Economic collapses are an intrinsic part of capitalism. The names of the really big crashes ring down through history: Tulip Mania in Holland in the 1600s, the South Sea Bubble in Britain in the 1700s, the Great Crash of 1929 in America. More recently, in the 1990s, the Japanese bubble ended with stock prices down two thirds and property prices down 70 percent. Seven years later the stock market has yet to recover and property prices are still falling.
Past infections do not provide future immunity. America in the 1970s and 1980s saw the effective bankruptcy of its largest city, a government bailout of Chrysler, one of its largest corporations, the collapse of its Savings and Loan banking industry, a stock market crash in 1987, and a sharp fall in property prices. The latter rolled around much of the rest of the industrial world. Canary Wharf in London, which cost twelve billion dollars to build, was at one time worth half a billion dollars.
Today it is the turn of large parts of Asia. In Korea on December 27, stock market values were down 42 percent for the year and the won had lost half its value against the dollar. Combining these declines, stock prices had, in dollar terms, fallen by two thirds for the year. And Samsung Electronics Company, the world’s largest producer of computer memory chips, according to a report in The New York Times, now has a market capitalization—the value of all its outstanding shares—of about what it would cost to build one of its factories. At the same time the company is carrying $7.9 billion in debt.1
The sequence of events in a crash are well known. Some asset rises in value to levels far above those that can be sustained. At the peak of Tulip Mania one black tulip bulb bought one of the row houses along the canals in Amsterdam. That price was crazy, and everyone knew it, but prices were just as crazy when six tulip bulbs bought one house and those who got out of the tulip market when it was 6 to 1 missed a chance to multiply their wealth by a factor of six. Short-run opportunities to make a lot of money overwhelm well-known long-run economic realities. Every investor (no one thinks of himself as a speculator) imagines that he will be able to see the end coming and get out in time—but few do.
As asset prices fall, what had been good loans become bad loans. Adequate collateral becomes inadequate collateral and loans with inadequate collateral get called for payment. Fearful of defaults or short of liquidity themselves, banks don’t renew short-term loans that normally would be automatically rolled over. Working capital dries up. Suppliers who are fearful of not being paid demand cash before delivery instead of being willing to wait the normal ninety days for payment. Within hours of the news of the recent crisis, ships loaded with raw materials for Korea were halted off the coast, waiting for payments to clear before they unloaded. Even financially sound firms find that they cannot pay their bills since they are suddenly, unexpectedly, asked to repay loans and pre-pay suppliers. Business firms that cannot finance themselves go broke. Their customers don’t get the supplies they need.
Worried about preserving their wealth, insiders and outsiders convert their holdings to currencies that are not expected to depreciate. Vast amounts of money leave the country; the central bank eventually runs out of foreign exchange reserves; the currency plunges; the real cost of paying international loans rises and the central bank has to beg for loans from the IMF. And when central banks lack international reserve currencies, as with Korea’s recently, even companies with sufficient funds in local currency to repay their international loans cannot get the necessary foreign funds to repay their loans. A business crisis becomes a crisis for the country. Credit markets freeze up. The contagion spreads to other countries. Brazil, for example, has been very shaky in the aftermath of the Asian collapse.
The problem before the collapse is not in knowing that prices will eventually fall but in predicting the timing and speed of the downturn. Economic models are very good at describing fundamental forces and pressures, but they have proved of little use when it comes to timing.
In this sense economics is much like geology. Geologists have a very good general understanding of the plate tectonics that underlie the San Andreas fault in California. They know with near certainty that there will be a big earthquake in California. But they don’t know whether it will be one second or a thousand years from now. All a geologist can do is chart the faults and understand the probabilities. But Californians build houses right on top of the state’s biggest faults, sure it won’t happen in their lifetimes.
The big economic fault lines on the Pacific Rim have long been well known, most obviously, perhaps, in the performance of land values. In the long run, commercial land values have to reflect the underlying earnings capacity—the productivity—of the economic activities carried out on the real estate in question. Bangkok, a city whose per capita productivity is about one twelfth that of San Francisco, should not have land values that are much higher than those in San Francisco. But it did—as did other Southeast Asian cities. Grossly inflated property values had to come down.
