What Form Should An Asian Economic Union Take?

By Wi n g Th y e Wo o , Th e Br o o k i n g s In s t i t u t i o n a n d University o f California a t Da v i s

The Impetus to Recent Initiatives Translation: Prior to July 2 1997, I might even say domestic for Asian Economic Integration: crony capitalism and economic financial crises, are built into The Asian Financial Crisis mismanagement in these Asian the human genome. When we economies had loaded their map the whole thing, we will A financial typhoon appeared national financial systems with find something there called in the Gulf of Siam on July 2, 1997, weak loans, and hence rendered greed and something called fear first toppling the Baht and the Thai their continued high growth and something called hubris. economy and then sweeping to-and- unsustainable. These Asian That is all you need to produce fro across East Asia for the next eight economies imploded for the international financial crises in months, doing severe economic and same reasons the Soviet bloc the future.” political damage to South Korea, economies had imploded in the Indonesia, and Malaysia. The ripples Finding 3: The victim died not early 1990s. Their industries of the typhoon were felt as far as from the bad cold she caught with the were not viable without various Brazil and Russia, with an equally change in weather but by the mistaken forms of subsidies (e.g. directed disastrous outcome in the latter. Post- administration of nitrogen instead of credit, protection), and the mortems have abounded since; initially oxygen while in the ambulance on the aggregate subsidy had reached a in the form of media and official way to the hospital. level in 1997 that the state could assertions; next in dissertations from Translation: The incompetence no longer provide. academic dissections; and finally in of the IMF turned a downturn Paul Blustein’s excellent book, The Finding 2: The victim died because into a depression with Chastening (Public Affairs, 2001). Each she was crushed in her sleep by the contractionary “rescue” autopsy report typically contained the coconut tree brought down by the gale. packages, and helped to following three findings, with each Translation: International exacerbate (if not initiate) work differing in emphasis on the financial markets, just like the regional panic with dire importance of individual findings in domestic financial markets, are diagnoses of the patient. The each country. susceptible to bouts of mania, Koreans were correct to dub Finding 1: The victim died because panics and crashes, causing them the perfect storm they found she was already so wasted internally to help stoke booms and busts in themselves in “The IMF Crisis.” by self-inflicted wounds that she their clients’ performance (which While the Asian financial crisis keeled over when the wind started in the periods of irrational was most probably the product of blowing. The role of the storm was exuberance are often dignified all these three factors, it would be happenstance because a sneeze later with self-congratulatory honors irresponsible to completely avoid on would also have caused her to like The Asian Miracle, and apportioning blame because this would crumble when her constitution had Japan as No. 1). Paul Volcker deny the importance of accountability. been rendered more fragile by the (1999) has put the matter well: It is convenient to embrace Finding 1 soft rot. “International financial crises, readily because no economy is without

No. 67 1 No v e m b e r 2007 flaws. However, the fact that output in Malaysia, South Korea and Thailand rebounded just as quickly as they had fallen falsifies the initial IMF belief that, beside monetary-fiscal tightening, It stretches credibility and the imagination that drastic overhaul of the economic all these governments coincidentally shifted system and incentive structure similar to those undertaken earlier in the to destabilizing policies in the same decade. former Soviet bloc (e.g. immediate increase in the capital adequacy ratio and abrupt large-scale closure of financial institutions) were necessary to restart growth. This initial misjudgment There has long been a tradition in 1992-93, the Mexican and Latin explains why the IMF kept under- of resistance within the economics American financial crisis in 1994-95, predicting until the end of 1998 the profession to acknowledge the the Asian financial crisis in 1997-98, strength of the growth that occurred. phenomenon of disorderly market the conversion of the Russian ruble The many careful studies in the behavior. The most commonly to a rubble in August 1998, and the voluminous literature on the Asian used defense against claims of collapse of the Brazilian real in January financial crisis have produced many speculative bubbles is the alternative 1999. It stretches credibility and the valuable insights on every dimension hypothesis that unstable asset imagination that all these governments of the crisis: the origins, early prices reflect unstable government coincidentally shifted to destabilizing detection, preemptive interventions, policies. The claim (labeled the “peso policies in the same decade. Herein lies emergency-room macroeconomics, problem”) is that observed flip-flop the first lesson insight from the Asian and post-crisis recovery.1 For the movements in asset prices reflected financial crisis: occasional excessive topic of the types of economic policy rational anticipations of changes in price movements in financial markets cooperation that are appropriate for government policies that turned out are normal and should not be labeled Asia, there are two lessons that are not to occur. The truth is that the peso ‘peso problems’ in a knee-jerk fashion. particularly useful. The first lesson problem hypothesis cannot really The second important relevant concerns the natural working of the be disproved—there is just no way lesson from the Asian financial crisis market mechanism, and the second of getting around the sophistry of a is that “the only form of reliable concerns the availability of help during determined peso problem believer. help during an economic emergency a financial crisis. The fact that financial contagion has is self-help.” The IMF could not be been common in the 1990’s cannot counted upon to be always correct in be in serious dispute: the European its diagnosis upon its first reading of 1 See, for example, Wing Thye Woo, Klaus Schwab and Jeffrey Sachs (edited), The Asian Financial Crisis: Exchange Rate Mechanism crisis the situation. Moreover, the United Lessons for a Resilient Asia, MIT Press, 2000.

