The Old Economist's Almanac (Pacific Rim Edition)
By Jock O'Connell

(This is the author's text of an article that was published in the Sacramento Bee's Forum section on Sunday, July 26, 1998.)


No, it's not that deplorable habit tobacco-chewing baseball players have, although it admittedly sounds like it. Rather, it's the practice of divining the future by examining the entrails of sacrificial animals. It was all the rage in ancient times. But somewhere along the line, the folks at PETA evidently persuaded the soothsayers' guild --- no doubt already distressed by the size of their dry-cleaning bills -- to take up the study of economics instead.

So today, we can be reasonably sure that no animals have been harmed in the production of economic forecasts. Other than that, economic forecasting is not a business that should merit a high degree of confidence.

Much more often than not, the legions of market analysts and economic gurus who proffer advice --- usually for a very handsome fee, thank you ----wind up being confounded by events. William Sherden is a former member of the forecasting fraternity and the author of The Fortune Sellers, a scathing critique of his old profession. In it, he observes that all of the leading research on the accuracy of economic forecasting conclusively shows that, regardless of the sophistication of their models and theories, "economists cannot predict the turning points in the economy."

In the most recent debacle, economists and international market analysts have been guilty of a catastrophic failure to anticipate a catastrophe, namely the severe financial and economic crisis that has beset the Far East over the past year.

Although seemingly remote from everyday life, the quality of economic forecasts are important. At some point, every Californian relies at least implicitly on expert judgments about the nation's or the Golden State's economic prospects before taking a major financial plunge. Families mulling over a new home purchase, company executives pondering business expansion plans, investors looking for sound investment opportunities, and elected officials weighing the prudence of permanent tax cuts all make assumptions based on what they hear about the economy's future.

Unfortunately, the record of most economic forecasters leaves a great deal to be desired.

Since at least the early 1980s, the great majority of economists, international market analysts, and professional Asia-watchers had been routinely forecasting gloomy days for a profligate, self-indulgent America and a bright, sunny outcome for industrious, thrifty Asia. If the boys and girls over at Pundit Central reached a consensus about anything, it was that America's time had passed and that the 21st century firmly belonged to Asia.

Clearly, then, a funny thing happened on the way to the millennium.

During the last twelve months, a slew of Asia's hard-charging economies — beginning with Thailand but quickly including South Korea, Malaysia, Indonesia, and the Philippines --- have piled up in the casualty ward at the International Monetary Fund (IMF). Hong Kong's economic output declined during this year's first quarter. Taiwan's economy is starting to unravel, with its leading economic indicators the most dismal since the oil crisis of the early 1970s. Despite official protestations, China remains under intense pressure to devalue its currency. And Japan, the world's second-largest economy, is now officially mired in recession after nearly a decade of sluggish growth and is facing a momentous political crisis.

By contrast, the economic picture in the United States these days is enough to provoke an attack of giddiness. Unemployment is lower than it's been since 1970. June marked the country's 86th consecutive month of overall economic growth. The stock market, notwithstanding periodic fits, flirts with record highs. Consumer confidence stands at its highest level in 29 years, and, according to the latest Business Week/Harris Poll, business executives share this bullish sentiment. All this and an inflation rate that is hardly worth mentioning makes for a nation willing to forgive a President most anything. Even Alan Greenspan is pleased.

Exactly what happened in Asia -- in many ways the story of the scarlet ledger -- remains a matter of heated controversy.

One characteristic shared by mist postmortems of the Asian financial crisis is a tendency to confuse insight with hindsight. Where nearly every analyst last year perceived efficiency and industriousness, the prevailing revisionist view emphasizes corruption, cronyism, and institutional ineptitude. The widespread impression is that East Asia's enviable economic growth rates over the past two or three decades were premised not on enlightened economic policies or superior corporate management but on the sort of financial legerdemain usually associated with the eponymous schemer Charles Ponzi.

But if the crisis was the inevitable consequence of overvalued currencies, short-term capital inflows, less than transparent financial systems, or one of several other seemingly obvious (at least in retrospect) flaws in East Asian capitalism, how come so many reputable institutions invested so much money in the region?

Janet Yellen, chair of the President's Council of Economic Advisors, supplies the most compelling answer. In a speech this past April, she observed: "It seems fair to say that a year ago nobody suspected that such a calamity was remotely possible, although all of what are now described as the fatal flaws of the East Asian economies were widely understood even then, at least by experts."

