© 1999 OXFORD UNIVERSITY PRESS AND THE OXFORD REVIEW OF ECONOMIC POLICY LIMITED110

IMPLICATIONS OF FINANCIAL CRISISFOR EAST ASIAN TREND GROWTH

OXFORD REVIEW OF ECONOMIC POLICY, VOL. 15, NO. 3

NICHOLAS CRAFTSLondon School of Economics1

The article sets the Asian financial crisis in the context of the developmental state model of Asian develop-ment and sees it as, in part, the downside risk of a financial liberalization that was badly handled butnevertheless appropriate as a stimulus to better productivity performance. The East Asian economies areshown still to have a large labour productivity gap with the leading OECD countries and substantial scopefor further rapid catch-up growth. Historical experience suggests that the policy response to the crisis isfundamental not only to immediate recovery prospects but also to realizing this remaining fast growthpotential.

I. INTRODUCTION

To the economist in the street brought up on ‘TheEast Asian Miracle’ the trauma that began in1997 and brought growth in many countries to anabrupt halt must have come as a dreadful sur-prise. Clearly, more is involved than a conven-tional currency crisis and the magnitude of theshock exceeds that of normal business-cyclefluctuations. This raises the question as to whetherit might have lasting effects on the growth rate.

To the historian, the challenge is to come up withprecedents. In fact, this is not difficult—bothAmerican and Japanese economic history offerimportant insights into both the ways in whichrapid growth can evaporate in the context of afinancial crisis and also the policy requirements ifthe fast growth path is to be resumed.

This paper offers a view of the Asian crisis basedon an historical perspective that may help toinform responses to the following questions.

1 I am grateful for comments on an earlier version from Bart van Ark, Jenny Corbett, Steven Fries, Kanhaya Gupta, Mark Harrison,and participants in the Asian Development Seminar, Leiden, 1999, and the Financial Instability Conference, Oxford, 1999. All errorsare mine.

• Were there aspects of the East Asian develop-ment model that exposed the region to the crisis?

• What are the lessons from history if a satisfac-tory recovery is to be achieved ?

• How is the crisis likely to affect future long-termEast Asian growth potential ?

II. BACKGROUND TO THE ASIANCRISIS

The historical record strongly suggests that reallyrapid growth of real GDP per person is confined tocases where countries that initially lag behind theleaders in terms of income and productivity levels gothrough a phase of catching up. Outside such peri-ods, growth of per-capita income does not typicallyexceed about 3 per cent per year. The end of rapidcatch-up growth therefore entails a deceleration ineconomic growth.

Two epochs in which remarkable catch-up growthwas experienced were the early post-Second-World-War decades in Western Europe and Japan throughthe mid-1970s and the last 30 years or so in severalother countries in East Asia. The ‘golden age’ sawWestern European real output per hour workedgrow at 4.7 per cent per year between 1950 and1973, much faster than before or since, while EastAsia enjoyed average growth of real GDP perperson at 4.6 per year from 1960 through the mid-1990s. Details of the growth rates and outputlevels achieved by individual countries are shownin Table 1.

It is important to distinguish two aspects of thereduction in labour productivity gaps that is charac-teristic of the catch-up process. One way in whichshortfalls in output per worker will diminish is throughreductions and ultimate elimination of shortfalls inhuman and physical capital per worker. This is thefamiliar process envisaged by traditional neoclassi-cal models of growth, in which the transition to thesteady state is characterized by a temporary periodof rapid growth during which diminishing returns toinvestment gradually intensify. A second possibilityis that the labour productivity gap stems from aninferior level of total factor productivity (TFP),

reflecting some combination of lags in technologicalknowledge and/or the diffusion of technology, inef-ficient allocation of resources, and inability to achieveeconomies of scale. This is ruled out by assumptionin the traditional growth models, but has alwaysloomed large in the growth accounting literature onwhy growth rates differ and could be encompassedwithin modern endogenous growth models. Histori-cal experiences of catch-up typically involve bothaspects, but not necessarily in the same proportions.

(i) Social Capability and Economic Backward-ness

The doyen of economic historians writing on thistopic, Abramovitz (1986), argued that these differ-ences in the experience of catch-up growth wouldreflect what he termed ‘social capability’, of whichthe standard of education is an important compo-nent. In this view, human capital operates in thecatch-up process not so much as a factor of produc-tion in the Augmented-Solow sense but as a deter-minant of the rate of change of TFP and ultimatelevel of TFP through catching-up. Econometricsupport for this formulation is found in the cross-section growth regression literature in the influentialpaper by Benhabib and Spiegel (1994).

Social capability, however, clearly involves muchmore than education. Abramovitz himself stressedthe role of institutions and the incentive structures towhich they give rise. At one level, this involves rent-seeking, the political process, and the ability ofvested interests to thwart modernization of theeconomy. More fundamentally, the appropriation ofprofits is central to investment and efforts to reducecosts through innovation. This suggests the impor-tance of political and institutional structures whichpermit strong yet restrained and predictable govern-ment. In particular, government needs to be able toprotect property rights and enforce contracts, but torefrain from expropriation, repudiation of its obliga-tions, and capricious behaviour.

It might be argued that central aspects of socialcapability concern the climate for investment andthe supply of finance. A key requirement is thattransactions costs are kept reasonably low and thatentrepreneurs are not deterred from investing infixed costs by opportunism and ‘hold-up’ problems.

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Table 1Recent Growth of Real GDP/Person in Europe and Asia

(% per year)

GDP/person, 1996 Growth Growth($1990 international) 1950–73 1973–96

Norway 22,256 3.2 3.4Switzerland 20,252 3.1 0.5Denmark 19,803 3.1 1.7West Germany 19,622 5.0 1.8Netherlands 18,504 3.4 1.6France 18,207 4.0 1.5Austria 17,951 4.9 2.0Belgium 17,756 3.5 1.8Sweden 17,566 3.1 1.2UK 17,326 2.5 1.6Italy 16,814 5.0 2.1Finland 15,864 4.3 1.7Ireland 15,820 3.1 3.6Spain 13,132 5.8 1.8Portugal 12,015 5.7 2.0Greece 10,950 6.2 1.5

Hong Kong 21,201 5.5 5.1Singapore 20,983 4.3 6.1Japan 19,582 8.0 2.5Taiwan 14,222 6.2 6.1Korea 12,874 5.2 6.8Malaysia 7,764 2.8 4.0Thailand 6,112 3.2 5.6Indonesia 3,464 2.5 3.6China 2,653 2.1 5.4Philippines 2,369 1.8 0.8

Sources: Maddison (1995, 1997) updated using Asian Development Bank (1997) and Maddison (1998);China income estimate relates to 1995 and growth rates are calculated over 1952–73 and 1973–95.

At the same time, capital market institutions need tobe able to allocate resources efficiently, to monitorborrowers effectively, and to reduce obstacles tofinancing investment arising from asymmetric infor-mation. In the early stages of development there islikely to be heavy reliance on bank-based financeand it is therefore important that banks do not takeexcessive risks, maintain capital adequacy, and areeffectively monitored by depositors or regulatorssuch that bank runs and financial crises are avoided.

Catching-up is not automatic, therefore, and ab-sence of social capability may be a crucial obstacle

to growth and development in some countries.Gerschenkron (1962) provided a famous discussionof the opportunities and difficulties of ‘economicbackwardness’. He suggested that backward coun-tries could achieve a take-off into very rapid growthif they could substitute for ‘missing prerequisites’, inparticular a lack of ‘entrepreneurship’. This mightbe regarded as much the same thing as establishingsocial capability. Gerschenkron’s arguments can bere-stated as proposing that institutional innovationsto establish larger vertically integrated enterprises,to provide strong cash-flows for incumbent produc-ers, and especially to develop investment banking

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under the auspices of a major role for the state ininvestment decisions could solve coordination andhold-up problems for investors, mitigate problems ofasymmetric information in the supply of finance forindustrialization, mobilize savings, and develop in-fant industries.

