World Bank's lessons from Indonesian economic crisis

Dennis de Tray, who was replaced by Mark Baird on April 1 as the World Bank Country Director for Indonesia, saw his tenure in Indonesia that started in July, 1994, as the greatest episode personally and professionally, of his life. De Tray made a self- reflection on his experiences at a farewell luncheon hosted by the Indonesian Forum of economists in Jakarta on March 30. The following is condensed from the transcript of his long unprepared speech.

JAKARTA: Based upon my experiences of the past few years, I would like to offer you a set of personal lessons for me, and a set of questions on which I think the economics profession and development profession needs to focus as it attempts to extract the right lessons for the future from the remarkable saga of the East Asia crisis.

Let me turn to lessons and questions for economists and for development economics that emerge for me out of the crisis. Some of these are obvious, but all are worth more thought.

The first lesson is that sustainable development requires equal parts good economic policies and appropriate, sustainable institutions. East Asia's crisis was not a crisis of bad economic policies. Of course they could have been better but that is not the point. By world standards they were in the upper range of good policy. What happened to East Asia is that it went through a difficult transition, in which its institutions were not up to carrying the load.

Indonesia's great shortfall was that it had too many weak institutions and one very strong and unsustainable institution. The weak institutions were the legal system, the financial system, the civil service, and an underdeveloped democratic process. The strong and unsustainable institution was Soeharto. People fail to remember that Soeharto was Indonesia for thirty years. Although it is utterly politically incorrect to say anything good about Mr. Soeharto these days, he did manage to run Indonesia Inc. almost single-handedly for 30 years, producing some extraordinary results. He also did many things extremely badly, but he did deliver equitable growth for thirty years, starting from scratch, from nothing. He did deliver substantial poverty reduction, he did deliver a remarkable increase in literacy, education, and in health. He did not deliver on institutions, and it is in large part, why Indonesia is in the crisis that it is today.

What carries countries through very difficult transitions are institutions that don't depend on individuals. That is what institutions are for. They are meant to provide bridges between people, between leadership.

This country did not have those bridges. So that when Mr. Soeharto left, Indonesia entered a very difficult period in which it had at the same time to build those bridges quickly and to use them. It clearly did not want to go back to the model where personalities provide the bridges.

The second lesson is that globalization changes the need for institutions faster than the institutions themselves are able to change.

If you think back not many months ago, we were in the era the famous "Washington Consensus", which stated openness, export- oriented growth, free markets and fairly limited government interventions were the way to the future. The East Asian experience appeared to have been build on a large part of this consensus recipe. One of the basic tenets of that theory which, by the way, I supported was that countries that were open and subjected themselves to external competition would create a demand for the domestic institutions that were needed to compete internationally. Demand, in turn, would create supply.

I, myself, argued for a very long time that Indonesia's open capital market was one of the most important safety valves, a safeguard that would keep Indonesia from straying too far from good, sustainable policies. If it did, I argued, markets would be quick to signal their displeasure by withdrawing capital. Indonesia couldn't get too far away from appropriate fiscal and monetary policies, otherwise, markets would respond, and a corrective action would be needed.

The message of the East Asian experience, simply put, is that globalization operates at light speed along fiber optic cables, while institutional development takes decades. This mismatch is something that I believe development economists around the world need to take on. We are not going to be able stop the onrush of globalization, so we have to ask ourselves how are we going to deal with the extraordinary institutional development demands that globalization is making on developing countries.

In a globalized world developing countries will be expected to operate by a set of rules that require functioning legal systems, appropriate contract law, financial systems that have a reasonable degree of disclosure, supervision, regulation, etc. If you are operating in the classic Asian business environment where "I know you, you know me" and the public sector, arms length institutions needed to do business seem unnecessary, the demand for institutions is not there.

In a sense, though this is probably a dangerous oversimplification, the period from the early phases of the New Order Government until about 1990 or 1992 was a period in which Indonesia and most of East Asia financed itself by internal domestic savings. So that the rules were internal rules, and they worked. It was from the early 1990s that there was an explosion of external capital moving into Indonesia, very flighty, very impermanent capital. And when this capital was threatened, the people who controlled it felt that there were no rules or information sources they could trust, and they evaporated.

