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    May 28, 2010

    Bitter Financial Medicine


    HONG KONG — The more one compares the 1997 Asian crisis and the ongoing Western-centered one, the gloomier one gets about prospects for the latter.

    The feared “double dip” in economic output may not happen, but from this Eastern perspective, sustained Western recovery looks very difficult because the trajectories of the two crises have been so different.

    Worse, the structure of global finance that has provided the West with a cushion now makes it more difficult for other regions to help pull the West back up in the same way as the West helped Asia.

    Within two years of the onset of the Asian crisis, not only had recovery begun but most of fundamental causes of the crisis had been addressed. This was not the result of any particular virtue but of sheer necessity. Asia’s dependence on dollars forced massive devaluations that in turn caused huge corporate bankruptcies and bank failures.

    In all three of the worst-affected countries — South Korea, Indonesia and Thailand — governments reluctantly made a virtue out of the trade liberalization, corporate reform, high interest rates and tight budgets forced on them by the International Monetary Fund. As much of the private sector foreign debt had to be written off, the pain was partly shared by foreign banks and investors.

    The need of governments to rescue failing banking systems caused huge rises in government debt from modest levels to over 80 percent of gross domestic product in Indonesia and 70 percent in Thailand. But the inability to borrow more forced them to live with small deficits. They could not borrow their way out of the economic slump.

    The immediate consequences were grave jobs losses and the destruction of middle class wealth. Governments changed but democracy flourished and social and economic structures survived. Two years of intense pain and financial sector reform set the stage for a decade of steady if unremarkable growth. Public debt has fallen to only around 30 percent of G.D.P. in all three countries and foreign exchange reserves have ballooned.

    Now look Westward. Because of their deep bond markets and the reserve currency status of dollars, euros and the pound, nations have been able to continue with massive government deficits on top of the billions needed for bank bail-outs. The recession has been mild by Asian standards. But not much has changed in the fundamentals. Banking may be partly reformed but policies that push millions of people into personal bankruptcy in the U.S. are more difficult politically than the bankruptcy forced on many of Asia’s deeply indebted companies. Europe is unwilling to bite the bullet and admit that holders of Greek government debt will have to take big losses.

    The U.S. and Europe both face an easily foreseen dilemma. Should they continue with massive deficits to prevent slippage back into recession? Or admit that the bigger danger is from the level of debt itself. Europe’s case is complicated by the imbalances within the region that require currency and labor market changes, not just cuts in deficits.

    A decade ago Asia had other advantages — youthful populations and ongoing industrialization, which provided natural economic growth rates of 3 to 5 percent. Europe’s workforce is virtually static, America’s is growing only slowly, and both are aging fast. Moreover, the United States, Britain and Australia were able to use borrowing in their own currencies to finance massive trade deficits — allowing Asia to recover through export-led growth.

    In theory, Asia should now be able to provide the West with its own export-led recovery. However, Asia remains mostly unwilling to change its export-or-die mindset. China’s trade surplus has come down but America’s overall deficit is going back up, a sign of short term recovery in U.S. demand but evidence that underlying imbalances remain to be addressed.

    The dominance of the dollar and the euro in trade and finance and the skittishness of financial markets impede international usage of even the freely traded currencies of Asia like the Korean won. In turn, this increases the defensiveness of these countries while providing the West with an ability to continue with unsound policies based on ready financing for government debt.

    However, as bond market investors grow ever more wary of bulging deficits, government borrowing costs will explode, serving a dose of the sort of medicine the I.M.F. forced on Asia. In the long run that would be good for the West and force Asia to find new avenues of growth. It will not be fun, but it will work.