Harley (1991) suggested that this amounted to thesubstitution of hierarchies for markets that transac-tions costs considerations suggest would be appro-priate in conditions of high specificity of assets andweak enforceability of contracts. At the same time,increased reliance on hierarchy can be expected tohave an agency cost in terms of reduced incentivesfor cost reduction and innovation. A clear implica-tion of Gerschenkron’s approach is that countrieswhich develop rapidly from a position of initialbackwardness will have a legacy of institutionswhich are ‘unorthodox’ from a conventional West-ern standpoint.

These arguments are important in the context ofEast Asia, as strategies to achieve rapid catch-upgrowth in many cases bore strong resemblance toGerschenkron’s recipe. Thus, the account by Rodrik(1995) of the approaches of Korea and Taiwan tomobilizing investment matches much of the abovedescription rather closely. Moreover, the well-known‘getting relative prices wrong’ and ‘governed mar-kets’ approaches of, respectively, Amsden (1989)and Wade (1990) to explaining rapid growth in thesecountries can be seen as having strong similarities.These cases of ‘late industrialization’ involved a strongand pro-active role for the state and the banking sector,with methods of oversight of the banking system farremoved from Western norms of prudential regula-tion, auditing, and disclosure. Industrial policy pre-vailed and competition policy was absent.

Obviously, there are several downsides to this de-velopmental state strategy for take-off. First, it maybe that the institutional structure delivers a lot ofinvestment, but is less good at providing incentivesfor the efficient use of funds or innovation, as a viewbased on incomplete contracts or agency theorymight suggest. Second, at some later stage, it is likelythat the allocative efficiency advantages of freercapital markets will become much more attractive,but the transition to such institutional arrangements

may be fraught with difficulties of preventing moralhazard and eventual financial crisis where bankersand regulators lack the relevant human capital andresources. A third possibility is that the institutionsthat work so well at the outset eventually becomedysfunctional but hard to change.

(ii) Growth Accounting

A good deal of insight into the growth process canbe obtained through the well-known growth ac-counting methodology which is set out in Maddison(1996). Results obtained with this approach shouldbe seen more as bench-marks and explicanda thanliteral truths, but nevertheless it provides an impor-tant quantitative framework for thinking aboutgrowth. Growth accounting typically starts from thefollowing identity:

∆Y/Y = α∆K/K + β∆L/L + ∆A/A

where α and β are the shares of wages and profitsin national income, respectively. It is an identitybecause ∆A/A is defined as the growth in output notaccounted for by increases in the factors of produc-tion, capital, and labour. This term is the residualafter calculating all the other components of theequation and represents the contribution of TFPgrowth. Improvements in the quality of labour,notably from additional education, and changes inhours worked are taken into account in measuringthe growth of labour inputs.

The terms α and β are intended to capture theelasticity of output with respect to growth of capitaland labour, and approximating these elasticities byfactor shares is strictly valid only under perfectcompetition and where private and social returns tocapital are identical. In fact, in the OECD countriesthe use of profits share seems to be a reasonableapproximation. In the Asian context, this may bemore doubtful and this has prompted some debate.Collins and Bosworth (1996) discuss a wide rangeof evidence, on the basis of which they argue for theimposition of a uniform value of 0.35 for α in eachcountry for international comparisons. Their esti-mates seem to be representative of recent work andconvenient by virtue of their wide coverage and willbe used in what follows.

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The most powerful reason for supposing that allthese TFP growth estimates are biased is that theyrely on underlying assumptions about the nature ofthe production function which may be misleading.These are a Cobb–Douglas specification with uni-tary elasticity of substitution between capital andlabour and Hicks-neutral technological change.Rodrik (1997) argues that the substitution elasticityis actually less than 1 and that technological changemay have been labour-saving. In that case, theconventional TFP estimate will be biased down-ward and the bias will be proportional to the growthof the capital-to-labour ratio which has been risingsteeply in the Tiger economies.

Table 2 sets out results from recent growth account-ing exercises. Before looking at its main messages,it is worth noting that the underlying data areimperfect in some cases. In particular, there arereasons to be cautious about the estimates for Chinaand Singapore. The estimates for TFP growth inChina are much lower than would be obtained using

official data. It is generally agreed that the officialdata exaggerate Chinese output and productivitygrowth by understating inflation. Maddison’s (1998)series seem to be by far the best alternative cur-rently available and so have been relied upon inTable 2, but growth estimates are likely to remaincontroversial.

By contrast, it has been claimed by Hsieh (1997)that official data almost certainly exaggerate thegrowth of the capital stock in Singapore, perhapssubstantially so, and this a strong reason to supposethat the contribution of capital to growth was lessand that of TFP growth was more. This claim hasbeen vigorously contested by Young (1998). Hisdiscussion of trends in factor returns, which indi-cates growth in real wages at 3 per cent per year andreal rentals declining at between 1 and 2 per cent peryear (1998, pp. 19–20), offers a check on theestimate of TFP growth of 1.5 per cent in Table 2and suggests that it is reasonable, given the factorshare weights adopted there. Nevertheless, the

Table 2Sources of Growth: Golden-age Europe and Japan versus Recent East Asia

(% per year)

Capital Labour TFP Output

1950–73France 1.6 0.3 3.1 5.0Italy 1.6 0.2 3.2 5.0Japan 3.1 2.5 3.6 9.2UK 1.6 0.2 1.2 3.0West Germany 2.2 0.5 3.3 6.0

1960–94China 3.1 2.7 1.7 7.5Hong Kong 2.8 2.1 2.4 7.3Indonesia 2.9 1.9 0.8 5.6Korea 4.3 2.5 1.5 8.3Malaysia 3.4 2.5 0.9 6.8Philippines 2.1 2.1 –0.4 3.8Singapore 4.4 2.2 1.5 8.1Taiwan 4.1 2.4 2.0 8.5Thailand 3.7 2.0 1.8 7.5

Sources: Europe and Japan from Maddison (1996) except Italy from Rossi et al. (1992); East Asia derivedfrom Collins and Bosworth (1996) except for Hong Kong which is based on Young (1995) and China basedon Maddison (1998), both with factor shares adjusted to match Collins and Bosworth’s assumptions. Chinaestimates are for the period of post-reform rapid growth, 1978–95.

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Singaporean data are also likely to remain contro-versial.

In Table 2 the tendency for Asian countries to havesubstantial growth from capital accumulation isclearly shown and is underlined by the comparisonwith their European predecessors. This originallyresulted from relatively low incremental capital-to-output ratios, rather than much higher investmentshares in GDP. Thus, over the period 1960–90 aninternational cross-section regression of capital stockgrowth against the share of GDP invested showspositive residuals of 6 per cent per year in each ofKorea, Singapore, and Taiwan, and 5 per cent forHong Kong (Fukuda, 1999). Recently, however,investment rates have been very high and during1981–96 investment averaged between 30 and 40per cent of GDP in each of China, Indonesia, Korea,Malaysia, Singapore, and Thailand.

Table 2 also documents the much stronger contribu-tion made by labour-force growth in Asian countriesthan in Europe, which is also quite important inaugmenting the faster growth of total factor input inAsia than in Europe. This reflects both the distinctive-ness of Asia in the context of its demographictransition and, to a lesser extent, the tendency ofhours worked per year to fall sharply during Europe’sgolden age, an experience that has not yet beenrepeated in East Asia. Thus annual hours per workerare still around 2,200–2,400 in East Asia comparedwith 1,700–1,900 in early 1970s Europe (Crafts, 1999).

