Global Intelligence Update
Weekly Analysis Septemer 20, 1999
World Bank Reverses Position on Financial Controls and on Malaysia
The World Bank reversed its opposition to short-term capital controls and announced that Malaysia's experiment with
capital controls was, in effect, a success. Since the World Bank acts on the distilled essence of conventional wisdom,
this means that the international financial community no longer regards either capital control or Malaysia's prime
minister as taboo.
The most important short-term consequence of this change will be on Japan, which has toyed with the idea of capital
controls. But more importantly in the long run, the rehabilitation of Mahathir from lunatic to visionary will bring his
other ideas into play. Of particular importance is his idea of a regional Asian bloc excluding the United States, based
on the yen and Japan, with capital controls as a regional management tool. Neither of these outcomes is intended by the
World Bank or the IMF, but both are the embodiment of the unintended consequence.
The World Bank has executed an important and somewhat startling reversal of position on Malaysia's use of capital
controls to solve its economic problems. Joseph Stiglitz, the World Bank's chief economist, said Sept. 15, "There has
been a fundamental change in mindset on the issue of short-term capital flows and these kind of interventions - a change
in the mind set that began two years ago." He went on to say that "in the context of Malaysia and the quick recovery in
Malaysia, the fact that the adverse effects that were predicted - some might say that some people wished upon Malaysia -
did not occur is also and important lesson."
These were not casual remarks. They were made during the presentation of a key World Bank annual document, the "World
Development Review," and were meant to be taken seriously. Indeed, Stiglitz's comments came a week after the
International Monetary Fund (IMF) praised Malaysia for its skillful handling of capital controls.
These comments represent a fundamental shift in the international economic establishment's understanding of how that
system works. The economists at the World Bank and the IMF are not particularly original or imaginative, and their track
record in predicting and managing the twists and turns of the international system is not, to say the least, impressive.
Thus, viewing their policy shifts as contributions to economic theory is not particularly useful. Stiglitz and his
colleagues at the World Bank and the IMF are not people who go out on the limb with dramatically novel idea. They like
to move with the herd.
That is what makes Stiglitz's statement extraordinarily important. It shows that the herd is making one of its periodic
migrations. The World Bank's chief economist doesn't lead the convention. He is a superbly sensitive weather vane - he
During the 1960s and 1970s, the World Bank was committed to massive, government-run infrastructure projects, reflecting
the conventional economic wisdom at the time that the state is the appropriate engine for economic growth, at least in
the developing world. During the 1980s, when the conventional system shifted to the view that the free market was the
most efficient means of capital allocation and economic growth, the World Bank slowly and painfully shifted again. They
stuck with the free market position throughout the Asian meltdown.
Now, two years after the bloodbath, they are slowly shifting again, not only endorsing capital controls, but praising
their own arch- nemesis, Malaysia's Mahathir. Stiglitz is following the new conventional wisdom: capital controls are
Whether capital controls are good or bad doesn't really matter. What matters is that they have been accepted by a highly
politicized, extremely powerful segment of the international community that the World Bank/IMF complex is part of and
serves. This is the international financial community, understood as the national bankers, the leading international
banks and the political elites to which they connect.
Stiglitz's comments reveal that the 20-year love affair with a purely free market approach to international financial
flows is, if not coming to an end, nevertheless being severely modified. There are now cases in which market regulations
are not only tolerable, but also a good idea.
This will lead to interesting debates among economists, most of whom will argue that controls create inefficiencies that
will retard recoveries and damage economies. The problem is that these economists tend to approach these issues from an
isolated angle. Stratfor's view has been that economic crises increase the pressure on governments to take steps that
stabilize the situation in the short run, even if they affect the economy negatively in the long run.
For example, assume that political chaos is something to be avoided. Assume further that the economically optimal policy
would quickly lead to political and social chaos. Finally assume that a policy could be found that avoided political and
social chaos at the price of poor economic performance in the long run. Which is the better policy?
As much as any country, Indonesia followed the conventional wisdom of the time, as transmitted by the IMF and World
Bank. As capital poured out of the country, trying to flee Indonesia's dangers, the government did nothing to interfere
with capital movements, assuming that the market would create stability.
Indeed, the markets did work, and the Indonesian economy was beginning to improve earlier this year. But by optimizing
its economic response to the crisis, Indonesia's social and political fabric was shredded. The pressures imposed by the
market on social cohesion created the extraordinary reality of an economy in recovery and a society in collapse. In the
end, of course, that collapsing society will shatter the economic recovery as well, so all will be for naught.
Indonesia's neighbor, Malaysia, followed a very different policy, which originated in a radically different analysis,
heavily ridiculed at the time and today. According to the Malaysian prime minister, the origins of the crisis had little
to do with imbalances in the country's economy. Rather, they had to do with the structure of the international financial
system and particularly the management of international currency flows.
According to Mahathir, it was an illusion to think of short-term capital flows as market driven. On a day-to-day basis,
control of short-term capital was in the hands of a relatively small number of massive currency hedge funds. Mahathir
claimed that George Soros and other hedge fund managers were orchestrating the collapse of Asia's currencies. Because
they profited from relatively small differentials, they were prepared to create sudden, massive and uncontrollable
outflows of capital that would wreck national economies by causing both short- and long-term capital flight.
