THE BENEFITS OF BANKRUPTCY

In the present discussion, the advantage of principle belongs to the left- labor Democrats and the Buchanan Republicans. They are forthright in deploring the “excesses” of global capitalism and the free movement of financial and physical capital. The administration’s position, for its part, has the advantage of being the official stance of the United States. The theme is “responsible management”: Foreign governments whose economies are in trouble will get access to billions of dollars of hard currency, in return for which they will promise to make internal reforms recommended by the IMF and other multilateral agencies. The model for this approach is Mexico.

In 1995, an American cum IMF program arguably prevented the Mexican government from defaulting on its obligations. More than a transfer of cash was involved: The markets inferred that the U.S. Treasury effectively stood behind Mexican government obligations. A major devaluation of the peso allowed the country to earn back through exports the hard currency it had borrowed. Although Mexican living standards took a dive, the international investors who bought Mexican government debt were repaid, and so was the U.S. government. Mexico, therefore, is touted as a “costless” model for buying global financial stability.

When it comes to the Asian crisis, however, neither a Mexican-style bailout nor the Economic Nationalists’ high-risk program of retreat from the world addresses the problem at its core. Nor is the right course some middle ground between the administration and the anti-globalists. Only markets, with their built-in mechanisms for correcting financial crises, can provide a principled alternative.

A financial crisis should be thought of as a dispute over who will own an economy’s productive assets. Resolving the crisis means removing the old owners and finding new ones who can run the productive assets at a profit. If this does not happen quickly enough, then the productive assets fall into disuse, and images from the 1930s of shuttered factories and soup lines begin to be relevant. Markets remove old owners by forcing them into some form of bankruptcy. The backers who lent a failed owner money and who are not getting repaid pull the financial plug, take over the company, and find someone who can run it profitably. The “someone” they find is usually the highest bidder, not necessarily a crony of the ruling party or even a citizen of the country in question.

Bankruptcy always sounds like a hard-hearted option. But it is actually quite merciful to society as a whole because it limits the danger that a financial crisis will turn into an economic crisis. When productive assets are placed on the auction block, they pass from owners who can’t operate them successfully to new ones who can. Often, this is simply the result of the new owners’ having paid much less for the enterprise than the old owners and therefore having much lower debt-service costs. Sometimes it involves concessions from other stakeholders, including labor. But how much easier it is on everyone — workers, consumers, and the society at large — to have the firm up and running, making payroll, producing goods, and paying taxes, than to have it sitting idle.

To build the bankruptcy option into a workable policy choice in the present crisis will require some persuasion. It is necessary to explain, first, why creditors should not be bailed out, but instead should be forced to take their chances in bankruptcy proceedings. This is fairly easy. Why should American taxpayers be asked to bail out the very firms with which they compete as workers and investors? (Economic nationalists ask this sensible question, which explains part of their appeal.) Banks make bad loans. People default. Economic circumstances change, and loans that once were sound turn sour. It happens in America. Why should things be different overseas?

Consider Texas in 1986. For reasons beyond any Texan’s control, the world price of oil fell from roughly $ 30 per barrel to about $ 10. Loans in Texas that were premised on $ 30-per-barrel oil went bad. Assets throughout the state, especially real estate, were put on the auction block. Many sold for a fraction of their original cost. The suppliers of equity lost everything. The suppliers of debt not only received no interest, but lost a good fraction of their principal as well. Every major bank in the state was in trouble. Today, 12 years later, eight of the top ten banks in Texas are owned by what Texans consider “foreigners,” people from places like North Carolina and New York.

Nor does the so-called S&L bailout of the early 1990s offer a precedent for an international rescue operation of the kind the administration advocates for Asia. In the S&L crisis, the only people who were bailed out were the depositors in the failed institutions. The assets of the failed savings and loans were put on the auction block. The equity holders generally lost everything, and many large suppliers of debt (other than depositors) took a haircut as well. Why is the administration proposing to treat South Korea and Indonesia better than we treated Texans and the owners of S&Ls?