During the demographic transition, in which birthand death rates both fall to much lower levels, thereis a phase when the proportion of working agepopulation increases sharply. Western Europeancountries had completed the demographic transitionprior to the post-war golden age of economic growth.They did not, therefore, experience a demographicboost to labour inputs per person during this period.By contrast, East Asian countries entered intodemographic transition much more recently and theproportion in the working age group rose rapidly inmany cases between the early 1970s and the early1990s.

Taking columns 1 and 2 of Table 2 together, it isclear that East Asian growth has relied much moreon the contribution of rapid factor accumulation, of

both capital and labour, than did Europe’s fastgrowth of its golden age. Conversely, East AsianTFP growth has been less strong than in the Euro-pean countries which experienced rapid catch-upgrowth in the early post-war decades. Indeed, theTigers have also fallen well short of what Japanachieved in this aspect of growth. Certainly, coun-tries such as Hong Kong and Singapore lacked theopportunity to transfer labour from low productivityagriculture, and the estimates in Maddison (1996)suggest this perhaps cut 0.5 per cent per year offtheir TFP growth compared with golden-age Franceand Germany. Even so, normalizing for the opportu-nities for catching-up presented by the initial pro-ductivity gaps and levels of education, the Tigers’TFP growth appears in a much less favourable lightand seems quite disappointing (Crafts, 1999).

These conclusions are unlikely to be seriously vul-nerable to the Rodrik critique. Simulations of thelikely bias in TFP growth if the elasticity of substi-tution is set at 0.6 suggest that the order of magni-tude in Korea, Singapore, and Taiwan in Table 2 isaround 0.7–0.9 per cent per year, which would stillleave their TFP growth short of the rates achievedin golden-age Europe. In any case, similar correc-tions for bias in estimated TFP growth probablyapply during the European golden age when capitaldeepening was also considerable.

When the differences between European and EastAsian demography and labour supply are recog-nized, it becomes apparent that conventional com-parisons of real GDP per person are quite mislead-ing as a guide to relative productivity performance.Table 3 reports estimates of hours worked andassociated purchasing power parity adjusted calcu-lations of real GDP per hour worked. Once agestructure and hours worked per worker each yearare taken into account, the labour productivity gapsbetween Asia and the West are revealed to be muchlarger than might be supposed from simply lookingat real GDP/person. This suggests that the opportu-nity for further rapid catch-up growth has not beencompletely eroded, even in the leading East Asianeconomies. An analysis of comparative manufac-turing productivity levels further supports theseconclusions. Timmer (1999) calculates that in 1993labour productivity in Korea and Taiwan was 36 and25 per cent of the American level, respectively.

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This analysis tends to reinforce the conclusion thatthe Asian developmental state has been much moresuccessful in promoting high levels of investmentthan in achieving exceptional productivity perform-ance. At least for the more successful Asian econo-mies, this should not detract from their unusuallysuccessful efforts to accumulate human capital andto improve and to develop imported technology (Belland Pavitt, 1993). Imports of capital goods andforeign direct investment have clearly been centralcomponents of technology transfer and far outstripthose of less successful regions, such as LatinAmerica.

This suggests that the Tigers’ disappointing TFPgrowth had its roots in other weaknesses in the

developmental state model. A danger is that thisspawns government policies which serve the inter-ests of special interest groups and actually inhibiteconomic growth by inducing misallocations of re-sources, for example, through so-called ‘industrialpolicy’. Although there is not yet consensus in theliterature on the overall effects of these policies,increasingly, econometric analysis is tending to findthat selective interventions on balance retardedrather than stimulated growth in both Korea andTaiwan. In Korea, directed loans and the clout of thechaebols appear to have distorted credit flows tothe detriment both of profitability and productivitygrowth (Borensztein and Lee, 1999). An analysis ofindustrial productivity growth across sectors inKorea during 1963–83 found that tax and financial

Table 3Annual Hours Worked and Real GDP/Hours Worked ($1990 international)

Per worker Per person GDP/HW

1973 1996 1973 1996 1996

Austria 1,778 1,710 741 725 24.76Belgium 1,872 1,637 720 595 29.84Denmark 1,742 1,644 842 797 24.85Finland 1,915 1,790 900 732 21.67France 1,904 1,666 783 600 28.47Greece 2,000 1,733 724 641 17.08Ireland 2,199 1,694 763 622 25.43Italy 1,885 1,830 781 641 26.23Netherlands 1,751 1,487 692 592 31.26Norway 1,721 1,407 728 686 32.46Portugal 1,900 2,009 768 853 14.09Spain 2,238 1,810 818 559 23.50Sweden 1,571 1,554 749 693 25.35Switzerland 1,930 1,643 982 874 23.17UK 1,929 1,732 861 764 22.68West Germany 1,865 1,558 817 661 29.68

Hong Kong 2,400 2,259 1,008 1,127 18.81Indonesia 2,010 2,200 754 903 3.75Japan 2,201 1,898 1,065 976 20.06Korea 2,428 2,453 798 1,099 11.70Philippines 2,235 2,110 776 679 2.87Singapore 2,410 2,318 872 1,193 15.87Taiwan 2,690 2,339 930 988 14.28Thailand 2,606 2,546 1,232 1,394 4.51

Source: Crafts (1999).

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incentives did not enhance productivity growth,while non-tariff barriers to trade reduced both capi-tal accumulation and TFP growth (Lee, 1995). Acomprehensive review of industrial policy in EastAsian countries finds that government interventionhas generally had adverse effects (Smith, 1995).

(iii) Financial Systems and Financial Crises

It is widely accepted that bank dominance of corpo-rate finance is generally appropriate for developingcountries. Banks have enormous advantages inmonitoring firms’ behaviour and gathering the infor-mation necessary to facilitate external finance. Totake full advantage of this in achieving economicgrowth and financial stability requires the develop-ment of an appropriate legal infrastructure andeffective bank regulation.

Recent research has shown that under-strengthrights for creditors and investors and/or weak en-forcement of the law is related to lower availabilityof bank credit to the private sector and externalfinance to firms. In turn, the supply of bank credit tothe private sector has important positive effects onlong-run growth, holding other obvious growth de-terminants constant. The results in Levine (1998)suggest that if Indonesia had had enforcement ofcontracts at the Singaporean level, the resultantexpansion of bank finance would have raised theaverage growth rate from the mid-1970s to the mid-1990s by about 2.5 percentage points per year. Thisaspect of East Asian financial systems is reported inTable 4(c).

It is also important that banks are prudently regu-lated and properly incentivized. In particular, in aworld of asymmetric information, both corporateborrowers and the banks may be exposed to prob-lems of moral hazard and tempted to gamble withfunds lent or deposited on the basis that, if theirinvestments turn out well, they enjoy the returns but,if they turn out badly, they cannot be held adequatelyto account or default is not very costly.

Problems of asymmetric information are central tomodern analyses of financial crises. Mishkin de-fines a financial crisis as ‘a nonlinear disruption tofinancial markets in which adverse selection andmoral hazard problems become much worse [which]prevents financial markets from functioning effi-

ciently, which leads to a sharp contraction in eco-nomic activity’ (1997, p. 39). A crisis is typicallytriggered by a macroeconomic disturbance which isreflected in sharp and unanticipated movements ininterest rates, exchange rates, etc.

During financial crises, problems of non-performingloans and shrinkage of collateral severely restrictthe credit available for investment. Economic his-tory offers many examples of financial crises occur-ring in basically sound and strong economies withhigh growth potential, but exposed to macroeco-nomic shocks where the banking system was frag-ile, for example, in nineteenth and early twentiethcentury America, and most notoriously in the Ameri-can Great Depression of the 1930s.

