The Proper Degree of Panic

When emerging-market economy after emerging-market economy starts to fall like proverbial dominos under the pressure of foreign capital flight, it’s accurate to say that we’re watching the bursting of a speculative bubble. And the spread of fear from Asia to Russia and now to Latin America, a spread that appears to be taking place without much regard for the very different economic fundamentals in work at each place, does have the look of a speculative panic. But in the rush to describe the recent turmoil as simply a fit of collective market irrationality, it’s easy to overlook some important truths that underlie what’s happened, not just in Asia but also in Latin America.

The best example of this is Brazil. Last week Brazil looked like it was on the verge of devaluing its currency. This week the country has enjoyed a remarkable stock-market rally that’s sent the market up 45 percent in three days. (A rally that itself smacks of some hysteria, it has to be said.) Brazil is obviously key to the entire future of Latin America, and for that matter of the global economy. And under President Fernando Henrique Cardoso, the country has made a remarkable recovery from the days of hyperinflation and high unemployment. In that sense, the punishment Brazil has taken at the hands of currency traders in the past few months must have been difficult to bear. And it’s understandable why economists like Joseph Stiglitz of the World Bank would argue that investors willing to put their money into Brazil are demanding interest rates too high for the small amount of risk involved. But the truth is that Brazil in some sense was asking for trouble.

Earlier this year, after pushing through a constitutional amendment that would allow him to run for president again, Cardoso promised to push through spending cuts (or, more unlikely, tax increases) that would trim the country’s budget deficit. Almost none of those cuts have been realized, in part because Cardoso is in an election campaign and doesn’t want to alienate anyone. As a result, Brazil’s budget deficit is now 9 percent of the country’s GDP. The equivalent for the United States would be a budget deficit of $630 billion. With a deficit that size, is it really surprising that interest rates are high, or that currency traders are skeptical of the value of the Brazilian real? For all the good that he’s done, Cardoso has essentially been living on IOUs for the past year. At some point those were bound to come due.

The same is true of the Asian countries that have been hit hardest in the past year. In Asia, the problem was not, given the relatively small size of the state sector, government borrowing, but rather the current-account deficit. Far from running trade surpluses, countries like Thailand and Malaysia were running trade deficits, which they could only finance by importing foreign capital. And living on short-term foreign capital is a little bit like living on money you’ve borrowed from a guy named Rocco: The vigorish is running the whole time, and eventually he’s going to come knocking on your door. The difference is that instead of breaking your legs, hedge funds just pull the chair out from under you and leave.

Speculative crises clearly do occur, and when they do the healthy as well as the sick take the pain. But with few exceptions, the countries that have suffered most were those whose underlying economies could not support the level of debt they were accumulating. Global markets have certainly overreacted to emerging-market problems, and the pain inflicted is out of proportion to the weaknesses of these economies. (More importantly, the people feeling the pain are not those who got these countries into the mess in the first place.) But busts follow booms when those booms are characterized by cheap credit and unproductive investment. That’s because those booms are fundamentally illusions, and eventually people wake up. The waking up has been overdone. But to see what’s happened as simply some unprovoked epidemic of fear is a guarantee that we’ll make the same mistakes again. After all, it’s the United States that has the biggest current-account deficit in the world.