What's going on right now is not, at least not so far, the worst economic slump we've had since the Great Depression. '85 was worse than this. '82 was worse than this. But the kind of things that are happening now are very '30s sorts of things.You've got Japan which has cut interest rates all the way to zero, and it's not enough. We haven't seen that happen since the 1930s. You've got countries which are being forced to raise interest rates, contract the economy to defend the exchange rate because they're terrified of speculators. We haven't seen that since the 1930s ... it's as if diseases that we thought were cured have suddenly reemerged in a form that's resistant to the usual antibiotics. It's not so much the depth of it, although for some countries it's been terrible, as the fact that the kinds of things that we thought were just history are back again in the world.

Why? What's happened?

Well, if we really knew the answer to that, it wouldn't be happening, right? But it seems as if by recreating many of the virtues of the old systems, markets are freer now than they have been since the 1920s. The international capital movement is much more open, much more unrestricted, than it's been for 70 years. The freedom of people to engage in various kinds of financial operations is greater. Inflation is lower than it's been for many decades. It seems as if by recreating all the virtues of the old world, we have also brought back some of its vices. We've opened the door for these old fashioned problems to reappear in the modern world.

The old fashioned problems like panics and bank runs?

Yes, bank runs were not supposed to happen in the modern world. We understood how to stop that. We have deposit insurance. We have the Fed ready to rush money to the banks if people demand their cash. In fact, we don't have runs on banks, but it turns out we've liberalized our financial sector so that a lot of other institutions are doing the kinds of things that banks used to do. And sure enough, last fall we had something that looked a whole lot like a bank run. It didn't involve anything that was called a bank, but it looked like a bank run, and certainly had the Feds scared to death. For a few weeks there, it looked as if the whole thing was going to implode.

Part of the result of this is ... a big argument about whether or not we should slow down this march to absolutely free capital markets that the U.S. government has been pushing ...

Well, sure. The things that people would have said two or three years ago about what a terrible thing an over regulated banking system is, how inefficient it is, about capital controls and how they distort incentives and create opportunities for corruption--all those things are true.But it also turns out now that free markets are, as John Maynard Keynes would have told you, sometimes desperately unstable. If you look at someplace like Indonesia, one 15% decline in GDP offsets a whole lot of efficiency gains in the past. So a lot of the old issues have been reopened. It's not easy to be a free marketer with a free conscience right now, unless you are completely blinkered, unless you just don't look at what's been happening in the world ...

Talk about exchange rates ... Why are they important to governments, to the financial markets?

Each country has its own money ... that money trades on a market against other monies. So there's an exchange market where people trade bahts for dollars. There's a price of dollars and bahts or price of bahts and dollars; it doesn't matter. Either way, between them is the exchange rate, which is determined by supply and demand like any other price.

The only thing is that the supply and demand for bahts and dollars in this market is mostly determined by investment decisions. People buy bahts because they think Thailand is a good place to put their money. Thai residents buy dollars because they think that Thailand is not such a good place to put their money. So it goes back and forth.

Now, if you're a big country like the United States, which doesn't do a lot of foreign trade relative to our income, which is just sort of big enough to ride out whatever happens, we don't care much. The news says that the Japanese yen has gone from 140 to 110 to the U.S. dollar. The average American citizen doesn't say, "Oh, my God. The dollar is losing value in yen." But if you're a small country like Thailand, it matters a lot.First of all, a lot of what you buy is imported, and the prices of those imports tend to be set in dollars rather than in bahts. So if the baht drops against the dollar, then your input prices surge. Even more important, this turned out to be crucial, a lot of the borrowing that Thai businesses do is not loans in bahts. A bank in New York doesn't want to make a loan that's defined in bahts. It's defined in dollars or in yens.

So when the baht drops, all of a sudden, the money that you borrowed, that looked like a tolerable amount of debt before, has suddenly increased. If the baht devalues by 50%, suddenly the baht value of those yen or dollar loans is 50% more than it was. Now you can be in very deep financial trouble. So small countries with a lot of foreign debt like Thailand or Mexico or Brazil find themselves very worried about the value of their currency on the foreign exchange market.