It is a basic axiom of economics, taught in every introductory class on international trade, that no country can run a large trade deficit forever where its foreign indebtedness grows faster than its GDP. Foreign currencies have to be borrowed to finance such trade deficits. At some point the size of the already existing outstanding loans will cause lenders to conclude that extending more loans is too risky; repayment seems too unlikely. The credit markets shut down. The Asian countries whose economies have recently been collapsing were all running large trade deficits—$8 billion in Indonesia, $4 billion in Malaysia, $10 billion in Thailand, $4 billion in the Philippines, and $19 billion in Korea.
Ten years ago these countries all had substantial trade surpluses. Their swing from surplus to deficit is di-rectly traceable to mainland China’s decision to concentrate on increasing exports as the engine of its economic growth—what economists call “export-led growth.” Since China could offer better educated but cheaper workers than Southeast Asia, and since it has a much bigger internal market for its own products, it quickly gained a $40 billion trade surplus, taking export trade away from other Asian countries. To find substitutes for the kinds of goods whose production China was taking over, these countries needed to go upscale in technology very rapidly. But some of them are not well educated enough to do so.
And while Korean workers are on the whole better educated than those in China, Korean companies had moved their low-wage manufacturing export operations to China, and could not replace these exports with high-wage manufacturing exports, because of Japanese competition and Japan’s rapidly rising trade surplus. As has so often happened in its history, Korea was once again squeezed between its two powerful neighbors.
Eventually stock market prices have to reflect profits. In the collapsing Asian countries, competition and the desire to increase market share kept profits low while Asian stock markets had risen to levels that could not be justified by earnings. Before its crash in 1990, the Japanese market had price/earnings multiples of more than 100.
Moreover, projects were being built that everyone knew would lose money. The two tallest buildings in the world were built in Kuala Lumpur although it is now widely known that such buildings do not make economic sense. The Sears Tower in Chicago has just been sold at half its replacement cost and the World Trade Center in New York could not be sold for anything like its replacement cost. Too much space goes into elevators and other support activities when buildings rise to these heights, and no transportation system can economically get so many people to one location at nine o’clock in the morning. But when countries have had a string of boom years megalomania sets in and their governments and large investors come to feel that ordinary economic rules that apply to others do not apply to them. In 1995, when I wrote The Future of Capitalism, I was only one of several commentators who believed that such trends could not continue:
The question is not whether an earthquake will occur. It will. The only question is when, and whether it occurs as one big shock or as a series of smaller shocks that do less damage. But when conditions have existed for a long period of time and nothing happens, humans, being human, begin to believe that it is possible to defy economic gravity forever…. But let no one doubt that this earthquake will happen…. The forces on each side of the fault are enormous.
But knowledge that an economic earthquake would eventually occur on the Pacific Rim would have been of little value to most investors. In financial markets most successful investors make money because of their timing—not through an understanding of basic economic forces. From their own short-term point of view, those in the financial markets were right to ignore such warnings.
What is clear by now is that crashes are not set off by outside speculators who see the internal weaknesses and attack. The first investors to leave the local market are always the local investors who have the best information. Indonesian industrialists got their money out of Indonesia first since they were the ones who had borrowed money in dollars; they would go broke if they didn’t switch from their local currency before it fell. The real value of a firm’s debts more than doubles if loans must be repaid when the exchange rate is 5500 to 1 rather than 2300 to 1. The threat of going broke concentrates the debtor’s attention. Property developers in Manila have the best information about the rising office vacancy rate in the many new office towers they have helped to build. They know new buildings are not being successfully rented. The Korean industrialist with a cousin working at the central bank knows that the statistics published by the Korean Central Bank about the size of its reserves are false. The Thai banker is the first to know about the phony bookkeeping in the companies to which his bank has been lending money.
Outsiders are the last to know. By the time international speculators join the flight, the panic is well underway. We know that insiders were the first to convert to dollars in both the 1982 and 1994-1995 Mexican crises. When the crisis in Asia has calmed down, it will be clear that insiders were once again the first to run. The impressive abilities of international fund managers to move large sums of money across borders vastly accelerate the forces pushing prices down; but contrary to some facile generalizations about “globalization,” they are never the triggering mechanism.
See The New York Times, December 27, 1997, pp. A1, A2.↩
See The New York Times, December 27, 1997, pp. A1, A2.↩