Elisabetta Marmoloa & Nimai M. Mehtab

a Asian Development Bank, Manila, Philippines (emarmolo@mail.asiandevbank.org). This paper was written by the author in her personal capacity. The views expressed herein are those of the author only, and do not reflect in any way the positions of the institution to which she belongs.

b Center for Integrative and Development Studies, University of the Philippines, Manila, Philippines (nimai@i-manila.com.ph).


Miracles and Meltdowns—

Reinventing Leviathan in East Asia


No other scholar has shunned the easy appeal of fashionable subjects as James Buchanan. In fact, one could say that Professor Buchanan has always liked unpopular subjects. It was at the onset of a time when anarchy and dissent became most fashionable, the uneasy sixties, that Professor Buchanan embraced his decades-long inquiry into the reason of rules and the genesis of consent. We are well aware, therefore, that we run the risk of being disliked by our honoree for choosing a topic, which is very popular at this time—the Asian crisis. We have, however, two good excuses.

One, our motivation for working on the Asian crisis arose from a remark made by Professor Buchanan to one of these authors. He found much of what had been written and said on the crisis to be uninteresting or nonsense—and we believe that in Professor’s Buchanan’s view of what the economic profession should do, the latter—being uninteresting—is much worse anathema. It is our hope that Professor Buchanan might find what follows of some interest, if nonsense!

Two, we did indeed find intellectual stimulation in thinking about the crisis along the lines of Buchanan’s well-known contributions to constitutional economics (Buchanan, 1975). We also sought to explore some of the implications of his more recent contributions on the pervasiveness of the Keynesian delusion (Buchanan, 1998) and the tragedy of commons (Buchanan and Yoon, 1998 [a], [b], [c]). While the challenge of bridging the gap between the analysis of macroeconomies and the politics of implementation may be beyond the scope of this essay, it certainly informs its directional thrust. We believe it is an area where much more work should be done.

Since the purpose of this essay is to show that the Buchanan brand of political economy is of much use in explaining the mysteries of economic miracles and tragedies–Asian or otherwise—we will not dwell at any depth into an exegesis of the current literature on our subject. In an easy, and—we concede--somewhat unfair, simplification, the professional interpreters of Asian economies and their troubles can be divided into two camps, namely the sympathetic and the less so.

The sympathetic put forward the view that East Asian economies were indeed basically sound, and that the errors of policy were imported under the pressures of the Washington consensus and the unholy Wall Street-US Treasury-IMF complex (Sachs, 1998; Wade and Veneroso, 1998; Wade, 1998 [a], [b]). The devastating impact on East Asia of the herd behavior of international investors is seen as the—otherwise avoidable--result of the ill-advised deregulation of financial markets and opening of capital accounts. These explanations of the crisis at times echo the spectrum of the Great Depression. Proposed solutions accordingly smell, vaguely or distinctly, of Keynesian economics: the liquidity crunch consequent to capital flight and bankruptcies should have been eased, rather than compounded by the tight monetary and fiscal policy prescriptions of the IMF.

In the other camp, the not-so-sympathetic see the problems of Asian economies essentially as the affected countries’ own fault. The excessive exposure of these economies to short-term capital flows—which they also view as the precipitating factor in the crisis-- was the result of ill-supervised, and unregulated, financial sectors, and weak corporate governance. These structural inadequacies compounded the macroeconomic problems of East Asian countries as evidenced, in the 1990s, by large and increasing current account deficits. These current account deficits financed excessive growth in the non-traded sector and--due also to pegged exchange rate policies, export slow-downs, and the non- or low profitability of many investments both in the non-traded and traded sectors--turned out not to be sustainable (Roubini, 1998).

We are mistrustful of both the camps. We will not go here into the detailed technical arguments which could be raised against each, but highlight some very broad causes of our suspicion. With respect to the first, the sympathetic camp, there is a basic internal inconsistency in their explanations. It is not clear why the good Asian rulers, the artificers of the Asian miracle, willingly succumbed to external pressures to abandon the safe and successful path, and hastened down the treacherous slope of liberalization. As we shall explain, we do not believe that there was a sudden shift in East Asian policies in the early to mid nineties. For the not-so-sympathetic ones, it should be noted that these were the same economists who hailed the miracle, and, what’s more, they acclaimed it for exactly the same reasons they later saw as causes of the financial collapse. Analysts, who had straitjacketed the miracle economies into the mold of neoclassical, standard "good" policies and sound fundamentals, chastised them later for being neglectful of regulation, distortionary, and corrupt.