Talk about the difference between fixed rates and floating rates.

There are a couple of ways you can manage this thing. You're a country. You have your own money. What do you do? One answer is, you do what the United States does, which is you say, "Okay. We're going to manage our money based on domestic considerations. If the economy's in a recession, we're going to print more money. If the economy's overheating, we're going to pull money back. We're going to let the foreign exchange rate do whatever it does." That's a market. It's like any other market. Supply and demand will let it go up and down.

The U.S. gets away with this. It works fine. Even smaller advanced countries get away with this. Australia does that, and they don't seem to have problems. But the alternative, if you're worried about that, if you think that we can't take the risk of having this price move too much, we can't have the risk of having the dollar debt of our companies blow up in value, or a burst of inflation or whatever, then instead you say, "Actually, no, we're not going to do that. We're going to make our monetary policy keyed on keeping the exchange rate fixed. We're going to declare a commitment to keep ... one peso to one dollar. Whatever we need to do, if it looks like people want to change pesos for dollars, instead of letting the peso drop in value, we're just going to reduce the supply of pesos, make them scarcer, keep the price up." That's a fixed exchange rate.

For the last 150 years, people have gone back and forth between the merits of those two systems. Basically, each system has got big problems. After some length of time with one system, you start to say, "Gee, maybe life would be easier if we had the other system." And you switch. Then after a while, you switch again, and back and forth.

In general, is it possible to say which of the two, countries prefer?

It varies a lot, depending on who you are. Basically, big countries like the United States, and to a lesser extent Japan, basically find that foreign trade, foreign investment, is not important enough for domestic policies to become hostage to the exchange rate. That would be the tail wagging the dog, and they're not prepared to do that. They may talk about stabilizing the exchange rate, but when push comes to shove, the domestic economy rules.

The smaller the country, the more it tends to be committed to keeping the exchange rate stable. The problem is particularly in a small country with bad history, Argentina--small country, terrible history of hyper-inflation. Their problem is always to convince people that pesos are real money. There's always the risk that people will go back to the old habit of thinking of pesos as being basically worthless pieces of paper and "I prefer to have dollars, thank you."

So they end up being prepared to sacrifice a lot to keep a peso stable, to keep a peso worth a dollar, so that people continue to regard those pesos as real money. It's an agonizing choice. And whenever the choice is made one way or the other, there are many recriminations, because inevitably something goes wrong. There don't seem to be any easy answers here ...

In general, don't investors wish that for the amount of dollars they put into a country, they know that they will get that amount or more back out?

Yes, but not doing so kills the domestic economy. The one thing you can say is that ... the markets prefer that whatever you do, you make a firm choice. Go to the church of your choice, but go, goddamn it. The worst of both worlds seems to be fixing the exchange rate, but not convincingly. If you have a fixed exchange rate, but people suspect that you really aren't going to stay there, then all hell breaks loose at the least provocation.

There are countries that have completely floating rates, and the market seemed happy with them. When their currency drops, the market says, "Oh, good, that's a buying opportunity," and it stabilizes. That's the case with Australia. That's the case of what happened when Britain let its exchange rate drop in 1992, after promising up and down that it never would. Everyone was relieved. It was good news.

There are other countries, mostly Third World countries, that the market decides are not reliable. If they promise to fix their exchange rate and then change their mind, the market treats it as a betrayal, the currency loses half its value, and a terrible recession results. It's a very difficult world. It's not fun to be a finance minister in this world. Whatever you do, it turns out that the market is very likely to say that was exactly the wrong policy.

What kinds of trouble does a small country potentially create for themselves by guaranteeing a fixed rate?

Well, suppose conditions change. You're a prosperous economy one year. Then something happens. The price of your primary export falls, or there's some sort of financial disturbance in the world. Investment drops, and money starts to flow out of your country.

If you've guaranteed a fixed exchange rate, you have no alternative when people take those pesos and want to turn them into dollars. You have to supply the dollars and reduce the supply of pesos. That means people pull their money out of your banks, which means the banks have less money to lend, which means that there's a further contraction of credit, which means the deposit falls still more. You're setting yourself up for a nasty recession, maybe even a banking crisis, a run on your whole banking system. If you are truly committed to that fixed exchange rate, there's nothing you can do ... Under the ordinary rules of the game, there is nothing they can do. They just have to sit there and hope that it's not a complete catastrophe.

