SMITH & RICARDO: THE READERS DIGEST VERSION

The International Monetary Fund prescribes the same drastic medicine for every country’s economic illness. In Southeast Asia it may start a deflationary spiral that could spread disastrously beyond the region.

I’m writing this in my hotel room in Paris, as I suddenly have five extra hours on my hands. A snowstorm has surprised the airport authorities at Charles DeGaulle Airport. (“Snow? In December? In a latitude similar to Moscow? How could we have guessed, monsieur?”) And it will take most of the morning to heat the de-icing machines. At least I didn’t go out to the airport where the traditional French Christmas transport workers strike has closed the restaurants and bathrooms.

The delay has forced me into watching French television, or more precisely, Euro MTV. I have watched this channel for years in sort of a morbidly transfixed way. I just can’t understand how a continent of 280 million people can’t find a single backup singer who can actually clap on the beat. At the rate of improvement that I’ve seen over the past decade it’s going to take centuries for these culturally primitive Europeans to even reach the level of “Baby Love” by the Supremes. It’s sad, really.

I have less sympathy for the French industrial and financial establishment. Meeting with the chairmen of two major French banks I was a little disheartened to hear each one saying that the problems in Asia did have a positive side in that it reduced the pressure on France and Europe to restructure in the face of global competition. I don’t know what the penalty is for beating the chairman of a French bank to death with your hands, but on at least one level I’ll always feel I missed a great opportunity to find out.

I have to admit to watching open-mouthed with astonishment as the International Monetary Fund, the Dr. Kevorkian of international financial organizations, has waded into the Asian fiasco. Anyone who has watched the organization for years would not have expected creativity from a group of bureaucrats l
ed by a French Socialist. But the so-called bailout is almost Soviet in its rigid application of a cretinously simplified economic orthodoxy. It will not work.

adam smith misunderstood

The organization essentially prescribes the same medicine in all situations, as it is currently doing in Asia. Countries are required to devalue their currencies, to raise taxes and to cut government spending, and to raise real interest rates to reduce domestic demand for imports. The IMF functions a little like a doctor who prescribes a bone marrow transplant for all conditions. Fine if you have cancer, but a little drastic for your basic impacted wisdom tooth. In more than one country, austerity has led to civil war and the overthrow of governments. But what’s a few thousand body bags among friends? And the important goals are achieved — staff salaries at the IMF did rise 60% between 1992 and 1994.

The core belief of the IMF system is that all balance-of-payment problems stem from governmentally imposed distortions that interfered with the totally beneficent workings of the international free trade system. Countries are supposed to specialize in those areas of manufacture where they have a “comparative advantage.” If all countries concentrate on those areas where they have such advantages and subsequently minimize protectionist distortions, all countries will benefit, if not equally, at least to the greatest possible extent.

This orthodoxy is variously traced back to Adam Smith’s “An Inquiry into the Nature and Causes of the Wealth of Nations” (1776) as later elaborated by David Ricardo in the far more systematic “Principals of Political Economy and Taxation” (1817). Unfortunately for everybody concerned, the IMF version is not what either economist believed or said. Many people have heard of Adam Smith’s “invisible hand” — very few have read the subsequent 700 pages of qualifiers.

Take the classic IMF intervention. A Third World country, let’s say in Africa, exports basic agri
cultural commodities. The exchange rate is artificially high to please urban consumers of imported luxury goods, but agricultural prices — controlled by the government — are static or declining. The IMF orders a devaluation and budget austerity. The austerity destabilizes the urban (money) economy, which is dependent on government spending and often includes the army. Devaluation reduces the prices of agricultural exports, but it takes years to actually increase production — there is no additional capital available for seed and you can’t increase agricultural production on demand from subsistence-based agricultural systems. Imports collapse, which as often as not sends a section of the army heading for the radio or TV station for a coup d’etat, but exports increase somewhat. Everybody is happy. Until the gunfire starts.

As theory, the IMF program would work superbly, as long as actual people or countries were not involved.

The problem is easily diagnosed — and crucial as it relates to the current situation in Asia. The IMF orthodoxy assumes an unlimited free movement of capital as a key aspect of the global free-trading system. The same idea was behind the recent push to sign a financial liberalization agreement under the auspices of the World Trade Organization. But the free movement of capital is exactly what the original inventors and proponents of free trade — Smith and Ricardo — warned would destabilize and destroy the system. The point is so important that it is worth briefly examining what Ricardo said on the subject.

Simply put, Ricardo held that in general, countries should focus on manufacturing those goods in which they had a comparative advantage and engage in trade for those goods that they were ill-equipped to make. The caveat was the assumption that free movement of capital was minimal.