It is our view that the crisis was--in a fundamental sense--caused by a specific model of development, and that the reasons for the failure of the model are rooted in its political economy. In looking at the at the interrelationship between macroeconomic dynamics and the underlying political economy, we shall also touch on the current debate on the global financial architecture. But we are running ahead of ourselves. In the remainder of this paper, we shall first tell our story, then delve deeper into its theoretical underpinnings, and finally come to some broad conclusions. So the story first.


1. The East Asian Story Retold

Before the telling of our parable, let us highlight a few basic facts, which we believe characterize the East Asian model of development:

  1. A strong state
  2. Sound macroeconomic management by the ordinary standards of the economic profession (but there is an important caveat to this as we shall see later)
  3. A growth model, revolving around the coordination of investment decisions by the state, which accorded priority to the deepening of the capital structure of economy and financed the needed imports through the creation of a viable export sector
  4. The use by the government of a range of instruments, including direct ownership of key enterprises, fiscal incentives, administrative guidance, but also--and crucially-- control over credit allocation to promote desired investment strategies

These are all well-known facts, and we shall not dwell much on each of them.1 All crisis- affected countries had strong governments, often with charismatic leaders at their helm. With the notable exception of the Philippines, which was the least advanced, but also the least affected, crisis economy, East Asian governments had far reaching control over the allocation of resources to the productive sectors through their influence on the supply and cost of inputs--including and, most importantly, capital.

After the crisis, the influence of the state in the intermediation and allocation of capital has been often dubbed as an unholy alliance between the state, the banks, and the corporations. This characterization really misses the point. The alliance was all too holy until it lasted. In fact, it was the very cornerstone of the East Asian growth model. It was through this alliance that the East Asian economies could finance, state-mandated, strategic growth objectives while maintaining relatively balanced budgets and low inflation, that is, the appearance of a sound macroeconomy. This was possible because of the existence of large private domestic savings. East Asian governments were able to take advantage of the thrift of their people to push their growth agenda. Through their influence over the banking sector—taking the form of such arrangements as directed credit, implicit guarantees to bank lending, government-backed financial/industrial conglomerates, main banks and the like--they were able to get cheap and steady capital to the core industries. And, as generally recognized, they were successful in spurring growth this way. The question is: What happened then?

We should distinguish two sets of problems: one, the fundamental pitfalls beseeching the sustainability of the East Asian model of development, which made a crisis unavoidable; two, the contingent factors that might have contributed to the timing of the crisis. Contingent factors are often mistaken, in the literature, as causes of the crisis. These include the increasing financial vulnerability of East Asian economies due to rising levels of short-term (private) debt, the "burst" of speculative investment bubbles, export sector slowdowns due to the loss of competitiveness from pegged exchange rate dynamics.2 The literature is, however, unable to place these factors in the context of a story consistent with the development model followed in the crisis countries, and sees them mostly as aberrations, the result of policy mistakes, or the materialization of bad states or random shocks. In the absence of obvious pitfalls in the macroeconomic "fundamentals" of the crisis countries, economists are left short of fundamental explanations of the crisis.

In our view, the fundamentals are linked to two key aspects of the Asian developmental model. The first is the one traditionally associated with the socialist fallacy, but that equally well applies to other, softer forms of state interventionism: the misallocation that necessarily derives from control over the economy or direction of production. In East Asia, the develomental state was, however, not a socialist state, nor a state in fiscal deficit or marred by inflationary propensities. Public exposure took instead the form of implicit public deficits, enforced through private sector flows.

We define the implicit deficit as the present value of the government’s off-budget economic commitments discounted by the probability that the government will actually be called to honor these commitments with actual cash outflows. Implicit commitments may include guarantees to lenders; implicit obligations to support critical industries if in trouble; and so on. In an open economy, if we start with a balanced current account, the implicit deficit is equivalent to the loss of reserves that would derive from cashing-in the potential economic claims against the government.

