Partying Like It’s 1998

start with a country that, for whatever reason, became a favorite of foreign lenders, and experienced a large inflow of foreign capital over a number of years. Crucially, the debt thus incurred is denominated in foreign currency, not domestic (which is why the U.S., also a recipient of large inflows in the past, isn’t similarly vulnerable — we borrow in dollars).

.. Whatever the shock, the crucial thing is that foreign debt has made your economy vulnerable to a death spiral. Loss of confidence causes your currency to drop; this makes it harder to repay debts in foreign currency; this hurts the real economy and further reduces confidence, leading to a further decline in your currency; and so on.

.. Indonesia came into the ’90s financial crisis with foreign debt less than 60 percent of GDP, roughly comparable to Turkey early this year. By 1998 a plunging rupiah had sent that debt to almost 170 percent of GDP.

.. How does such a crisis end? If there is no effective policy response, what happens is that the currency drops and debt measured in domestic currency balloons until everyone who can go bankrupt, does. At that point the weak currency fuels an export boom, and the economy starts a recovery built around huge trade surpluses.

..  stop the explosion of the debt ratio with some combination of temporary capital controls, to place a curfew on panicked capital flight, and possibly the repudiation of some foreign-currency debt.

.. get things in place for a fiscally sustainable regime once the crisis is over.

.. Malaysia did this in 1998; South Korea, with U.S. aid, effectively did something like it at the same time, by pressuring banks into maintaining their short-term credit lines. A decade later, Iceland did very well with a combination of capital controls and debt repudiation (strictly speaking, refusing to take public responsibility for the debts run up by private bankers).

.. Argentina also did quite well with heterodox policies in 2002 and for a few years after, effectively repudiating 2/3 of its debt.

  • .. You need a government that is both
  • flexible and
  • responsible, not to mention
  • technically competent enough to implement special measures and
  • honest enough to carry out that implementation without massive corruption.