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I don't think I ever remember an economics story on your
mail-outs, but the attached, from Stratfor is about the biggest news story
of the year - a major paradigm shift.
Global Intelligence Update
Weekly Analysis Septemer 20, 1999
World Bank Reverses Position on Financial Controls and on Malaysia
The World Bank reversed its opposition to short-term
capital controls and announced that Malaysia's experiment with
capital controls was, in effect, a success. Since the World Bank
acts on the distilled essence of conventional wisdom, this means
that the international financial community no longer regards either
capital control or Malaysia's prime minister as taboo.
The most important short-term consequence of this change will be on
Japan, which has toyed with the idea of capital controls. But more
importantly in the long run, the rehabilitation of Mahathir from
lunatic to visionary will bring his other ideas into play. Of
particular importance is his idea of a regional Asian bloc
excluding the United States, based on the yen and Japan, with
capital controls as a regional management tool. Neither of these
outcomes is intended by the World Bank or the IMF, but both are the
embodiment of the unintended consequence.
The World Bank has executed an important and somewhat startling
reversal of position on Malaysia's use of capital controls to solve
its economic problems. Joseph Stiglitz, the World Bank's chief
economist, said Sept. 15, "There has been a fundamental change in
mindset on the issue of short-term capital flows and these kind of
interventions - a change in the mind set that began two years ago."
He went on to say that "in the context of Malaysia and the quick
recovery in Malaysia, the fact that the adverse effects that were
predicted - some might say that some people wished upon Malaysia -
did not occur is also and important lesson."
These were not casual remarks. They were made during the
presentation of a key World Bank annual document, the "World
Development Review," and were meant to be taken seriously. Indeed,
Stiglitz's comments came a week after the International Monetary
Fund (IMF) praised Malaysia for its skillful handling of capital
These comments represent a fundamental shift in the international
economic establishment's understanding of how that system works.
The economists at the World Bank and the IMF are not particularly
original or imaginative, and their track record in predicting and
managing the twists and turns of the international system is not,
to say the least, impressive. Thus, viewing their policy shifts as
contributions to economic theory is not particularly useful.
Stiglitz and his colleagues at the World Bank and the IMF are not
people who go out on the limb with dramatically novel idea. They
like to move with the herd.
That is what makes Stiglitz's statement extraordinarily important.
It shows that the herd is making one of its periodic migrations.
The World Bank's chief economist doesn't lead the convention. He
is a superbly sensitive weather vane - he follows it.
During the 1960s and 1970s, the World Bank was committed to
massive, government-run infrastructure projects, reflecting the
conventional economic wisdom at the time that the state is the
appropriate engine for economic growth, at least in the developing
world. During the 1980s, when the conventional system shifted to
the view that the free market was the most efficient means of
capital allocation and economic growth, the World Bank slowly and
painfully shifted again. They stuck with the free market position
throughout the Asian meltdown.
Now, two years after the bloodbath, they are slowly shifting again,
not only endorsing capital controls, but praising their own arch-
nemesis, Malaysia's Mahathir. Stiglitz is following the new
conventional wisdom: capital controls are chic.
Whether capital controls are good or bad doesn't really matter.
What matters is that they have been accepted by a highly
politicized, extremely powerful segment of the international
community that the World Bank/IMF complex is part of and serves.
This is the international financial community, understood as the
national bankers, the leading international banks and the political
elites to which they connect.
Stiglitz's comments reveal that the 20-year love affair with a
purely free market approach to international financial flows is, if
not coming to an end, nevertheless being severely modified. There
are now cases in which market regulations are not only tolerable,
but also a good idea.
This will lead to interesting debates among economists, most of
whom will argue that controls create inefficiencies that will
retard recoveries and damage economies. The problem is that these
economists tend to approach these issues from an isolated angle.
Stratfor's view has been that economic crises increase the pressure
on governments to take steps that stabilize the situation in the
short run, even if they affect the economy negatively in the long
For example, assume that political chaos is something to be
avoided. Assume further that the economically optimal policy would
quickly lead to political and social chaos. Finally assume that a
policy could be found that avoided political and social chaos at
the price of poor economic performance in the long run. Which is
the better policy?
As much as any country, Indonesia followed the conventional wisdom
of the time, as transmitted by the IMF and World Bank. As capital
poured out of the country, trying to flee Indonesia's dangers, the
government did nothing to interfere with capital movements,
assuming that the market would create stability.
Indeed, the markets did work, and the Indonesian economy was
beginning to improve earlier this year. But by optimizing its
economic response to the crisis, Indonesia's social and political
fabric was shredded. The pressures imposed by the market on social
cohesion created the extraordinary reality of an economy in
recovery and a society in collapse. In the end, of course, that
collapsing society will shatter the economic recovery as well, so
all will be for naught.
Indonesia's neighbor, Malaysia, followed a very different policy,
which originated in a radically different analysis, heavily
ridiculed at the time and today. According to the Malaysian prime
minister, the origins of the crisis had little to do with
imbalances in the country's economy. Rather, they had to do with
the structure of the international financial system and
particularly the management of international currency flows.
According to Mahathir, it was an illusion to think of short-term
capital flows as market driven. On a day-to-day basis, control of
short-term capital was in the hands of a relatively small number of
massive currency hedge funds. Mahathir claimed that George Soros
and other hedge fund managers were orchestrating the collapse of
Asia's currencies. Because they profited from relatively small
differentials, they were prepared to create sudden, massive and
uncontrollable outflows of capital that would wreck national
economies by causing both short- and long-term capital flight.