The second step in building the bankruptcy option into a real policy alternative is to point out that the very people to whom we are asked to entrust a bailout failed to foresee the crisis in the first place and have so far handled it ineptly. Consider the IMF. In its annual report on the Korean economy issued this fall, it found no cause for alarm. Instead, it dubbed the Korean economy fundamentally healthy. This is not a record on which U.S. taxpayers should be asked to bet billions of dollars.

Meanwhile, the Clinton administration’s international economic policy is so lacking in credibility that the president could rally only one fifth of his own party to support his major trade initiative of 1997. That vote of no confidence was for good cause: The country is reaping the rewards of a foreign policy run by focus groups and campaign donors. The administration’s handling of the run-up to the Asian financial crisis has been especially shabby, characterized by hubris, denial, and excessive risk-taking.

In June, at the G-7 summit in Denver, the president and top Treasury officials lectured global leaders about the superiority of their handling of the U.S. economy, alienating the Europeans and causing Japanese prime minister Ryutaro Hashimoto to hint darkly about liquidating his nation’s U.S. bonds. Then in November at the Vancouver APEC meeting, the president termed the Asian crisis just a small “glitch in the road,” generating widespread incredulity in world markets and doubts about the American government’s grounding in reality.

Most remarkably, the administration has been conducting a highly confrontational trade policy in the very midst of the crisis. In late September it instituted Super 301 trade sanctions against South Korea, driving another nail into the coffin of an already dying economy. In October, the administration’s handling of a relatively minor dispute involving the behavior of the Japanese mafia at the docks in Japanese ports threatened to end oceangoing trade between the world’s two largest economies. Whatever the merits of the U.S. case, this was reckless behavior, given what was happening at the time in Asian financial markets.

Even more amazing, the administration is seeking money for an IMF Asian bailout after blocking for a year a Japanese-led effort to have the Asian economies deal with the problem themselves. This proposal, advanced by the Japanese Ministry of Finance, could have accomplished everything the administration is now trying to do in a much timelier fashion and without risking U.S. tax dollars. A senior European central banker told me that the only reason he could find for the U.S. refusal to cooperate was that our Treasury officials wanted to be seen playing a role. Unfortunately, U.S. contributions to a bailout may have as much to do with bureaucratic empire- building as with solving an economic crisis.

The third step toward a principled, market-based response to the Asian situation is to explain why such a policy is in the U.S. national interest. Bailout advocates can always claim they are buying something that benefits the country: international economic stability. What would we get for America by forcing a bankruptcy sale?

First and foremost, we would get at least as much stability as could be expected from a bailout. In the current crisis, debt-holders are not receiving the interest they were promised. They are increasingly skeptical about ever getting their principal back. So they are unwilling to extend new loans to enterprises. Note that last week international banks would extend new loans only if they were guaranteed by the Korean government.

With new loans hard to get, firms can’t even meet short-term contingencies like payroll and inventory, much less invest in new plant and equipment. Managers struggle just to make it through the day. They are selling their output at any price they can get and deferring purchases.

This causes the crisis to spread and turn into an economic problem. A failing company’s competitors find it hard to compete with the desperation prices at which output is being sold, and the company’s suppliers see their own sales start to fall. Some of these competitors and suppliers are American firms. The administration is correct, and the Economic Nationalists are wrong, about whether we can protect ourselves through regulations: We can’t. The question is how to stop the credit crunch quickly.

Under the administration’s bailout plan, owners and their crony system would stay in place in countries like Korea. While international creditors would get their money back, only very foolish ones would make new longterm commitments to the same management that is now on the verge of default. The best way to stop the credit crunch in Asia, end the downward spiral, and allow the economies to revive is to put new management in place. As we have seen, that’s what the bankruptcy option is all about.

Incidentally, wouldn’t it be in the U.S. national interest if American entrepreneurs could buy and run some of the bankrupt companies in Asia? Regardless of who the new owners might be, though, we gain nothing by giving the present owners and the political system that supported them a fresh lease on life.

