Wednesday, April 16, 2014
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Death by Finance

PRINCETON – How quickly emerging markets’ fortunes have turned. Not long ago, they were touted as the salvation of the world economy – the dynamic engines of growth that would take over as the economies of the United States and Europe sputtered. Economists at Citigroup, McKinsey, PricewaterhouseCoopers, and elsewhere were predicting an era of broad and sustained growth from Asia to Africa.

But now the emerging-market blues are back. The beating that these countries’ currencies have taken as the US Federal Reserve begins to tighten monetary policy is just the start; everywhere one looks, it seems, there are deep-seated problems.

Argentina and Venezuela have run out of heterodox policy tricks. Brazil and India need new growth models. Turkey and Thailand are mired in political crises that reflect long-simmering domestic conflicts. In Africa, concern is mounting about the lack of structural change and industrialization. And the main question concerning China is whether its economic slowdown will take the form of a soft or hard landing.

This is not the first time that developing countries have been hit hard by abrupt mood swings in global financial markets. The surprise is that we are surprised. Economists, in particular, should have learned a few fundamental lessons long ago.

First, emerging-market hype is just that. Economic miracles rarely occur, and for good reason. Governments that can intervene massively to restructure and diversify the economy, while preventing the state from becoming a mechanism of corruption and rent-seeking, are the exception. China and (in their heyday) South Korea, Taiwan, Japan, and a few others had such governments; but the rapid industrialization that they engineered has eluded most of Latin America, the Middle East, Africa, and South Asia.

Instead, emerging markets’ growth over the last two decades was based on a fortuitous (and temporary) set of external circumstances: high commodity prices, low interest rates, and seemingly endless buckets of foreign finance. Improved macroeconomic policy and overall governance helped, too, but these are growth enablers, not growth triggers.

Second, financial globalization has been greatly oversold. Openness to capital flows was supposed to boost domestic investment and reduce macroeconomic volatility. Instead, it has accomplished pretty much the opposite.

We have long known that portfolio and short-term inflows fuel consumption booms and real-estate bubbles, with disastrous consequences when market sentiment inevitably sours and finance dries up. Governments that enjoyed the rollercoaster ride on the way up should not have been surprised by the plunge that inevitably follows.

Third, floating exchange rates are flawed shock absorbers. In theory, market-determined currency values are supposed to isolate the domestic economy from the vagaries of international finance, rising when money floods in and falling when the flows are reversed. In reality, few economies can bear the requisite currency alignments without pain.

Sharp currency revaluations wreak havoc on a country’s international competitiveness. And rapid depreciations are a central bank’s nightmare, given the inflationary consequences. Floating exchange rates may moderate the adjustment difficulties, but they do not eliminate them.

Fourth, faith in global economic-policy coordination is misplaced. America’s fiscal and monetary policies, for example, will always be driven by domestic considerations first (if not second and third as well). And European countries can barely look after their own common interests, let alone the world’s. It is naïve for emerging-market governments to expect major financial centers to adjust their policies in response to economic conditions elsewhere.

For the most part, that is not a bad thing. The Fed’s huge monthly purchases of long-term assets – so-called quantitative easing – have benefited the world as a whole by propping up demand and economic activity in the US. Without QE, which the Fed is now gradually tapering, world trade would have taken a much bigger hit. Similarly, the rest of the world will benefit when Europeans are able to get their policies right and boost their economies.

The rest is in the hands of officials in the developing world. They must resist the temptation to binge on foreign finance when it is cheap and plentiful. In the midst of a foreign-capital bonanza, stagnant levels of private investment in tradable goods are a particularly powerful danger signal that no amount of government mythmaking should be allowed to override. Officials face a simple choice: maintain strong prudential controls on capital flows, or be prepared to invest a large share of resources in self-insurance by accumulating large foreign reserves.

The deeper problem lies with the excessive financialization of the global economy that has occurred since the 1990’s. The policy dilemmas that have resulted – rising inequality, greater volatility, reduced room to manage the real economy – will continue to preoccupy policymakers in the decades ahead.

