as a rule,quite small events are sufficient to undermine the funding scenario and precipitate thecrisis.

Example: Turkey had forever been on the short list for a crisis but somehow got by. Thefailure of a Rumanian subsidiary of a bad Turkish bank, in an environment of politicalagitation about a sleazy banking system, got the stone rolling and within days reached theprospect of immediate currency collapse.

Contamination easily fits the pattern of balance sheets bad enough to be waiting for anaccident. When that is the case, in time the right circumstances will materialize. It takeslonger than you think but then it happens faster than you would have thought. A shift inthe external environment – G3 exchange rates, Fed interest rates, a slump in newcommodity exports all can work as triggers.

Example: The spread of crisis in Asia fits this pattern.

IV. Good Balance Sheets, No Crisis

Do countries with good balance sheets and a currency that is not vastly misaligned facecrisis risks? Of course, there is the trivial answer that for any exchange rate or anybalance sheet there is a shock large enough to make it unviable. But the striking fact of

31

the past 20 years of crises is surely this: well-managed emerging market economies havesuffered slowdowns in growth, high interest rates and currency depreciation. But theyhave not suffered crises. Moreover, the better the balance sheets, the better the ability toabsorb shocks to capital flows and trade without outsized adjustments in exchange ratesor interest rats.

The proposition "good balance sheets, no crisis" risks being circular; but pending a goodcounter example, let it strand.

Example: The good balance sheets of banks in Singapore, Hong Kong and Argentina area large part of why these countries while surely affected were not pushed under by thecrises of Mexico or Russia-Brazil.

IV. Why are Collapses so Large?

Currency collapses are large for two reasons: value at risk is extraordinarily large becauseof the interaction of mismatch factors and because of the difficulty of governments, oncea meltdown is underway, to establish their willingness and ability to engage in anuncompromising stabilization effort. In this environment, the IMF's role is to restorecredibility and hence credit.3

R E AL E X C H AN G E (In itia l L e ve l In d ex =1 00 , J P M o rg a n D a ta ))

0

20

40

60

80

100

120

Indones ia K o rea M alays ia P h ilipp ines Tha iland M exico B raz il R uss ia

troughnow

3 For the Asian economies the initial level is January 99; for Mexico January 94, for Brazil and Russia Jan98. The most recent data are for December 2000.

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The interaction of mismatch factors produces an instability in the response of assetholders: the more the exchange rate goes, the more bankrupt the balance sheet and hencethe more reason to deny credit and get out. The higher the maturity mismatch, the moreliquid the creditors and the more easily the debtor is moved to the gray zone betweenilliquidity and insolvency. The interaction of depreciation and illiquidity causes marketsto cease functioning and hence record interest rates and initially a vast overshooting ofexchange rates are the rule.

The crisis itself weakens the government politically and makes it doubtful whether it iswilling to stick with a policy that dries up credit and hence staves off capital flight; theabsence of effective property rights and the total absence of transparency renders thepossibility of bottom fishing very hazardous. Hence there are no capital inflows, nostabilizing speculation and just a one-way downward pressure on asset prices, thecurrency and the balance sheets.

Example: Indonesia, with a political collapse and an ongoing struggle about who will paythe debts and who will gain offers a clear case of an unresolved crisis.

Disorganization in the Blanchard-Kremer sense becomes a dramatic issue whencreditworthiness collapses, bankruptcy spreads and from that side attacks the realeconomy. The real economy consists of complex layers of relationships in two ways:first, there is an input-output relationship that can be disrupted at any point in the chainbecause a critical supply or demand link disappears and hence impairs or brings down thewhole chain. Second, there is often a credit relationship, rather than cash and carry, andthis is sensitive to creditworthiness suspicions, which can become the disruptive factor.Disorganization is an important part of the output collapse.

The IMF's role in reversing the dramatic immediate events is twofold. First it offers acommitment device for governments to underwrite a stabilization strategy that is knownto work. Second, it offers temporary credits and debt reorganization, including lock-up ofshort-term commercial bank creditors, and thus helps stem the outflows.

High interest rates may hurt growth and the balance sheets but they definitely stem thedepreciation of the currency. Ultimately that is the single most important beachhead ofthe stabilization program. As long as the currency melts, there is no prospect ofstabilization. (We discuss below an alternative of controls).

Example: In the collapse phase currencies depreciate formidably relative to any currentaccount-based view of what is necessary for adjustment. They are driven by the capitalaccount. When a credible program is put in place, there is a rapid normalization as inKorea or Brazil.

The adoption of an IMF strategy, and demonstrated adherence to it, soon shut off thehemorrhage and turn around into a path of currency recovery and a decline in interest

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rates. The combination of post-collapse over-depreciated exchange rates and a crediblecredit program provides for appreciating exchange and declining interest rates. A virtuouscircle is entered. Wavering commitment, by contrast, remains reflected in volatilecurrency and high interest rates.