2 No. 67 No v e m b e r 2007 that they could continue to command a disproportionate influence on world affairs, and China was not prepared to The only country that was willing to commit be rushed by events into supporting a immediate large-scale financial assistance new regional institution without careful to the crashing Asian economies was consideration of all the implications. the neighboring country of Japan, which These two lessons propelled the East Asian countries after their recovery proposed the Asian Monetary Fund (AMF). to go on a reserves accumulation spree to insulate themselves from future speculative attacks (i.e. be independent of the supervision of States could not be expected to be their costly experience with hanging on the IMF). These lessons also led always ready to help out countries in to the Shah of Iran until the bitter end the Asian countries—the 10 ASEAN desperate straits. In the three-decade in 1979) had become more interested countries, China, Japan and South long rule of General Soeharto, he had in who would be replacing him than in Korea, collectively called ASEAN+3— been bailed out several times before by maintaining him in power. to start the process of currency and the US and its allies (notably Australia, The only country that was willing financial cooperation when they met Japan, Holland, and the international to commit immediate large-scale in Chiangmai, Thailand, in 2000. The financial institutions), and it was financial assistance to the crashing resulting Chiangmai Initiative had two thus quite natural for him to expect Asian economies was the neighboring major components: some external aid when things started country of Japan, which proposed 1. The countries agreed to come going awry in the last quarter of 1997. the Asian Monetary Fund (AMF). to each other’s aid if similar Soeharto was mistaken. He did not Japan did not succeed in establishing speculative attacks were realize that with the end of the Cold the AMF, however. Three of the key to reoccur. This pooling of War in 1992, he was dispensable to US reasons for the failure of the AMF reserves to defend the existing security and ideological interests just initiative were that some important values of their exchange rates as his fellow general, Joseph Mobuto of was enabled by each country developed countries believed in the Congo-Leopoville, was; that a newly- entering into a web of bilateral crony capitalism explanation of the impoverished Indonesia, not being an swap arrangements. crisis and concluded that an AMF immediate geographical neighbor to 2. An Asian Bond Market (ABM) would merely mean throwing more the US, could not send a tsunami of would be established to keep unemployed workers into the US as money to the undeserving, corrupt funds within the region. The a newly-impoverished Mexico could; elite of these countries, some other assumption is that if there and that as he neared the end of his developed countries wanted to protect were an unjustified (i.e. panic- natural life-span, the Americans (after the monopoly position of the IMF so stricken) capital flight from one

