Krugman doubts Asian recovery

June 18, 1999 -- HERE he goes again. After predicting a collapse of Asia's miracle in 1994, urging ailing crisis-hit Asian countries to adopt capital controls to stabilise their economies last year, Paul Krugman, the MIT economics professor, has poured scorn over the recent hype over the Asian recovery story.

Writing in the cover story of the latest edition of Time magazine (June 21), Krugman, who has reached stardom status by popularising his economic writings, cast doubt about the prospects of the Asian patients staging a full recovery.

''... if by recovery you mean not just a return to growth, but one that brings the region's performance back to something like what people used to regard as the Asian norm, they have a long way to go -- and there are a couple of good reasons to think that they won't get there,'' he wrote.

First, Krugman argued that Asia is handicapped by a lack of Western-style corporations. ''Institutions that looked, on paper, like modern corporations were really overgrown family firms whose growth depended on the personal wealth of their owners and their ability to leverage that wealth through bank loans,'' he said.

It will take time before the banks restore their health and start lending at a normal pace again. Besides, the entrepreneurs, who were the driving force behind the Asian economic machine, have been hardest hit by the crisis and are not likely to bounce back any time soon. If new entrepreneurs are to enter the scene after the modernisation of the economic and financial systems, it will still take them years before they can make any impact, he said.

Second, Krugman makes a point that even before the crisis in 1997 the Asian economies were suffering from diminishing returns. In other words, rapid growth was not sustained by innovations or productivity but by the ever increasing foreign capital inflows.

In his controversial article, ''The Myth of Asia's Miracle,'' published in Foreign Affairs (Nov-Dec 1984), Krugman argued that Asian growth had its limits because it depended more on hard work or investments than on productivity. Economic growth in theory can be explained by the sum of two sources of growth: increases in inputs such as growth in employment and in the education level of workers, and in the stock of physical capital (machines, buildings, roads and so on); and the other source is increases in the output per unit of input, generally known as productivity.

Krugman found similarities between the growth of the Soviet economy three decades ago, which depended almost solely on increases in inputs and showed very little evidence of productivity, and growth in the Asian economy.

''Asian growth, like that of the Soviet Union in its high-growth era, seems to be driven by extraordinary growth in inputs like labour and capital rather than by gains in efficiency,'' he concluded.

This article, which had been disputed by Asian scholars and the IMF, became a modern bible for the hedge funds, who spanned the globe looking for opportunities to make money. One of the hedge-fund operators, who laid siege to the baht in 1997, reconstructed the unfolding drama behind the collapse of the baht: ''We are like wolves on the ridgeline looking down on a herd of elk. (''How to Kill a Tiger,'' Time, Nov 3, 1997).'' In that herd of elk, they found Thailand, whose vulnerabilities appeared to fit perfectly Krugman's predictions.

''Well, well -- Asian growth may have a limit,'' said another currency speculator, who pondered on Asia before the attack against the baht in late 1996 and the first half of 1997.

Krugman added that foreign capital that used to fuel Asian growth is not likely to flock back at the pre-crisis scale. ''So while there may be a year or two of growth at something like pre-1997 rates as Asian economies take up some of their slack, the post-crisis trend is probably going to be far below previous expectations,'' he said.

Third, the Asian crisis may not repeat itself in the same 1997-98 scenario because short-term debts have mostly been repaid and the economies have built up adequate foreign-exchange reserves by running a current account surplus. A greater risk posed for Asia is the recovery prospects of Japan. If Japan, the big brother of Asia, cannot pull out of the recession it will continue to create pressures for Asia, which will face a different set of problems.

Most of Krugman's provocative arguments are nothing new. Nobody in Asia expects the region to stage a full recovery any time soon. It will take at least three to five years to mend the mistakes of the past or to reform the institutions and modernise the financial, economic and legal systems. Dealing with the serious bad-debt problem in the fragile banking system will take years, implying that lower growth than the normal Asian standard will be expected.

The next question that Asia, Thailand in particular, is pondering is how it will return to sustainable economic growth driven by innovations and productivity coupled with foreign direct investment.