Only a throatful of voices had been raising the possibility that the Asia economic miracle could falter. For the most part, pre-deluge assessments were much more upbeat as analysts chloroformed both clients and innocent by-standers with run-of-the-mill, mainstream cant.

Just a few months before the crisis began in July 1997, the chief economist for the San Francisco-based Asia Foundation assured a state Assembly committee in Sacramento of "how strong the economic fundamentals are in East Asia and the Pacific Region in general." He went on to insist that "there has not been a bursting of the bubble, but really a maturing in the ability of the East Asian economy to manage their economies."

There were also those who, over the past year, thought the crisis had bottomed out only to be then pushed aside by a new team of excavators.

At a February 17, 1998, meeting at Lincoln Plaza headquarters in downtown Sacramento, officials of the huge California Public Employees Retirement System met with representatives of four money management firms that help the pension fund manage its Pacific Rim investments. The consultants were cautiously optimistic. Like many other market analysts at the time, they were inclined to think the worst was over in Asia, except perhaps for Indonesia.

"We are beginning to see the start of the end of this crisis in some selected countries," the chief investment officer at Nomura Asset Management, told the CalPERS investment committee.

Later at the same meeting, a representative of Newport Pacific Management, sought to minimize the crisis. "'s really small portions of Asia's economies that are really the sick ones. It's Korea, Indonesia, Thailand and Malaysia, primarily. The vast majority of fundamentally quite sound and here we include Japan, what we call greater China (which is China, Hong Kong and Taiwan), and...Singapore."

Newport Pacific's man then predicted the Japanese and Chinese economies would "grow faster over the next six to 18 months than they're growing now."

Now that five months have past, the considered opinions of CalPERS' highly regarded (and well-compensated) consultants seem of dubious value. Since February, full- blown recessions have overtaken Hong Kong and Japan, where the bulk of CalPERS' East Asian investments have been parked. As a result, the economic future of the entire Far East looks grimmer than ever.

To be fair, misjudging the situation in Asia seemed to be par for the course.

The World Bank, the IMF, the big commercial banks, legions of international market analysts, and the world's principal credit-rating agencies all had things pretty much wrong.

IMF Managing Director Michael Camdessus conceded in a speech last month that the IMF had "admired the ‘Asian miracle' based on saving, prudent fiscal policies, investment in physical and human capital, and the liberalization and opening up—albeit in unequal measure—of economies."

Sure enough, in its May 1997 World Outlook, the IMF had "strongly praised Thailand's remarkable economic performance and the authorities' consistent record of sound macroeconomic policies."

Similarly less than prescient was the Economist Intelligence Unit, part of the Economist magazine group. The EIU publishes quarterly reports assessing economic and political conditions in several dozen countries around the world. In its report on South Korea dated May 30, 1997, the EIU predicted "economic growth will slow to 5.9% in 1997...but will rebound to 6.8% in 1998." By the end of the year, the Korean won had lost 70 percent of its value against the dollar, its economy had been thrown into reverse, and its stock market was in a shambles.

Some of the harshest criticism has been aimed at the major credit-rating agencies. Not only had these agencies failed to foresee the crisis, they were among the last to acknowledge its onset and severity.

Going a long way to deserve classification as lagging economic indicators, the two most important credit-rating agencies, Moody's Investors Service and Standard & Poor's, both continued to rank Thai government bonds as grade A until last October, three months after the baht's collapse. Both agencies only downgraded their ratings for Yamaichi Securities days before the Japanese investment house's bankruptcy last November. In the case of South Korea, the agencies had rated the country at the same level as Italy and Sweden as recently as last October. (South Korean securities were later downgraded to virtual junk bond status.)

In an unusually candid admission, Fitch IBCA, Europe's largest credit-rating agency, issued a statement in January admitting that not only it but its larger American rivals, Standard & Poor's and Moody's, had largely failed to predict the turmoil in Asia.

The firm said it and its competitors had underestimated the spread of "market contagion" in Asia. It had also failed to appreciate fully the impact that high levels of external private sector debt would have on the credit-worthiness of sovereign borrowers. Fitch and its competitors had also placed too much faith in the capabilities of Asian governments to take sensible decisions. "We over-estimated the sophistication of Asian policymakers, who have proved good fair weather navigators but very poor sailors in a storm," the Fitch statement read.