Both economic theory and economic history showthat problems of market failure imply that effectiveregulation of banks is essential to the well-being ofthe financial system, both to prevent excessive risk-taking and to reduce the likelihood both of bankinsolvencies and bank runs. Regulation should, interalia, enforce disclosure of information and theadoption of proper accounting standards and capitaladequacy standards that ensure that bank ownersare exposed to severe losses from bad loans.

Recent appraisals of East Asian banking systemshave commented on a number of serious weak-nesses that were common, although with differingseverity, through much of the region. These includelow capital-adequacy ratios of banks, excessiveexposure of banks to single borrowers, unduly leni-ent provisioning rules for non-performing loans,weak supervision, absence of proper auditing andaccounting, etc. which, combined with high lever-age of the corporate sector, have implied vulnerabil-ity to financial shocks (World Bank, 1998). It shouldbe noted also that these judgements do not reflectthe value of hindsight—just the same view can befound in assessments made before the crisis (White,1995). The implication of these weak balance sheetswas a high risk of financial crisis with mountingasymmetric information problems if the macroeco-nomic environment turned difficult (Mishkin, 1999).

The immediate source of shocks to the financialsystem appears to have been a weakening in exportperformance. The background to this is a boom andbust resulting from financial liberalization in the

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presence of monetary policy regimes tied to fixedexchange rates that permitted short-term borrowingin foreign currency from lenders who expected to beprotected by an implicit government safety net.Negative shocks precipitated devaluations and sig-nificant losses to the financial system and thusfinancial crisis in the exposed countries consequenton the macroeconomic policy errors which exposedweaknesses in banking systems (Corbett and Vines,1998).

Not surprisingly, there are important differencesacross East Asian financial systems and some ofthese are captured in Table 4. On balance, thepicture that is reported there suggests more sys-temic weakness in those countries that followed thedevelopmental state mode of growth, such as Ko-rea, than in those who were more laissez faire, suchas Hong Kong. It is also clear that those countriesthat were the most susceptible to a significant

financial crisis in the event of macroeconomic shockswere those in which the incentive and informationsystems were weakest, such as Thailand, ratherthan those with stricter bank regulatory frame-works, such as Singapore (Caprio, 1998).

The evaluation of the bank regulatory environmentin Table 4(a) comprises aspects that relate to thelikelihood of restraining excessive risk-taking andare conducive to financial stability. Rankings aregiven (1 is best) rather than raw data and manycomponents of the index are themselves synthesesof several sub-components. Loan classification isjudged on time before failure to service debt rendersa loan as non-performing and the extent of provi-sions required. The extent of foreign ownership istaken to be a sign of the quality of management andthe types of owner that are allowed into the industry.Liquidity is judged on minimum requirements andthe inclusion of foreign exchange as a separate

Table 4Aspects of East Asian Financial Systems

(a) Bank regulatory environment

Capital Loan Foreign Liquidity Operating Transparency Overalladequacy classification ownership environment ranking

Singapore 1 1= 2 2 1 1 1Hong Kong 2 4= 1 1 2 2 2Malaysia 4 4= 4 4= 3= 5= 3=Philippines 3 1= 3 3 7 7 3=Korea 5= 4= 6 6 3= 3 5Indonesia 5= 3 5 7 6 5= 6Thailand 5= 7 7 4= 5 4 7

(b) Corporate cash flow/ Corporate average Altman’s (c) Law enforcementinterest payable (1996) Z-score (1996)

Hong Kong 11.1 Hong Kong 6.9 Taiwan 8.84Singapore 8.0 Malaysia 3.9 Singapore 8.72Malaysia 6.7 Philippines 3.4 Hong Kong 8.52Taiwan 4.1 Taiwan 3.2 Malaysia 7.11Philippines 3.7 Singapore 2.9 Korea 6.97Indonesia 2.4 Indonesia 2.8 Thailand 6.91Thailand 1.9 Korea 1.5 Indonesia 5.04Korea 1.1 Thailand 1.5 Philippines 3.77

Sources: Bank regulatory environment derived from Caprio (1998); cashflow/interest payable and Z-scorefrom Pomerleano (1998); banking law enforcement from Levine (1998).

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reason for liquidity. Operating environment includesmeasures of property rights, creditors’ rights, and ameasure of the enforcement of the laws. Transpar-ency is based on an index of corruption, togetherwith the number of top ten banks with ratings frominternational firms and whether bank ratings arerequired.

The interest coverage data in Table 4(b) are basedon earnings before interest, taxes, and depreciationrelative to annual debt service for a sample ofcompanies. To put the ratios reported in Table 4(b)in perspective, US companies in 1994–6 rated byStandard and Poor as AAA have a median score of20.3, those rated as BBB 6, and those rated B 2.3.Clearly, the Indonesian, Thai, and Korean samplesreflect a situation in which weak financial ratios arethe pre-crisis norm. Precisely the same messagecomes from the Z-scores in Table 4(b). These arealso based on a weighted average of financial ratiosincluding return on assets, retained earnings toassets, sales to assets, working capital to assets, andequity to debt, and can range from –4 to +8.Companies which score less than 1.81 are financial-ly distressed and potentially bankrupt, while scoresabove 2.99 indicate financially sound companies.

China does not feature in Table 4, but it is clear thatin terms of the bank regulatory environment it wouldbe easily bottom of the league table. In particular, itsbanks score very badly on capital adequacy andnon-performing loans, have abysmal standards ofinformation disclosure and virtually no foreign own-ership, and a recent assessment suggested that thefour major banks are insolvent (Lardy, 1998). Stateinterference (‘policy lending’) has led to seriousmisallocation of funds, with a high fraction of bankloans directed to state-owned enterprises. Chinaexhibits symptoms of excessive and misdirectedinvestment and a chronically badly regulated bank-ing system similar to those in the worst affectedeconomies in the Asian crisis, but has been pro-tected from the consequences by not having capitalaccount convertibility. This allows a breathing spacefor reform but does not detract from its urgency.

Financial liberalization and the development ofgreater financial depth is potentially beneficial asdevelopment proceeds, in particular, when the em-phasis on addressing coordination problems recedesand allocative efficiency attains a higher priority.

For developing countries, opening the economy tointernational capital flows offers many potentialgains, including allowing investment to escape fromdomestic savings constraints, discouraging exces-sive domestic investment, and permitting the smooth-ing of consumption through time.

Equally, however, premature financial liberalizationwhich overburdens the regulatory authorities ortakes place in the absence of appropriate standardsof auditing, disclosure, and capital adequacy isknown to be a strong leading indicator of a subse-quent financial crisis (Caprio, 1998). Vulnerability tothe onset of adverse sentiment is exacerbated if, asin several East Asian countries, liberalization leadsto substantial short-term borrowing in foreign cur-rencies relative to foreign exchange reserves(Radelet and Sachs, 1998).

The financial sector policies of a developmentalstate tended to place little weight on proper auditing,accounting, credit rating, disclosure requirements,or experienced and independent regulators (Park,1994). Thus, to a significant extent, the current crisisfollowing liberalization in countries such as Koreacan be seen as the unfortunate aftermath of aGerschenkronian-style development. This doesnot imply that the aim of financial liberalizationwas wrong, rather that it has been badly mishan-dled. Other Tigers, such as Singapore and Tai-wan, may have been better placed to avoid suchmistakes.

What, then, does the current crisis tell us about thepreceding East Asian growth process? It should notbe taken to suggest that several decades of stronggrowth should be seen as some sort of mirage.Rather, it reminds us that a key lesson of history isthat, without adequate regulation of the bankingsystem, severe disruptions to economic growth arealways likely. It probably does reinforce the sugges-tions made above that East Asian productivity per-formance has been below par and that capital hasbeen badly used in some countries. It underlinesweaknesses in the legal infrastructure in some EastAsian countries, which have not only added to therisks of financial crisis but also have led to theunderdevelopment of the banking system and re-duced economic growth. It need not, however,imply that, in general, long-term growth potential isweak or has been permanently damaged.

