<nettime> World Bank Reverses Position on Financial Controls

[nettimes_roving_reporter <nettime-l@bbs.thing.net>]

STRATFOR.COM
Global Intelligence Update
Weekly Analysis Septemer 20, 1999

World Bank Reverses Position on Financial Controls and on Malaysia

Summary:

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. 


Analysis: 

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 controls. 

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 run. 

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 political effect. 

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 international systems. 

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 regulation. 

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 performance. 

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 economic bloc. 

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 high enough. 


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