No. 67 3 No v e m b e r 2007 Asian country, the existence of the ABM would channel these funds to the other Asian countries. ABM is a defensive Would Asia in three years after Hyderabad, mechanism (just like the anti- as Europe did in 1979, form the Asian ballistic missile), and it worked by reducing the probability of a equivalent of the European Monetary System? collective capital flight from out And then grow into an Asian Monetary of Asia. Union another twenty years later? At the May 2006 meeting of the Asian Development Bank (ADB) in Hyderabad, India, the ADB led the call for the introduction of an Asian ASEAN had made enough progress Given the many parallels between Currency Unit (ACU) to coordinate to sign the framework agreement for the fast Asian developments in the last exchange rate movements within the the ASEAN+1 FTA. This fast pace of decade with the movement in Europe region. This ACU proposal was similar economic embrace between ASEAN from the Treaty of Rome in 1957 that to the first major step toward currency and China had the synergistic effect established the European Economic unification in Europe when the of accelerating what has been a Community to the Maastricht Treaty European Currency Unit (ECU), more leisurely-paced process of incremental in 1993 that formalized the European popularly as the European Currency economic integration within ASEAN, Union (EU), the sense of history Snake, was introduced in 1976 to and energizing Japan into active FTA repeating itself is naturally a strong one. coordinate a joint float against the US negotiations with ASEAN. Is there an Asian Economic Union (AEU) dollar. Would Asia in three years after in the offing? Would it come soon, just Hyderabad, as Europe did in 1979, form The ambition of Asian economic like a late industrialist normally taking the Asian equivalent of the European integration, or at least its rhetoric, off at an explosive speed compared to Monetary System? And then grow into has continued to broaden. The the first industrialist? annual ASEAN+3 conference in 2005 an Asian Monetary Union another We know enough from painful was supplemented by the East Asian twenty years later? experiences, however, to be wary of Summit (effectively an ASEAN+6 The Chiangmai Initiative turned linear thinking, otherwise, there would conference) to include Australia, out to be only the first part of a more never be any turning points in history. India and New Zealand; and the comprehensive program of regional We do well to remember the famous host of the 2005 conference, Prime economic integration. In November words of “History repeats itself, first as Minister Abdullah Badawi of Malaysia, 2001, China and ASEAN agreed to start tragedy, second as farce.”2 expounded on his vision of an negotiations for an ASEAN+1 free trade Asian community. area (FTA) that would be achieved in 2 This is the common paraphrase of the opening 2010. By November 2002, China and sentences in Karl Marx’s The Eighteenth Brumaire of Louis Bonaparte (1852).

4 No. 67 No v e m b e r 2007 an AEU should take based on political considerations alone, but it would be even more rational if we also explicitly In our opinion, we cannot compare the acknowledge the economic costs of these political decisions. relative merits of an EU-type AEU and a To put the issue more fundamentally, NAFTA-type AEU without stating what the is there a case for exchange rate world would look like in the future. coordination (and, maybe, monetary integration) within AEU in the absence of political unification? In our opinion, we cannot compare the relative merits of an EU-type AEU and a NAFTA-type The Economic Basis for Exchange Rate has no plans to coordinate exchange AEU without stating what the world Coordination and a Common Currency rate policies; and does not envisage an would look like in the future. Luckily eventual political union. It is important to note that most for us, the conventional view of the attempts at regional economic The most commonly proposed forms state of the world in 2025 and 2050 are integration have ended in barely- of the Asian Economic Union (AEU) conveniently contained in a Goldman- integrating customs unions, with are closer to NAFTA rather than to Sachs study3 Table 1 reports the their high points being the signing EU. The proposals, especially those projections of the inflation-adjusted ceremonies that announced ambitious not associated with ADB sponsorship, GDP in 2025 and 2050 in the major targets and forecasted enormous gains generally anticipate exchange rate countries in EU, NAFTA and AEU. all round, e.g. Mercusor and ASEAN. coordination to be possible only in the Part A of Table 1 focuses on the The two possibly most successful far future; foresee no future political three NAFTA countries; USA, Canada free trade areas in existent are the union; and have tighter restrictions and Mexico. If we select for the European Union (EU) and the North on labor mobility than NAFTA. What normalization of GDP the country that American Free Trade Area (NAFTA). is the basis of these proposals for had the smallest GDP in 2005, then EU and NAFTA are similar in that a NAFTA-type AEU? Are they based the GDP ratio of USA-Canada-Mexico they permit free movement of goods on unjustified fears about loss of would be: and capital within their respective national identity? If these NAFTA- • 17.9 : 1.7 : 1.0 in 2005; groupings. However, they also differ type AEU proposals were not the • 8.2 : 0.8 : 1.0 in 2025; and in many significant aspects. Unlike the results of economic calculation, then • 4.8 : 0.4 : 1.0 in 2050. EU, NAFTA allows only limited labor would an EU-type AEU result in higher mobility across countries (notably economic welfare for its members? restrictions on labor movements from It is of course rational to make 3 O’Neill, Jim, Dominic Wilson, Roopa, Purushothaman and Anna Stupnytska, “How Solid Mexico to the other two countries); recommendations about what form are the BRICs?” Global Economics Paper No: 134, Goldman Sachs, December 15, 2005.

