The Year Of the Paper Tiger: Asia Is in Economic As Well As Financial Crisis

Listener 14 February, 1998.

Keywords: Growth & Innovation; Macroeconomics & Money;

This column gets written about a month before it is first read. So there is a discipline to avoid instant comment which will prove facile a few weeks later. But the lead time also limits commenting on a rapidly unfolding scenario, as is occurring in East Asia. I have not been one to assume that the current bailout of this or that country by this or that institution will be the last, nor that the bailout will resolve quickly some underlying problem.

The problem is usually presented as a financial one, in which the Asian financial system is even more compromised that the Australasian ones in 1987. Certainly there are parallels but that it is not the full story. (The ideologues throw in that the crisis is also due to the high levels of intervention in the East Asian economies, which should be abandoned. They would, wouldn’t they? A few years ago they were extolling East Asia as unintervened economies we should imitate.)

The financial crisis is almost certainly on top of an underlying economic problem, explained by Joseph Schumpeter (1883-1950), who was the oxymoron of a great economist who had been a Minister of Finance. (He said he wanted to be a great horseman, a great lover, and a great economist, but only attained two of his goals.) His theory of economic growth integrated with the business cycle had a number of distinctive features centred around entrepreneurs, adventurist business people who introduce new innovations. Schumpeter had a wide definition of “innovation”, which included new products, new methods of production, new markets, new sources of raw materials, and reorganizing of industry. These innovations require credit, which the banking sector generates because of the profitable opportunities the innovations present. This credit flows into other ancillary investments and credit, so a significant innovation can generate a major credit expansion and an economic boom.

The innovations do not go on for ever, so the financial expansion becomes exhausted. Typically some of the judgements of the bankers prove faulty; some financial institutions become unsound, even if the financiers are of the highest prudence and integrity. A credit contraction follows, and production stagnates and contracts. Eventually the downswing peters out, like the upswing, but material output is higher at the end of the cycle. Thus economic growth and business cycles are intimately linked. (I argued similarly for New Zealand in my recent book In Stormy Seas, but the linkage is slightly different because Schumpeter is describing the core of the world economy and I was concerned with New Zealand on its periphery.)

The Schumpeterian description fits nicely with the East Asian experience, with its new products (especially the computer chip), new production technologies, and also the falling costs of international transport and communication. The entrepreneurial opportunities were financed by a credit expansion, including sucking in credit from outside the region. It over-reached itself, many of the financiers were not of the highest prudence and integrity, while some of those who loaned to them were imperceptive. There is a lot more detail which could be added to the story, including the stagnation of the Japanese economy for most of this decade and the growth from rural Asians pouring into work in the cities. But the central feature is a cycle of new innovation, credit boom, innovation petering out, and credit bust.

If this Schumpeterian account has any significance, it suggests that we may be facing a prolonged economic contraction which will not be resolved by international finance lending to the failing East Asian financial system (even if that is necessary to prevent a world financial crash). The innovation period may be over, although East Asian and world economies will settle at a higher level of production than before the boom began. We await a new cluster of innovations to lift the world economy to a higher level, albeit with a new boom and bust cycle.

Note how Schumpeter’s vision clashes with the usual picture of steady economic growth, in which the business cycle is an irritating irrelevance (and whose advocates promise the end of the cycle). As Schumpeter said “economic progress in capitalist society means turmoil”. It is a rising helter skelter, with an exhilarating upswing and much sickness on the downswing.

New Zealand has benefited from the East Asian boom which bought our exports and sold us cheap products. We will similarly suffer during the downswing. While we have diversified exports by destination there is too big a proportion of the world economy exposed to Asia for us to avoid this crisis. And while New Zealand diversified from over-dependence on pastoral exports, we are still primarily a commodity exporter. Commodity prices swing more over the business cycle, up and down. We have failed to promote elaborately transformed manufactures which are more stable. I am still pondering on the forestry company which announced, with regret, that because Asia was buying fewer logs, the timber would have to be processed in New Zealand.