Fiscal positions in Asia were far weaker than they initially appeared to be because of the enormous contingent liabilities that governments faced as a result of the collapse of the banking systems. This limited the room for countercyclical fiscal policy, although each government moved eventually to put in place modest fiscal stimulus. This diagnosis of financial vulnerabilities led to a very substantial improvement in the quality of national balance sheets in the region. More on this later. Exchange rate regimes and the perils of the middle A second, and closely related lesson, relates to the exchange rate regime. In the crisis countries, the exchange rate regime of choice had been a fixed but adjustable peg. This was softer than a currency board – the possibility of adjustment was built into the arrangement, but it was presented as a commitment to a fixed nominal exchange rate for an indefinite period of time. Although these regimes of limited exchange rate flexibility had been regarded as a means of achieving economic stability, in fact they turned out to be a source of instability. Nominal exchange rates against the dollar had been held fixed for some time, while real effective exchange rates had appreciated significantly. Because of weaknesses in the financial system, the investment booms of the previous decade had not translated into increased productivity. As investors grew concerned about potential weakness, pressure on the exchange rate further intensified until it became unsustainable. Exchange rate intervention proved ineffective.
The more promising approach is to invest in the complement of institutions and policies that enable an economy to live more comfortably with openness. Focusing on those measures that will enable an economy to be more flexible and to adapt more quickly to change ultimately will be a more effective policy strategy. It is politically more difficult, but economically more effective than those solutions that seem to offer protection from competition and volatility. Crisis resolution A fourth lesson, or series of lessons, comes from our experience in crisis resolution. The strategies adopted to stabilize markets and then to foster recovery varied significantly across the crisis economies. Each involved a somewhat different mix of policy reforms and temporary financial assistance, tailored to the different conditions that prevailed. Where there was success, the common feature was what Larry Summers called the Powell Doctrine applied to international finance – the overwhelming use of force, with a clear strategy for resolution. The “force” in this sense applied both to the scale of financing made available relative to the need and to the quality of the policy measures. Very substantial resources were deployed in support of the recovery efforts, and a large share of the resources was made available upfront, in order to try to mitigate the liquidity problem and to stem the loss of confidence.