No. 67 5 No v e m b e r 2007 While the United States would and Mexico could use the exchange would be increased if national economic become increasingly large vis-a-vis rate as an additional instrument to help policies were coordinated in a manner Canada and decreasingly large vis-a-vis offset shocks (especially trade shocks) that reduces negative spillover effects. Mexico, the fact is that the US is the originating from the US economy. One instrument for achieving this welfare-enhancing cooperative solution overwhelmingly dominant country in Part B of Table 1 reports the GDP of is a common currency. NAFTA at the present and will continue the three largest economies in the EU; to be overwhelmingly dominant in the Germany, United Kingdom, and France. Furthermore, on the political future. In 2050, the US would be twelve Again using the smallest country in dimension, the natural compromise times larger than Canada and almost 2005 (France in this case) to normalize solution for a group of equally five times larger than Mexico. Given GDP, we see that the GDP ratio of powerful countries would be a this great disparity in economic size, it Germany-UK-France would be: common currency rather than the adoption of any particular national will always be true that independent • 1.3 : 1.0 : 1.0 in 2005; currency. The fact that Europe is economic shocks in Canada and Mexico • 1.2 : 1.0 : 1.0 in 2025; and anxious to undertake political union would have very limited impact on • 1.1 : 1.0 : 1.0 in 2050. the US economy, while a sneeze by in order to minimise the possibility of The GDP ratios reveal clearly that the US could send powerful tremors another war among Germany, UK, and the biggest EU economies are of the to the other two NAFTA members. In France means that a common currency same magnitude now and will continue such an unequal situation, the survival is a necessary by-product. to be so in the future. This means that of individual currencies is natural Part C of Table 1 projects that the independent shocks in each country distribution GDP of the three major because the giant US economy sees will have sizable spillover effects on East Asian economies—Japan, China, no advantage in allowing its monetary the others. This high level of economic and South Korea—display drastic policy to be influenced by the concerns interdependence amongst EU members changes over time. The GDP ratio of of the smaller economies, and Canada means that the welfare of each member Japan-China-South Korea will be: • 6.6 : 2.4 : 1.0 in 2005; • 2.6 : 4.5 : 1.0 in 2025; and • 2.2 : 13.1 : 1.0 in 2050. The GDP ratios reveal clearly that the biggest EU Unlike the EU, AEU will not be a club of equals at any point in time; economies are of the same magnitude now and and, unlike NAFTA, there is no stable will continue to be so in the future. This means dominant economic giant across time. that independent shocks in each country will Japan is the economic giant in 2005; have sizable spillover effects on the others. but China will be the economic giant in 2050. If there is a compelling economic argument to form a Yen-bloc today, then the same compelling economic

