Krugman on Ecuador

Michael Pollak mpollak at panix.com
Wed Jan 19 03:45:09 PST 2000


[If this either/or scheme is true, Ecuador's pain will be the rest of the developing world's gain]

New York Times

January 19, 2000

RECKONINGS / By PAUL KRUGMAN

Dollars and Desperation

Ecuador is a small, faraway country of which most Americans probably

know nothing. (Hint: it's on the equator.) Last week, amid the hoopla

of the AOL-Time Warner deal, one suspects that few noticed the

surprise announcement by President Jamil Mahuad that he would abolish

his nation's currency and replace it with the U.S. dollar. But there

is an important story behind that story, which is not so much about

Ecuador as about the great financial crisis that swept Asia in

1997-98, and the continuing debate over what to do when the next

crisis strikes.

Everyone agrees that the Asian crisis was, in the first instance, a

case of financial panic: basically, after enthusiastically putting

hundreds of billions of dollars into Asia in the years before 1997,

investors suddenly lost their nerve and began pulling out all at once,

with catastrophic consequences. But there is a sharp difference of

views over what could have prevented or at least mitigated that

crisis.

Broadly speaking, one view holds that in times of panic the normal

rules of business should be suspended -- that investors should be

persuaded, or if necessary forced, to keep their money in place while

the authorities get things under control. In the oddly euphemistic

jargon of international finance, this is known as "burden-sharing," or

even more obscurely as "private sector involvement."

The other view holds that the way to deal with panic is to try to

reassure investors that their money is absolutely secure -- and that

one way to do that is to offer an ironclad guarantee that their

holdings of Korean won, or Indonesian rupiah, or Ecuadorian sucres,

will not lose their value in terms of dollars. This can be done by

establishing a "currency board," which holds dollar reserves large

enough to back the entire national money supply; it can be done even

more decisively by "dollarizing" -- that is, abandoning the national

currency and using dollars instead.

It is an unresolved debate, because neither approach was given much of

a trial. Hong Kong has a currency board, but was never itself the

object of investor panic -- it just happened to be living in a bad

neighborhood. Malaysia imposed controls on investors, but only after

the worst of the panic was past.

And that's where Ecuador comes in. The small Latin nation has the

dubious distinction of having plunged into crisis just as Asia climbed

out; and as a result it has become a sort of guinea pig for economic

nostrums. It is by no means an ideal choice as a clinical model. After

all, at the beginning of 1997 Asian economies looked robustly healthy,

with their government budgets balanced or in surplus; their crisis

came, as it were, out of a clear blue sky.

Ecuador, by contrast, has always been more or less a mess; its

plunging currency is only the outward sign of an inward disgrace, of a

bankrupt banking system that cannot be rescued by an equally bankrupt

government. But nonetheless, Ecuador is the test case we have, and its

experience is likely to have a disproportionate effect on how the next

big crisis is handled.

Indeed, the tiny nation has already done much to discredit the notion

of "private sector involvement." Last September Ecuador decided, with

more or less explicit encouragement from the International Monetary

Fund, to temporarily suspend payment of some of its foreign debt. The

experiment was a failure: while some investors found their money

locked up, others continued to flee Ecuador, and the economy's

tailspin continued.

Now its government has swung to the other extreme, and is trying to

restore confidence in the currency by abolishing it. Observers say

that this could work if it is accompanied by extensive domestic reform

-- which is a bit like the old line that you can kill someone with

witchcraft, if you also give him plenty of arsenic. But if it works,

it will do much to make dollarization likely elsewhere (Argentina, for

example); if it fails, as is much more likely, it will give

dollarization a bad name.

And the outcome matters. Sometime -- almost surely sometime this

decade -- there will be another great financial crisis like the ones

that struck Mexico in 1994 or Asia in 1997. What will we do about it?

Believe it or not, Ecuador may determine the answer.

Copyright 2000 The New York Times Company



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