Defenders of the IMF bailout talk about attaching “conditions” to the loans. But what will the IMF do if the new Korean government fails to honor the conditions to which the old one agreed? Tactically speaking, we would certainly achieve more far-reaching reform of South Korea’s economy if we forced a bankruptcy sale than we ever could through IMF negotiations. If the South Korean government refused to allow foreigners to invest or Korean firms to repay their debts, creditors would go to courts in other countries to claim any available assets. The cost for Korea would be a loss of export markets and of access to credit worldwide. The price of competing in the global economy and enjoying its benefits is playing by the rules.

Finally, advocates of a free-market solution must be prepared to counter two of the shibboleths of the administration’s position: “systemic contagion” and the “Mexican success story.” Systemic contagion is really a respectable way of saying we should worry that large multinational banks and other lenders might lose a bundle. Of course, the real concern is not that the bankers who made these bad loans might have a bad year. Rather, it is that their losses could impair their banks’ financial soundness and import the Asian banking crisis to the United States.

In this regard, there are no guarantees. A series of bad policy moves by our government, a failure of regulatory oversight, and a collapse of prudence on the part of U.S. financial institutions could always come together to create a problem. But, on a list of imminent worries, this should rank about ten spaces behind global warming. We Americans have made some very important changes since the early 1990s. First, we have made our banks build their capital positions so as to be able to sustain losses. Taken as a whole, the capital reserves of the U.S. banking system are at record levels. Second, the Federal Reserve and other financial regulators established elaborate and sophisticated models that “stress test” bank portfolios. While these measures are no guarantee that problems will be averted, our banks are far better prepared for major loan losses than are others — notably European and Japanese banks. Our third line of defense is the Federal Reserve’s ability to create money. The Fed has real-time on-site supervision authority and can, has, and will step in to provide liquidity should the need arise.

Adequate capital, appropriate regulatory supervision, and an able and willing central bank are the defenses any government has against systemic contagion. The IMF bailout package contains none of these. With regard to preventing systemic contagion, it is, at best, beside the point.

In fact, an IMF bailout will probably make systemic contagion more likely in the long run. The best protection we have against bankers’ overextending themselves to imprudent borrowers is the bankers’ fear of losing money. If we reinforce the precedent, already established in the case of Mexico, that the IMF and the U.S. Treasury will come to the rescue when something goes wrong, we eliminate the bankers’ fear.

There is ample evidence that the Mexican bailout prompted the flood of lending to Asia that is now causing trouble there. Outside of Washington, no one takes seriously the story that the Mexican bailout was a success. Investment bankers on Wall Street talk about how they actively promoted loans to Asia once the Mexican rescue was in place. A very senior official in the British Treasury who spoke on condition of anonymity bluntly blames “systemic contagion caused by Mexico” for the Asian problem. Federal Reserve chairman Alan Greenspan, who is intimately aware of the consequences of the Mexican experience, spoke in early December of how an IMF bailout could be “worse than useless” because of the precedent it sets. Mexico set us up for Asia. An IMF bailout of Asia may postpone the day of reckoning, but it will make it much more severe, and therefore less containable, when it finally occurs.

The bankruptcy option is the opposite of postponing the day of reckoning, and it is clearly in the American national interest. We have shown our system of corporate management to be the best on the planet. To retreat into our shell, as the Economic Nationalists urge, would be an especially stupid strategy at a time when economic trends are on our side. It is equally foolish for us to try to cloak our global role in a mantle of multilateralism, meanwhile actually catering to campaign-donor interests and generally behaving, as we have for five years, as though all political economy were local. But to avoid these mistakes — to curb the costly bungling of the administration and stave off the protectionist backlash it is likely to provoke — we must adopt an alternative policy grounded in market principles. Someone — why not the Republican leadership in Congress? — should be making the case for it now.

Lawrence B. Lindsey is managing director of Economic Strategies Inc., a global consulting firm. He holds the Arthur F. Burns chair at the American Enterprise Institute and is a former governor of the Federal Reserve System.