6 No. 67 No v e m b e r 2007 reasoning would dictate that this Yen- present efforts to promote closer competent to recognise good behavior. bloc transform itself into a Yuan-bloc exchange rate cooperation will not This means that a regional surveillance by about 2035. succeed in the long-run. The proposed mechanism is required if regional swap closer exchange rate cooperation arrangements (the pooled reserves) are However, because Chinese policy might be justified for the 2015-2025 to reach meaningful sums. makers must be well aware of the period when the GDP of Japan and In our opinion, an Asian Monetary changing balance in economic power China are of the same magnitude. within East Asia over the next three Fund (AMF) would be such a 4 decades, it is hard to see why China The Feasible Financial Architecture surveillance mechanism. Just as we have the system of the World Bank today would want to support the for an Asian Economic Union and several regional development establishment of a regional economic It must be recognized that the banks (like the Asian Development architecture that would establish a present system of (bilateral and Bank, and the African Development Yen-bloc. Similarly, even if China were multilateral) swap arrangements is not Bank), it is also natural and desirable to agree to the formation of a Yen-bloc sustainable and would not increase right now, it is hard to see why it would to meaningful sums unless members to have regional monetary funds not seek to change the fundamental believe that the borrowed funds would (RMFs) in addition to the IMF. The nature of the regional financial be used only to defend an exchange IMF is by no means obsolete with the architecture after 2035. rate against speculative attacks not establishment of RMFs. The IMF can play a very helpful role in speeding up Our opinion is that the NAFTA-like justified by fundamentals (i.e. the the institutional maturity of the RMF, disparity in economic power in AEU at borrowed funds would not be used to the present and in the future means defend an exchange rate that has been and in keeping up the competition that the only stable configuration is rendered overvalued by inflationary of ideas. domestic policies). In addition, the survival of individual East Asian Given the large size of East Asian members would not have such faith currencies with limited coordination foreign reserves, the AMF should take unless each country has been pre- among them in normal times. It on the additional task of designing a therefore appears to us that the many qualified by an objective party that is pooling scheme where part of the East Asian reserves could be safely used to finance sound infrastructure projects Our opinion is that the NAFTA-like disparity in in the poorest Asian countries. This outcome would be superior to the economic power in AEU at the present and in the present practice of putting almost all future means that the only stable configuration is 4 Yunjong Wang and Wing Thye Woo, “A timely the survival of individual East Asian currencies with information exchange mechanism, an effective surveillance system, and an improved financial limited coordination among them in normal times. architecture for East Asia,” in Asian Development Bank, Monetary and Financial Integration in East Asia: The Way Forward, Volume 2, Palgrave Macmillan, 2004, pp. 425-458.

No. 67 7 No v e m b e r 2007 of the East Asian foreign reserves into Table 1 the assets of G7 economies. The World Economy in 2005, 2025 and 2050 It is important that the AMF does (GDP is measured in trillions of US$ in 2005 prices) not suffer from the institutional inertia that is characteristic of the Case 1. NAFTA GDP: US dominates now and in future USA Canada Mexico present global organizations like the 2005 12.5 1.2 0.7 United Nations, the World Bank and the International Monetary Fund. The 2025 19.6 1.8 2.4 leadership structure of the AMF should be designed to avoid simply locking in 2050 37.7 3.0 7.8 the balance of economic power that existed at the time of its founding; Case 2. EU GDP: Fairly equal size France Germany UK much like the unchanging composition 2005 2.3 3.1 2.3 of the permanent members of the UN Security Council, the head of the World 2025 3.2 3.9 3.3 Bank always being a US appointee and the head of the IMF always being 2050 4.9 5.4 5.1 a European. If AMF can adopt a self- Case 3. Asia GDP: Japan now, China in future China South Korea Japan updating type of leadership structure, its first contribution to the world (as 2005 1.9 0.8 5.3 well as to the East Asian region) would be the provision of an example to 2025 11.7 2.6 6.7 inspire positive developments in the 2050 48.6 3.7 8.0 reform of the leadership structure in Source: Jim O’Neill et al., op. cit. the global organizations. To summarize, an Asian Economic Union should take the form of a free trade and open investment area that power in East Asia, and the greater Wing Thye Woo is a Senior Fellow in has a regional monetary fund. And it restrictions on labor mobility within the Global Economy and Development cannot be over-emphasized that there the (commonly proposed) Asian and Foreign Policy Studies programs at is no economic logic for a regional Economic Union, a NAFTA-type of the Brookings Institution in Washington monetary fund to naturally morph Asian Economic Union would be DC, and a Professor of Economics at the into the regional central bank. Given preferable to an EU-type of Asian University of California at Davis. the great disparity in the present Economic Union. and future distribution of economic

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