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The East Asian developmental states delivered along period of high investment and very rapid growth.Although never as efficient as their proponentsclaimed, they served their purpose pretty well,despite the predictable downsides of directed lend-ing and industrial policy. In some ways, presentproblems are a result of earlier success whichpropelled the leading Tigers to a point at which moreemphasis needed to be placed on strong productivityperformance, and reform of the developmentalstate model seemed appropriate.

III. LESSONS FROM HISTORY

It is always tempting to look for precedents that canput present problems in perspective. In this section,two quite separate historical episodes are consid-ered which may have some relevance to EastAsia’s growth prospects in the aftermath of thecrisis, namely the relatively successful recoveryfrom the 1930s depression and financial crisis in theUnited States and the protracted growth slow-downin Japan in the 1990s. Obviously, caution is requiredin arguing the relevance of these examples, butnevertheless they offer useful policy lessons.

(i) 1930s America

The Great Depression represented a dramatic set-back to the American economy, which had becomethe world’s leading economy early in the twentiethcentury and had since been growing strongly, withlabour productivity growth averaging 2 per cent andTFP growth at 1.6 per cent per year through 1905–27 (Abramovitz, 1993). The 29 and 33 per cent falls

in output and the money supply, respectively, re-corded in Table 5 accompanied a spectacular finan-cial crisis which, although unprecedented in itsseverity, was the last in a long sequence (Mishkin,1991). The banking system was weakly regulated,especially where banks opted for state as opposedto federal regulation, and undercapitalized.

Yet, following a disastrous catalogue of policyerrors, the economy turned around and made a goodrecovery that began in 1933. The ingredients of thissuccessful renaissance include an expansionarymonetary policy following departure from the GoldStandard and the successful resolution of the bank-ing crisis which began with the Emergency BankingAct of March 1933 and was fairly complete by theend of 1937. Recent econometric analysis suggeststhat the depression represented a break of trend,after which the economy made up the lost groundand then returned to the old steady-state growth rateon a slightly higher growth path than before (BenDavid and Papell, 1995). GDP per head got back tothe old trend path in 1941. The time to recovery was12 years and the cumulative loss of output relativeto trend in this period was about three times the 1929GDP. Labour productivity growth and TFP growthwere 2 and 1.8 per cent per year, respectively,during 1929–48 (Abramovitz, 1993).

Recent discussions of the 1930s American depres-sion have emphasized the importance of a financialcrisis in which the role of asymmetric informationwas central, rather than treating the event simply asa monetary shock to aggregate demand. The impli-cation is that there was a drying up of the supply aswell as a collapse in the demand for loans. This has

Table 5Aspects of the American Great Depression

GNP Real M0 M2 Deps/ Deps/ Equities Bank Bid/ Dep. def. I/Y($bn) GNP ($bn) ($bn) resvs currcy index failures ask premium (%)

1929 104.4 100.0 7.1 46.2 13.0 11.0 260.2 658 2.74 33.46 15.51933 55.6 71.1 8.2 30.8 8.2 5.1 89.6 3,252 5.41 41.69 0.41937 90.8 104.5 13.4 45.0 5.0 7.1 154.1 58 4.28 0.60 13.4

Note: I/Y is the domestic investment ratio.Source: Temin (1976), except: bank failures—US Treasury Department (1938); bid–ask spread in % ofshare price and deposit default premium in basis points—Calomiris and Wilson (1998). These last data relateto a sample of New York banks (see text).

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been most clearly shown in the analysis of NewYork City banks by Calomiris and Wilson (1998). Inthe economic downturn, depositors (who were notinsured) faced increased risks of default by banks,and banks faced strong incentives to limit depositrisk. Adverse economic shocks impaired bank capi-tal, sharply raised adverse selection costs of raisingequity, and reduced quasi-rents from lending. Facedwith this situation, banks opted for holding muchhigher reserves, thereby lowering asset risk, andcurtailed loans, while depositors held more of theirmoney in the form of cash. The symptoms of theseproblems are reported in Table 5 in the form of highdeposit default premia reflecting the decline in bankstock values and of the doubling in bid–ask spreadson bank shares which indicates the increased issu-ing costs that banks faced.

It follows, as contemporaries realized, that eco-nomic recovery needed not only policies to raisespending, which in a large economy could be pro-vided by domestic demand stimulus following thesuspension of the Gold Standard, but also a govern-ment strategy to rehabilitate the banking system andrestore the supply of credit. Tackling the bankingcrisis proved too difficult for the Hoover presidency,although the plan ultimately adopted under Roosevelt,with the legitimacy of a newly elected leader, hadactually been formulated by the outgoing adminis-tration (Olson, 1988).

The plan involved, firstly, the March 1933 BankHoliday in which banks were inspected and re-licensed if they were perceived to be sound. Thiswas deemed crucial to restoring public confidenceand was followed by the 1934 Federal DepositInsurance Act, under which qualifying banks had toachieve appropriate capital adequacy, and the Glass–Steagall Act which separated commercial and in-vestment banking. The Emergency Banking Actallowed new powers to bank receivers to prevent asmall minority of shareholders obstructing capitalrestructuring by refusing to accept losses and towaive a proportion of creditors’ claims provided 75per cent approved (O’Connor, 1938). About three-quarters of the 4,000 banks (25 per cent of the total)that were initially refused licences after the BankHoliday were eventually recapitalized and re-openedand the others were closed. This was facilitated bysubstantial purchases of preferred capital by gov-ernment credit agencies, notably the Reconstruc-

tion Finance Corporation which also made substan-tial loans both to aid recapitalization and to speed uppayment of dividends to depositors. By the end of1935, the government in effect owned about a thirdof all bank capital and total state aid extended to thefinancial system including loans was $9.4 billion, i.e.about 13 per cent of GNP (Chandler, 1971, p. 268).

This was a clear departure from the previous ap-proach to bank failure which amounted to straight-forward liquidation and pay-off, in which depositorstypically lost about a third of all deposits and share-holders usually lost all their capital (Upham andLamke, 1934). The switch from liquidation towardsrecapitalization was not, however, a bail-out and thegovernment appears to have suffered no overalllosses on its temporary banking investments andloans (O’Connor, 1938). Shareholders were usuallycalled upon to make as substantial a contribution tothe recapitalization as possible, large depositorswere still exposed to losses in the event of bankfailure, and, with new tighter regulation, moral haz-ard was contained while the danger of bank runswas much reduced and non-viable banks wereeliminated fairly quickly.

Clearly, different options for bank restructuringinvolve trade-offs (World Bank, 1998, p. 49), andthe Roosevelt administration sacrificed speed infavour of sustaining confidence in the banking sys-tem and limiting the fiscal costs of intervention. Theoutcome reflected in Table 5 was one in whichbanks continued to hold far more reserves than inthe 1920s, where bank failures virtually ceased andbank deposits partly recovered, but in which thecosts of issuing new bank equity remained high. Thepoliticians appear to have overreacted in the prohi-bition of universal banking, which subsequent re-search has shown threatened neither capital ad-equacy nor the liquidity of the banking system andalso did not lead to widespread defrauding of inves-tors (Kroszner and Rajan, 1994; White, 1986).

Overall, the 1930s American experience may havesome optimistic implications for Asian crisis coun-tries. In the long run, the trend rate of growth wasunaffected, despite the severity of the economicshock. In the short to medium term, a package ofpolicies was devised that repaired the damage to thefinancial system, even though it was flawed in somerespects, and the United States entered an era of

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much greater financial stability. The situation did,however, require effective government interven-tion, and recovery was by no means instantaneous,even though it was not dependent on externaldemand.