Mahathir's analysis tended to be more colorful, charging Jewish
conspiracies against Muslim countries. The primary purpose of his
analysis was political. Mahathir used his analysis to explain why
his government had not failed. Rather, he argued Malaysia and the
rest of Asia had been victimized by the international system. He
personalized the system into the person of George Soros for further
In short, needing to stabilize his polity, Mahathir created an
economic analysis in which the stabilization of his society was its
grand purpose. He successfully diverted his attention from the
Pan-Asian economic practices that had triggered the crisis, such as
irrational capital allocation, absurdly low rates of return on
capital, an undercapitalized banking system and the failure to
create domestic demand while relying on exports. Instead, he
refocused domestic attention on the claimed defects of
It was effective politics. It also spawned economic policies that
the World Bank has now endorsed. If the central problem were the
nonexistence of a free market in short-term currency flows, and
that these flows were instead controlled by a few financial
institutions, then the rational answer to oligopoly was government
Accordingly, Mahathir slammed currency controls on the flow of
money into and out of Malaysia. Conventional economic theory said
this should have had a devastating effect. In fact, compared to
Indonesia, the actions (along with other acts of repression, such
as the trial of Anwar Ibrahim, Mahathir's former protege and
advocate of the international economic community in Malaysia) not
only helped stabilize the political system, but also did not seem
to have produced a great deal of economic harm.
Malaysia's economy contracted by 7.5 percent before controls were
imposed. In the year following the imposition of controls, the
official growth projection has gone to 1 percent, while unofficial
projections go as high as 5 percent. It is no surprise that
Stiglitz stated that the bank had been "humbled" by Malaysia's
Stratfor has long regarded Mahathir as one of the most interesting
figures in Asia. Long ridiculed by conventional economists as a
lunatic - an image reinforced by the rhetoric he chooses for
domestic consumption - Mahathir has nevertheless made some cogent
points. His argument that short-term capital flows were too
vulnerable to a small number of hedge funds has some empirical
validity. If those funds can create short-term oscillations that
become uncontrollable, they can and have created long-term
problems. Healthy economies are not vulnerable to these events, but
unhealthy ones are. Mahathir argued that the medicine imposed is
likely to kill the patients rather than rejuvenate them.
Since 1990, Mahathir has made the broader argument that Asia's
economies are overly dependent on the United States as a market. He
has not only been an advocate of capital controls on the national
level, but also an advocate for the creation of a regional economic
bloc in Asia, built around the yen, and insulated from the United
States by policies and trade frameworks.
Mahathir believes a Japanese-led, regional economic bloc is needed
for two reasons. First, he argues that dependence on the United
States for the absorption of Asian production cannot be sustained
in the long run. Second, the United States will use this
dependence to manipulate and divide Asians so that, inevitably,
what happened in 1997 would happen again.
Everyone dismissed Mahathir. We have long argued that he has been
pointing the way. This does not mean that we agree with him. It
simply means that we have felt that a Mahathirian worldview would
eventually carry the day in Asia.
Stiglitz's bow toward Malaysia is therefore critical in two ways.
First, the World Bank and the IMF have now endorsed the principle
of capital controls, at least in the short run. Since you cannot
be a little bit pregnant, even at the World Bank, that means
conventional wisdom now says capital controls are a legitimate tool
in economic policy.
This is of extreme importance for nations in Asia that have not and
cannot solve their structural problems without destabilizing their
societies. We mean, of course, the Japanese. Japan has
contemplated capital controls and has, in highly informal ways,
actually employed them. But Japan, as a charter member of the
international financial community's conventional wisdom, has never
formally implemented nor even endorsed them.
Now that the World Bank and IMF have both praised Mahathir, with
whom the Japanese have interestingly warm relations, the taboo has
been lifted. Japan, adverse to taboo smashing, can now use capital
controls as a conventional tool. So can other Asian countries.
The tremendous pressure for an Asian solution has eased with the
current recovery among some the region's nations. Since we
regarded this as less a recovery than the end of the collapse and
the beginning of long-term malaise - for Malaysia included - the
short-term pressure is being replaced by a less urgent, but
nonetheless real search for structural alternatives.
Which brings us to the second point. Japan's problems are the
region's problems. If Japan cannot find a purely domestic solution
to its problems and the global environment is too inhospitable,
then regional solutions might well be the answer. Just as Europe
has the EU and North America has NAFTA, Asia must seek, according
to Mahathir, an Asian entity.
Joseph Stiglitz's comments legitimized capital controls, the tool
that any region-wide plan would require. They also turned Mahathir
from an official pariah into an official visionary. Dismissing his
ideas on other matters now becomes much more difficult. For many
in Japan who have quietly agreed with his ideas, the change in the
international economic community's perspective will open the
floodgates to ideas that have thus far been taboo: an East Asian
Thus, the World Bank and the IMF have effectively handed Asia
legitimization for a regional bloc designed not only to facilitate
intra-bloc trade, but also to create regional regulatory bodies to
manage the capital flow in and out of the bloc. True, this would
destroy the essence of Asia's free markets. But, as we have argued
for a long time, the idea that Asia had domestic free markets was
quite illusory to begin with.
There is much mistrust of Japan in the rest of Asia. Memories run
long. But if the Poles and Czechs can work with the Germans, be
assured that southeast Asia can work with Japan - if the stakes are