Let’s go a full circle. Robert Rubin says, "The purpose of IMF packages is to help Korea, a by-product is that we help investors and creditors"

Do we really agree with this? Or do we think that IMF packages do this? Or do they mainly create moral hazard. Start with Mexico. Of course it is impossible to demonstrate from the data that the Mexican bailout, through creating moral hazard, contributed to what we have observed in Asia. But I believe, passionately, that it did. I would be delighted if anybody here could suggest ways in which we could observe in the data the effects of the moral hazard that such rescues create. But what we have observed in the Asian sequence is the creation of furthermoral hazard.

Take the Korean bailout. What happened? At the end of November/very beginning of December last year the IMF package of 10 billion dollars went directly into reducing the short-term exposure of the banks. That is demonstrable and the Fund itself at the highest level will concede precisely that. It was not until the orchestrated rescheduling that the banks stopped taking out their short-term funds. In general these mega packages that we have observed just keep on growing, and it is very hard to figure out where they are going to stop.

Now the last time around, after Mexico, of course there was discussion on trying to make the creditors take a bigger hit. There was the work I did with Barry Eichengreen, followed by the G10 report in May 1996. But market participants reacted so strongly to what Barry and I had said that the G10 report pulled its punches. Indeed they surveyed market participants who said, "Oh gosh! If you do what Eichengreen and Portes say, the debtors will just take that as an invitation to default." So the G10 said that markets had to do it themselves, had to come up with orderly workout arrangements, contractual changes in debt contracts, and so forth. Of course nothing has happened.

Now, it is said that this time around the creditors has taken some hits. This is not obvious to me. Of course equity investors took a hit, but they did so in Mexico as well. No news.

Bond owners? Yes, bond prices have fallen, but people are holding. You can hold bonds to redemption after all, and meanwhile get paid. There have been no defaults as far as I know on bond interest.

In Indonesia we may see the banks finally taking some loss on loans to the private sector. They are not, of course, taking losses on loans to private sector banks in Korea, because the Korean government guaranteed all those. So all this, as I say, is evidence of considerable moral hazard, part of that created by intervention by the Fund and by the international community.

To move to the International lender-of-last-resort issue. Can the Fund be an International lender-of-last-resort? It cannot create money, it does not have a sustained supervisory presence in any of the countries that it deals with, and cannot do, and that is a very important element in exacerbating the moral hazard dangers arising from Fund bailout intervention. In addition, the Fund does not have the fiscal redistributive authority that a lender of last resort has to be able to call on if there are actually solvency issues, rather than merely temporary liquidity questions. So the Fund cannot deal with the cross-country incidence, creditor-debtor incidence, of loss. The Fund has therefore played international lender-of-last-resort, without the key supporting structures that are necessary to do so. I conclude from that that we need more market-based solution and that we need more incentives for the markets, and the market participants to come up with the solutions, such as changes in debt contracts, such as ex-ante tiered debt instruments, credit insurance, that sort of thing. That will only come if the creditors have to take much more in the way of losses than they have done so far.

Finally I want to talk about the "early warning" literature. I switch to that in my remaining three minutes. David Vines and I dealt with that in our Commonwealth Secretariat Paper over a year ago Portes, R. and D. Vines (1997) Coping with International Capital Flows. London: Commonwealth Secretariat, and quoted Morris Goldstein, who at that point we noted as being rather sceptical about the indications. Now of course Morris is adding to the literature. It is a big literature, it dates back 25 years at least, to Frank and Klein in predicting debt rescheduling. It is as unsuccessful as ever in my view.

If you take the latest papers and proceedings in the EI you get Goldstein and Mulder’s paper saying, "Real exchange rate misalignment is a good predictor, but further work should repeat the exercise, and actually from the perspective adopted in this paper exchange rate crises are largely unpredictable events". In fact, further work shows that the real exchange rate in not much good.

Take Cosetti, Pesenti and Roubini’s "Paper Tigers" article where we find that the real exchange rate taken alone does not work so well. So what do we do? We "interact" it with the current account and then we get a story. But that’s exactly what all this literature does. We have some vague theoretical ideas that suggest what variables ought to go on the right hand side. Theory tells us nothing about lag structures, nothing about functional form, and permits us to do as much data minding as is necessary.

