On a number of occasions during recent months economists have come under attack on this list for flawed analysis and failure to predict major economic events such as the Asian flu. I have argued that such attacks were unjustified, much like blaming geophysicists for not being able to predict the timing and magnitude of an earthquake. However, I had little at hand that would permit me to say that someone, using good economic analysis, did indeed predict the events which have occurred in Asia during the past couple of years, and which are now spilling over into a global recession.
I now have the ammunition I need. On a recent trip, I took "Pop Internationalism", a short book of essays by Paul Krugman, along for my spare-time reading. Krugman, for those who do not know him, is both a staunch defender of economic analysis as taught by competent professors at universities and a highly intelligent practitioner of economics.
One of his essays, "The Myth of Asia's Miracle", originally published in the journal "Foreign Affairs" in November/December, 1994, deals with the nature of growth among the Asian tiger economies. In it, Krugman argues that the miraculously high growth rates manifested by Asian economies in the 1980s and 1990s could not be sustained because they were "input driven", and did not result in any significant increases in productivity. Essentially, high growth was achieved by adding continuous units of identical or similar inputs to production. Each unit was capable of producing about as much as the last one, little more or little less. Consequently, two things had to happen, both of which are well grounded in conventional economics: inputs would eventually run out, and successive inputs would encounter diminishing returns.
Economics 101 suggests that, given demand, a growing scarcity of inputs would result in increasing input price. What may have happened in Asia is that price did not generally rise, but inputs of lower quality were increasingly put into production at the given price. It would in fact seem that the inputs used during the most recent periods of growth were of such poor quality that they resulted in widespread business failure. Because they were financed by bank loans, which in turn were often financed by foreign borrowing, they brought down the banking sector when investors began to realize their predicament and to withdraw their capital. (Decision making in the banking sector was also of poor quality, which didn't matter initially, but mattered a great deal in the later stages of the growth process.)
This was one part of the problem. Diminishing returns was the other. Economists have long recognized that simply applying successive units of approximately identical inputs to a fixed resource base would eventually result in diminishing returns. However, a nation could counter the drag of diminishing returns by innovating and raising the productivity of successive inputs. Krugman argues that the failure to innovate - to make successive units of inputs more efficient and productive - was at the very heart of the Asian problem.
This, of course, is not the whole story. There was a significant improvement in Asian inputs during the early stages of rapid growth. A high standard of education was achieved, for example. However, such positive factors were of insufficient consequence to outweigh cultural factors such as including friends, "cronies" and family in business ventures even if this did not make good economic sense. As well, the tiger economies, while nominally "free enterprise", were covertly governed by obligatory rules and observances which dampened competition, and hence the discipline and drive to innovate which competition implies.
Krugman was, as mentioned, unable to predict the timing and magnitude of the Asian meltdown. However, he was correct in pointing out that the high rates of growth that the Asian economies had achieved was unsustainable and that something would necessarily have to give.
It might be noted - as Krugman does - that this is not the first time that input driven growth has brought economic ruin. Input driven, but essentially not innovative, the Soviet economy grew very rapidly during the 1920s and 1930s, but then slowed down, ground to a halt and finally came apart. Measures such as "perestroika" and "shock therapy" were about as meaningful as flogging a horse that had already died.
It might also be noted that the Asian meltdown is most often viewed as a financial crisis. It is that, but if we follow Krugman, it is also much more than that. It became a financial crisis only after it had become a more generalized economic crisis - a crisis which was in the process of gestation for many years before its financial aspects became manifest. It is, however, true that its method of transmission to the rest of the world was essentially financial. The process went something like this: First, Asian growth was in part fueled by high rates of domestic savings, but also in part by foreign investment. When things began to come apart, both domestic and foreign investors pulled their money out and sought safe havens, forcing currency devaluations. Second, anxiety about "emerging markets" in general spread among investors, and money began to move out of relatively safe countries such as Brazil. And third, a more general anxiety ensued, resulting in large losses in the bourses of the safe haven countries of Europe and North America.
It is probable that the crisis is far from over. The situation we have now is one in which economies are not functioning well, investors are confused, and everyone is waiting for the other shoe to drop. And there is an anxiety abroad that it may be a very big shoe.
Ed Weick