(ii) 1990s Japan

The golden age of rapid growth, reported in Tables1 and 2, now seems a long way removed from recentJapanese experience. That period can be thought ofin Gerschenkronian terms as an escape from back-wardness. It was based on distinctively Japaneseinstitutions revolving around the main bank system,the keiretsu, and lifetime employment, all of whichcan be seen as responses to the early stages ofeconomic development transactions costs problem.They represent institutional innovations that emergedas a result of the wartime experience (Noguchi,1998) and led to enhanced social capability forcatch-up, expressed in high rates both of factoraccumulation and of TFP growth.

Recently, these institutional arrangements havestarted to be questioned and seen as obstacles toovercoming the difficulties of the Japanese economyin the 1990s (Ito, 1996). Most obviously, this is trueof the banking system which, since deregulation inthe 1980s, has developed serious and persistentproblems. The collapse of asset prices at the start ofthe 1990s was a shock leading to a protractedfinancial crisis, reflecting both serious moral hazardproblems in the banking system and a delay inregulatory response that seems to have its roots inthe political arena (Cargill et al., 1997), but also toreflect a hope that the banks would eventually tradeout of the worst of their difficulties and a fear ofcreating a major bank panic if the magnitude of non-performing loans were revealed (Horiuchi, 1996).In early 1998, non-performing bank loans appear tohave been at least 14 per cent of GDP (IMF, 1998).

Econometric analysis suggests that domestic assetprice falls have had a strong impact on the supply ofbank loans, and thus on output, as undercapitalizedbanks have responded by restraining lending tomaintain capital adequacy standards. The centralrole played by financial intermediation in the reces-sion has severely curtailed the effectiveness ofconventional macroeconomic policies in stimulatingaggregate demand (Bayoumi, 1999). In failing to

address the banking crisis, Japanese policy foreconomic recovery has lacked key componentsand, in this respect, it compares unfavourably withRoosevelt’s America.

The fundamental weaknesses of the Japanese fi-nancial system have a longer history. In particular,the post-war bank finance arrangements were es-tablished to deliver a low cost of capital rather thanto promote the efficient use of capital or shareholdervalue. The outcome was effective mobilization ofresources, but tolerance for low efficiency andprofitability and a bias towards overexpansion (Ide,1996). These arrangements needed a well-designedreform, but the incentives delivered by the deregu-lation of the 1980s appear to have encouraged realestate speculation rather than a more efficientallocation of capital. Here is a good example of thedifficulties of making an appropriate institutionaltransition following the initial escape from back-wardness. Although Japan has continued to investhigh proportions of its GDP, capital productivity hasdeclined dramatically at an average rate of 2 percent per year during 1979–96 (OECD, 1997).

Table 6 reports on Japanese productivity perform-ance since the golden age in a comparative context.Plainly, this has been rather disappointing and theslow-down in TFP growth to 1.2 per cent per yearcompared with 3.2 per cent in 1950–73 is moreabrupt than earlier investigators, notably Denisonand Chung (1976), projected. While they recognizedthat earlier Japanese growth had a very high transi-tory catch-up component, they thought that thiswould not be completely exhausted until around2002. They projected an average growth rate of 6.2per cent for real GDP from 1971 to 2000 (1976, p.126) with growth in the first half of the 1990s still uparound 5.5 per cent per year.

Why were Denison and Chung wrong? The mainreason is that they assumed much stronger growthin TFP from continued catch-up. In fact, Japan hasbecome a somewhat sclerotic economy and hasweak productivity performance in much of the non-tradables sector. Even in manufacturing, Japan didnot close the TFP gap with the USA at all betweenthe mid-1980s and the mid-1990s. Table 6 reportsonly one other sector (distributive trades) where thelevel of Japanese relative to British TFP has im-proved appreciably since 1973, while in the majority

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Table 6Total Factor Productivity Performance, 1973–95

(a) Levels (UK = 100)

France Germany USA Japan

Agriculture 1973 61 45 88 311995 65 46 100 15

Mining and oil refining 1973 83 186 146 201995 177 240 140 22

Electricity, gas, and water 1973 88 119 219 2131995 87 79 115 100

Manufacturing 1973 89 102 159 881995 103 108 142 116

Construction 1973 87 101 150 1341995 78 70 84 74

Transport and communications 1973 107 81 139 861995 110 85 111 59

Distributive trades 1973 116 90 119 611995 126 106 135 94

Financial and business services 1973 215 150 182 821995 134 141 122 59

Miscellaneous personal services 1973 170 87 157 1231995 131 115 135 83

Total market sectors 1973 107 115 146 821995 108 115 119 76

(b) Rates of Growth (%)

France Germany UK USA Japan

Agriculture 4.3 3.2 2.9 2.3 1.1Mining and oil refining 0.9 –1.1 –2.1 –1.1 –0.4Electricity, gas, and water 2.9 1.0 2.9 –0.1 –0.9Manufacturing 2.5 1.9 1.8 1.2 2.3Construction 1.8 0.7 2.2 –0.4 –0.8Transport and communications 3.0 3.2 3.1 2.1 1.0Distributive trades 0.4 1.2 0.4 0.6 2.4Financial and business services –1.1 0.2 1.0 –0.9 –1.0Miscellaneous personal services –0.9 2.1 1.2 0.4 –1.3Total market sectors 1.7 1.6 1.7 0.7 1.1

Source: O’Mahony (1999).

of sectors there has been considerable relativedecline.

In part, poor Japanese TFP performance reflectsexcessive and wasteful investment, and thus weak-nesses in the financial system and in corporate

governance. Beyond this, however, policy errorshave also played a part. As elsewhere in East Asia,industrial policies appear to have diverted resourcesaway from high growth sectors towards decliningindustries and did not have a positive effect on TFPgrowth during 1960–90 (Beason and Weinstein,

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1996). The Japanese economy has also been sub-jected to excessive regulation, which has beencostly in terms of productivity, and has continued tohave high hidden unemployment in non-tradables.The scope for TFP gains from deregulation in Japanappears to be about six times as large as in theUnited States (Blondal and Pilat, 1997).

Recent Japanese economic history should act as awarning tale for other East Asian countries. Thereare two messages. First, that it is important forpolicy-makers to address problems in the bankingsystem and the issue of who bears the costs ofinsolvent banks immediately, rather than to seek tocover them up and risk a prolonged credit crunch.The contrast between the Roosevelt administrationand 1990s Japanese politics is depressing.

Second, faltering Japanese productivity growth un-derlines the point that catch-up growth is not auto-matic, as the neoclassical model would have usbelieve, but depends on social capability and can beeroded by poor policy choices. The premature endto Japanese catch-up resonates with recent econo-metric evidence that rejects hypotheses of conver-gence, either in the strong form that long-termforecasts of differences in output per person forOECD countries tend to zero or in the weak formthat long-run forecasts of output per person areproportional with a single long-term trend for allOECD countries (Bernard and Durlauf, 1995; Millsand Crafts, 1999).

IV. THE CRISIS AND REFORM

Recovery from the Asian crisis plainly entails asubstantial increase in aggregate demand, for whichdevaluation may be helpful and which macro-economic policy must address. Nevertheless, the1997/8 crisis reflects weaknesses in the institutionalarrangements of the East Asian developmentalstate model in an age of financial liberalization.Clearly, reform is also necessary, not simply torecover from the immediate dire situation but also toensure that the unfortunate Japanese precedent offaltering catch-up is not followed. While the Ameri-can example of the 1930s argues that even amassive financial crisis need not damage long-termgrowth potential, provided that the banking system

is rehabilitated and re-regulated, this does not de-tract from the case for wider-ranging reforms to theconduct of both firms and governments in East Asiaif future growth potential is to be fully realized.