The results typically do not indicate vulnerability in advance, only as the crisis is about to occur. Of course some of the key variables are very slow-moving variables anyway, relatively speaking, in terms of crisis prediction (current account, real exchange rate, non-performing loans – if you can get that kind of variable – etc).

I think the bottom line of this is that every crisis is different. This explains why we get a new generation of literature every time we have a crisis, and a new set of theories about crises! If I had time I would make some observations about Type 1 and Type 2 errors in the paper by Kumar et al. that we heard this morning. This is a revised version of the paper discussed on page 8 of this newsletter, in the report by Uma Moorthy>. Because I do not, I will simply confine myself to one remark, I believe that this sort of exercise, may be useful in marketing; and clearly the results in Kumar et al. show that it may be useful in helping to market trading strategies. But I do not think that they will be useful for "policy proofing".

I start with the observation that behind this [Asian] crisis there is a paradox. In theory we would have expected a big increase in capital flows to have made economies more stable, because risks would have been better spread across different countries. But in practise they’ve made economies more vulnerable.

The answer to this paradox is not of course an autarchic solution. It is obvious that a case of sharing the risks involved in domestic investment with foreigners is clearly a strong one. The problem of course is that the market for risk is more difficult to manage than the market for goods. Unlike the market for goods, when you are dealing in international transactions of risks you don’t really get what you see. Outcomes depend on how well risks are managed, and on how well information is processed, and so on. It is here that there are major shortcomings.

The response to recent crises has been an enormous increase in resources devoted to quantifying risk, as we saw this morning, including country risks, and also other research examining correlations between different sectors of the market, in order to design more efficient portfolios. Now all of this is fine. However, I think one lesson taught by the crisis is just how difficult it is to quantify risk with any degree of precision. The scale of the adjustment of the key variables, of exchange rates, and of interest rates is almost always under-estimated. Second, the correlation between markets that can be established when markets are calm is quite different from what emerges when markets are under pressure. A common experience is that the correlation between markets tends to rise in a crisis, so that diversification possibilities (which market participants imagined were there on the basis of correlation based on calm times) are actually not there exactly when markets most need them.

I think that one implication of the fact that risks are difficult to quantify is that there needs to be put in place in the financial system some kind of prudential buffers which protect the financial system against shocks that cannot be quantified with any degree of precision. In particular, it is necessary to take measures to limit leverage in the economy. This can be done in many ways. It can be done in a regulatory way through a higher capital ratio for banks and a lower loan-to-value ratio that banks give to people who want to borrow. Or it can be done in a market orientated way by making "stress tests" more demanding: putting variables in stress tests that allow for shocks well beyond the size of shocks recently experienced. Getting the benefits of capital flow, and making sure that risks are properly measured, means that a number of things need to be done. If information is to flow properly, and risks are to be properly internalised, the list of what needs to be done is actually quite a long list. I will mention only three things.

The first one is that it is very important to avoid government policies that lead to risks being mispriced. There is a lot of discussion about implicit guarantees before the event, and I share Richard Portes’ concerns about the effects of bailouts on moral hazard. Fixed exchange rates maintained for many years lead markets to systematically underestimate the risk of the exchange rate.

The second measure is that something must be done to prevent borrowers absorbing excessive risks and to allow lenders to take some or more of the risks. In particular governments who borrow short term are exposing themselves to very large liquidity risks. If short-term government borrowing had been limited, both in the case of Mexico and the case in a number of Asian countries, short-term capital inflows would have been less. Likewise banks should price exchange rates and interest rates risks properly. They did not in the Asian crisis and once again if banks had been pricing the risks they were running correctly, they would have been much less active in the interbank markets and the short-term capital inflows would have been much less, so that the destabilising features of capital inflows would have been greatly reduced by putting in place simple prudential measures.

The final thing that I will finish on is that you cannot have a proper market for risk unless you have full information. In particular two things are important. First, there needs to be much fuller disclosure of foreign exchange liabilities, public and private, contingent and actual. This data should include information on the maturity of claims. It should also include information on central bank forward obligations. Second, there should be fuller information on public debt, in particular how much of it is short term. We do not have good information in very large numbers of emerging markets regarding these two elementary sets of data. The IMF often does not have accurate data on these. It is here that an urgent start needs to be made.

