(FORTUNE Magazine) – By imposing stringent capital controls on Malaysia's econo my on Sept. 1, Prime Minister Mahathir Mohamad launched an assault on the foreign "speculators" and the international financial orthodoxy that he hates. But there's a lot more to it than that. If Mahathir's extreme plan works, which is highly unlikely, virtually every emerging economy would be tempted to follow suit, leading the world back to the closed capital-account regimes of the 1950s. Even more worrisome: The Prime Minister's recent behavior points up the extent to which the Asian financial and economic debacle has now shuddered through to politics and geopolitics--another frightening reminder, as if any more were needed, of how much 1998 is coming to resemble 1931.

Mahathir's economic logic is straightforward. In a free market, high interest rates were needed to keep the ringgit from going into free fall against the dollar; yet tight money was strangling Malaysia's domestic economy, which shrank almost 7% in the second quarter. Now, with the capital account closed and the exchange rate against the dollar fixed, Malaysia is easing credit with impunity. In the three months since July, interbank rates have fallen by three percentage points. Banks have also been ordered to keep loan growth across the board at a minimum of 8% a year. And that, Mahathir believes, will kick-start the economy.

To ensure that his plan would sail through without opposition, Mahathir sacked from his cabinet the man respon-sible for the tight-money policy, Anwar Ibrahim, the Finance Minister and Mahathir's No. 2 and designated political heir. Citing his deputy's "low morals" (the sexual-misconduct allegations against Anwar being "investigated" by the police make Bill Clinton seem monkish), Mahathir took charge of the finance portfolio himself. The day-to-day running of the economy will be in the hands of Daim Zainuddin, a longtime ally of the Prime Minister's, who has held a special cabinet post since June.

So far, Mahathir's plan seems off to a strong start. The most obvious indication: In the two weeks following the imposition of capital controls, a loyal pack of local buyers pushed the Kuala Lumpur stock market up by 50%. But what are the long-term chances that this plan will work? Good, claims Salomon Smith Barney. But then this paragon of Wall Street capitalism would say that, since it has been hired by Mahathir to raise international capital for Malaysia's bank-restructuring agency and to present the country's case to foreign investors. Stephen Taran, the Hong Kong-based sovereign-credit specialist for Salomon who is in charge of the firm's Malaysia effort, argues that capital controls will make it possible for the government to successfully carry out structural reforms. The breathing space given by lower interest rates and by a domestic economy that should by next year be back on a modest growth path can be used to clean up the banks (nonperforming loans may double by the end of 1998, to 20% of GDP) and company finances (domestic debt, at 170% of GDP, is the highest in Southeast Asia).

Ultimately this rosy scenario is not very persuasive. For one thing, it is hard to believe that Malaysia's loose monetary and fiscal policies (this year's budget deficit will probably be close to 5% of GDP) will not lead in a few months' time to roaring inflation. Second, an inflating economy in a deflationary world seems very unlikely to run a fat trade surplus over the next year. If it runs a deficit instead, Malaysia's reserves will shrink, calling into question its ability to do as it says it will and let foreign direct investors freely repatriate their profits.

Then there are the little matters of administration and corruption. The paperwork Malaysia's central bank will have to process to sort permitted currency transactions from forbidden ones will be staggering, and is unlikely to be speedy. Singaporean bankers are already getting phone calls from children of high officials in the ruling party, the United Malays National Organization (UMNO), asking how they can get their money out of the country. And the official exchange rate will spawn an unofficial one. Just one week after its rate was fixed, the ringgit was trading on the street at 10% below its official value.

But the crucial question is whether Mahathir will use this temporary breathing room to mount a thorough purge of banks and companies. Optimists point to the nation's apparently well-designed bank-restructuring agencies and to a corporate-debt restructuring committee set up in August. They also note that Daim Zainuddin, the economic czar, is a tough operator who, almost uniquely in Malaysia, can stand up to Mahathir.

This seems to be wildly wishful thinking. In Malaysia's peculiar mix of political patronage, race-based politics, and capitalism, the government and UMNO have spent more than a decade backing favored businessmen--mostly, but not all, ethnic Malays. Many of them are now in deep trouble. Most have close ties to Daim--indeed they are often called "Daim's boys"--and the idea that he will now happily throw over his friends is improbable.

Mahathir may not have much time to prove that his radical plan will work. Anwar has surprised everyone by continuing to campaign in speeches, videos, and public rallies against the capital controls and against the Prime Minister. Two weeks after his expulsion, he had not yet been arrested, though several of his associates had been. With the net tightening, it seems only a matter of time before he is detained. He still may come back. These are revolutionary times, as Indonesia's former President Suharto discovered in May, and if Mahathir's experiment bogs down, Anwar will again seem like the logical successor.

Apart from neighboring Singapore, no one will have a keener interest in these developments than Indonesia, which for its part is already being buffeted in the slipstream of Malaysia's capital controls. Rumors that Indonesia may follow Malaysia are growing and are sending down the rupiah and the Jakarta stock market despite explicit denials by the central bank governor and by President B.J. Habibie himself. The market's fear is senseless. Indonesia is a huge archipelago in which smuggling is already rife, with an extremely weak civil service far more prone to corruption than Malaysia's. There is little capital left in the country to control.

And, in the greatest irony of all, Indonesia's economic adjustment is actually going rather well and, in the right circumstances, could start yielding some benefits fairly soon. True, under IMF discipline Indonesia is suffering suffocatingly high interest rates of 50% to 60%. Rini Soewandi, the astute CEO of Astra International--a car manufacturing and distribution company, among other things--and a former vice chairman of Indonesia's bank-restructuring agency, thinks rates should be brought sharply down. Professedly "no fan" of the IMF, she believes that the rupiah exchange rate is being moved hardly at all by interest-rate spreads. Her solution: Forget both capital controls and the exchange rate and radically drive down interest rates to help reignite the economy.

It might well work. Indonesia's attitude toward reform is almost diametrically opposed to Malaysia's. A real bankruptcy law has been introduced that gives creditors far more rights than they have in South Korea, Thailand, or Malaysia. A bank-restructuring push has the potential not only to sort out the banks' appalling balance sheets but to compel industrial restructuring as well (see box).

Some Indonesian companies are becoming supercompetitive. Patrick Yu, who runs Indovalue, an Indonesian investment fund, says that companies whose products have a high-energy content (like glassmaking) or that use local materials and sell internationally now have a huge global advantage. Example: Indah Kiat, a pulp producer whose costs, he says, are $70 a ton, compared with world prices of $300.

Then, why is Indonesia not noticeably bouncing back? Almost the whole of the answer is political risk. Physical security is the worry that most crops up in conversations with local Chinese businessmen, who, if the guesswork is to be believed, control much more than half the domestic economy--and who were the victims of terrifying mob riots last spring. President Habibie is not improving the climate with his frantic flip-flops, but he has much to worry about. The army as well as democratic and Islamic activists are agitating. In November the constitutional assembly meets to set the rules for presidential elections next year.

The trouble, as Astra's Soewandi points out, is that Indonesia does not have the luxury to dither for so long. But in Indonesia, as in Malaysia, it is hard to see matters being resolved quickly. In a region where, blessedly, politics used to seem a third-rate sideshow to the exhilarating business of doing business, it is now coming to dominate everything--so far, to everybody's detriment.