One Fiscal Size Does Not Fit All
Op-ed in Eurointelligence
Twelve years ago, the Asian Financial Crisis hit. The International Monetary Fund took a common approach across the crisis countries, prioritizing fiscal austerity. In retrospect, outside observers and the Fund itself came to the conclusion this was a mistake-while appropriate for Indonesia, the "It's Mostly Fiscal" approach made the situation worse than it needed to be in South Korea, with negative spillovers for the rest of the region. The euro area governments, under pressure from Berlin and Brussels, are repeating this mistake.
Yet, if excessive austerity is imposed on Spain, the result will be even more miserable than for Korea, with at least as bad an international impact.
European politicians, particularly in Germany, are visibly sick of Americans and others telling them that imposing uniform austerity beyond Greece and Portugal is in error. But facts are facts, and it is an error. The experience of the Asian Financial Crisis is directly relevant, and the willingness of the IMF to reconsider its position in the time since would be a good example to follow. What matters is getting policies right, not adhering to a foolish consistency, either in policy recommendations across countries or in publicly taken positions.
To recap, in 1997-98, a few small East Asian economies came up against limits after extended booms funded by capital inflows. Indonesia and Thailand had run large current account deficits and accumulated public debt. They also had significant structural problems that made their high rates of growth unsustainable. Just as in the euro area today, financial markets suddenly woke up to this reality, and began pulling out money. Interest rates rose for these countries and their solvency problems turned into shortages of liquidity. As usual, ratings agencies had backed their borrowing on the way up, and turned on these economies accelerating their difficulties on the way down.
So far, so simple, though also sad. Similar to Greece and arguably Portugal, today, the Asian economies that had lived beyond their means found it had caught up with them. Their creditors, public and private, were understandably upset-though of course the creditors were the ones that made the mistaken assumption that exchange rate pegs assured repayment of debts, justifying the loans at low interest rates. The IMF came in to perform its primary role of financing and designing adjustment plans, with an appropriate emphasis on austerity in Indonesia and Thailand.
The much bigger and much sounder South Korean economy then fell into difficulties. The direct effects of contraction in its neighboring trading partners hurt Korea. Despite being far more advanced in what it produced and at a higher income level than the rest of non-Japan Asia, Korea also suffered competitively from depreciations and wage falls in its region. Worst of all, financial panic prompted in part by worries about the exposures and funding of Korean banks fed a downward spiral. And thus the IMF came in there, too.
Yet, then the austerity treatment was taken too far. Rather than differentiating its requirements of South Korea to reflect the better fundamentals of the economy (and its size), sharp fiscal tightening was made a requirement of IMF lending there as well. The austerity had significant contractionary effects, because lack of confidence in Korean solvency beyond the panic was unjustified. No benefit accrued from these measures-interest rates dropped when the panic ended, but not through a consolidation channel. The contraction in South Korea was longer and deeper than it had to be as a result.
The effects were not limited to this honest though costly mistake, which the IMF-to its credit-has since recognized and not repeated. The deeper contraction in Korea sent around the world the effects of the Asian financial crisis with renewed force. It arguably led, in part, to the Russian default and global difficulties of October 1998. Less obviously, but probably doing more lasting damage, this set of policies in Korea also gave renewed vigor to the complaints among Asian emerging markets that the IMF was unfair and autocratic. Desire to avoid future IMF involvement has fed the accumulation of reserves through exchange rate undervaluation , and thus mercantilist or protectionist policies, from Beijing to Kuala Lumpur, and beyond. That in turn has contributed to the global imbalances we have today, the ongoing political fragility of the open world economy, and the inability of the G-20 to gain agreements beyond immediate crisis response.
That is an awful lot of damage from one misguided application of austerity to a country that could have had a less costly adjustment. But those are the facts. That kind of costly mistake is what the governments of the euro area are now potentially repeating in their treatment of Spain. Spain is not Greece or Portugal. Spain has much stronger fundamentals and has suffered less justifiably from financial panic than its neighbors or Ireland. The voluntary disclosure of stringent stress test results on Spanish banks is a commendable and constructive policy move by the Spanish government-a brilliant way of differentiating itself to markets by doing something right and that will be economically enhancing. On this measure, it beats out South Korea for bravery, since Korea did allow its banking problems to last.
Yet, if excessive austerity is imposed on Spain, the result will be even more miserable than for Korea, with at least as bad an international impact. South Korea in the end was able to recover through a significant currency devaluation and expansion of trade. That is not available to Spain, especially if its major trading partners within the euro area contract their own demand and compress their own wages. The unfairness, perceived and actual, of such an outcome for the Spanish economy will promote political resentment across borders, if not outright conflict-and that is much more harmful within a political union than with regard to some far off international institution like the IMF. There is still time for the euro area to learn from and avoid repeating the South Korean mistake. The IMF did.