None of this speaks well for the skills of market analysts and economic forecasters. As the Bank of International Settlements Annual Report (June 1998) concludes: "Although some difficulties had been foreseen, the suddenness with which the crisis began, the relentless process of contagion across countries and the magnitude of the collapse in exchange rates and asset prices were all unexpected and unprecedented in recent times...the shock was all the greater in view of the emerging consensus that Asia was the model for the future."

Sorting out the cause of the Asian crisis is not a purely academic exercise. Valuable lessons can be learned about how the global financial system operates and whether aspects of it may have become dangerously dysfunctional.

One school of thought holds that the Far Eastern crisis was initially a financial crisis triggered by an abrupt, massive and largely unjustified shift in investor sentiment. According to this view, any relative weakening of the region's economic ‘fundamentals' was scarcely enough to have warranted the financial panic that occurred during the second half of 1997.

Unfortunately for the countries in question, an over-reaction by investors and creditors led to massive capital flight from the region. Furthermore, inadequate or inappropriate policy responses by domestic governments and international authorities drove the crisis ever deeper and wider. So as capital -- the lifeblood of any economic system -- was withdrawn, local economies slowed and faltered, seemingly justifying the earlier capital flight.

Perhaps the most prominent exponent of this thesis is Harvard economist Jeffrey Sachs, director of Harvard's Institute for International Development. Sachs writes that the crisis was largely " withdrawals by creditors cascaded into a financial panic and result in an unnecessarily deep contraction. The panic itself may be ‘rational' on the part of individual creditors, each of whom is trying to flee ahead of other creditors. But the collective result is disastrous." Sachs concludes that international financial markets "demonstrated a high degree of intrinsic instability." As such, he claims, "the Asian crisis has been as much a crisis of Western capitalism as Asian capitalism."

Economic affairs writer Robert Kuttner echoes this view. "The fundamentals of most Asian economies remain enviable — high savings rates, well-educated and disciplined workforces, high rates of productivity growth." To Kuttner, the real villain of the Asian crisis was "the short-term, often irrational character of financial markets."

Not exactly, counters MIT economist Paul Krugman who contends that the crisis in the Far East actually did reflect "an unsustainable deterioration in macroeconomic fundamentals and poor economic policies in the countries of the region." Structural factors set off the currency and financial crisis, even though investor over-reaction and a strong tendency toward herding -- as most major creditors and investors ran for the exits at the first whiff of trouble -- did help things spin out of control.

What is worth emphasizing is that in both Krugman's and Sachs' otherwise distinctive scenarios, creditors and investors were profoundly influenced at some point in the unraveling of the crisis more by their concerns about how other creditors and investors might react than by their expectations of how the region's economies would behave. Like many others casting about for culpable factors to explain Asia's downfall, IMF director Camdessus has pointed to "socioeconomic parameters" (read corruption, cronyism, nepotism, and unresponsive or inept governments).

But if that's the case, a familiarity with game theory or even psychology or organized criminal activity might be preferable than a narrow appreciation of economic fundamentals in predicting at least cataclysmic changes.

And that seems to the general direction in which the Pulitzer Prize-winning Harvard biologist Edward O. Wilson is moving in his influential new book, Consilience: The Unity of Knowledge. As Wilson observes, the bureaucratization of scientific inquiry appears to come between a great many scholars and the real world they seek to describe, explain, and occasionally predict.

If nothing else, the manner in which the Asian crisis unfolded reminds us that what passes for economic stability and growth is often just a thin, deceptively tranquil veneer masking a real world of enormous stress, flux and turbulence. Indeed, the prevailing mood of most economies -- even those in optimal circumstances -- was perhaps best captured by the Austrian-American economist Joseph Schumpeter in the classic phrase "creative destruction."

Since Schumpeter's days earlier this century, a potentially destabilizing new dynamic has been added to the mix. Advances in modern communications and computer technology means that what formerly took days or weeks now can be achieved almost instantaneously. Meanwhile, unimaginable volumes of stocks, bonds and currencies are traded daily. And, as in any situation where the premium is on speed, the collective edginess of the market grows more pronounced.

Unfortunately, those upon whom society relies to forecast major shifts in economic conditions have not proven to be especially reliable or consistent. The shame is that those who, a year ago, were full of assurances about Asia's economic vitality are today peddling their estimates of how long Asia economic recovery will take.

Unlike baseball players, whose every action becomes grist for a statistical mill that will haunt them for life, economists seldom have their batting averages flashed on the screen when they appear on television.

It's a pity there are no box scores for pundits.

Copyright(c)1998 by J.A. O'Connell