Currency crises...if a country thought its currency was overvalued, that was creating a problem--its exports were too expensive. If they decided to devalue or let their currency float, the markets run out because of that too.

Yes, the '90s have been a bonus year for currency crises and a bonus decade for currency crises. We've had more of them than in any decade since the '30s. It started with good news. In 1992, Britain and Sweden dropped out of their exchange rate commitments and nothing terrible happened. We all thought, "Okay, there's a financial crises. Government officials get to look foolish, but nothing really terrible happens." But since the middle of this decade, every time a Third World country has tried to let its exchange rate go, has decided that rescuing the banking system or fighting a recession was more important than some exchange rate commitment, the result has been a catastrophic panic.

Mexico, at the end of '94, devalued by 15%. Nothing unreasonable about that. Lots of people thought they needed that. The reaction of the markets was, "Oh, my God, they're still a Third World country. They're still Mexico." Within a couple of month the peso has lost half its value.

Thailand devalued in the summer of '97. Again, that was perfectly reasonable. A lot of calculations suggested that was a reasonable thing to do. This was a country with a spectacular record of economic growth. It didn't matter. But as soon as it happened, people said, "Oh, my God, the Asian miracle was a myth. Wow."

So in this world of hyper-mobile capital, the market seemed sort of manic depressive about Third World countries. One day, "They're emerging markets and they're the hope of the future." The next day, "They're bums and they always were. It's crony capitalism." Countries are desperately afraid to do anything. They feel that it doesn't matter what the economics are. As long as they have a commitment or they're perceived to have a commitment to the exchange rate, to break that for whatever reason is to open the flood gates.

Instead of taking the steps that might pull them out of recession, they're afraid that if they take those steps, more money rushes out.

That's right.

So they're trapped.

Yes. Hong Kong, at this moment, is an economy where there's deflation. The unemployment rate is the highest its been in a generation. Everybody can see that they have, at best, years and years of grinding slow adjustment as wages are squeezed down. Perfect case, according to the textbook, for devaluation. All their neighbors have devalued. Why not devalue the Hong Kong dollar to match them?

The answer is that everybody believes that if Hong Kong were to go off its current peg, that would destroy the credibility of their administration. And because everybody believes it, it's true. It doesn't matter whether you believe it, as long as you believe that every other investor believes it, then it would be catastrophic. They are stuck. They are as stuck as an economy that was by law committed to the gold standard in 1907 ...

You've called a lot of what we're talking about a confidence game. Tell me what you mean by that.

The perfect case is Brazil. Brazil has a budget deficit ... that is not the worst budget deficit in the world, but it's serious ... It doesn't seem like something that has to be done now, but the markets have fixated on Brazil's budget deficit and think that it must be reduced instantly. So it becomes urgent to reduce it to satisfy the market. It's not because of the fundamental economics. Of course, if you slash government spending and raise taxes, that causes a recession. You might say, "Well, let's lower interest rates to not have the recession." But they don't dare do that, because if they did that, the currency would fall and that would unleash a sudden loss of confidence.

They end up having to do everything, not because, if you sat down and work through the underlying economic situation, it's necessary, but because they believe that the market believes that these are the right things to do. And the market believes that these things are the right things to do because each market participant thinks the other market participant thinks these are the right things to do. They end up entirely in a game of psychology ...

Isn't it also the case that the IMF and the U.S. Treasury is telling Brazil that this is what everyone believes?

The saddest thing for me personally is that we have the smartest, best economists in the highest level positions ever in the history of the world. The top people at U.S. Treasury, top people at the International Monetary Fund are fabulously good economists, who are, by the logic of the situation, forced pretty much to toss aside the textbook and cater to the prejudices of the market.

They knew when talking to Brazil, they understood that everything they were telling Brazil to do was practically a checklist of how can I generate a terrible recession in this country. But they felt, with fairly good reason, that they had to do these things, because the markets were demanding them. The markets were demanding them, not because they had that much to do with the fundamentals in Brazil, as because the markets believed there would be a panic if these things weren't done, and the markets were right, because the markets would themselves generate that panic.

