Death by Finance

Feb 10, 2014 Dani Rodrik

While emerging economies have been hit hard in recent weeks by a severe mood swing in global financial markets, the only surprise is that we are surprised. Economists, in particular, should have learned a few fundamental lessons long ago.

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.

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0 Comments on this paragraph, 21 Comments on this article

ezra abrams Jan 3, 2015

Not *one* word on CIA coups or corporate bribes ? Not one word on how we allow people to export stolen wealth to our banks ?
A bowdlerized description of what drives finance - the commission on the deal

and, on a population basis, the hype is right: the Chinese are, what, 30% of the developing world ? so they alone are enough to justify the hype ?
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Lance Brofman Jan 1, 2015

"..A slight variation on the regulatory fallacy is the financial innovation fallacy. As with the regulatory fallacy, both left and right versions, there is a miniscule grain of truth to it. Financial innovations such as credit default swaps and regulatory changes like repeal of the Glass-Steagall Act slightly affected the exact timing of the onset of the depression. However, once the tax burden was shifted from the rich to the middle class it was just a matter of time before middle-class consumers became unable to absorb the increased production and service the debt that accompanied the overinvestment. Different regulatory policies might have shifted the bubble more towards commercial real estate rather than residential real estate or visa versa but the outcome would have been similar.

Blaming regulatory policies and financial innovation for the depression is like blaming the armaments manufactures and soldiers for World War II. In order for the war to occur there had to some weapons made and some soldiers to fight. If those particular armaments manufactures and soldiers were not available, others would have taken their place.

Equally unhelpful in terms of addressing the income and wealth inequality which results in the overinvestment cycle that caused the depression are those who emphasize various non-tax factors. Issues such a globalization, free trade, unionization, minimum wage laws, single parents, problems with our education system and infrastructure can increase the income and wealth inequality. However, these are extremely minor when compared to the shift of the tax burden from the rich to the middle class. It is the compounding year after year of the effect of the shift away from taxes on capital income such as dividends over time as the rich get proverbially richer which is the prime generator of inequality..."
http://seekingalpha.com/article/1543642
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Virendra Pandey Feb 19, 2014

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.
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Jason Gower Feb 14, 2014

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.
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James Edwards Feb 13, 2014

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.
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Joshua Ioji Konov Feb 12, 2014

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!
- Craig Stevenson Feb 12, 2014
  
  Joshua:
  
  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.
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kiers sohn Feb 11, 2014

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.
- Craig Stevenson Feb 12, 2014
  
  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.
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Zsolt Hermann Feb 10, 2014

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.
- Craig Stevenson Feb 12, 2014
  
  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.
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Andres Castillo Feb 10, 2014

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"
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JM Keynes Feb 10, 2014

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).
- Jim Nail Feb 14, 2014
  
  @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.
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- JM Keynes Feb 13, 2014
  
  @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.
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- Jim Nail Feb 12, 2014
  
  @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...
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- JM Keynes Feb 11, 2014
  
  @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 http://www.hks.harvard.edu/var/ezp_site/storage/fckeditor/file/pdfs/centers-programs/centers/cid/publications/faculty/wp/161.pdf including list of Harvard and other academics
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- Jim Nail Feb 10, 2014
  
  @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:
  1. http://www.hks.harvard.edu/var/ezp_site/storage/fckeditor/file/pdfs/centers-programs/centers/cid/publications/faculty/wp/168.pdf
  
  2. http://www.sss.ias.edu/files/pdfs/Rodrik/Research/Understanding-South-Africa.pdf
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wasteBodyInRottenWorld getRealNews Feb 10, 2014

"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.
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Kubilay M Öztürk Feb 10, 2014

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.
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Procyon Mukherjee Feb 10, 2014

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?
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