It is the mutually re-enforcing build-up, over time, of these two elements – the implicit public deficit and resource misallocations – that provided the fundamentals which made a crisis unavoidable. If we recast the crisis story in this mold, the following account may capture in essence what happened. In East Asia, the developmental state actively supported the creation of physical capital through aggressive investment strategies. In doing so, it opened a wedge between domestic demand and supply--with a move away of domestic demand from exportables and non-tradeables, an increase in imports particularly of capital goods, and the possibility of exploiting the import-finance opportunities provided by rising exports. Until high export rates continued to finance the demand for imports, the shortages and gluts typical of controlled or directed economies did not surface. In this sense, while the growth strategies of East Asian countries were not export-led, they were certainly export-dependent.

Due to information lags and the natural rigidity of directed systems, East Asian growth strategies were bound to run into problems at some point. In our story, governments were not able to foresee the demand shifts on the international markets which took place in the nineties (for example, away from sectors like semiconductors, petrochemicals, shipbuilding and automobiles).3 They were also unable to secure the necessary coordination between factor demand and supply at all times (for example, skilled labor shortages in Malaysia). Inappropriate exchande rate management might have contributed to the problems.4

As export sectors entered into a crisis, capital increasingly went into areas, such as real estate, which were indeed more speculative. The main attraction of these investments, from the perspective of East Asian governments, was the fact that they allowed the economy to maintain momentum in spite of the export crisis, through high employment levels and sustained internal demand. The view that the government was not aware of excessive speculation and banking sector weaknesses and failed to regulate, is naïve.5 The absence of "prudent" or "western-type" regulation, which outsiders have later interpreted as a weakness of the East Asian systems, was essentially the fall-out of a deliberate model of development finance.

With slow-downs in export, and other key, economic sectors, and the boom in the non-traded sectors coming to an end, pressures started building on the current account. The potential loss of reserves implied by the existence of an implicit public deficit became real, as investors felt that a devaluation was likely and withdrew capital. The wave of competitive devaluations that originated the crisis took place.

While the dynamics of the crisis worked themselves out through the financial sector and the capital account, it is our view that the East Asian crisis was not an essentially financial crisis. Nor it was a "balance sheet" crisis (Krugman, 1999). It was an institutional crisis which manifested itself through the unchecked growth of the implicit public sector. We now need to examine at some length the theoretical underpinnings of our interpretation of the events. Our aim is to find an answer to some of the questions that our account must have generated in the mind of the reader: What is the link between the East Asian growth model and the implicit deficit? What determines the size of the implicit deficit? Is a large public sector necessarily bad because of the allocative distortions it generates? What can be done to limit these? And what are the policy lessons that we can draw for the Asian countries affected by the crisis? Here we move into ground first plowed by Buchanan: constitutional economics.




2. The Implicit Deficit and the Developmental State--Back to the True Fundamentals

Recognition of implicit deficits, and of the fact that they had a role to play in the crisis, is not something new. Krugman (1998) makes much of the link between implicit government guarantees—one component of the implicit deficits--and moral hazard issues in his first attempts at explaining the crisis. Burnside, Eichenbaum, and Rebelo (1998) analyze the role of large prospective deficits in the Asian crisis. In their view, troubles in the banking system, and the prospect of government-sponsored bailouts, cause expected deficits to rise. Rational economic agents expect that the higher prospective deficits will be financed by seignorage, and the dynamics connected with anticipation of the new monetary policy make exchange rates collapse before deficits are actually monetized. In this account, problems in the banking sector, which cause expectations of higher deficits, are still the ultimate cause of the crisis.6

Contra to these views, what matters in our story is that a systematic bias towards implicit deficits existed in East Asian countries because of their specific development model. In assuming substantial responsibility for the extra-normal allocation of private resources to selected productive sectors, governments had necessarily to take up responsibility for the negative impact of possible misallocations, while ensuring adequate returns to private capital. This entailed both ex-ante and ex-post commitments: ex-ante, towards policies that created adequate rent for private capital; and, ex-post, to bailouts of banks and corporations, were adverse circumstances to threaten their profitability. Implicit deficits existed in the East Asian economies long before the crisis. And rational economic agents could not have been unaware of their existence, which was made quite obvious by the web of relationships and obligations connected with the state direction of the economy.