So what's happened, in a way, it doesn't matter how much economics you know, it doesn't matter how thoroughly you understand the fundamentals of the situation. Everybody ends up having to cater to the need to have market confidence. That's the story of the last two years.

How did we get into that situation? When did the U.S. Treasury decide that the markets were going to direct its policies?

I think [they] sort of slid into it. A lot of it is the story of Mexico. At the end of '94, Mexico ran out of foreign exchange, hit the wall, devalued. They botched it. It's a long story, but there was a terrible plunge in the Mexican peso, and policy had to be made on the fly. The IMF and the U.S. Treasury put together a plan which, I think you have to say, was improvised. They were riffing there.

What the plan was, the Mexicans were supposed to do lots of things that were tough--raise interest rates to 75%, cut spending, raise taxes--tough stuff which might convince the markets that they were serious, might regain the confidence they'd lost a few months earlier. The U.S. and the IMF and other sources would rush them emergency cash to back up the procedure. And it worked.

In retrospect, you have to say we're not quite sure why it worked. It wasn't as if it was a well thought out plan. It was an emergency response. They saw the ball whizzing past them. They reached out and they managed to grab it. But having seen that work, the natural thing to say was, "Well, that's the way we're going to deal with every crisis. We're going to focus everything on regaining the confidence of the markets." And that's what they did in Asia. Unfortunately, it didn't work as well as it did in Mexico. Basically, we got suckered in by the success of the Mexican rescue into playing this confidence game every time a crisis occurs.

There are others who take a less benign view of the lessons of Mexico ... that the markets learned they could take whatever risks they wanted to, and they would always get bailed out ...

Well, this is the issue of moral hazard. Do people say they can go out and take risks because someone will bail them out? There's a lot of moral hazard out there, though I think you can be excessively literal about it.

Certainly people, to some extent, investors, George Soros or whatever, believe that in many cases, there will actually be dollars from the IMF or the U.S. Treasury or the Japanese that will bail out their investments if they go bad. But I think it's something broader, which is that Mexico gave us a false sense that we knew what we were doing.

Now, people got the incorrect belief that Bob Rubin and Alan Greenspan really had this thing under control, and all future crises would be comfortably managed the way Mexico was. The truth is, Greenspan and Rubin and the people who work for them are smart people, but like everybody in the situation, are mostly groping. They got very lucky in '95, and it was a mistake on everybody's part to assume they would always be so lucky in the future.

You have been very critical of the response to the crisis in Asia, once it got going ...

Actually, I'm one of the people who was less critical. Among the people who are critical, I'm one of the softies, because I can very easily imagine I would have done the same thing as the people at the IMF and Treasury did, at least in the first few months. The more we look back at it, the more we can see that they really missed a lot. There were a lot of mistakes. The important thing now is to try not to keep on making those mistakes.

A lot of what happened was that because this was viewed as a confidence issue, the responses were totally focused on building confidence at the domestic economy. Countries were told to raise taxes and slash spending in the face of a recession because that was supposed to be a confidence building measure. It turns out, it intensified the recession.

Countries were told to completely steer away from anything that might limit the outflow of capital from their countries, because the threat of such measures would reduce confidence. But it turns out, the money went streaming out anyway.

If there was something I would really single out for criticism, it is that Washington took the crisis as a signal that now is the time to push for wholesale reforms in the country, that they've got a banking and financial crisis. Good. Let's tell the president to eliminate the clove monopoly. While the clove monopoly was a terrible thing, it had no relevance here. What it did was to create an adversarial atmosphere between the country and Washington that did a lot to feed the downward spiral of confidence.

If I get really critical, it's about things like the Brazilian plan. This is now a year and some months after the first wave of crisis, and we've learned something now. Yet, we go into Brazil with exactly the same set of recommendations as before. It's a plan with no end game. There was no way out. It was telling the Brazilians, "Suffer, raise your interest rates, slash your budget, endure the recession," and there was no sort of clause that followed. That, I think, was a lot less forgivable than what went before.