Mahathir's analysis tended to be more colorful, charging Jewish conspiracies against Muslim countries. The primary
purpose of his analysis was political. Mahathir used his analysis to explain why his government had not failed. Rather,
he argued Malaysia and the rest of Asia had been victimized by the international system. He personalized the system into
the person of George Soros for further political effect.
In short, needing to stabilize his polity, Mahathir created an economic analysis in which the stabilization of his
society was its grand purpose. He successfully diverted his attention from the Pan-Asian economic practices that had
triggered the crisis, such as irrational capital allocation, absurdly low rates of return on capital, an
undercapitalized banking system and the failure to create domestic demand while relying on exports. Instead, he
refocused domestic attention on the claimed defects of international systems.
It was effective politics. It also spawned economic policies that the World Bank has now endorsed. If the central
problem were the nonexistence of a free market in short-term currency flows, and that these flows were instead
controlled by a few financial institutions, then the rational answer to oligopoly was government regulation.
Accordingly, Mahathir slammed currency controls on the flow of money into and out of Malaysia. Conventional economic
theory said this should have had a devastating effect. In fact, compared to Indonesia, the actions (along with other
acts of repression, such as the trial of Anwar Ibrahim, Mahathir's former protege and advocate of the international
economic community in Malaysia) not only helped stabilize the political system, but also did not seem to have produced a
great deal of economic harm.
Malaysia's economy contracted by 7.5 percent before controls were imposed. In the year following the imposition of
controls, the official growth projection has gone to 1 percent, while unofficial projections go as high as 5 percent. It
is no surprise that Stiglitz stated that the bank had been "humbled" by Malaysia's performance.
Stratfor has long regarded Mahathir as one of the most interesting figures in Asia. Long ridiculed by conventional
economists as a lunatic - an image reinforced by the rhetoric he chooses for domestic consumption - Mahathir has
nevertheless made some cogent points. His argument that short-term capital flows were too vulnerable to a small number
of hedge funds has some empirical validity. If those funds can create short-term oscillations that become
uncontrollable, they can and have created long-term problems. Healthy economies are not vulnerable to these events, but
unhealthy ones are. Mahathir argued that the medicine imposed is likely to kill the patients rather than rejuvenate
Since 1990, Mahathir has made the broader argument that Asia's economies are overly dependent on the United States as a
market. He has not only been an advocate of capital controls on the national level, but also an advocate for the
creation of a regional economic bloc in Asia, built around the yen, and insulated from the United States by policies and
Mahathir believes a Japanese-led, regional economic bloc is needed for two reasons. First, he argues that dependence on
the United States for the absorption of Asian production cannot be sustained in the long run. Second, the United States
will use this dependence to manipulate and divide Asians so that, inevitably, what happened in 1997 would happen again.
Everyone dismissed Mahathir. We have long argued that he has been pointing the way. This does not mean that we agree
with him. It simply means that we have felt that a Mahathirian worldview would eventually carry the day in Asia.
Stiglitz's bow toward Malaysia is therefore critical in two ways. First, the World Bank and the IMF have now endorsed
the principle of capital controls, at least in the short run. Since you cannot be a little bit pregnant, even at the
World Bank, that means conventional wisdom now says capital controls are a legitimate tool in economic policy.
This is of extreme importance for nations in Asia that have not and cannot solve their structural problems without
destabilizing their societies. We mean, of course, the Japanese. Japan has contemplated capital controls and has, in
highly informal ways, actually employed them. But Japan, as a charter member of the international financial community's
conventional wisdom, has never formally implemented nor even endorsed them.
Now that the World Bank and IMF have both praised Mahathir, with whom the Japanese have interestingly warm relations,
the taboo has been lifted. Japan, adverse to taboo smashing, can now use capital controls as a conventional tool. So can
other Asian countries.
The tremendous pressure for an Asian solution has eased with the current recovery among some the region's nations. Since
we regarded this as less a recovery than the end of the collapse and the beginning of long-term malaise - for Malaysia
included - the short-term pressure is being replaced by a less urgent, but nonetheless real search for structural
Which brings us to the second point. Japan's problems are the region's problems. If Japan cannot find a purely domestic
solution to its problems and the global environment is too inhospitable, then regional solutions might well be the
answer. Just as Europe has the EU and North America has NAFTA, Asia must seek, according to Mahathir, an Asian entity.
Joseph Stiglitz's comments legitimized capital controls, the tool that any region-wide plan would require. They also
turned Mahathir from an official pariah into an official visionary. Dismissing his ideas on other matters now becomes
much more difficult. For many in Japan who have quietly agreed with his ideas, the change in the international economic
community's perspective will open the floodgates to ideas that have thus far been taboo: an East Asian economic bloc.
Thus, the World Bank and the IMF have effectively handed Asia legitimization for a regional bloc designed not only to
facilitate intra-bloc trade, but also to create regional regulatory bodies to manage the capital flow in and out of the
bloc. True, this would destroy the essence of Asia's free markets. But, as we have argued for a long time, the idea that
Asia had domestic free markets was quite illusory to begin with.
There is much mistrust of Japan in the rest of Asia. Memories run long. But if the Poles and Czechs can work with the
Germans, be assured that southeast Asia can work with Japan - if the stakes are high enough.
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