Further, as misallocation risks and potential policy distortions are necessarily large, and are perceived to be so by economic agents, there is a tendency in these systems to overextend the socialization of investment risks7. For the non-socialist, developmental state8, implicit deficits are a critical tool in this respect because they effectively ease the direct budget financing constraint to the socialization of investment risks. Therefore--in a sort of circular logic that leads from strategic direction of the economy to misallocation, and back to the need for more public intervention – there is a natural tendency in these economies to overextend the public through the implicit deficit. This is something akin to the tragedy of the commons, and was clearly observable in the developmental states of East Asia9.

It is important to understand why implicit deficits are such an important tool in the context of the developmental state model, and why they are sustainable over long periods of time. There are two main reasons for which governments may prefer implicit over explicit deficits:

The advantages deriving from lack of transparency and flexibility may induce a government to shift its obligations to the implicit sphere. However, there are two critical conditions to the sustainability of the implicit deficit. From the economic standpoint, sustainability requires that the government be able to deliver high growth through its development strategy. From the political standpoint, it is only when a government has an acknowledged and substantially unrestrained mandate for direction of the economy that a large implicit debt may be sustainable for an extended period of time. Individually, each of these conditions is necessary, but not sufficient for the sustainability of implicit deficits. It is, in our view, likely that both these conditions may indeed exist for developing countries, and that they were in fact present in the case of the East Asian economies.10

It is this last point that we wish to explore further by linking it with the constitutional metaphor. A constitution is defined here as the basic document establishing to what extent the public might interfere with the private, including the economic sphere. In other words, the constitution determines to role of the government. The constitutional calculus of rational individuals, under a veil of uncertainty, will place in the public sphere those activities for which interdependence costs tends to be high, i.e., those activities that are likely, in post-constitutional settings, to generate externalities which much exceed private costs/benefits. These include not only the provision of public goods such as justice, defense, or money, but also goods which are not conventionally considered public but are characterized by high utility interdependencies.11 The latter may encompass economic resources that are critical to economic development.

An interesting conjecture to make is that there is a link between the constitutionally determined scope of the public sector and the stage of development. As economies mature, the role of the state tends to be more narrowly defined by individuals at the constitutional stage, and constitutions will be periodically amended to reflect this. In societies that are poorer, individuals will tend to be more skeptical of the powers of the "invisible hand" and more supportive of an extended, active role for the state, because resources and opportunities are extremely scarce. In a situation of extreme scarcity, independent use of resources by each individual will impose—by definition—relatively much larger external costs on others in post-constitutional settings than in a situation where there are more resources and opportunities available. In other words, the domain of high interdependence costs will be generally perceived to be much larger in the constitutional calculus of individuals in poorer countries. The role of the state may be correspondingly larger and deeper, and the basic mandate for the government is likely to be development itself, defined as both economic growth and social progress through access to basic goods.12

At the same time, the costs from misallocation of resources are likely to be much lower than the benefits from socialization of investment risks at the initial stages of development. This situation will change—with misallocation costs becoming relatively larger and social benefits smaller—as an economy moves up the development ladder. While certainly there is a need to look more in depth into this conjecture in another work, it has a certain intuitive appeal. At the initial stages of the catch-up process, developing countries are less likely to make "mistakes" in their strategic choices because they can follow the example of the more developed economies. As developing countries progress, the old economic game becomes progressively less rewarding.13 Further, as economic growth brings relative abundance, the social benefits of further state intervention start to shrink.

These two conjectures—i.e., one, that the developing countries are likely to endorse larger governments, and, two, that the benefits of larger governments are likely to decrease as these countries progress—have an important implication. This is that the fundamental problem of how to constrain the Leviathan is even more significant in the context of developing countries than it is for developed countries. The issue is how to avoid that state intervention may lead to the destruction, rather than the creation of economic value.

The destruction of economic value is directly related to the possible overextension of the public sphere in postconstitutional settings. A government is overextended when its interventions cause misallocation costs that exceed substantially social benefits. The possibility of substantial overextension of the public makes it essential that a developmental mandate, to work effectively, must be accompanied by sufficient constraints on the explicit and implicit size of the government. The key issue is how to limit the scope of the pervasive tragedy of the commons.