It doesn't sound like you have much confidence that Washington has learned any lessons.

Well, I think they are groping. But, in a way ... they have the same problem that the Mexicans had at the end of 1994, which is, that to reverse their earlier assurances would itself be enormously devastating to confidence. Take an extreme case. Suppose that the U.S. Treasury Department became intellectually convinced that Prime Minister Mahathir is right in Malaysia to impose capital controls--they're not, but suppose that they were. They could never admit that. To say that, would itself unleash cataclysmic events, because it would be saying Washington doesn't know what it's doing. I think anybody who's been at all in public life knows that you never, ever admit a mistake. In this case, I believe we're all somewhat trapped by our history here.

Meanwhile, we have recessions and threatened depressions in many parts of the globe. Doesn't someone have to admit a mistake somewhere along the lines?

If you look ahead, what will actually happen is that countries will craft their own responses. They will never be initiated from Washington, but they might be acquiesced in by Washington. Malaysia is an extreme case. They've gone to draconian capital controls. They've almost really gone too far and will back off.

But other countries will do things like institute measures to discourage companies from borrowing in dollars. That's clearly one of the core issues in this crisis. People in Washington will say, "Oh, that's a terrible thing; that's interfering with free markets." But they won't actually take any sanctions against countries that do it. So what I imagine will happen, assuming that things don't fall apart before, the way out will be through a process of steady deviations from the Washington consensus, which Washington itself accepts without actually encouraging ...

You also wrote that the response to the Asian crisis was essentially a betrayal of a deal made a couple of generations back.

Yes. That's the core. There are economists and there are economic commentators who are free markets 100%. The market solves all the problems. But most sensible people are aware that there are things like recessions, that the 1930s did happen. The deal that we as economists made, the deal that governments of advanced countries was, "We will take care of those. We will have monetary policy. We will have fiscal policy. We will fight recessions. The 1930s experiences are not going to occur. And given that, we can have free markets in the economy at large. You don't have to have socialism, because we can stabilize." That's the Keynesian deal. We can stabilize the economy. We can prevent depressions. And that means that we can continue to have a free market economy.

Everybody wins a bit from the free market.

That's right. There's a lot to be said for that. The free markets are very, very good things. Attempts to better on them usually fail ... that's what's so disturbing about the world in the last couple of years, is that that deal has fallen apart. We have many countries that are now suffering from severe recessions, that are heading with eyes wide open into recessions, because they feel that there's nothing else they can do. They can no longer fight it. In that case, the deal is off ...

One economist has said that this rolling crisis that began in Asia is the greatest manmade disaster since the '30s.

That's right. That shouldn't even be a controversial remark. We've had the two worst economic crises since the '30s. We had the first and second oil crisis, and what those were about, we can debate. But the thing is, if you're going to suddenly restrict the world's supply of oil, a global economic crisis is comprehensible.

Nothing went wrong this time. There's no shortage of raw materials ... basically, we just had technical issues that went wrong. Yet, we've had a human catastrophe that's taken up about half a billion people and thrown them back into severe poverty, and we don't know quite where it stops.

How has something that was just a couple of technical issues that needed some correction, turned into this disaster?

The thing that maybe is one of the greatest mysteries of macroeconomics is that small causes can sometimes have enormous effects. If you take what I believe to be the case--we're talking, in the case of the Asian economies or for Latin Americans, about a technical interaction between foreign currency, denominated debt, plunging exchange rate, capital flight--none of these actually are a very difficult issue to deal with, if you got to it soon enough. None of them is a fundamental statement about the weaknesses of the economy. Nonetheless, devastating impacts.

Economists like me now believe that the Great Depression in the United States was entirely preventable. At the time, people said, "Ah, it's the excesses of the 1920s." Or people said, "Look, this is the death throes of capitalism." We now think that if only the Federal Reserve had printed more money early in the process and had rushed cash to those banks that were threatening to close in 1930 and 1931, none of it would have happened. Small causes, a little mishandling at a crucial moment, produced a devastating event ...

What is the biggest question in your mind today?