V. Costs

Currency crises are formidably expensive; even more so is a history of recurrent crises.The costs arise in three ways: a substantial increase in public debt associated with thecrisis, a loss of output and disruption, and the possibility of socially controversialredistribution of income and wealth.

In a currency crisis, because the government will bail out banks and often evencompanies, public debt increases substantially and with that future tax liabilities. Thedeterioration in public finance also arises from a period of high interest rates in the run-up to the crisis and in the stabilization phase. It will also arise from the fall in output andhence tax revenues in the crisis period. Moreover, the increase in debt may itself bear theseeds of future crisis if it occurs in a situation where the government dos not have theability to meet the higher debt service burden by taxation or reduction in spending.

The numbers can be staggeringly large. It is easy to have the government burden 20 oreven 30 percent and more of GDP from a bank bail out. In addition, there is easily a 10 or15 percent increase in debt from high interest rates applied to a large debt and fromrecession-induced tax losses.

There is also always a large loss of reserves, which are sacrificed during the defense partof the crisis. To some extent these may be captured by the private sector and hencemerely amount to a transfer but often they are the counterpart of a bet the governmentmakes with the rest of the world and loses.

To the extent that a crisis experience deteriorates a country's credit rating, there is also alasting cost in terms of a higher international cost of capital. A currency crisisredistributes wealth and income. It is said that more money was made in the few years ofcollapse of the Holy Roman Empire than in the long years of its existence. The same istrue of crises that enrich those who can get into foreign exchange in time or can get thegovernment to assume their debt while keeping the assets. That is routine. The strikingregularity, of course, is the dramatic fall in real wages and employment as well as thebankruptcy of small debtors.

Periods of recurrent currency crises translate into poor growth performance, shorthorizons, slow increases in the standard of living, a deteriorating social and economicinfrastructure. Major asset sales along the way, or increases in external debt, and spurts ofreform can obscure the degradation of the productive economy at any one time. Butultimately medium term growth rates, far from reflecting catch-up, reflect the costs ofpersistently poor finance.

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VI. The Alternative Medicine Controversy

There are two areas of controversy. The first involves capital controls and the secondsurrounds the appropriateness of IMF programs. On both issues the controversy is aliveand conducted with great vehemence.The appropriateness of IMF programs is quite obviously questioned because it seems, atleast on the surface, to make a bad situation worse. Raising interest rates at a time wherebalance sheets are already under water makes a bad debt situation worse. Raising interestrates and tightening fiscal policy at a time where the economy is already in steep declineseems to be outright counter productive.

What are the alternatives? The capital flight will certainly continue as long as the centralbank pumps in credit at unchanged interest rates. The reason is obviously that theimmediate gains from borrowing in a depreciating currency far outweigh the cost ofborrowing. Hence borrowing and capital flight remain active, depreciation deepens,balance sheet problems widen -- there is no obvious end to the process.

There are, of course, two ways of trying to reconcile unchanging interest rates-- ratherthan extraordinary short run levels of 100 or 1000 percent p.a. -- with an end to capitaloutflows. One possibility is credit allocation controls and the other is capital control andbest both combined. There are obvious questions of effectiveness of controls but even ifthat is accepted, there is also the issue of efficiency. If controls were temporary thatmight not be an issue; if they are lasting then suspending the capital market is much moreof an issue. For the system at large the presumption that controls are the response tooutflows will reduce the perception of liquidity and hence translate into a higher cost ofcapital and more trigger-happy investors.

Surely there is agreement that the better strategy is to reduce the risks of a crisis situation,including by predetermined limits on liquidity and profitability, but that leaves open thequestion of what to do in the midst of a crisis: IMF or controls. The debate continues.

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APPENDIX: FORECASTS AND DATA

Table A-1 Inflation and Growth

Growth Inflation

2000 2001 2000 2001Ind. Countries

USJapanEuroland

FranceGermanyItalyUKSpainCanada

3.8

5.01.73.4

3.43.12.63.14.14.9

2.1

1.81.42.9

2.62.42.22.53.12.8

2.5

3.4 0.7

2.3

2.32.02.52.43.42.7

1.9

2.5 -.4

2.0

1.91.52.12.22.92.4

Source: Economist Consensus Forecast

Table A-2 World Bank Per Capita Growth Scenarios

1971-80 1981-90 1991-99 2000-2010 ScenariosCentral Low

High IncomeDevelopingEast AsiaSouth AsiaL.America

2.43.24.50.63.4

2.40.85.63.5-0.9

1.61.65.93.51.7

2.7 1.73.7 2.35.4 3.93.9 2.53.0 1.4