The ingredients necessary to deal with the bankingcrisis and the longer-term reforms to banking sys-tems in East Asia are well understood and there areencouraging signs that some progress is being made(Goldstein, 1998). Insolvent banks should be closed,viable banks need to be recapitalized and subject toproper risk management, capital adequacy, ac-counting, and information disclosure standards. Regu-latory forbearance needs to be replaced by strictenforcement. Shareholders should bear the mainbrunt, but cleaning up bank balance sheets whilelargely protecting depositors will imply substantialfiscal costs, perhaps anything up to 30 per cent ofGDP in the worst cases (World Bank, 1998, p. 49).

Given the evidence of negative credit channel im-pacts on industrial production in countries such asKorea (Domac and Ferri, 1998), an early resolution tothe banking crisis is important to recovery. Therehave been strong signs that this may be achieved. TheKorean government has intervened effectively tostrengthen financial regulation and supervision, butalso identify and close non-viable banks while actingto recapitalize viable institutions. Public funds equiva-lent to 17.5 per cent of 1997 GDP had been commit-ted by August 1998 (Balino and Ubide, 1999).

The quality of the legal system and the conduct ofthe bureaucracy are important not only for theavailability of external finance and foreign invest-ment, but also for the reduction of transactions costsmore generally. Recent research strongly suggeststhat measures of these aspects of institutional qual-ity are positively related to growth performance,holding constant levels of human capital, scope forcatch-up, etc. (Knack and Keefer, 1995; Barro,1997). It seems probable that a main channel forthese effects is that identified by Levine (1998),namely that weak legal underpinnings restrain theavailability of bank finance and that this has seriousadverse growth effects. If this is correct, at theonset of the crisis, several East Asian countrieswere still handicapped by corruption and weakproperty rights, for example, Indonesia, Philippines,Malaysia, and Thailand.

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In the longer term, it seems likely that in the laterstages of development it will be desirable for EastAsian countries to move away from bank-domi-nated finance and to develop better methods ofcorporate governance. In most cases, this will entailthe establishment of better legal rights for outsideshareholders and will be facilitated by the emer-gence of ownership characterized by large andpowerful investors (La Porta et al., 1997). Theimportance of investor protection and availability ofequity finance appears to be especially significant infostering growth in R&D-intensive activities whichare starting to be important in the leading Tigereconomies (Carlin and Mayer, 1998).

In the absence of effective control by shareholders,the best restraint on inefficient management offirms is competition (Nickell, 1996). This impliesthat it is important that policies of greater opennessto international trade and foreign companies arepursued. In particular, the Japanese example sug-gests that this should extend to the relatively back-ward services sector, important parts of which, suchas telecommunications, utilities, and transportation,have generally been government dominated. Yetcompetition policy in East Asia has been seriouslyneglected; for example, Association of South EastAsian Nations (ASEAN) countries, with the excep-tion of Thailand, do not have anti-trust laws and, inthe Thai case, the law has been used as an instru-ment of price control rather than to promote eco-nomic efficiency (Lall, 1997). This is also an areawhere reform to the developmental state modelseems to be urgently required.

As Rodrik (1996) points out, it has become com-monplace to assert that crisis is the instigator ofreform, but it is less clear what are the analytic orempirical underpinnings of such a claim, despite itsintuitive appeal. Rodrik himself suggests that onejustification may be that the opportunity provided bydeep crisis is that it is possible to deliver widespreadincome gains by policies to revive economic activity,and this allows reformist policy-makers to add onmicroeconomic and structural reforms that wouldbe difficult to implement in normal circumstancesbecause of their distributional implications (1996,pp. 28–9). Given that microeconomic reform to theAsian development state model is clearly required,it is possible that the crisis will actually be helpful to

long-run growth, despite its devastating short-termimpact.

History does not entitle us to be too optimistic in thisregard. Indeed, in the crisis of the 1930s, the generalexperience of policy reforms, especially in LatinAmerica, was that measures adopted as a quick fixtended to reduce long-term growth prospects. Thehallmark of these changes was that they encour-aged inwardly oriented development policies, basedon protectionism and capital controls. Restrictivepolicies initiated in the 1930s delivered a relativelyrapid recovery from the depression, but had aseriously adverse impact on accumulation of capitalover the next half century (Taylor, 1998a). In thecase of Argentina, where after 1930 developmentwas essentially domestically financed, by 1960 capi-tal goods were about two or three times as expen-sive as in the USA, while the marginal product ofcapital was about 30 per cent lower (Taylor, 1998b).The European experience was less malign becausethe policies of the 1930s were reversed during thegolden age.

V. GROWTH PROSPECTS

In a much discussed article, Krugman stressed wellbefore the recent Asian crisis that a growth slow-down would happen quite soon to the Tigers, asgrowth would run into diminishing returns and themiracle would soon become a distant memory, justas the golden age is for Western Europe (1994, pp.77–8). Krugman based his view on the propositionthat growth in the region had primarily relied oncapital accumulation rather than productivity growthand that rising incremental capital-to-output ratioswould soon reduce growth to rates more typical ofWestern economies. In particular, Krugman em-phasized that this was the prospect for Singaporewhere the growth accounting estimates available tohim at that time suggested that TFP growth wasvery low.

This seems to have been an unduly pessimistic viewof East Asian growth prospects before the crisis.First, as Table 2 showed, strong growth of labourinputs has tended to retard the onset of diminishingreturns and, especially in Singapore, actual TFPgrowth appears to have been somewhat stronger

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than Krugman thought. Second, as was reported inTable 3, once comparisons are made in terms ofGDP per hour worked rather than GDP per person,it becomes apparent there is still substantial scope toreduce productivity gaps and thus opportunity forsignificant catch-up growth. Krugman was right,however, to highlight the importance of improvingTFP if this potential is to be realized.

One way to provide an illustrative bench-mark forfuture growth prospects is to consider what asteady-state growth path for real GDP per personmight look like and then to compare the outcome

with past performance, ignoring for the moment anyimplications of the present crisis. A similar approachhas recently been employed for ASEAN countriesin Sarel (1997). The starting point for any suchcalculation is to choose an estimate for TFP growthand growth of labour inputs per person. Capitalaccumulation is assumed to come into line as in anAugmented-Solow or endogenous innovation growthmodel. The results of an exercise of this type areshown in Table 7.

Before considering Table 7 in detail, it is vital torecognize that the numbers in it are not forecasts,

Table 7Illustrative Steady-state Growth Projections

(% per year)

TFP Labour/ K/Y I/Y GDP/ 2015 S/Y I/Yperson reqd head income 1991–6 1991–6

China 3.6 0.8 1.7 21.1 6.3 8,998 40.1 39.2Indonesia 3.4 1.2 2.8 35.8 6.4 11,253 32.1 34.7Korea 2.2 0.6 2.9 28.1 4.0 27,120 35.4 36.9Malaysia 1.9 1.1 2.5 27.0 4.0 16,354 35.0 41.5Philippines 3.6 1.1 2.0 26.6 6.6 7,970 19.0 22.2Singapore 1.3 0.6 2.9 24.7 2.6 34,165 47.8 34.6Taiwan 1.4 0.6 1.8 15.5 2.8 24,031 27.4 23.4Thailand 2.6 1.4 2.2 23.8 4.9 15,210 34.9 42.6

Sources:TFP: projected TFP growth based on catch-up component using Benhabib and Spiegel (1994, p. 162,equation 5), except for China and the Philippines, where it is assumed that catch-up would not exceedJapanese TFP growth in 1950–73, and Korea, Singapore, and Taiwan, where the development of an R&Dcapability is assumed to add a further 0.4 per cent per year to TFP growth.Labour/person: projected growth of labour inputs per person derived from United Nations (1995) and anaddition of 0.5 per cent per year (0.7 per cent in China, Indonesia, and Singapore) for improved labour forcequality from extra schooling based on past trends as estimated by Collins and Bosworth (1996).K/Y: the 1994 capital-to-output ratio (Collins and Bosworth, 1996, p. 189).I/Yreqd: the percentage of GDP needed to be invested to maintain the capital-to-labour ratio along thesteady-state path, assuming 5 per cent of the capital stock depreciates each year and α = 0.35. The steady-state growth path is characterized by a constant capital-to-output ratio in which case

∆ ∆ ∆Y Y L L

A A/ /

/

( ).= +

−1 αGDP/head: derived steady-state growth rate for real GDP per head.2015 income: projected real GDP per person measured in 1990 $ international (comparable with theestimates in Table 1), assuming the steady state is maintained.S/Y: the domestic savings ratio (Asian Development Bank, 1997).I/Y: the domestic investment ratio (Asian Development Bank, 1997).

