Who poisoned Asia's currency markets?
By Paul Krugman
posted Thursday Aug. 14)
cherish the memory of George Brown, Britain's minister of economic affairs
in the mid-1960s--the man who blamed his troubles on the "gnomes of
Zurich." (He was misinformed; the relevant gnomes are actually in
But we may have
to remove Brown from his pedestal, and make room for Malaysian Prime Minister
Mahathir Mohamad. Last month Malaysia's neighbor Thailand, after months
of promising that it wouldn't, devalued the baht; and spooked investors
began selling Malaysian ringgits (and Philippine pesos, Indonesian rupiahs,
and so on) as well. This provoked an outburst on Mahathir's part that surely
counts as an instant classic. Where Brown was vague about both the identity
of the villains and their motives, Mahathir had a full-fledged conspiracy
theory: The U.S. government had prompted palindromic speculator George
Soros to undermine Asia's economies, because it wants to impose Western
values (like democracy and civil rights) on them. And Mahathir's ministers
expanded on his remarks with a rhetoric that was unusual for a government
with a long-term interest in maintaining the goodwill of international
investors: Currency fluctuations are caused by "hostile elements bent
on ... unholy actions" that constitute "villainous acts of sabotage"
and "the height of international criminality."
remarks were entertaining both because, as far as we can tell, Soros was
not a major player in the crisis (indeed, he seems to have taken a bit
of a bath by failing to anticipate this one), and because in the early
1990s one of the world's most ambitious and reckless currency speculators
was ... Malaysia's government-controlled central bank, which got out of
the business only after losing nearly $6 billion.
Currency crises often provoke hysterical
reactions in government officials. One day your country's economy is humming
along nicely, your bonds are triple-A, you have billions of dollars in
foreign exchange reserves socked away. Then all of a sudden the reserves
are depleted, nobody will buy your paper, and you can only keep money in
the country by raising interest rates to recession-inducing levels. How
can things go wrong so fast?
standard response of economists is that to blame the financial markets
in such a situation is to shoot the messenger, that a crisis is simply
the market's way of telling a government that its policies aren't sustainable.
You may wonder at the abruptness with which that message is delivered.
But that, says the canonical model,
is simply part of the logic of the situation.
To see why, forget about currencies
for a minute, and imagine a government trying to stabilize the price of
some commodity, such as gold. The government can do this, at least for
a while, if it starts with a sufficiently large stockpile of the stuff:
All it has to do is sell some of its hoard whenever the price threatens
to rise above the target level.
suppose that this stockpile is gradually dwindling, so that far-sighted
speculators can foresee the day--perhaps many years distant--when it will
be exhausted. They will realize that this offers them an opportunity. Once
the government has exhausted its stockpile, it can no longer stabilize
the price--which will therefore shoot up. All they have to do, then, is
buy some of the stuff a little while before the reserves are gone, then
resell it at a large capital gain.
But these speculative purchases of
gold or whatever will accelerate the exhaustion of the stockpile, bringing
the day of reckoning closer. So the smart speculators will try to get ahead
of the crowd, buying earlier--and thereby running down the stocks even
sooner, leading to still earlier purchases. The result is that, while the
government's stockpile may decline only gradually for a long time, when
it falls below some critical point, all hell suddenly--and predictably--breaks
loose (as actually happened in the gold market in 1969).
a bit of imagination this same story can be applied to currency crises.
Imagine a government that is trying to support the dollar value of the
ringgit--or, what is the same thing, to keep a lid on the price of a dollar
measured in ringgits--through foreign exchange market "intervention,"
which basically means selling dollars to keep the ringgit price down. And
suppose the government's policies are, for whatever reason, inconsistent
with keeping the exchange rate fixed forever. Then there is a complete
parallel with the previous story, with foreign exchange reserves taking
on the role of the gold stockpile. And by the same logic as before, we
can conclude that speculators will not wait for events to take their course:
At some critical moment they will all move in at once--and billions of
dollars in reserves may vanish in days, even hours.
The abruptness of a currency crisis,
then, does not mean that it strikes out of a clear blue sky. In the standard
economic model, the real villain is the inconsistency of the government's
Mahathir's complaint therefore unadulterated nonsense? No--as Art Buchwald
once said of his own writing, it is adulterated nonsense. The truth is
that speculators may not always be quite as blameless as the standard model
would have it.
