CAMBRIDGE: The Asian economic crisis is not going according to plan. Last Fall when the Western Governments and the IMF sponsored more than $100 billion in bailout loans to Asia, the hope was for a quick rebound. Those hopes are now dashed. Output is falling sharply everywhere. Japan is falling into deep recession. Some knowledgeable observers speak of an Asian Depression.

To understand these fast moving events, we have to understand Asia’s financial systems. Asia’s economies were built on debt finance more than equity finance. Asian households put money in the banks which was then lent to Asia’s enterprises. The banks made large loans to undercapitalized enterprises, which were thereby able to expand rapidly despite a shortage of equity capital. Debt financing allowed the Asian countries to grow at rates that were unprecedented in world history.

So far so good. The system worked well until the early 1990s, when Asia’s financial markets were opened to international capital markets. For the first time in many countries, Asia’s banks were allowed to borrow from abroad. Unfortunately, foreign bankers were not conservative like Asian households. Money that came in one day could come out the next.

This is what happened. Foreign bankers lent $55 billion to five Asian countries (Indonesia, Korea, Malaysia, the Philippines, and Thailand) in 1996. They withdrew at least $17 billion in 1997 when they got scared by the devaluation of the Thai Baht. Suddenly, the entire debt-financed system was broken. Asian banks had to demand the repayment of loans from industrial borrowers, so that the banks could pay off their own foreign creditors. Heavily indebted Asian enterprises didn’t have the cash to repay their loans, since the loans had been sunk into new factories, real estate, and other long-term ventures.

The ferocity of the Asian crisis has resulted from at least four facts. First, panic has fed panic. Once the bankers realized that the other bankers were leaving Asia, a race to the exits ensued.

Second, the IMF and the U.S. Government played with fire. They decided that the best way to handle the panic was to raise interest rates so sharply in Asia that the outflow of funds would be reversed by short-term speculators. But the credit squeeze engineered by the IMF simply pushed the enterprises into bankruptcy.

Third, foreign panic combined with the IMF credit squeeze created what economists call a debt-deflation cycle. Bad loans worsened the balance sheets of the Asian banks. These in turn caused the banks to demand repayments of even more loans from enterprises, which caused even more enterprises to fall into bankruptcy.

Fourth, the collapse of Asian lending has had a "multiplier effect" within the region. The downturn in Southeast Asia has meant a decline of Japan’s exports to the region. This pushed Japan into recession. Japan’s recession, in turn, is now deepening the crisis in the rest of Asia.

The key to solving this deepening crisis is to break the debt-deflation spiral so that Asia’s industrial enterprises can begin to function once again. The following financial policies will be crucial.

First, the industrial enterprises must be relieved of their heavy debt burden. One key step, therefore, is a large-scale conversion of enterprise debt to equity. The banks would no longer hold unpayable debt, but rather marketable equity. This equity could then be sold to foreign and domestic investors.

Second, the banks will need a major recapitalization. The bank balance sheets are in miserable shape, since many bank loans have gone bad. Asian governments will have to provide new capital to the banks, in effect partially or fully nationalizing the banks on a temporary basis. The Governments would then turn around and sell their stakes in the banks, seeking foreign as well as domestic investors.

Third, the IMF should end its credit squeeze policies, letting interest rates come down, and restoring the flow of working capital to enterprises.

These measures will almost surely lead to a further depreciation of the major Asian currencies. We should not panic at the prospect. Modest inflation in Asia, combined with a surge of export-led growth, is far preferable to an Asian Depression. Yes, the Yen is likely to weaken further. Yes, the Chinese Yuan is likely to depreciate. But these are not reasons for gloom.

There is little time to lose in a fundamental overhaul of the Asian strategy. The current approach of monetary stringency has failed. Time to try a different approach.

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