In my current work, I am trying to compare the Asian crises with nineteenth century financial crises. In some ways what is surprising is how surprised everyone is about the Asian crises because they have an enormous amount of common ground with the nineteenth century crises. Almost all the kind of preconditions, both empirical and theoretical – as set out in Philippe Aghion’s paper – occurred in the nineteenth century crises as much as in 1997/8. Just to emphasise that this isn’t something specifically, necessarily, to do with Asia or Asian characteristics, you will recall that during the nineteenth century, crises were more frequent and common in the United States than in any other single country in the world. I am looking, for example, at the crises in 1873, 1890, 1893, and 1907. In every single case the United States was in a crisis situation. So that if we think about Asian virtue as not being so great in the twentieth century, we must remember the new American virtue was not so great in the nineteenth century. Not only were the preconditions really similar, but the actual context and arrangement of the collapse (with a downturn in housing prices, land prices, equity prices, impinging on a fragile banking system, with weaknesses, and on occasions fraud, leading to banking failures in the banking system) being similar in both cases.

The key difference between the nineteenth century crisis and the 1997/8 crisis so far has actually been on the external side. What happened in the nineteenth century crises was that in most cases the countries were pretty firmly on the gold standard or, in the case of Australia in 1893, effectively on a sterling standard. This case was expected to revert very quickly although in several cases, again in Australia or in the United States for example in 1907, there was a temporary gold premium, which was expected to be short term. Now the combination of a belief that the exchange rate would revert to the underlying anchor, combined with the temporary premium and a decline in asset prices, led to a situation of bottom fishing. Capital inflows on a short-term basis took advantage of what was seen as a temporary opportunity, with the result that in these countries there was a very large gold inflow, more or less immediately after the crisis. Thus the monetary base expanded again really quite rapidly, and nominal interest rates that had been spiked upwards briefly, shortly reverted to levels that were actually lower than they had been previously.

That wasn’t always the case. It was not the case, for example in Argentina which because of credibility problems of a well known form, you didn’t actually expect, when the Peso went further away from gold, that it would come back. What happened in the Argentinean case in the 1890s was that the Argentines repudiated. As a result they neither paid interest nor repaid principal. That meant that the underlying strong shift in the current account surplus (exactly the same as that happening in East Asia) lead to very large gold inflows, rebuilding the financial base and lowering the interest rates in those countries. Not of course that you didn’t have very strong effects. Loads and loads of banks went bust. Nevertheless, in the nineteenth century there was either a nominal anchor and expected reversion, or a repudiation.

Neither have occurred in the Asian crisis. You have had neither a nominal anchor – people were worried that the won and the rupia would go on going down – nor was there effectively a repudiation and therefore a removal of the outstanding foreign currency debts. The combination of devaluation and the failure to repudiate the outstanding debt has imposed a stronger burden on the Asian countries than that which was present in the nineteenth century, and this has made the whole situation very much worse.

How do we get away from this continuously worsening spiral? One of the suggestions is that you make the creditors lose money on interbank debt. I think that there is a problem with that. If you start telling banks that they are going to lose money on interbank debt then that drives contagion even faster from one country to another, and it could lead to collapse of the interbank market, which is generally highly undesirable. I would very strongly support the argument that there ought to be a supervisory capital adequacy requirement, which depends on the perceived and publicly known standard of regulation in the developing countries.

Private sector debt is a different matter. The only time when it looked, temporarily, as if the Indonesian crisis was going to be resolved was when it appeared that there was going to be an orderly workout of the private sector debt, that this would impose very considerable losses on the creditors and that it would reduce the out-payments of capital from Indonesia.

There is a problem there for the International Monetary Fund, because if the purpose of the exercise is to reduce the outstanding weight of the debt of the private sector debtors, what can the Fund do to help, as it finds itself in a very difficult position? I think that: "how do you deal with the Fund or, rather, how should the Fund, if at all, deal with an overwhelming problem of private sector foreign currency debt?" is the particular policy problem that we have at the moment. Maybe the answer is that the Fund cannot deal with it, and when the problem is essentially private sector foreign currency debt the Fund ought to say, "Please sir, not me sir." and allow the country to get on with whatever repudiation and workout is actually necessary.