It is true, but unhelpful, to say that governments have only themselves to blame for having recklessly rushed into this wild ride. It is now time to think about how the world can create a saner balance between finance and the real economy.

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  1. CommentedVirendra Pandey

    India does have its problems, faltering annual GDP growth, high consumer inflation, massive fiscal and current account deficit etc.
    These are indeed deficiencies, and they must be fixed for ensuring strong and stable growth.
    Part of stimulus flowing into Indian economy; by far exceed the required, triggering a growth spurt.
    Strong growth increased the scarcity and value of resources such as land or mineral wealth.
    There was reward to misallocating them. Growth increased the rents to corruption.
    Irresponsible expansion of fiscal deficit made India vulnerable but that went unnoticed.
    Growth spurt enabled by foreign capital flow resulted into inflation. To fight inflation central bank resorted to tight monetary policy. Tight monetary policies used as a tool to curb inflation led a consumption and investment slowdown.
    India’s central bank governors, Dr. Raghuram Rajan don’t see these issues as structural problems.
    Indeed they are all fixable by means of modest reform.

  2. CommentedJason Gower

    The final sentence of this article gets at precisely the problem which the author alluded to himself earlier on. While the dollar is still the world currency, there is no world central bank, nobody optimizing markets on a global level; actually love to see somebody try (and you thought the economies of the EZ were tough to manage?). So as markets become ever more linked through technology, etc., and without this global regulator or economic policymaker, every nation, as expected, is looking out for itself first and foremost. We can say something similar about global action on climate change or global regulation in general (espionage is still a hot topic here in Europe) but it is really little more than utopian thinking to believe that this sort of collective action for the good of all is anywhere in sight.

  3. CommentedJames Edwards

    Governments that enjoyed the rollercoaster ride on the way up should not have been surprised by the plunge that inevitably follows
    The reason it is sold as a bill of goods for growth lies in the fact elections have consequences when you have politicians promising the economy will go up but not face the possible downside until they are long out of office.

  4. CommentedJoshua Ioji Konov

    This article uses a very simplistic and quite generalizing approach for appraising methodology by overstating the power of financing and investment overall when e.g. Chinese internal policies for gaining consumption and balancing the declining export is underestimated, the stimulus packages, the raising income, the policies empowering the Small Businesses and Investors, i.d. are the reasons that prompted Chinese sustained growth not the QE only. It seems easier to count on the West for all good,and one the Liberal Economics for all good and success!

    1. CommentedCraig Stevenson


      China is more than 50%, cloaser to 60%, investment in the construction of its GDP. The domestic consumption is only mid 30% of its GDP. Its mutliplier has been declining, where a yuan of investment, likely no longer even returns a yuan of value. It is building, building, building and bloating assets, assets, assets. Its debt is rising quickly, far too quickly, and far too large for a country at its stage of development; with the grave domestic poverty that still exists. It, since 2003, has cycled ever greater amounts of its economy toward investment, as it has over-built, and amassed ever higher levels of over-capacity. Much of this is due, because while it attempts to use state led planning mechanisms, its control at the local level is quite limited, and promotion is based on growth, in addition to alterations in how local governments are financed, as china has tried to limit transfers to locales after it centralized tax intake (a component of governance in any advanced country) forcing local governments to be creative in financing and development. Problem is local banks are run by local party members who also are under party leadership. So what has been occuring, over-investment, over building, more capacity across a slew of industries than is needed, rising debt (250% of GDP, where countries that have been industrilaized for a hundred years are not growing at such percentages, and are only several tens of percentage points or a 100% more with social security systems, and longevity totax take in place). So your notions of ideology, or merely ideological assertions that have been commonly popular of decrying liberal economics, are frankly hogwash, and waning hogwash.

      take a typical Chinese city, imagine that last year they built 25% more houses than the city had. That goes to GDP, plus it goes at all the input components and the sales prices. But no buyers, this is essentially what has been happening throughout the decade, but accelerated since the 2008 downturn and Chinese spending. Once again, while the system as such has enabled and encouraged the rise of china, it has been the party that has taken risky bets, since at least 2003, in not moving in the direction of greater domestic consumption as a component of GDP, and moving toward greater investment, where, as the economy is engineered to create the surplus and savings required for investment, under conditions of artificial asset bloat and money printing, led to their FOREX reserves. So, am not sure what you are talking about empowering small businesses and similar, while they did choose to raise incomes from 2010, this is not altering the construction or proportions of GDP, which cycle the economy, of their own choosing toward instability.