The East Asian crisis challenges the world's community of development scholars to explain two facts:

Fact one: East Asia, including Japan, is the home of one of the best regional development records in economic history, an extraordinary record of economic growth.

Fact two: East Asia's regional collapse was as severe as any we have seen and was not obviously driven by deep external shocks.

It is in a common explanation of these two facts in which the seeds of a serious rethinking of our approach to development policy lie.

Indonesia is an especially clear example of what I would call the curse of success. Indonesia demonstrated that the ability to promote good policy is inversely related to the success of economy. If the economy is booming, the ability to influence policy makers is very low, and when it is crisis period, it is very high. The Bank knew that, as did others, but what we missed was that Indonesia's success did not manifest itself in bad economic policies but in an inability to influence institutional policies. That is what I view as the major shortfall in our vision in Indonesia. It is not that we did not know that institutions were weak, we most certainly did. It was that we, or at least I, really didn't understand how critical those weaknesses would be in the transition from Soeharto to post- Soeharto. That is a fairly obvious line of argument today. What for me personally is much more difficult is to asked what we, I should have, could have done, what Indonesia should have done, five years ago, ten years ago.

* Indonesia: the Dangers of Globalization

I would also argue, in a point related to the globalization argument, that there are hidden dangers in global capital flows. I first heard this from Paul Volker, so I call it the Volker hypothesis. It goes as follows: global investment and hedge funds are so large and the fraction of their investment in any one developing country so small that, in effect, the managers of these funds don't have an incentive to pay attention. They base decisions on almost mechanical signals of what is and what is not going on. It reminds me of my son, who has just been bitten by the Wall Street bug and become a day trader in New York. He cares not at all about the fundamentals of the companies he trades. His money is made on a quarter point this way or that. He is interested in stock trade volumes, not future prospects. In a sense the managers of international investment funds and hedge funds are a bit like that. These fund managers weren't really looking at the fundamentals of the countries. They were looking at quarter-point margins and were prepared to walk away from these countries very quickly. That was unfortunately just what happened.

* Cultural Values

The final message of this experience for me is that culture matters. Now, of course everyone knows this. We are taught to be sensitive to different cultures. We've all read Culture Shock, Indonesia. But I am convinced that we really do not understand the implication of cultural differences in designing interventions, especially in a time of crisis. I am sure that "culture" will be a part of the ultimate explanation of what happened in East Asia. Different cultures really do look on business relations differently. This is no more clearly illustrated than the area of conflict of interest. It is just not a concept that is in people's vocabulary here in Indonesia. It is not understood. In fact, the opposite is true: it is my obligation to help you as a friend and colleague.

In the negotiations that the international financial institutions have had here with the government, I have watched our technical people become extraordinarily frustrated with the government because they can't impose their highly western, aggressive, conflictual program that requires people to admit their errors and be very open and transparent. These are antithetical to the cultural foundation of much of this country. That's a fact, it's not good or bad, just a fact. I had many times to tell my colleagues, "Be patient. This is their country, their culture. We have to figure out how to operate in it, not the other way around." These were seasoned people who have worked a long time in Indonesia, but it is not until you reach a level where things have to be done in a hurry that you realize how broad the cultural gap really is.

I would like to end with four concluding points.

On a personal front, my time in Indonesia has been a life experience, par excellence. There were many dark days, but I would not have missed any of it.

At a professional level, I have learned that sustainable development is a great deal more complicated than I had thought when I entered Indonesia in 1994. But we must be careful not to "throw the baby out with the wash water." In Indonesia's crisis lie the seeds of a revolution in development thinking. The key is in understanding the reversal of Indonesia's fortune, which must be one of the great turnarounds in the annals of economic history.

For the Bank itself, of course the Bank made mistakes. Many of them are quite clear. That is the easy part. The remedies are much less clear. It is still not at all obvious to me what we should or could have done five years ago, three years ago, two years ago that would have kept Indonesia from so much suffering. This is something that I want to spend some time thinking about. What we should have done in the context of the times is, I think, the right way to ask the question. What should I have done when I arrived in July 1994 that would have provided a softer landing for the Indonesian people and its economy?