As a final comment, when you are dealing with private sector net indebtedness do not expect information improvements to get you out of the problem. It just is never going to be possible to calculate the net private sector indebtedness of a country. For example, if Germany, the United Kingdom or the United States was asked "what is your net private sector indebtedness, say of and under one year maturity?" The answer is for all of those three countries, "We have not got a single idea!"

I want to talk about minimising vulnerability and also about crisis resolution. What I think we have learned about minimising vulnerability is that you must not liberalise until two things have been done. The first is to put in place much better kinds of financial structures than the Asia-Pacific countries had in place in the mid 1980s when they liberalised. Philip Turner has talked about a large number of measures that could be taken, need to be taken, to strengthen financial systems. The shopping list of what needs to be done before liberalisation is undertaken is a long one. Joshua Eizenman’s paper paper related to that discussed on page 8 of this newsletter, in the report by Uma Moorthy is about the second best economics of liberalising when there are flaws in the financial system. It is a straight "imiserising growth" argument that liberalising in those circumstances can make you worse-off.

The second thing required to minimise vulnerability is to have a macroeconomic strategy that is appropriate to open international capital markets. This is not fixed exchange rates. Here this story has lurked in various forms all the way through the conference. My own preferred version of it is that fixed exchange rates give you a short-term stabilisation problem at precisely the time when you’re likely to have to deal with the biggest stabilisation difficulty that you have ever had, as a result of the big boom that liberalisation means. This means that on the shopping list before liberalising is establishing a whole new strategy of macroeconomic management, with a clear nominal anchor that is not the exchange rate, but that is some form of inflation target that works well operationally. This is very difficult.

So these two things about minimising vulnerability say that ten years on we are much more cautious about moves towards open international capital markets. The whole push by the Fund only two years ago to make capital-account convertibility an essential aspect of membership now looks something that is extremely contingent. It must wait upon appropriate institutional developments.

In turning to crisis management, I again want to say two things and again they are about the financial system, and about macroeconomics.

Let me discuss the macroeconomic issue first. We haven’t had any discussion during this conference about the burning issue at the moment – the interest rates defence in face of crisis. You all know the positions that have been staked out. It does seem to me that there is no alternative to the interest rate defence. I stand on the side of Fischer and others in this dispute, but it seems to me that you can do it badly or you can do it well, and to simply spit into the wind with an interest rate defence seems to be the worst way possible of conducting it. What you need is an interest rate defence in a structure where there is a clearly understood nominal anchor. If you are simply saying that the currency is, as at one time in Indonesia, a sixth of what it was, and you are going to arbitrarily raise real interest rates to 20%, or 30%, or 60%, or more, and hope that it is enough and do no more, you are just not doing what is necessary. Similarly in Korea with real rates approaching that, to give no indication of what you think the exchange rate needs to come back to, and what the long-run anchor that you are aiming at with this interest rate defence, is to cut off two-thirds of your sword as you wave it in the air. You really do need to say, "this is the nominal anchor that I am aiming, with my interest rate, for. This is the glide trajectory that I am working with, and this is the interest rate that I am pursuing along it". Without that statement about the future no-one knows whether prices are intended to be 20% higher, or 100% higher, in a year’s time. Nobody therefore knows whether an interest rate of 50% is savagely tight, or too loose. Furthermore, with such a statement a relatively low interest rate may be enough to defend the currency because the announced anchor might well imply an appreciation.

Charles Goodhart has pointed out nicely the connection between this issue and the debt workout problem. He points out that either you can have a well-constructed nominal anchor, in which case you can make the debt workout much more easy, because everyone knows that the exchange rate will come back, or you can repudiate. The macroeconomics and the microeconomics are, in fact, very closely tied together here.

