Financial crises will always be with us, according to Takatoshi Ito and Richard Portes. So how should we deal with them?

Investors take risks, and naturally some of their investments fail. So we have domestic bankruptcy laws that provide for ‘orderly workouts’. Similarly, if the international capital markets are functioning well, mistakes will be made. Then a country (or its private sector borrowers) will fail: a financial crisis. History records many. We should not expect or even wish to prevent them all. That would be at the cost of insufficient, excessively risk-averse investment.

The Mexican crisis inspired many analyses of the fundamental causes and triggers of a financial crisis. Some claim to have found indicators that predict a coming crisis - but the Asian crisis was not foreseen. The IMF said that if the data were published regularly, market discipline would prevent a major crisis. The Special Data Dissemination Standard was launched on the IMF home page with great fanfare - but little result.

Does the IMF itself perform better than early warning indicators? It maintains that Thailand was warned in the summer of 1996. But the December 1996 IMF report raises no suspicions; and its 1997 Annual Report finds no fault with Thai or Korean macroeconomic management. In the September 1997 IMF report on International Capital Markets, any warnings of possible contagion are conspicuously absent: indeed, only 5 pages out of 265 address the Asian currency crisis.

In the Mexican crisis, IMF programmes for Mexico and Argentina helped to prevent contagion. This time, contagion has spread to other countries in Asia, and currencies and stock prices have continued to slide despite the swiftly installed programmes for Thailand, Indonesia, and Korea. This raises questions about whether such programmes are right for the Asian crisis.

The Asian macroeconomic fundamentals are good. And the crisis is primarily a private sector one, occurring in economies with high aggregate savings, sound fiscal positions, open and outward-looking policies, and relatively low sovereign debt. Rather than high inflation, the key feature of the crisis is debt deflation – or bursting of an asset bubble. So this is very different from Mexico.

The economies in crisis do have weak banking systems and began with somewhat overvalued exchange rates (some but not all pegged). Those are common features of financial crises. But the causes and appearance of this crisis are different from previous episodes. Common factors are de facto exchange rate pegs to the dollar, which resulted in overvaluation and large current account deficits, and excessive private sector foreign borrowing.

But the idiosyncratic factors are at least as important: Thailand’s central bank took forward positions that depleted net foreign reserves, and its financial companies accumulated massive non-performing loans; Indonesian industrial structures are politically motivated and inefficient; and Korean banks borrowed too much abroad on short maturities.

Despite these differences, the basic anatomy of financial crises exhibits a nexus of debt default, foreign exchange disturbances, and banking system failures. The recent widespread securitization of debt has not changed things – one of the major historical examples is the 1930s crisis of defaults on sovereign bonds.

All crises are ‘crises of success’. The initial capital inflow that ultimately proves unsustainable is both a sign and, for a time, a cause of economic success. But we have not yet learned how best to cope withcapital inflows, so success may lead to failure - and contagion may follow.

All crises raise the problem of distinguishing between insolvency and illiquidity. Today, some say that the ‘Asian miracle’ economies are actually ‘hollowed out’, ‘zombie’ economies: all that investment just went into creating excess capacity or driving up real estate prices. Others argue that the growth was real and the problem was simply overvalued exchange rates and a classic ‘run’ - a self-fulfilling crisis of liquidation of short-term loans. We will not know for some time which view is correct.

In the 1980s, creditor banks and the official sector denied debt reduction for years (until the Brady Plan), with the incantation of ‘moral hazard’. They said that letting debtors off the hook would violate the sanctity of contracts. Even worse, it would encourage them to follow bad policies in the future, again expecting someone else to pick up the bill.

But overborrowing is overlending - moral hazard cuts both ways. Only a few then argued that creditors too were subject to moral hazard and had to take some share of the cost of mistakes. In practice, they suffered little: recent studies calculate that the banks’ returns on the loans of the 1970s were quite reasonable, just as earlier work had found that the bond issues of the 1920s were profitable on average, despite the defaults.

High interest rates with a dollar peg cannot be a free lunch for both borrowers and lenders. The IMF and the G10 should reflect now on whether the Mexican bailout was really necessary to avoid systemic risk. Had there been no bailout, would we really have seen anything like the same extent of unwise lending to the Asian countries?

Borrower countries can do better at avoiding or minimizing crises:

• Do not liberalize the capital account prematurely and indiscriminately, and consider market-based discouragements and prudential regulations on short-term capital inflows as in Chile.
• If an exchange rate peg for stabilization is used, think early about how to exit.
• Weak bank balance sheets are a warning, so use restrictive lending policies.
• When the crisis hits:
• Float the exchange rate before using large amounts of foreign exchange reserves. The ‘interest rate defence’ of a currency peg will not work where there is financial fragility.
• Do not accept responsibility for private sector obligations to foreign creditors.
• If the problem is debt deflation and a credit crunch, do not impose a monetary squeeze.
• When the exchange rate depreciates, the profitability of exporters and importers changes quickly, so devise financing for exporters.
• International financial institutions and creditor countries too must do better at avoiding or minimizing crises:
• The IMF should not act as a credit rating agency, but neither should it conceal any concerns or mislead the markets.
• The IMF should not orchestrate bailouts of creditors, and it should discourage guarantees to creditors of insolvent financial institutions.
• Go back to the recommendations in Crisis? What Crisis? Orderly Workouts for Sovereign Debtors (CEPR, 1995) and the 1996 Rey Report on The Resolution of Sovereign Debt Crises.
• In the current crisis:
• Relax the absurdly tight macroeconomic policies being imposed in the name of ‘conditionality’.
• Financial distress will only be exacerbated if the IMF requires capital flow liberalization before institutional reforms and domestic recapitalization.
• Regardless of the economics, the domestic political response to the current IMF programmes threatens to be counter-productive. Contagion may result from a market perception that the programmes will do more harm than good. The Fund must reconsider urgently.