The Asian financial crisis and the virtues of democracy

Challenge, July-August, 1999 by Dani Rodrik

Why did democratic institutions help Thailand and South Korea manage the crisis?

In 1996, five Asian economies (South Korea, Indonesia, Malaysia, Thailand, and the Philippines) received net private capital inflows amounting to $93 billion. One year later (in 1997), they experienced an estimated outflow of $12.1 billion (IIF 1998), a turnaround in a single year of $105 billion, amounting to more than 10 percent of the combined gross domestic product (GDP) of these economies. By 1998, three of these economies (Indonesia, Thailand, and South Korea) had become mired in a severe economic crisis, the magnitude of which would have seemed inconceivable just months before even to the most knowledgeable and insightful observers of the region.

Three Lessons of the Asian Crisis

One lesson of the crisis is that international capital markets do a poor job of discriminating between good and bad risks. It is hard to believe that there was much collective rationality in investor behavior before and during the crisis: Financial markets got it badly wrong either in 1996, when they poured money into the region, or in 1997, when they pulled back en masse. The implication is that relying excessively on liquid, short-term capital (as all of the three worst-affected countries did) is a dangerous strategy.

Second, the crisis has demonstrated that trade orientation per se has little to do with the propensity to be hit with severe liquidity problems. The Asian economies most affected by the reversal in capital flows were among the most outward-oriented in the world, routinely pointed out as examples for other countries to follow. The determinants of the crisis - as with the debt crisis of 1982 and the Mexican peso crisis of 1994 - were financial and macroeconomic. Trade and industrial policies were, at best, secondary factors.(1)

In keeping with the general theme of this chapter, a third lesson of the crisis is that domestic institutions of conflict management are critical in containing the adverse economic consequences of the initial shock. At the onset of the crisis, it seemed that authoritarian governments would have a better chance of preventing the social explosions that the crisis might create, while "messy" democracies would suffer. In fact, many critics of Western-style liberal democracy viewed the Thai and South Korean troubles in the early stages of the crisis - and the apparent Indonesian resolve - as an illustration of the economic superiority of governments based on so-called Asian values. The outcome has been quite the opposite. Indonesia, an ethnically divided society ruled by an autocracy, eventually descended into chaos, with a reduction in GDP predicted at 20 percent or more. South Korea and Thailand's democratic institutions, and their practices of consultation and cooperation among social partners, made these countries much more adept at generating the requisite policy adjustments. Although neither of the two economies was out of the woods as of late 1998, their experience has demonstrated the importance of institutions, and of democratic institutions in particular, in dealing with external shocks.

Why Thailand and South Korea Coped Well

Even though democratic institutions developed relatively recently in Thailand and South Korea, they helped these two countries adjust to the crisis in a number of ways.(2) First, they facilitated a smooth transfer of power from a discredited set of politicians to a new group of government leaders. Second, democracy imposed mechanisms of participation, consultation, and bargaining, enabling policymakers to fashion the consensus needed to undertake the necessary policy adjustments decisively. Third, because democracy provides for institutionalized mechanisms of "voice," the South Korean and Thai institutions obviated the need for riots, protests, and other kinds of disruptive actions by affected groups, and, furthermore, undercut support for such behavior by other groups in society.

In Thailand, Prime Minister Chavalit Yongchaiyudh resigned on November 6, 1997, shortly after "several hundred white-collar workers led demonstrations in Bangkok" (Bell 1998), and one month after the adoption of a new, anticorruption constitution. Three days later, an eight-party coalition led by Chuan Leekpai managed to obtain a majority of votes in the parliament. News articles about Thailand abound with stories illustrating the willingness of the Thai people to give the new government the benefit of the doubt in the belief that the government has their best interest in mind. Chuan's new finance minister, Tarrin Nimmanahaeminda, related a story to the press about a letter he received from "a young Thai girl wishing him well in his efforts to turn around the economy and enclosing a 20-baht note that she had taken from her father's wallet - her contribution toward paying off the International Monetary Fund" (Rahul 1998, 21). The government savings bank started a program under which people can open accounts designed to ameliorate the situation for those particularly hard-hit by the crisis - a campaign referred to as "Thais Helping Thais" (The Economist 1998a, 38). In a more nationalistic effort, the government has also tried to cushion the employment loss to its own citizens by expelling thousands of foreign workers (particularly the large number of Burmese working there), to demonstrate that "the government is doing its best to protect the livelihoods of its own people" (ibid., 38). As instability has grown in Indonesia, Thailand's currency has strengthened. The IMF has suggested that Thailand might emerge as the leader in recovery from the "Asian flu." Thailand's relative success thus far in weathering this economic crisis has come, in Chuan's words, from "the utility of a democratic process that gives people the right to choose a government they believe can solve their problems" (Larimer, McCarthy; and Chuan 1998, 16).