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although they may represent feasible paths thateach country could sustain. The discussion of earliersections gave several reasons why exercises of thiskind only produce bench-marks. In particular, it wasargued that forecasting TFP growth during catch-up is extremely difficult because it depends on socialcapability and policy choices and cannot be inferredfrom the predictions of a pure neoclassical conver-gence model.

Feasible TFP growth depends on scope for catch-up and the projections in Table 7 therefore make useof a model to predict the potential for catch-upgrowth through improved TFP, taking into accountthe initial productivity gap. Realizing this potentialdepends on good policy and is certainly not auto-matic. For example, the TFP projections for China,Indonesia, and the Philippines far exceed theirrecent performance and would surely require majorsupply-side reforms to be realized, including elimi-nation of crony capitalism and policy-directed lend-ing, and substantial improvements in the legal infra-structure on which financial markets depend. Theprojected TFP growth is a function of years ofschooling and is based on the work of Benhabib andSpiegel (1994)

For most of the economies in Table 7, the steady-state growth projection is below the rates that theyhave achieved in the recent past. There are threereasons for this:

• scope for further catch-up is now reduced, al-though not exhausted;

• labour force growth will slow appreciably as thedemographic transition unwinds;

• most countries have been enjoying transitionalgrowth with capital-deepening at above the steadystate rate.

Nevertheless, even in Singapore and Taiwan, growthrates would exceed those of most of WesternEurope since 1973. One way for growth to be higherthan these projections would be for countries tocontinue to invest more. For example, if Korea andSingapore, while sustaining the TFP growth ofTable 7, invested sufficient to reach the Japanesecapital-to-output ratio of 4.6 by 2015, growth of realGDP per person would be projected over the 20-

year period to average 5.1 and 3.7 per cent, respec-tively.

The steady-state projections themselves are nota-ble for the relatively modest demands they wouldplace on domestic savings relative to recent levelsand could be achieved with lower domestic invest-ment rates than have prevailed in the past. Giventhat demographic factors will not tend to reducedomestic savings much, even in the countries wherethe demographic transition is most advanced, before2010 (Heller and Symansky, 1997), savings wouldnot seem to be a constraint on achieving thesegrowth rates, even if foreign investment were not toreturn to the region after the crisis.

This review of Asian growth prospects essentiallyrepresents the situation before the present crisis.Indeed, the TFP growth rates chosen to illustrate thesteady-state paths are broadly within the rangethought likely in a recent pre-crisis OECD projec-tion that projected TFP growth for ‘Dynamic Asia’at 2–2.8 per cent and for China at 2–3.4 per cent peryear through 2020 (Richardson, 1997). It is surelytoo soon to be sure how much has changed or evenhow many countries will eventually become directlyrather than indirectly affected by financial and/orcurrency crises.

Some favourable features of strong growth coun-tries will presumably be resilient—these might in-clude stocks of human capital, high personal sav-ings, effective mechanisms for technology transfer,and their outward orientation. Others, such as highinvestment rates, are likely to be undermined in theshort term, although not necessarily in the longerterm, as American experience during the GreatDepression suggests. The biggest uncertainty at-taches to future TFP growth, as the failure of 1970sprojections for Japanese growth reminds us. If thepotential for growth set out in Table 7 is to berealized, there will need to be changes in the Asiandevelopmental state model and an avoidance of thepolicy errors made after the golden age in Europeand Japan.

As with Japan, the slow-down in European produc-tivity growth after the golden age probably alsoreflects a reluctance to de-regulate. A quantitative

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study by Koedijk and Kremers (1996) found that, ifWest Germany had de-regulated its product mar-kets to the same extent as Ireland, its TFP growthin the business sector could have been over 1 percent per year higher. In the European case, a furthernegative influence on overall productivity growthhas been the rapid growth of the public sector andtaxation as a proportion of GDP. While currentgovernment spending in the median West Europeancountry was 31.9 per cent of GDP in 1960–73, in thefirst half of the 1990s this had risen to 50.6 per cent(OECD, 1995, 1997). The impact that rising taxburdens have on growth rates is a very controversialtopic in applied economics, but the trend in recentstudies has been to find that an increase of thismagnitude in the tax burden could have a sizeable,negative impact on growth of at least 1 and perhaps2 per cent per year (de la Fuente, 1997; Leibfritz etal., 1997).

The implications of this discussion together with thatof section IV for East Asian growth prospects, areas follows.

• Some aspects of the Asian situation appear morefavourable than in the European case, notablythe absence of the pressures of aging on fiscalpolicy and the lack of a tradition of expensivesocial programmes which may reduce the risk ofrising taxation inhibiting growth.

• Full catch-up of the USA requires that attentionis paid to non-tradables and other sectors as wellas manufacturing. It seems likely that the tradi-tional Asian developmental state model, with itsemphasis on export targets and performance tolimit rent seeking and to inform the allocation ofcredit, is not particularly well-suited to this re-quirement.

• Catch-up is not automatic and would tend to beheld back by inappropriate policy or inefficientuse of capital. The industrial policy prescriptionsof the developmental state, which are liable toresult in the support of declining industries at theexpense of the rapid exploitation of new service-sector opportunities, are likely to be still lesshelpful to the next phase of catch-up. Wellhandled, financial liberalization can help strengthenmarket disciplines, which will facilitate betterproductivity performance.

VI. CONCLUSIONS

It is now time to reflect on the questions posed in theintroduction in the light of the discussion of theintervening sections of the paper. The comments tobe made are in the nature of generalizations thatreally deserve to be heavily nuanced and qualified,but may nevertheless serve a useful purpose.

The current Asian crisis seems to owe a great dealto the weakness of financial systems reflected inoverborrowing and excessive risk-taking, togetherwith inadequate regulatory responses which werevulnerable to adverse macroeconomic shocks. Cri-sis probably says more about the way that financialliberalization has been handled than about the fun-damental growth potential of the economies con-cerned. In the early stages of industrialization, aGerschenkronian approach to development deliv-ered a remarkable, sustained growth spurt. Thereare, however, downsides to the ‘developmentalstate’ model that its proponents tend to gloss over.In particular, these are tendencies to wasteful in-vestment and deleterious industrial policies, togetherwith inadequate attention to establishing sound legaland regulatory underpinnings for the financial sys-tem which could obviate the difficulties that mayotherwise result in the eventual transition to a freercapital markets model.

The latter will tend to grow in attractiveness afterthe initial phase of development when coordinationproblems loom much less large and diminishingreturns become a bigger threat such that efficientuse rather than sheer volume of investment be-comes a higher priority. The greatest successes ofthe managed development approach have tended tocome in the context of export-orientated manufac-turing and industrialization. In the coming years ofde-industrialization, a different model may be moreappealing.

The experience of the United States in the 1930soffers considerable encouragement that even avery severe crisis need not undermine long-termtrend growth. In that case, after initial and unfortu-nate delay, from 1933 effective policy action wasput in place, both to reform the banking system andto repair bank balance sheets. Restoration of thesupply of credit and expansion of aggregate demandwere both central to this outcome.

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