Clearly in Korea the decision has been made not to repudiate, and the issue at hand is the nominal anchor question. In Indonesia this is not possible, for both political and economic reasons. Like all of the speakers before me, I think we must have institutional structure that does more than is possible now about repudiation. Lending into arrears is a modest beginning. It seems important to be able to enforce payment standstills, by blocking capital flows in some way institutionally during the workout process. And finally a workout on asset values really seems necessary in these circumstances. Richard Portes has been the foremost advocate of this strategy. But everyone who looks at it in detail is appalled by how difficult it is. As Vinod Aggerwal said yesterday, we can see that the Latin American debt crisis was only really resolved when it became too important for the hegemon to let Latin America continue in a state of permanent crisis: Brazil and others were in such difficult circumstances that the US was just not prepared to let it continue. Bt this requires the hegemon to say, "this is the number of cents in the dollar that you are going to get and this is how the settlement is going to be orchestrated". To demand a new international financial architecture in which there is some key player in the background who is in the final result going to do this, is to demand a large amount of the new architecture.

Indeed we face a choice between the devil and the deep blue sea. If we don’t have such a threat in the background we have lender moral hazard, with the lenders always holding out to get their money back, and making life difficult. And if we do have it we have all the financial system screaming, and in particular all the US senators screaming, "this is moral hazard".

Nevertheless, this is what we must work for. The Indonesian crisis is so serious – and it has such enormous implications for the whole of the Asia-Pacific region – that it must be in the interest of the hegemon, and of all other OECD countries – to search for a way to help solve it.

I am going to talk about the role of the United States as a hegemony, and depending upon how you look at the United States, it is either a knight in shining armour, or a Darth Vader which is destroying the universe.

I am also going to describe how I view negotiations on the debt problem. I have done work looking at debt rescheduling over almost 200 years, and have examined about 70 cases. I would like to talk about the sort of lessons that we can learn from this long period of rescheduling, in Latin America and elsewhere.

What I find is the following. First, leaving debt crises alone "works". But, it takes indebted countries sixty years or so to work out their debt which is costly and a long period of time. So that may work, but it is a very difficult avenue to pursue.

Second, I find that if you look at the role of the IMF it is not always as positive as some people say. It is not always as negative, but the IMF by itself has really never been able to resolve debt crises. What is has done has always been with the backing of very strong creditor governments who establish the point of view. (These points have already been raised to some extent.)

Let me here mention the work of Eichengreen and Fishlow my current and former colleagues in the Economics department at Berkeley who have a different view. They say that in the 1930s there was not much intervention in debt rescheduling. They say that in the 1980s the IMF did a pretty good job of managing things and in the 1990s the United States was the key player. They thus indentify examples, in these three historical periods, of each of the debt-resolution methods that I have already mentioned: letting the problem alone, letting the IMF the problem, or having the United States play a lead role.

The only problem with their analysis is that there was no debt resolution in the 1930s. There was no intervention; but there was no resolution. In fact all of the debt resolution of all the Latin American cases took place in the 1940s and 1950s. So yes, there was no intervention in the 1930s, but there was also no debt resolution.

In the 1980s it really was not the IMF that resolved the problem. Basically the United States played a very active role. It was really the United States taking on the Brady plan, which was based on the Miyazawa plan, something that had been suggested by the French and the Japanese together, and then using that plan to promote debt write-downs. So how can we explain what was going on in terms of the US view. One can develop a model of the strategic interests and actions of the United States, and indeed of any creditor government in such hegemonic circumstances. Their actions depend on three things.

They have strategic interests in the international financial system and they are engaged in international strategic competition with other creditor governments, and so that is one factor that influences what creditor governments do.

The second factor is, of course, their own national financial interests. How heavily exposed are their own banks? Are their banks in danger of going under? Or, in the case of the nineteenth century, what is the position of their bondholders. How many bondholders are there in this kind of situation? This often determines what they want to do.

Third, of course, is the political dimension, which has not been talked about much at this conference. What are the political interests of the creditor governments in particular countries. We have seen that we Americans do Latin America, and what Germany does in Poland. What about Asia? Well maybe this is the area of strategic interest to the Japanese. (We all know that they have not managed that interest terribly well lately.)

So what are some examples?