      One last note, the top 50 members of the peoples congress have 57 billion in personal assets, and the top 50 memebers of the US congress have 1.5 billion in assets, this is illustrative, of the mechanisms that drive growth in the Chinese economy, so if reading 5 year plans, you would want to cycle back a few, and compare if plans have been implemented, or merely growth has evolved as I have just stated.

  5. Commentedkiers sohn

    The world needs an international trade currency NOT domiciled in any specific country! No central bank should have "exorbitant privilege". And yet despite having exorbitant privilege the US economy screwed up.

    1. CommentedCraig Stevenson

      the holding of the USD is no exorbitant privilege, rather a US provided global public good, despite the remonstrations of Eichengreen and DeGaulle (he never did recover from Suez). The SDR would not displace the currencies of any nation but shift the current situation to a basket of currencies. This would result in nothing but constant shifting, a shell game of activity of money into bonds, and then into others bonds, and into further more peoples bonds without changing any of the underlying dynamics. But this would require those countries that engineer their economies (those who follow the Asian Development Model, or interfere with freely floating currencies) to stop, open their markets, create asset classes, and accept foreign purchases of their assets. The US has provided this to the globe in support of global development. The US neither benefits form the small percentage of supposed Eichengreenian seignorage gains, which is far less than the money it pays on interest for the structured surpluses that others have engendered over the last decade. QE proved that the US didn't need such, foreign purchases have only created greater compeittion for the class and has driven the institutional investor further afield in search of yield, displacing those who would fund, while others believing that funding was necessary. Actually this structure was a large reason why the world grew so quickly during the 2000'2 and why it blew up in 2007-2008. So back to school for you, dated economics are no longer needed, especially as narrowly a focused an ideological perspective as such.

  6. CommentedZsolt Hermann

    This article is basically discussing the same problem as the other recent article on the site "The Global Economy Without Steroids".
    It seems the authors only concentrate on the Emerging Markets as if the rest of the global economy was in order, "without steroids", without bubbles.
    In truth for a long time the only "growth", "stabilization" has been happening as a result of pumping "freshly printed" or virtual money into the system, but the actual growth, development has slowed down or even stopped.
    The whole human system is in deep crisis.
    We can see that while the quoted numbers, statistics seem to show "recovery", ongoing although sluggish growth, unemployment figures, realistic household incomes, generally the life of the public, the mood, future prospects of people shows steadily and significantly worsening conditions.
    We are watching a "scientific experiment", politicians, economists, other "specialists" experimenting with the system in theory, on a "philosophical level", patting each other on the shoulder how well they are doing while the "real life patient", the actual people on the streets are getting worse by the minute.
    And it is not surprising since up to this point we have been cheating all along, imagining ourselves outside of the closed and finite natural system we exist in, "dreaming a human bubble", where we can do whatever we want, we can artificially and excessively demand whatever we think of without any consequences.
    But now our bluff has been called and all this dream is collapsing.
    The question is how long we keep on pretending everything is all right, and we can continue like this infinitely.
    The longer we postpone looking into the mirror and start the necessary self-adjustment, building a completely new human socio-economic system based on real life conditions without 'steroids" and bubbles, the more difficult and prolonged it will be to recover from the inevitable collapse.