For one thing, markets aren't always
cool, calm, and collected. There is abundant evidence that financial markets
are subject to occasional bouts of what is known technically as "herding";
everyone sells simply because everyone else is selling. This may happen
because individual investors are irrational. It may also happen because
so much of the world's money is controlled by fund managers, who will not
be blamed if they do what everyone else is doing. One consequence of herding,
however, is that a country's currency may be subjected to an unjustified
It is also true that the long-term
sustainability of a country's policies is to some extent a matter of opinion--and
that policies that might have worked out, given time, may be abandoned
in the face of market pressures. This leads to the possibility of self-fulfilling
prophecies--for example, a competent finance minister may be fired because
of a currency crisis and the irresponsible policies of his successor end
up ratifying the market's bad opinion of the country.
this, in turn, creates a possible way for private investors with
big enough resources to play a nefarious financial game. Here's how it
would work, in theory: Suppose that a country's currency is in a somewhat
ambiguous situation--its current value might be sustainable, or it might
not. A big investor quietly takes a short position in that country's currency--that
is, he borrows money in pounds, or baht, or ringgits, and invests the money
in some other country. Once he has a big enough position, he begins ostentatiously
selling the target currency, gives interviews to the Financial Times
about how he thinks it is vulnerable, and so on. With luck he provokes
a run on the currency by other investors, forcing a devaluation that immediately
reduces the value of those carefully acquired debts, but not the value
of the matching assets, leaving him hundreds of millions of dollars richer.
In short, speculative sharp practice
can play a role in destabilizing currencies. But how important is
that role in reality?
George Soros pulled the trick off in Britain in 1992, but as far as anyone
knows, even he has done it only once. True, it was an amazing coup: He
is supposed to have made more than a billion dollars. It's also true, however,
that there were good reasons for the pound's devaluation, and it is unclear
whether Soros really caused the crisis or was merely smart enough to anticipate
it. Maybe he brought it on a few weeks early.
The other currency crises of the '90s--and
it has been a great decade for such crises--have taken place without the
help of sinister financial masterminds. This is no accident; opportunities
like the one Soros discovered in 1992 are rare. They require that a country's
currency be vulnerable, but not yet under attack--a narrow window at best,
since there is a sort of Murphy's Law in these things: If something can
go wrong with a currency, it usually will. Financial markets are not in
the habit of giving countries the benefit of the doubt.
this mean that there is no defense against speculative attack? Not at all.
In fact, there are two very effective ways to prevent runs on your currency.
One--call it the "benign neglect" strategy--is simply to deny
speculators a fixed target. Speculators can't make an easy profit betting
against the U.S. dollar, because the U.S. government doesn't try to defend
any particular exchange rate--which means that any obvious downside risk
is already reflected in the price, and on any given day the dollar is as
likely to go up as down. The other--call it the "Caesar's wife"
strategy--is to make very sure that your commitment to a particular exchange
rate is credible. Nobody attacks the guilder, because the Dutch clearly
have both the capability and the intention of keeping it pegged to the
Oh yes, there is also a third option.
You can erect elaborate regulations to keep people from moving money out
of your country. Of course, if investors know that it will be hard to get
money out, they will be reluctant to put it in to begin with. There is
a case to be made--an unfashionable case, but not a totally crazy one--that
it is worth forgoing the benefits of capital inflows in order to avoid
the risk of capital outflows. But Asian leaders uttered not a word of complaint
when they were receiving huge inflows of money, much of it going to dubious
real-estate ventures. Only when irrational exuberance turned into probably
rational skittishness did the accusations begin.
So Mahathir's claims that he is the
victim of an American conspiracy are just plain silly. He has nobody but
himself to blame for his difficulties. Or at least that's what George,
Bob, and Madeleine told me to say.
The Federal Reserve Bank of San Francisco posts an essay
speculation. One trading firm maintains a whimsical A-Z
of market crashes. The Soros Foundations Network Web site includes
a George Soros
page, complete with a bio, personal statements, and speeches in
RealAudio. The PACIFIC group at the University of British Columbia charts
of currencies, listing denominations, currency regimes, and a link
to daily exchange rates. Traveloco offers this useful currency
converter. Also, see Paul Krugman's piece on the crisis
in Mexico, as well as Bradford De Long's essay
on the same topic.
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.