Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

How the Asian Crisis Affected the World Economy: A General Equilibrium Perspective

Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

How the Asian Crisis Affected the World Economy: A General Equilibrium Perspective

Article excerpt

It has been more than two years since the financial crisis first broke out in East Asia in the summer of 1997. Now that much of the dust has settled, it is clear that the world economy was far from being mired in a global slump.1 Furthermore, although the growth in the crisis-afflicted countries and other emerging market economies did slow quite significantly, growth was sustained in North America and Western Europe. Indeed, growth accelerated in some cases.2

Until very recently, the conventional view was rather pessimistic. Observers feared that the economic stress that had begun in Southeast Asia would worsen and spread. For the world economy as a whole, as well as for key industrial countries, growth was expected to be slower, risks higher, and flows of capital further dislocated. Even in the United States, a country that, for most of its history, has shrugged off economic turmoil abroad, there was a fair amount of nervousness. Many economists forecasted much slower growth rates for the next few years (see among others, DRI forecasts) in light of the intensity of the Asian crisis and the distinct possibility that it could spread worldwide. The puzzling question that naturally arises is, "Why didn't the whole world economy enter a slump?"

In this article, we attempt to answer this question from a general equilibrium perspective. The strategy here is to use a standard growth model augmented with multi-region and multi-production sectors to analyze how a set of real shocks hitting crisis countries affects the world economy as well as economies in different regions. These shocks, as will become clear later, are identified by recent research on the causes of the crisis. The mechanism that connects regions and that transmits shocks across them consists of two links: commodity trade and capital flows. Our analysis shows that much of the fear of a global recession spreading to industrial economies was not well grounded. Moreover, the burden of adjustment to the crisis was uneven across regions. The developing countries bore the brunt of this adjustment, suffering declines in economic activities. By contrast, industrial countries escaped largely unscathed. The impact the crisis had on them was small and even positive in its initial stages.

This article does not attempt to explain the crisis and its causes. Rather it measures, with the aid of a general equilibrium model of real trade and capital flows, the spillover effects of the crisis on the other regions of the world. Surprisingly, while various explanations of the East Asian financial crisis have been advanced, little effort has been devoted to analyzing its effects on the world economy. More is the pity, for the importance of such an analysis is great and indeed goes beyond what we conduct in this article. The results here suggest that policy actions that have generally been viewed as responsible for the robust growth of industrialized nations in the face of the financial crisis may not matter much after all. These actions include monetary policies adopted by industrial countries. They also include the stabilization and reform package that Asian crisis countries implemented at the insistence of the IMF. In other words, it could well be that many common concerns were overstated and not based on careful economic analysis.


While there is little consensus on the definite causes of the crisis, there is now evidence that the region's economies had been confronting a deteriorating macroeconomic environment since the early 1990s (see, e.g., Krugman [1998], Radelet and Sachs [1998], Flood and Marion [1998], Corsetti et al. [1998], Chang [1999], and Whitt [1999]. A description shared by many is that given by Chang [1999]).

Several countries in the region experienced a real appreciation in their currencies during the 1990s and by 1997 had sustained sizable current account deficits. These deficits were mostly financed through short-term foreign borrowing. …

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