Let’s look at the historical record and see quickly how intervention worked out. In the Mexican case, the first rescheduling in the nineteenth century, which began in 1824, saw values worked out in the 1800’s. The process took sixty years. People got their money back, they made about 1.5% interest. They beat consol. It was a good investment if you were willing to wait sixty five years. That is a good long-term investment. But sixty years is a long time. Mexico went through a few things including Emperor Maximal who had to take over and rule Mexico for a few years. So that was not ideal for Mexico, I would say.

Then in the twentieth century what happened? There was debt default in 1913 after the Mexican revolution. There was an effort to resolve this in the 1930s that essentially proved to be a failure. Then along came – to Mexico’s benefit – World War II, and with it a sense that the US was very worried about the consequences of this war. As a result of this the US concluded all sorts of agreements with the Mexicans in 1940. Very clear signals were sent by the United States to bondholders that, "Okay folks, let’s resolve this debt crisis", and debt was written down at 10%. Fifty million dollars of payment took care of five hundred million dollars of Mexican debt. (These figures are not in current dollars, but in 1940s dollars). So clearly that was a very good deal for the Mexicans, and that good deal was reflected by the fact that there was a very big problem for the United States in terms of strategic insecurity interest.

Now, by contrast, the Peruvian case. Their rescheduling went on and on until the 1950s, and the US did not have as many strategic interests in Peru. In fact the US was quite happy to cooperate with the World Bank. When the World Bank was going to make Peru a loan the British took violent exception to the loan, warning that, "the City will have nothing further to do with the Bank, if the Bank pursues such a course". So even if the Bank was trying to be the good guy, the Bank backed down immediately under British creditor government pressure. Here is an example of a very important dynamic interaction between international institutions and creditor governments.

You will be familiar with the history of the 1980s where you had the Jumbo loans in the 1982 period to 1985. These did not do much, they simply kept rolling over debt. By this means the crisis was contained, so it was probably a good immediate emergency action. Then you had the Baker plan in 1985, which was more of the same, which actually proved to not resolve the crisis at all. In 1987 the Brazilians declared a moratorium on debt. After they declared a moratorium, and the City responded by running down its debt, we began to see much more concern on the part of the creditor governments. Then, too, the Mexican government was in crisis in 1988. There were deep political difficulties. At that point we had the development of the Brady plan. What Brady planned was the write-down of debt. There were three options given to banks (you probably know all about those three options) and that is what lead to the resolution of the crisis.

A similar thing has happened in the Mexico crisis of 1994-95. In the initial stages of the 1994-95 crisis period the US did not take very dramatic action, the initial period meaning a couple of months. But then the US immediately moved very actively to develop a rescue package, and despite the fact that there was opposition by Congress, $50 billion was put together and this clearly signalled that the United States was heavily committed.

What was the context leading to that? The US had just negotiated a very important trade agreement between Mexico, Canada and the United States. The US could not afford to let Mexico down, particularly since there was a great concern about immigration pressures in California and elsewhere. The last thing the United States would be willing to do is to let the Mexicans go under. So there again it really was not the IMF playing the crucial role, but the United States putting together a large package.

In Asia we have seen very similar things, in Indonesia and a few other countries we have seen initially that the United States did not do much. Then it did a lot and put a lot of pressure on the banks. In the Korean case of debt rescheduling of January 1998, just a few months ago, it put on a lot of pressure.

All of this is very ironic for someone who has made a career writing about international institutions. I write about how nice they are and how important they are, and my conclusion here is of course they are nice and they are important, but by themselves they just cannot do what they need to do. My view of the problem is that if you want to do institutional design, (design institutions that are appropriate to deal with debt crisis), the design begins at home. You have to build a political coalition, not only in the United States, but in other countries as well. What is required is a coalition which will not be like the right wing of the Republican party and the left wing of the Democratic party, who make nice bed fellows all sitting together and talking about how the IMF are so evil. You have to build a larger political coalition, which will support these kinds of things. It is so difficult even to get the IMF additional money, can you imagine some of these ideas and the new architecture for Bretton Woods where the IMF will essentially run all the bailout packages? That is simply not going to happen.

So what we need to do is something that has been talked about only spasmodically at this conference. What you need is to really understand the respective roles that creditor governments and institutions will play, and to design institutions in such a way that there will be a role played by the major creditor governments in resolving the debt. So that they are able to come up with additional Funds in crisis periods.