The Dismal Science
Illustration by Robert Neubecker Paradigms of Panic
Asia goes back to the future.

By Paul Krugman
(posted Thursday, March 12)

       There were warning signs aplenty. Anyone could have told you about the epic corruption--about tycoons whose empires depended on their political connections and about politicians growing rich in ways best not discussed. Speculation, often ill informed, was rampant. Besides, how could investors hope to know what they were buying, when few businesses kept scrupulous accounts? Yet most brushed off these well-known vices as incidental to the real story, which was about economic growth that was the wonder of the world. Indeed, many regarded the cronyism as a virtue rather than a vice, the signature of an economic system that was more concerned with getting results than with the niceties of the process. And for years, the faint voices of the skeptics were drowned out by the roar of an economic engine fueled by ever larger infusions of foreign capital.
       The crisis began small, with the failure of a few financial institutions that had bet too heavily that the boom would continue, and the bankruptcy of a few corporations that had taken on too much debt. These failures frightened investors, whose attempts to pull their money out led to more bank failures; the desperate attempts of surviving banks to raise cash caused both a credit crunch (pushing many businesses that had seemed financially sound only months before over the brink) and plunging stock prices, bankrupting still more financial houses. Within months, the panic had reduced thousands of people to sudden destitution. Moreover, the financial disaster soon took its toll on the real economy, too: As industrial production skidded and unemployment soared, there was a surge in crime and worker unrest.

But why am I telling you what happened to the United States 125 years ago, in the Panic of 1873?
       Anyone who claims to fully understand the economic disaster that has overtaken Asia proves, by that very certainty, that he doesn't know what he is talking about. The truth is that we have never seen anything quite like this, and that everyone--from the country doctors at the International Monetary Fund and the Treasury Department who must prescribe economic medicine to those of us who have the luxury of irresponsibility--is groping frantically for models and metaphors to make sense of this thing. The usual round of academic and quasiacademic conferences and round tables has turned into a sort of rolling rap session, in which the usual suspects meet again and again to trade theories and, occasionally, accusations. Much of the discussion has focused on the hidden weaknesses of the Asian economies and how they produced fertile ground for a financial crisis; the role of runaway banks that exploited political connections to gamble with other people's money has emerged as the prime suspect. But amid the tales of rupiah and ringgit one also hears surprisingly old-fashioned references--to Charles Kindleberger's classic 1978 book Manias, Panics, and Crashes, and even to Walter Bagehot's Lombard Street (1873). Asia's debacle, a growing number of us now think, is at least in part a souped-up modern version of a traditional, 1873-style financial panic.
       The logic of financial panic is fairly well understood in principle, thanks both to the old literary classics and to a 1983 mathematical formalization by Douglas Diamond and Philip Dybvig. The starting point for panic theory is the observation that there is a tension between the desire of individuals for flexibility--the ability to spend whenever they feel like it--and the economic payoff to commitment, to sticking with long-term projects until they are finished. In a primitive economy there is no way to avoid this tradeoff--if you want to be able to leave for the desert on short notice, you settle for matzo instead of bread, and if you want ready cash, you keep gold coins under the mattress. But in a more sophisticated economy this dilemma can be finessed. BankBoston is largely in the business of lending money at long term--say, 30-year mortgages--yet it offers depositors such as me, who supply that money, the right to withdraw it any time we like.

Illustration by Robert Neubecker What a financial intermediary (a bank or something more or less like a bank) does is pool the money of a large number of people and put most of that money into long-term investments that are "illiquid"--that is, hard to turn quickly into cash. Only a fairly small reserve is held in cash and other "liquid" assets. The reason this works is the law of averages: On any given day, deposits and withdrawals more or less balance out, and there is enough cash on hand to take care of any difference. The individual depositor is free to pull his money out whenever he wants; yet that money can be used to finance projects that require long-term commitment. It is a sort of magic trick that is fundamental to making a complex economy work.
       Magic, however, has its risks. Normally, financial intermediation is a wonderful thing; but now and then, disaster strikes. Suppose that for some reason--maybe a groundless rumor--many of a bank's depositors begin to worry that their money isn't safe. They rush to pull their money out. But there isn't enough cash to satisfy all of them, and because the bank's other assets are illiquid, it cannot sell them quickly to raise more cash (or can do so only at fire-sale prices). So the bank goes bust, and the slowest-moving depositors lose their money. And those who rushed to pull their money out are proved right--the bank wasn't safe, after all. In short, financial intermediation carries with it the risk of bank runs, of self-fulfilling panic.
       A panic, when it occurs, can do far more than destroy a single bank. Like the Panic of 1873--or the similar panics of 1893; 1907; 1920; and 1931, that mother of all bank runs (which, much more than the 1929 stock crash, caused the Great Depression)--it can spread to engulf the whole economy. Nor is strong long-term economic performance any guarantee against such crises. As the list suggests, the United States was not only subject to panics but also unusually crisis-prone compared with other advanced countries during the very years that it was establishing its economic and technological dominance.

Why, then, did the Asian crisis catch everyone by surprise? Because there was a half-century, from the '30s to the '80s, when they just didn't seem to make panics the way they used to. In fact, we--by which I mean economists, politicians, business leaders, and everyone else I can think of--had pretty much forgotten what a good old-fashioned panic was like. Well, now we remember.
       I'm not saying that Asia's economies were "fundamentally sound," that this was a completely unnecessary crisis. There are some smart people--most notably Harvard's Jeffrey Sachs--who believe that, but my view is that Asian economies had gone seriously off the rails well before last summer, and that some kind of unpleasant comeuppance was inevitable. That said, it is also true that Asia's experience is not unique; it follows the quite similar Latin American "tequila" crisis of 1995, and bears at least some resemblance to the earlier Latin American debt crisis of the 1980s. In each case there were some serious policy mistakes made that helped make the economies vulnerable. Yet governments are no more stupid or irresponsible now than they used to be; how come the punishment has become so much more severe?

Part of the answer may be that our financial system has become dangerously efficient. In response to the Great Depression, the United States and just about everyone else imposed elaborate regulations on their banking systems. Like most regulatory regimes, this one ended up working largely for the benefit of the regulatees--restricting competition and making ownership of a bank a more or less guaranteed sinecure. But while the regulations may have made banks fat and sluggish, it also made them safe. Nowadays banks are by no means guaranteed to make money: To turn a profit they must work hard, innovate--and take big risks.
       Another part of the answer--one that Kindleberger suggested two decades ago--is that to introduce global financial markets into a world of merely national monetary authorities is, in a very real sense, to walk a tightrope without a net. As long as finance is a mainly domestic affair, what people want in a bank run is local money--and, guess what, the government is able to print as much as it wants. But when Indonesians started running from their banks a few months ago, what they wanted was dollars--and neither the Indonesian government nor the IMF can give them enough of what they want.
       I am not one of those people who believes that the Asian crisis will or even can cause a world depression. In fact, I think that the United States is still, despite Asia, more at risk from inflation than deflation. But what worries me--aside from the small matter that Indonesia, with a mere 200 million people, seems at the time of writing to be sliding toward the abyss--is the thought that we may have to get used to such crises. Welcome to the New World Order.

If you missed our previous link to the sidebar, click here.


One-stop shopping may be found at the mother of all Asia crisis pages, maintained by New York University's Nouriel Roubini. Does Roubini still have a day job?

Paul Krugman is a professor of economics at MIT whose books include The Age of Diminished Expectations and Peddling Prosperity. His home page contains links to many of his other articles and essays.

Illustrations by Robert Neubecker.

Slate contents
Slate Search

More The Dismal Science
More by Paul Krugman
Search Slate: