that we reserve 100% of the surplus—that's every penny of any
surplus—until we have taken all the necessary measures to
strengthen the Social Security system for the 21st century.
The crux of Clinton's "necessary measures," it quickly emerged, was to
set aside the lion's share of any surplus to pay down the debt. I was impressed
that Clinton had preempted much of the debate that would have
arisen had he focused on debt reduction pure and simple. "I'm amazed," I
told Gene Sperling. "You've found a way to make debt reduction politically
attractive."
As the budget surpluses mounted over the next few years—all the way
from $70 billion in 1998 to $124 billion in 1999 and to $237 billion in
2000—I watched Congress grab again and again for the money. In the summer
of 1999, the Republicans put forward a plan to cut taxes by almost
$800 billion over ten years, and the Senate Banking Committee summoned
me to testify whether the plan made long-term economic sense. I had to
tell them it did not, or at least not yet. "We probably would be better off
holding off on a tax cut," I said, "largely because of the fact that it is apparent
that the surpluses are doing a great deal of positive good to the economy."
I had two other arguments, I added. First, while projections of the
surplus over the next decade were now up to $3 trillion, uncertainty about
the economy put those big numbers in doubt. "They could just as rapidly
go in the other direction," I said. Second, given how strong the economy al
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ready was, the stimulus of a major tax cut might cause it to overheat. On
the other hand, I said, I saw "no problem" in delaying such a cut.
These observations made a few headlines but did not dissuade Congress
from proceeding with the bill. It passed a week later—only to be vetoed by
the president. "At a time when America is moving in the right direction,
this bill would turn us back to the failed policies of the past," he said as he
signed the veto in the Rose Garden.
President Clinton's old-fashioned attitude toward debt might have had
a more lasting effect on the nation's priorities. Instead, his influence was diluted
by the uproar about Monica Lewinsky, whose name surfaced in news
reports just days before he unveiled his approach for the surplus. As the
scandal unfolded and details of their alleged encounters appeared in the
press, I was incredulous. "There is no way these stories could be correct," I
told my friends. "I've been in the area of the White House between the
Oval Office and the private dining room. There are staff people and Secret
Service in and out all the time. No way." Later, when it came out that the
accounts were true, I wondered how the president could take such a risk. It
seemed so alien to the Bill Clinton I knew, and made me feel disappointed
and sad. And it had a devastating effect—you could see it, for example, in a
pair of headlines that appeared side by side on CNN's Web site: "Lewinsky
Set to Provide Handwriting, Fingerprint Samples" and "Clinton Announces
$39 Billion Projected Budget Surplus."
W
W
hile America was booming, the rest of the world shook. In the wake
of the end of the cold war and the demise of much central planning,
developing nations were seeking ways to attract direct foreign investment
by further securing property rights and opening up larger sectors of
their economies. But as part of those initiatives, an unsettling pattern started
to emerge: U.S. investors, rich with capital gains from the U.S. boom, would
crowd into unfamiliar emerging markets in search of diversification. Big
banks would come, too, seeking higher returns on loans than they could get
in the United States, where interest rates had now reached near-historic
lows. To attract such capital and promote trade, some developing nations
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tied their currency to the dollar at a fixed exchange rate. In that way; U.S.
and foreign investors could consider themselves protected from exchange-
rate risk at least for a while. The borrowers of the dollars, meanwhile, would
convert them into the domestic currency and lend the money within the
developing country at the prevailing high interest rates. By doing so, they
were gambling that when the loan was repaid, they'd be able to convert the
money back into dollars at the fixed exchange rate and repay their own
dollar borrowings with no exchange-rate loss. When shrewd market players
who didn't believe in the tooth fairy realized that the developing countries
could maintain the fixed-exchange-rate regime only so long, and they
started to sell the domestic currencies for dollars, the game was up. Central
banks trying to hold their dollar exchange rate fixed rapidly ran out of their
reserves of dollars.
This sequence of events led to the so-called Asian contagion, a series of
financial crises that began with the collapse of the Thai baht and Malaysian
ringgit in the summer of 1997 and grew into a threat to the world economy.
Almost immediately, Thailand and Malaysia plunged into recession. The
economies of Hong Kong, the Philippines, and Singapore were hard-hit too.
In Indonesia, a nation of two hundred million people, the rupiah imploded,
the stock market collapsed, and the ensuing economic disarray led to food
riots, widespread misery, and eventually the fall of President Suharto.
Just as during Mexico's crisis two years before, the International Monetary
Fund moved in with financial support. Bob Rubin, Larry Summers,
and the Treasury Department again spearheaded the U.S. response; the Fed
again played largely an advisory role. I got more deeply involved only in
November, when a senior official at the Bank of Japan called the Fed to warn
that South Korea would be the next to go. "The dam is bursting" is how the
official put it, explaining that Japanese banks had lost confidence in Korea
and were about to stop renewing tens of billions of dollars in loans.
This was a shock. A symbol of Asia's remarkable growth, South Korea
was now the world's eleventh-largest economy, twice the size of Russia.
Korea was so successful that it was no longer even considered a developing
nation—the World Bank officially listed it as part of the first world. And
while market watchers knew that there had been problems recently, the
economy by all indications was still growing solidly and fast. Korea's central
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bank was also sitting on $25 billion in dollar reserves—ample protection
against the Asian contagion, or so we thought.
