Japan, the Fed and the Asian Crisis

Abstract

The Asian Crisis of 1997-1998 represented the biggest shock to the global economy of the post-WWII period up to that point. Paradoxically, the crisis economies happened to be the Asian members of the group of so-called "emerging markets" – the best and the brightest of the industrializing economies, the ones that had managed to forge ahead of the others and to establish themselves as the next group of economies seemingly destined to graduate to industrialized country status. This paper argues that these economies did not self-select for crisis through unusually bad policies; accordingly it makes sense to look to external factors. Intuitively, big waves are caused by big ships. The two biggest ships in the Asia Pacific at the time were the United States and Japan. Accordingly, the paper examines relevant policies of these two economies to explain the rogue waves that capsized smaller East Asian economies and subsequently other emerging markets. Three specific developments in the lead-up to the Crisis are identified as key contributing factors: Japan's withdrawal of fiscal and monetary stimulus in the belief that its economy had returned to a sustainable growth path, which reduced economic support for East Asia immediately prior to the Crisis; the Federal Reserve Board's decision to accommodate the nascent "bubble" in the U.S. financial markets which triggered a massive flow of funds into industrialized countries' asset markets; and Japan's policy decision to rapidly write-down non-performing assets in its banking system which constrained Japanese banks ability to provide liquidity support to clients in Southeast Asian economies when they came under pressure. The withdrawal of economic support from Japan and the tidal flow of capital towards the United States and other industrialized country asset markets resulted in a liquidity crisis in emerging Asian markets. Remedial measures based on the misdiagnosis of the event as a solvency crisis in the impacted economies served to worsen the situation.