3. The Implicit Budget and the Commons—How to Constrain Leviathan?

The tragedy of the commons arises from a situation where a common resource generates economic value through the application of privately owned inputs. Generally, the independent exploitation of the common resource will extend use beyond the optimal level. This notion of commons can be extended to the public sector budget. Budgetary financing of partitionable goods, which are allocated through criteria other than price, can generate situations similar to the tragedy of the commons. Buchanan and Tullock have shown that the logic of majoritarian choice may stretch public provision of partitionable goods beyond the desirable or optimal level. There is a natural propensity in majoritarian democracy for overextending the budget as the commons at the post-constitutional stage. As we have discussed, there is a natural propensity to overextend the commons in directed, non-socialist economies such as the developmental states of East Asia.

There is much to be learned from looking into other rules, besides decision-making rules, that may either contain or compound the natural tendency to overextend the common. One of these is, of course, the balanced-budget rule. This may help reduce the scope for overextension of the commons. However, as the Asian experience shows, the balanced-budget rule can be substantially circumvented by the existence of a large implicit deficit. The existence of an implicit public deficit makes the threat of the Leviathan more elusive if pervasive.

It is certainly beyond the scope of this paper to look into institutional set-ups that might help constrain the explicit (budget) and implicit size of government intervention. However, a few general points can be made.

First, there is the issue of transparency. It is our view that in a context such as that of developing countries, where the scope of government intervention and interference with the economy tends to be wider, particular care should be taken to assure at the constitutional level that the government initiatives are kept on, rather than off, the books. An explicit budget deficit is definitely the lesser evil as compared to the unchecked growth of the implicit public sector. There reason for this is simple. Visibility allows for oversight, and a more consistent check on government activities. The implicit budget only comes to light when it is too late. The extent of damage is therefore potentially much larger.14

Second, there is the issue of voice. Clearly the availability of institutional means to express disapproval of economic choices is important. This should not be necessarily understood as a need to import acritically models of western-style, representative democracy. In some cases, these may work well. In other, they may be rather ineffectual, as for example in a context—not the East Asia one--where income inequalities are extremely large, and there are large number of poor lacking access to basic education, information, etc. What is necessary is that appropriate institutional vehicles to voice and address grievances must exist. It also means that a system of checks and balances must be carefully built and embodied in the constitution in a way that is best suited to the cultural, traditional, and institutional milieu of a country. In some cases, this may mean a strong role for the judiciary. In other cases, it may work out in the form of an effectively decentralized system of government where exit becomes a meaningful choice option. If a strong executive, and in the context of Asia, charismatic leadership, may have a role to play in spurring development, this should not go unchecked.

Third, there is the issue of consistency between economic policies and the basic principles informing a country’s constitution. In contexts where the state has a clear constitutional mandate to promote development, and where the government’s model of development is generally supported, external attempts to impose alternative models may be highly counterproductive. They may simply induce a policy move towards the implicit budget with a larger wastage of resources that is likely to result from unchecked expansion of the size of implicit government interference.

It is important to stress that the economic reforms which started taking place in Asia from the end of the eighties did not affect in any substantial way the nature of the developmental state and its role in directing the economy. As a fall-out of the Latin American debt crises, strong international pressures were placed on developing countries to put their fiscal and monetary house in order. Privatization and deregulation became the name of the game. East Asian countries adapted the neoclassical creed, as distilled through the Washington consensus, to suit their model of development highly dependent on state intervention.

As East Asian governments divested of state-owned enterprises, their influence over the economy all but disappeared. In fact, it strengthened. The East Asian governments continued to support those sectors of the economy they deemed critical to their growth agenda. These included now the former state-owned enterprises.15 Similarly, capital account opening did not mean freer markets or the end of state direction of the economy. It simply implied that the government would, through the guarantees to the banking sector, allow the injection of external funds into the economy to ease the pressure on the current account deriving from a slow-down in exports.

These reforms caused a further shift from explicit public budget financing into implicit support of critical economic sectors—reinforcing a tendency that already existed in East Asia. In this sense, the "reforms" might have contributed to aggravate rather than solve the problems of these economies16.


4. A Conclusion and Some Thoughts on the Global Dimension

Our account is admidtedly still quite rough. We believe, though, that it is broadly consistent in that

Going back to East Asia, in the crisis-affected countries there might have been a ground level mandate for the developmental state, at least up to a point. But this was allowed to grow beyond limits that were acceptable by absence of constitutional checks and the increasingly off-budget nature of government commitment. Solutions to the crisis will have to go beyond the quick fix of banking and corporate sectors. They will need touch the heart of the constitutional set-up of the countries affected. And solutions will need to be essentially homegrown.