What we didn't know, but soon discovered, was that the government
had played games with those reserves. It had quietly sold or lent most of
the dollars to South Korean commercial banks, which in turn had used
them to shore up bad loans. So when Charlie Siegman, one of our top international
economists, phoned a Korean central banker on Thanksgiving
weekend and asked, "Why don't you release more of your reserves?" the
banker answered, "We don't have any." What they'd published as reserves
had already been spoken for.
This mess took weeks to unwind. Rubin's task forces worked virtually
around the clock, and the IMF assembled a financial-support package of
$55 billion—its largest financial rescue ever. The deal required the cooperation
of Kim Dae Jung, Korea's newly elected president, whose first major
decision was to commit to stringent economic reforms. Part of the challenge
for the Treasury and the Fed, meanwhile, was to talk scores of the
world's largest banks into not calling in their Korea loans. All these initiatives
came to a head at the same time, prompting Bob to say in retrospect,
"We must have set some kind of record for disturbing the slumber of finance
ministers and central bankers all over the world."
There was always the chance that a rescue this large would set a bad
precedent: how many more times would investors pour money into willing
but shaky economies, figuring that if they got into big enough trouble, the
IMF would bail them out? This was a version of what the insurance industry
calls the "moral hazard" of protecting individuals from risk. The bigger
the safety net, the theory goes, the greater the recklessness with which
people, businesses, or governments will tend to behave.
Yet the consequences of allowing South Korea to default would have
been worse, possibly far worse. A default by a nation of Korea's size would
almost certainly have destabilized global markets. Major banks in Japan and
elsewhere would likely have failed, sending additional tremors through the
system. Shell-shocked investors would have withdrawn not just from East
Asia but from Latin America and other emerging regions, causing development
to stall. Credit would very likely have become much tighter in the
industrialized nations as well. And that is leaving aside the military risk
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unique to South Korea's situation. For their handling of that crisis alone;
Bob Rubin and Larry Summers belong in the finance ministers' hall of fame.
I
I
n the United States, things were still booming, as the Internet wove itself
into people's lifestyles. The computer in the household was becoming as
essential as the phone, the refrigerator, and the TV. It became a way to get
news: in summer 1997, millions had gone online to view dazzling photos
from Pathfinder, the first U.S. probe to set down successfully on Mars in
twenty years. And it became a way to shop: in 1998 "e-commerce" arrived
in a big way, with people flocking to Web sites like Amazon and eToys and
eBay, especially during the holiday season.
But the Asian contagion wasn't finished with us yet. The grim scenario
we'd imagined in the Korean crisis came perilously close to being realized
eight months later: in August 1998, Russia defaulted on a vast dollar debt.
Like the crises in Asia, Russia's resulted from the toxic interaction of
overeager investing by foreigners and irresponsible management at home.
The precipitating factor was a drop in the price of oil, which eventually hit
$11 a barrel, the lowest level in twenty-five years, as the economic impact
of the Asian crises sapped worldwide demand. Since oil was a major Rus
sian export, this meant big trouble for the Kremlin: suddenly Russia could
no longer afford to pay the interest on its debts.
I'd last visited Moscow seven years before, on the eve of the Soviet
Union's dissolution, and still remembered the high hopes of the economic
reformers and the gray desolation on the streets. Conditions, if anything,
were now worse. In the vacuum left by the collapse of central planning,
Boris Yeltsin's economists had tried and failed to foster reliable markets to
supply food, clothing, and other essentials. Families and businesses got by
largely off the books, with the result that the government could not even
collect the taxes it needed to provide basic services or pay its debts. Oligarchs
had come to control large shares of the nation's resources and wealth,
and inflation periodically ran rampant, amplifying the misery of tens of
millions of Russians on limited incomes. The government had singularly
failed to establish, or even to comprehend the need for, property rights and
the rule of law.
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As the crisis unfolded, the IMF again stood ready with financial aid—it
announced a $23 billion support package in July. But as soon as Russia received
the first payments, its parliament made clear that it had no intention
of accepting the usual IMF conditions of better fiscal management and
economic reform. This defiance prompted the IMF to conclude that sending
the rest of the aid would be throwing good money after bad: it would
only postpone, and probably worsen, the inevitable default. By mid-August,
the Russian central bank had burned through more than half of its
foreign-exchange reserves. Frenzied last-minute diplomacy failed, and on
August 26 the central bank withdrew support for the ruble. The exchange
rate fell 38 percent overnight. The IMF package was withdrawn.
The default, when it came, stunned investors and banks that had poured
money into Russia in spite of the obvious risks. Many operated on the assumption
that the West would always bail out the fallen superpower—if
for no other reason, the saying went, than that Russia was "too nuclear to
fail."Those investors bet wrong. The United States and its allies had worked
quietly and effectively to help Yeltsin's government keep its warheads
under lock and key; it turned out that the Russians were much better at
controlling an arsenal than at managing an economy. So after careful deliberation,
President Clinton and other leaders judged that the IMF's withdrawal
would not increase the nuclear risk, and approved its decision to pull
the plug. We all held our breath.
Sure enough, the shock wave from Russia's default hit Wall Street much
harder than the Asian crises had. In the last four trading days of August
alone, the Dow lost more than 1,000 points, or 12 percent of its value. The
bond markets reacted even more strongly, as investors fled to the safety of
treasuries. Banks, too, pulled back from new lending and raised interest
rates on commercial loans.
Lurking behind all these expressions of uncertainty was the growing
fear that after seven spectacular years, the U.S. economic boom was coming
to an end. That fear, it turned out, was premature. Once we coped with the
Russian crisis, the boom would continue for another two years, until late
2000, when the business cycle finally turned. But I could see the dangers,
