The world economy is in the throes of a nightmare. The emerging markets from Asia to Russia have tumbled like so many dominoes, and now they're taking the leading stock markets down with them. Investors have lost billions of dollars in this wholesale destruction of assets, with the worst--the collapse of Japan's banking system--possibly still to come. Everywhere you look, there's nothing but bad news.
The analogy that people have been grasping for in the midst of this turmoil is the debt crisis of the 1980s, when the governments of developing countries stopped paying their obligations to creditors in the United States and Western Europe. But that financial crisis was successfully managed by the immensely popular Reagan administration, which cajoled Congress into providing the international system with the liquidity it desperately needed until economic growth was restored. Today, such leadership is sorely lacking.
Sadly, a better analogy is provided by the experience of the early 1930s. The United States was led by President Herbert C. Hoover, a brilliant engineer who failed to understand the depth of the world crisis that followed from the October 1929 stock-market crash. Convinced that the U.S. economy was not only healthy, but would actually be strengthened by its biblical test with the financial gods, Hoover adopted a do-nothing platform that deepened and expanded the Great Depression. Rejected by the American people as unemployment spread, he was replaced by Franklin D. Roosevelt, who adopted the New Deal at home but was also slow to recognize the global role that the United States must play in leading the world out of its morass.
In Germany, meanwhile, the weak coalition government that presided over the post-World War I Weimar Republic found itself in an increasingly untenable economic situation. Squashed by the heavy reparations payments it had to make under the 1919 Versailles peace treaty, Germany found it impossible to earn the necessary foreign exchange through exports because of the Great Depression. The government saw no alternative but to crash the economy in order to save it, which it did in 1932. It drove the economy into such despair with its austerity package that the Allies had no choice but to renegotiate Germany's debts. The Weimar government won that gambit, but too late for a peaceful, democratic future. In 1933, Adolf Hitler won a plurality, as the Germans threw out the ruling coalition because of the suffering it had caused.
During the 1930s, the global economy turned to wreckage. States adopted beggar-thy-neighbor economic policies, devaluing currencies in a doomed effort to maximize exports and minimize imports, an impossible strategy when practiced by all. Rather than cooperate in the interest of overall growth, the great powers, including the United States, sought to isolate themselves in a desperate attempt to escape from the world's economic pain.
But these policies inevitably took an aggressive turn. Each of the world's major players formed self-sufficient economic blocs as the depression wore on, including the U.S.-led dollar bloc; the Japanese Co-Prosperity Sphere; the Zone Franc, which linked France and West Africa, and the British sterling bloc, which tied London and its colonies in a protectionist bond. Left out of this great game, Germany looked to Eastern Europe, expanding its influence in that region until it rubbed up against the Soviet border. Ultimately, the Great Depression came to an end on the battlefields of World War II.
The events of the 1930s remind us that the international economy ultimately rests on a political foundation, for good or ill. Despite all the talk about globalization and free markets, the world economy is nothing without governments and the paths they chart for their citizens. In the absence of a firm sense of economic direction provided by the great economic powers, especially the United States, investors must lose confidence in the future and, in the process, pull the plug of the financial markets.
This is what is happening today. Scanning a horizon that includes a Weimar Russia, a moribund Japan and a headless United States, investors are naturally seeking a safe haven. Withdrawing funds from emerging markets and stock funds, they are placing assets in banks and government obligations. None of these will help fuel future growth and, as growth prospects diminish, investors will become even more bearish. The world economy is on the verge of becoming trapped in this sort of vicious cycle, and it can only be broken by a massive liquidity injection.
Such an act would require a coordinated effort by the Group of 7 industrial nations. Upon his return from Russia and Ireland, President Bill Clinton should immediately call for an emergency meeting of his fellow leaders. The agenda is clear: Cut interest rates, refill the depleted coffers of the International Monetary Fund and maintain open markets for the world's goods and services. These actions are needed in the short run to prevent any further meltdown of the financial markets.
But a long-term strategy is also needed to reintegrate the emerging markets now locked out of the global economy. That strategy must rest on the following lesson provided by the current financial crisis: Free markets cannot exist without a supporting set of political institutions. Law and order, business codes of conduct, regulatory structures, tax regimes and the like are no less a requirement for a market economy than privatization, price liberalization and monetary stabilization. The economists running the U.S. Treasury were seemingly unaware of this connection between capitalist economies and political institutions, instead believing that markets are a "natural" part of society and must inevitably evolve and become self-sustaining. The experiences of East Asia and Russia have given lie to that belief. Now we know that states and markets must grow in tandem.
Over the longer term, then, the industrial countries should devote their foreign-aid programs to state-building rather than economic stabilization, narrowly defined. Contrary to popular opinion, the great powers can play a significant role in strengthening the many weak democracies around the world. They can do so by providing them with the technical assistance needed for full participation in the existing set of global economic institutions. Governments and private- sector actors are then faced with a clear choice: Play by the rules or stay at home.
Among the rules should be:
* Banks in the industrial countries will not be permitted to conduct any financial activity with banks in emerging markets that do not adopt the regulatory standards set by the Basle Committee on Banking Supervision, based at the Bank for International Settlements in Basle, Switzerland. Further, they will not lend to firms that do not adopt international accounting standards.
* Investors in industrial countries will only be permitted to invest in stock exchanges supervised by regulatory bodies that are members of the International Organization of Securities Commissions. They will not invest in companies that have not adopted international accounting standards.
* Trade will not be conducted with countries that do not adopt the core labor standards of the International Labor Organization.
* The granting of most-favored-nation trade status will be limited to members of the World Trade Organization.
* No country will obtain an IMF loan that has devalued its currency and defaulted on its external-debt obligations under prior IMF agreement.
Others could be added, but the point is clear: The world economy has rules, and all players must abide by them in the interests of global stability and fairness. This does the governments of emerging markets a favor, for it allows them to turn to private-sector actors with a simple choice: Either we join the global system or we opt out. By opting in, we must take these steps and become a more "normal" political economy. By opting out, we remain isolated, but with the freedom to do our own thing, even at the price of extreme poverty.
This approach might strike some as insensitive to local cultures and economic practices. It is, but that is required in the interest of system stability. The world needs leadership, and it needs rules and institutions. That is the lesson of the 1930s, and we dare not repeat the tragic experience.*