    1. CommentedCraig Stevenson

      Interesting perspective, but not so fast. The system has done very well at advancing the human condition, all the while as the human population has advanced and the human is living longer. What we need is more maturity and a grand new global bargain. But, the numbers must work, actuary is in. It is in this realm that human initiative can be maximized at the individual and group level. We have experienced far too many free-riders; and can multiply them because easily said, rather than achieved heightened values, merely. But a more mature, global accommodation is necessary.

  7. CommentedAndres Castillo

    Yes, it seems totally surprising that people would think that EMs were going to keep on growing and growing. It is obvious that developing countries (DCs) have to do the arduous and painful process of building institutions, before they can maintain high growth in the long run.
    My only point of disagreement is that there are indeed some DC that have steadily built institutions and will be in a better position that those that did not. South Korea is a perfect example, but some other countries are in that process as well. I would say Chile and Mexico (and maybe even Peru and Colombia) in Latam.
    So my critique goes towards this generalization of EMs. EMs represent a large number of countries, completely different among themselves. So any generalization is bound to be an "average" with very high "variance"

  8. CommentedJM Keynes

    Dear Dani, this is a deeply ironic piece given the work you and your Harvard colleagues did on the South African economy in 2008. In the face of large and volatile short-term capital flows did you and your colleagues propose "strong prudential controls on capital flows" or similar measures? You did not. Rather you advocated further liberalisation of the capital account (particularly outflows). And more trade liberalisation, despite similar pieces you have written questioning the logic of large scale trade liberalisation (when South Africa had already liberalised more than most peer middle-income developing countries).

    1. CommentedJim Nail

      @JM KEYNES Okay, it seems we're at a point of principle we agree on, just making different judgments on a specific case. The reason I reacted was that I've watched Rodrik's work since taking a class with him in 1999 or 2000. There are few if any economists of his stature with the same sensitivity to emerging market vulnerabilities and social dynamics.

    2. CommentedJM Keynes

      @JIM NAIL. As one of the two lead authors of the recommendations Dani knew full well that the real issue at the time was the surge in inflows and the need to deal with these. The further opening of outflows - with a sop to capital account management in proposing unspecified 'openness to controls on outflows' knowing full well these would be extremely unlikely to be implemented, as subsequent events have proven - have had the practical effect of further capital account liberalization and increasing rather than decreasing vulnerability. What would be really refreshing is that after prominent economists parachute into developing countries with policy advice, that they go back and reflect on this advice and have the intellectual integrity to make an honest assessment of the appropriateness of their recommendations. Only one person can do this and I'm afraid it is not you.

    3. CommentedJim Nail

      @JM KEYNES -- an interesting paper, thank you, which I wasn't familiar with, and which Rodrik along with 27 other economists contributed to. I've only skimmed it so far, but it appears to propose currency intervention (as opposed to a floating currency) to control the current account deficit, along with export-promotion and efficiency-oriented industrial policies. These ideas are not contradictory to those of the current paper, as far as I can make out, except perhaps in one thing: the recommendation you rightly mentioned, that restrictions on capital outflows were playing no useful role at that time and could be lifted. Why did you neglect to cite the very next sentence, which suggests keeping the legal framework for reimposing capital controls later, in case of need? Sorry, but I'm left wondering exactly what axe you are trying to grind...

    4. CommentedJM Keynes

      @JIM NAIL given your concern to get the facts straight here - verbatim - is what the Harvard panel said in their final recommendations:
      "Recommendation 3. "The National Treasury should eliminate the existing restriction on
      capital outflows."
      Recommendation 5. "[T]rade policies should be reformed using a strategy that focuses on liberalizing input tariffs so that tariffs on final products can also be reduced."
      Full paper at including list of Harvard and other academics

    5. CommentedJim Nail

      @JM KEYNES: I was surprised to read your comment about Dani and his unnamed "Harvard colleagues." You might want to get your facts straight. In case you care what he actually had to say about South Africa in 2008 (prescriptions: industrial policy plus currency intervention to maintain competitiveness), you can check out these two sample links I happened to find:


  9. CommentedGustavo Scaron

    Muerte por Finanzas
    Dani Rodrik
    PRINCETON – Cuán rápido se ha invertido la fortuna de los mercados emergentes. No hace mucho tiempo, eran promocionados como la salvación de la economía mundial - los motores dinámicos de crecimiento que tomarían el control mientras las economías de Estados Unidos y Europa chisporroteaban. Los economistas de Citigroup, McKinsey, PricewaterhouseCoopers, y demás estaban prediciendo una era de crecimiento amplio y sostenido desde Asia a África.
    Pero ahora de los mercados emergentes blues están de vuelta. La paliza que las monedas de estos países se han llevado cuando la Reserva Federal de EE.UU. comenzó a endurecer la política monetaria es solo el comienzo; como cualquiera puede ver, al parecer, tienen problemas profundamente arraigados.
    Argentina y Venezuela se han quedado sin trucos de políticas heterodoxas. Brasil y la India necesitan nuevos modelos de crecimiento. Turquía y Tailandia están sumidos en crisis políticas que reflejan persistentes conflictos internos de largo plazo. En África, la preocupación va en aumento por la falta de cambio estructural e industrialización. Y la pregunta principal referente a China es si su desaceleración económica se hará en forma de un aterrizaje suave o duro.
    Esta no es la primera vez que los países en desarrollo se han visto muy afectadas por cambios de humor bruscos en los mercados financieros globales. La sorpresa es que nos sorprenda. Los economistas, en particular, deberían haber aprendido algunas lecciones fundamentales hace mucho tiempo.
    En primer lugar, el bombo de los mercados emergentes es sólo eso. Milagros económicos rara vez se producen, y por buenas razones. Los gobiernos que pueden intervenir masivamente para reestructurar y diversificar la economía, al tiempo que evitan que el estado se convierta en un mecanismo de corrupción y búsqueda de rentas, son la excepción. China y (en su apogeo) Corea del Sur, Taiwán, Japón y unos pocos más tuvieron dichos gobiernos; pero la rápida industrialización que diseñaron ha eludido a la mayoría de América Latina, Oriente Medio, África, y Asia del Sur.
    En cambio, el crecimiento de los mercados emergentes en las últimas dos décadas se basó en un conjunto fortuito (y temporal) de circunstancias externas: altos precios de las materias primas, tipos de interés bajos, y baldes de financiación extranjera aparentemente interminables. Mejoras de la política macroeconómica y la gobernabilidad global ayudaron, también, pero estos son facilitadores del crecimiento, no provocadores del crecimiento.
    En segundo lugar, la globalización financiera ha sido fuertemente sobrevendida. Se suponía que la apertura a los flujos de capital era para impulsar la inversión interna y reducir la volatilidad macroeconómica. En cambio, ha logrado más o menos lo contrario.
    Sabemos desde hace tiempo que la afluencia de inversiones de corto plazo alimentan la booms de consumo y burbujas inmobiliarias, con consecuencias desastrosas cuando el sentimiento del mercado inevitablemente se estropea y las finanzas se secan. Los gobiernos que disfrutaron de la montaña rusa en el camino no deberían ser sorprendidos por el derrumbe que inevitablemente sigue.
    En tercer lugar, los tipos de cambio flotantes son amortiguadores defectuosos. En teoría, se supone que los valores determinados por el mercado de divisas aíslan la economía doméstica de los vaivenes de las finanzas internacionales, aumentando cuando el dinero inunda y cayendo cuando los flujos se revierten. En realidad, pocas economías pueden soportar las alineaciones monetarias necesarias sin dolor.
    Las revaluaciones monetarias agudas causan estragos en la competitividad internacional de un país. Y las depreciaciones rápidas son la pesadilla de un Banco Central, dadas las consecuencias inflacionarias. Los tipos de cambio flotantes pueden moderar las dificultades de ajuste, pero no eliminarlos.
    En cuarto lugar, la fe en la coordinación global de la política económica está fuera de lugar. Las políticas fiscales y monetarias de los Estados Unidos, por ejemplo, siempre serán impulsados por consideraciones domésticas primero (si no segundo y tercero también). Y los países europeos apenas pueden ocuparse de sus propios intereses comunes, mucho menos los del mundo. Es ingenuo que los gobiernos de los mercados emergentes esperen por los principales centros financieros para ajustar sus políticas en respuesta a condiciones económicas en otros lugares.
    En su mayor parte, esto no es una mala cosa. Las grandes compras mensuales de la Fed de activos a largo plazo -la llamada flexibilización cuantitativa (QE)- han beneficiado al mundo en su totalidad apuntalando la demanda y la actividad económica en los EE.UU.. Sin QE, que la Fed ahora está disminuyendo gradualmente, el comercio mundial habría tenido un golpe mucho más grande. De forma similar, el resto del mundo se beneficia cuando los europeos son capaces de diseñar políticas adecuadas e impulsar sus economías.
    El resto está en las manos de las autoridades públicas en el mundo en desarrollo. Deben resistir la tentación de ir de farra sobre la financiación exterior, cuando es barata y abundante. En medio de una bonanza de capital extranjero, los niveles de estancamiento de la inversión privada en bienes transables son una señal de peligro particularmente poderosa que ninguna cantidad de creación de mitos gubernamentales debería permitir sustituir. Las autoridades públicas se enfrentan a una elección simple: mantener fuertes controles prudenciales sobre los flujos de capital, o estar dispuestos a invertir una gran parte de los recursos en auto-aseguramientos mediante la acumulación de grandes reservas de divisas.
    El problema de fondo radica en la excesiva financiarización de la economía mundial que se ha producido desde la década de 1990. Los dilemas de la política que han resultado -el aumento de la desigualdad, mayor volatilidad, espacio reducido para gestionar la economía real- seguirán preocupando a los responsables políticos en las próximas décadas.
    Es cierto, pero inútil, decir que los gobiernos sólo se tienen a sí mismos para culpar por haber corrido imprudentemente en estas corridas. Ahora es tiempo de pensar acerca de cómo el mundo puede crear un equilibrio más sano entre las finanzas y la economía real.