In talking of homegrown solutions, we essentially refer to solutions that must be attuned to the politial realities of the countries affected, without being complacent. The East Asian economies will certainly need to take a hard look at whether their traditional model of development can still work. We also hope that the political pressures generated by the crisis may lead to constitutional compacts that more effectively constraint the Leviathan.

At this point, it may be appropriate to introduce some qualifiers to the approach followed in this paper.

First, our analysis is concerned with the fundamentals of the crisis, rather than with the specific trigger factors that may have contributed to the timing of the crisis. On the basis of fundamentals, one way to explain off-the-cuff why, for example, Korea had a crisis and Taiwan had not, is that the latter relies on more explicit forms of public control over the economy than the former. For example, public enterprises play a much larger role in Taiwan than in Korea. A complete explanation would need, however, a much deeper examination of the two economies, and might also encompass some of the trigger factors besides fundamentals.

Second, on a somewhat broader point, the paper examines factors that make implicit deficits a preferred and sustainable instrument in the context of the developmental state model. However, it does not look sufficiently at the specific dynamics that may undermine sustainability of implicit deficits as a country moves up the development ladder. Also, it does not look at the instructive cases where a developmental mandate could have been justified and sustainable in principle, but, differently from the East Asian cases, it has not emerged or it has not worked—e.g., India. There is room for expanding our research in these directions.

Finally, our conclusion that solutions to the problems of East Asia must be homegrown, may seem not to square well with a fact that the crisis has brought dramatically to the forefront, that is that economic problems have today a "global" dimension. The single factor that has been most emphasized in explanations of the crisis has been the role of external finance, as a source of increasing vulnerability and economic instability and an immediate trigger of the crisis. Some have gone to the extent of seeing this as the main culprit in the downfall of East Asian economies and of recommending capital controls as a legitimate solution to the economic troubles in East Asia.

As discussed earlier, open capital accounts were not in dissonance with, but necessitated by the demands of the developmental state in East Asia. As economic ambitions grew, steering of domestic savings was not sufficient any more. Luring in capital, by deliberately allowing speculative gains (this was no lack of oversight), was a consistent, not a "wrong" move from the perspective of the developmental state. In our constitutional approach, the opening up of capital accounts removed an important limit on the size of the implicit budget. Contra to the common wisdom, it may have helped delay, rather than accelerate the exposure of the economic problems of East Asian economies. These problems are essentially due to the absence of effective constraints on the proliferation of state interference, and, therefore, require domestic solutions which will address this.

However, external private and public finance has certainly a role to play in our story to the extent that it causes significant crossboundary externalities through the transfer of resources from tax-payers in developed countries to ill-disciplined governments and international speculators--something the IMF has been much criticized for helping. The interesting issue this transfer of resources poses from a constitutional economic perspective is that the costs of developmental choices of the East Asian governments are partly born by individuals who were not party to the (implicit) agreement on the mandate of the developmental state. These individuals were not voluntarily drawn in by the search of profit as in the case of speculators. It is our view that the current debate on the re-design of the international financial architecture should focus on this supranational dimension, i.e., how to minimize these crossnational externalities. These are again areas for further research.


1 There is a lot of material on this. Rodrik (1994) offers a summary of key literature and has a very good account of the growth story of South Korea and Taiwan, which focuses on the active role played by the state in creating an investment boom in these countries. His view is that the state was successful in engineering growth in East Asia because its interventions addressed effectively a coordination failure. In this paper, while we broadly agree with his account of the facts of the miracle, we shall offer a different explanation that focuses on the constitutional rationale for a developmental mandate and the dangers that this might entail.

2 In this paper, we examine the fundamentals of the crisis. We are implicitly taking the position that the contingent factors or triggers, determining the timing of the crisis, need not be different in our explanation from those highlighted by the current literature. In a different paper, we shall try to look at the trigger factors more carefully in light of our analysis of the fundamentals.

3 A possible reason for this is that as the catch-up took place, the East Asian countries could not avail any more of the example provided by the more advanced countries in selecting key industrial sectors. In a way, at least for some of these economies, the crisis might have ensued because of the fact that their relative maturity did not allow them to play the same economic game any longer (Rodrik, 1994).