Ricardo believed that there was a natural limit to the export of capital due to the “fancied or real insecurity of capital, together with the natural disinclination which every man has to quit th
e country of his birth, and intrust himself to a strange government and new laws.” The inability of capital to circulate across borders protected countries with limited natural advantages. Ricardo predicted that the free movement of capital in a free trade system would be a disaster for all but a handful of countries. If capital is imprisoned in a country, it will move to produce what it is best at, even if that output is of limited economic value — at least the country will not be drained of capital and all economic activity. Pathetic production is still better than starving in the streets, as quite a few Russians would be willing to testify.

follow the money

The Asian countries currently in the tender care of the IMF — Thailand, Indonesia, the Philippines and South Korea — would not seem to be candidates for the traditional IMF treatment. After all, they all have trade surpluses, high savings rates, export-based economies and relatively low inflation, and the Philippines itself has been under IMF monitoring for the past 30 years. Ah, but their financial systems are closed to foreign ownership, which on Planet IMF is the reason for excessive investment and misallocation of capital.

One more time? The World Bank, a sister agency of the IMF, was lending money to all four countries for infrastructure spending and studying additional projects. As was the Asian Development Bank, the banks of Japan, Europe and the United States, and for all I know, the Boy Scouts. The only discipline that would have ensued from foreign ownership of the banks in these countries is to cut out the local middleman — it wouldn’t have affected the absolute level of lending in the slightest. Foreigners couldn’t have pumped more capital into these economies without using transport aircraft to fly in currency.

Opening up these countries’ financial systems while causing a lending crunch and devaluations is deflationary. And we’ve seen what happens when an investment bubble turns into deflation — anyone for a few more Japans?< p>When the asset bubble was popped in Japan in the late ’80s most people agreed that it was long overdue. Unfortunately, the decline in stock and property prices submerged the economy. To correct the situation, Japan initially used a combination of low interest rates and government spending (approximately $700 billion) in a classic Keynesian demand-stimulus approach. The problem is that this spending just recycled very high levels of domestic savings that could not be profitably invested domestically. (Karl Marx predicted this outcome exactly in 1857 in the “Foundations of the Critique of Political Economy,” but let’s not get into that). When the stimulus stopped, the deflationary momentum accelerated, leading to the present collapse.

What the IMF is proposing for Asia, particularly South Korea, is this exact remedy. The credit crunch will cause a collapse in domestic demand and the Korean won, in the medium term, will strengthen as exports rise on the back of a devalued currency. Domestic spending will collapse as the government reduces spending, and as households save additional amounts due to increasing economic uncertainty. The marginal value of the export surplus will be limited by the fact that roughly one-third of the world’s population will be following an export-based strategy at the same time. Deflationary pressure will consume the economy once the artificial life-support system of the export regime dissipates.

Assuming, of course, that we even get to the implementation stage. The ability of the IMF to force even the reasonable changes it recommends — the breaking up of monopolies and the closing of insolvent banks, for example — has to be considered a dubious proposition, particularly in countries such as Thailand and Indonesia, where the owners of many of these banks are called “General” by their associates. But then the IMF has never allowed the prospect of utter social chaos to divert it from its mission.

big boomerang

The danger in all of this, of course, is not to a
handful of developing countries, but the Big Boomerang — a devaluation in China that takes down the Japanese financial system. For the moment I would still guess that the chance is less than 10% of a systemic problem developing. But the recent economic statistics out of China are worrying.

Consumption growth, which is probably a better economic indicator in China than gross domestic product, is clearly slowing, from about 12% to as little as 2% in September. A collapse in Korea would probably take out the Taiwan dollar and the Hong Kong dollar peg — and perhaps the yuan as well. Well, the IMF could just do its magic again couldn’t it? Before you get comfortable with that idea, chant the following names: Bank of China, Industrial & Commercial Bank of China, China Construction Bank and Agricultural Bank of China. The bailout of Korea is estimated at $60 billion. Each of these banks has bad debts exceeding $60 billion. And the Chinese economy is roughly the size of Canada’s.

time for a reality check

The situation in Asia will clearly mean higher trade deficits for the United States, and many Europeans are cutting their growth forecasts for the U.S. accordingly. Yet banks in the larger European countries have much larger exposure to Asian markets than their U.S. counterparts — roughly 3.5% of gross domestic product in Europe is tied to Asia, compared to less than 1% of GDP in the United States. In the absolute meltdown scenario, Europe would fare much worse than the United States, and Japan (4.5% of GDP) would implode. But it’s far too early to assume the worst.

On the bright side, there is a coherent philosophy behind the IMF’s behavior. Unfortunately, it has no corresponding relationship to reality. We had better understand the error of the economic orthodoxy that IMF “structural adjustment” represents or we are going to be looking back at the last few months of Asian financial meltdown as “the good old days.”

Mr. Tyson is chief investment officer and managing director of Bellevue,
Wash.-based Mastholm Asset Management LLC, an institutional international equity investment management firm.