  10. CommentedwasteBodyInRottenWorld getRealNews

    "They must resist the temptation to binge on foreign finance when it is cheap and plentiful. "

    Wishful @ best. Counter question would be : "Will Americans be able to afford real interest rates , well atleast of the order of 7% on their home mortgages ?" . This WILL break the finances of most households. When Americans or others can't do it, why do you expect EM not to have cheap money ? The source of cheap money is not EM by the way.

  11. CommentedKubilay M Öztürk

    Another novel article by Rodrik. Particularly, his proposal to use (the lack of) private investment in tradable goods during external-driven boom times as an indicator of financial profligacy could be a very useful variable for policy-makers to gauge the extent of macro (in)stability embedded within the system.

  12. CommentedJohn Hoehn

    "emerging-market type hype is just that"--Great point. There's been a lot of catchup due to capital transfers to India and
    China. There've been too few libertarian internal reforms to develop and sustain entrepreneurial exchange economies. The result is as indicated: economies that are hypersensitive to the ebb and flow of global finances--including the big tides induced by US Federal Reserve policy.

  13. CommentedProcyon Mukherjee

    There are a number of BIS papers that have dealt with the spillover effects of Central Bank monetary easing on the emerging economies and the conclusions of these papers are pretty much cast in stone: ‘what starts in Washington ends in Hong Kong or Mumbai’ and the gyrations of finance capital leaves a daunting trail; an action by the central banks of these economies in isolation is impossible to give any short term respite to these economies in absence of broader coordination, something which Raghuram has recently highlighted.

    Rodrik is right at the end about the "excessive financialization", no wonder if one goes by the latest reports of some banks, the recent gyrations were in hundreds of billions of dollars, something which points out to the fragile nature of investment vehicles that the current milieu of entrepreneurs are seeking their yields to ride on, or should I say broadly value investment is replaced by speculation in the retinue that finance has orchestrated.
    Is that good news for any world, developed or emerging?