The Macroeconomics of the East Asian Crisis and the Implications of the Crisis for Macroeconomic Theory

In the first part of the paper I argue that the afflicted East Asian countries’ opening up to short‐term international capital flows resulted not only in financial vulnerabilities, which have been emphasized as the cause of the crisis, but also in macroeconomic weaknesses that contributed to the eruption of the crisis. These macroeconomic weaknesses are in the form of deteriorating foreign exchange earning capabilities, coupled with overvaluation of the currencies. The overvaluation led to distortion in relative prices that contributed to the speculative bubbles. In the second part of the paper I argue strongly that Keynes’s theories are very relevant to the present crisis. They include Keynes’s denial of the dichotomy between the real and monetary sectors, and the speculative demand for money and its role in the ‘liquidity’ and ‘investment’ traps. Most important is Keynes’s neglected psychological and ‘animal spirits’ factors, which were discussed in Chapter 12 of The General Theory. A rereading of this chapter shows that Keynes’s analysis is stronger and more perceptive than the ‘market failure’ analysis of Stiglitz, Rodrik and Krugman in arguing for strong financial regulation and supervision, as well as capital controls of short‐term international flows. The monetarist and rational expectations schools of thought are strongly criticized. These schools of thought paradoxically were the theoretical bases for the initial monetary and fiscal austerity measures imposed on the afflicted countries, which deepened and prolonged their crisis. Finally I also briefly discuss the implications of the crisis on the endogenous growth models and on the economics of institutions and governance.