In retrospect, all fools become wise. — Ludwig von Mises

In the November/December 1994 issue of Foreign Affairs, Stanford economist Paul Krugman wrote a controversial article titled “The Myth of Asia’s Miracle.” He argued that, like Stalinist Russia and other centrally planned economies of Eastern Europe, the Southeast Asian nations were authoritarian and engaged in “growth achieved purely through mobilization of resources” rather than real productivity. He predicted that growth would continue, but at a slower pace. In sum, these Asian tigers were subject to the law of diminishing returns.

In my July 1996 Freeman column, I disputed Krugman’s thesis, countering that they had adopted sound principles of economics, such as budget surpluses, low taxes on investment, no welfare schemes, and high levels of saving and investment.

Krugman proved to be more accurate, although the reasons for the Asian crisis are more complex than either one of us realized.

As I see it, there were two factors at work that led to the collapse in the Asian markets and recession. First, overinvestment, and second, the strength of the U.S. dollar. Let’s review each of these factors and the lessons we can learn from each.

Malinvestment and the Boom-Bust Cycle

First, it is clear that most of the Southeast Asian economies, including Singapore, Thailand, Malaysia, the Philippines, and South Korea, suffered from overinvestment, or what Ludwig von Mises called “malinvestment.” The authoritarian regimes engaged in a “forced savings” program, demanding its citizens and businesses to overinvest. When voluntary savings were deemed insufficient to build up the nation’s infrastructure and capital formation, the state promoted industrial planning. Moreover, it created cheap credit policies and encouraged foreign investment at low interest rates. In sum, Southeast Asia created a classic inflationary boom.

The Austrian school has warned time and time again that an inflationary boom in capital investment not only causes prices to rise, but also makes unsustainable projects look attractive. Eventually, interest rates must rise and the economy is hit by a recession.[1]

The Dollar as a Quasi-Gold Standard

What brought about the crash in Asia? Strangely enough, it was the strength of the U.S. dollar. While not predicting the Asian crisis, I did forecast a strong dollar in the second half of the 1990s. I just failed to think through all the ramifications of a strong dollar around the world.

Most of the Southeast Asian currencies were tied to the dollar, and that was their demise. In some ways, it reminds me of the specie-flow mechanism under the gold standard. Under a classic gold standard, when a nation inflates, gold flows out of the inflationary country, forcing the economy to contract. That’s more or less what happened in Southeast Asia, except that instead of gold, the standard was the U.S. dollar.

When the dollar rose 30 percent against the other major currencies, Southeast Asian economies that were export-oriented and linked to the dollar, were placed at a disadvantage. Their exports suddenly became 30 percent more expensive, and demand for their goods declined. Exports dropped, profits fell, and debts couldn’t be repaid at current exchange rates. Consequently, their governments were forced to delink from the dollar and their currencies collapsed. The boom turned into a bust.

Silver Lining: Free-Market Reforms Coming

There is a silver lining in the Asian crisis. It is forcing Southeast Asian countries and their governments to adopt market capitalism. No longer can these authoritarian regimes afford to subsidize favored corporations or play political favorites. Inefficient or corrupt businesses must be allowed to go bankrupt. Easy credit is not the solution to a shortage of capital. In all this, Business Week has sounded the alarm and warned Asia not to fall back to angry nationalism or anti-capitalism. This is all the more amazing because Business Week has long had the reputation for being anti-free market. But it has changed for the better. To quote a recent editorial: “There is a strong chance that the Asian crisis can act as a solvent, dissolving authoritarian governments and economic practices while spreading democratic market capitalism” (January 26, 1998). Amen.