Oh, the biggest question is what about the big advanced countries? This is an enormous human tragedy. But so far, it's only affected people who didn't have that much money to begin with. So in dollars and cents terms, it doesn't really matter that much. The question is: Can this thing spread to us? By us, I mean, basically, all of the rich, stable, democratic countries of the first world.

So far, mostly it hasn't, but there are some scary things out there. The Japanese are fairly close to entering into a deflationary spiral. The United States had one heck of a scare in the fall when the bond market froze. I remember a Fed official in a private meeting, when people asked him what are we going to do about this, [he] said, "Pray," which was not very encouraging. We got out of that. We don't quite know how. So the scary question, the big question is: How immune are the big advanced economies? I'd give you 10 to one odds that it's not the 1930s over again for those economies. But those are not the kinds of odds I'd like to be hearing.

Aren't we already seeing [people] in the oil industry, steel industry, in this country beginning to feel the effects?

Yes. Clearly some groups are hurt, because they are dependent on those markets, or one way or another are directly in the path of this storm. On the whole, the United States' economy remains astonishingly prosperous in the face of what's going on there. There's no necessary reason why that can't continue. But then, there was no necessary reason for any of this to happen. So you've got to be concerned. The great revelation here is that we don't know what we're doing as well as we thought we did. That problems we thought were solved are not solved. That economic analysts like me, economic managers like the people at Treasury, hopefully know something, but don't know as much as we thought we did. That means that problems that we thought were impossible may turn out to be quite real in the modern world.

In your Foreign Affairs article, you talked about whether or not governments would take enough steps to stimulate demand at this moment ...

If you look at two of the three great centers in the advanced world, Japan, first and foremost, and then also Europe, you start to wonder, what are they thinking? Look at Japan right now. It's an economy that's been shrinking for the past two years. Prices are falling. Wages are falling, which never happens. You say, "Well, they must be moving heaven and earth to get that economy moving again." The answer is, they aren't. They're spending a lot of money on public works, but they're not printing a lot of money. When the yen surged in value for complicated market reasons, which is a terrible thing for an economy that's on the verge of a deflationary spiral, the Japanese actually seem to be proud of it.

So that's scary. That's making me wonder, is it really possible that here in the modern world, there are people who don't understand even that much and are prepared to take those kinds of risks with a big economy? If you look at Europe, where they talk about price stability and are sitting there again on the edge of deflation, you wonder, are they prepared to do what's necessary?

Meaning, spend money?

Well, in particular, print money. You print money, and you spend money. Print money is the easier alternative and the preferred one, if you can do it. Again, the Europeans start to talk about the virtues of the strong Euro, which is the last thing they need right now. What worries me about Japan and Europe is the people in charge seem to be like the old line about French generals, prepared to fight the last war. They remember very well the inflation of the 1970s and early 1980s. They remember the excesses of speculation in their markets during the bubbly economy in Japan during the 1980s. Here, they are in a world which is that world turned upside down, where the clear and present danger is deflation, not inflation; where the problem is crashing asset prices, not overvalued ones. They don't seem to be prepared to make the mental shift. And when they do, it might be too late.

Add into that mix the U.S. economy running a budget surplus. Isn't that a problem at this moment in time?

... Well, so far that's not a problem, because U.S. consumers are making up for it. What happened is the U.S. government has gone from heavy dissaving to substantial saving. But U.S. consumers decided to stop saving altogether at the same time, so it hasn't created a problem.

I'm less worried about the U.S. I don't think that we are a contractionary force in the world now, or are likely to be. And in Greenspan I trust--not really, but the fact is, that the U.S., whatever criticisms you can make about its policies and for the rest of the world, our domestic policies are more flexible, more open minded, than that of anyplace else. That is one of our great strengths ...

If Asia heads into depression and Europe is in a deflationary cycle, how long do we think that we are protected?

Oh, we have to move fast. The world is not all that integrated. It is possible to have prosperity in the U.S. while the rest of the world is in trouble. It's possible in principle, but we'll have to move fast. If there is a slump that spreads to the first world outside the U.S., then we have got to cut interest rates, start spending that budget surplus ... The Great Depression would have been easy to stop in 1930. It was very hard to get out of by 1935. The point is, that the time to act would be quickly. I think Washington understands that. Famous last words?