4 The list of problems could of course be expanded. There is some good recent literature exploring issues of centrally controlled or directed economies from the perspective of the soft budget constraint syndrome (Kornai, 1980). Maskin (1999) highlights a systematic bias towards low profitability in the presence of soft budget constraints. His analysis is relevant in the context of the contingent factors that might have contributed to the crisis. The sustainability of current account deficits is, in fact, clearly dependent on the quality of investments the deficit is used to finance. In a contribution explicitly addressing the "myth of the East Asian miracle," Bai and Wang (1999) illustrate the implications of soft budget constraints for inefficient allocation which is compatible with high growth, high volatility and high savings.

5 Merton Miller (1998) offers an interesting account of the government strategies to support the banking sector in Japan and their impact on the East Asian economies. What is clear from his story is that the problems of the banking sector, and decisions on how to address those, were an integral component of the economic growth strategies of Japan as well as other East Asian economies.

6 Some have argued that banking sector troubles were indeed not pervasive in East Asia before the crisis. These were, instead, largely created by the crisis itself and the vicious circle of depreciation, bankruptcy and insolvency it generated (World Bank, 1998). According to Krugman (1999), banks did not necessarily play a big role in a crisis that originated in the financial fragility of economies much exposed to external capital. These arguments much weaken support for the view that prospective deficits, originating in the expected need for bank bailouts, were at the heart of the crisis.

7 The socialization of investment risks here, is not - contrary to conventional interpretations - simply the public provision of insurance or subsidization of market risks. It is, instead, the necessary public guarantee of adequate returns for private firms that undertake extra-market investments as desired by the developmental state.

8 That is, one that uphold private property rights.

9 The widespread liquidity crunch that crippled a vast proportion of both production and financial sectors in the immediate aftermath of the 1997 currency crisis indicates, to us, the extensive, and inter-related, nature of implicit commitments that had been sustained in these sectors.

10 Looking at the East Asian case, a large mandate for the state probably existed probably until the crisis. Further, the fact that at the beginning of their development story, these countries had substantial catching-up to do, and could follow the example of more successful economies in picking sectors, assured that they could continue growing for over three decades. The premises existed for both the political and economic sustainability of the implicit deficit in East Asian countries over extended periods of time.

11 Marmolo (1999) discusses the logic of constitutional calculus as applied to public goods, and the role played by utility interdependency in this calculus.

12 In East Asia, governments took seriously both aspects of the developmental mandate, the social and the economic. In fact, in some cases, countries gave the social mandate priority and had reached substantial progress on social indicators, and reduced substantially inequality in income distribution, already at the time of launching their growth strategy. According to many, it is because they got this sequence right, the East Asian countries were able to succeed.

13 Krugman has not used his old (1994) low productivity argument as a prediction of the crisis. However, we find that it could play an important function in our model in two ways. First, it could offer an explanation of why East Asian economies were never able to get out of a substantially imitative mode and assume technological leadership. Second, it could provide an additional argument for why the East Asian growth paradigm implied exponential growth of the implicit budget. Low productivity, in fact, requires progressively larger injections of capital to sustain rapid growth.

14 Our hypothesis, may, thus, explain the dramatic difference between the severity of the currency crisis that affected Korea and the relatively unaffected Taiwan economy. While the state in both countries have vigorously pursued developmental objectives, Taiwan did so mainly through state-owned enterprises, public research institutes, tax incentives, etc. (Wade, 1990). That is, the state’s role in Taiwan was effected mainly through explicit, budgeted means. State owned enterprises has always allocated a much smaller share of national income in Korea (Rodrik, 1994). Instead, the Korean state’s support has predominantly been through implicit commitments enforced through the private sector.

15 In the early 1970s, state-owned enterprises accounted for roughly 10 percent of South Korea’s GDP (Rodrik, 1994). This gives some rough indication of the potential implicit claims generated as a consequence of privatization.

16 The liberalization in financial markets and of capital flows was, in main, for these economies, a shift in the external "budget constraint" - without any significant change in the internal "production function." That is, the institutional makeup, and objectives, of the developmental state had not undergone any significant alteration. Thus, according to Ito (1999), banks in Korea continued to lend to industries deemed to be important from the strategic-industry point of view. See also Ha-Joon Chang (1997) for a critical appraisal of the post-liberalization investment regime in Korea.





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