THE BEAR'S LAIR Merely a hiccup
By Martin Hutchinson
Emerging market stocks, bonds and currencies have suffered much more than
developed-country markets during 2008, in spite of the original real estate
bubble and credit disaster having been contained almost entirely in rich
countries. That suggests that globalization, by which emerging markets gain
capital and access to developed markets for their goods and services exports,
may be something of a Faustian bargain.
There is no question that the decline in some emerging markets' stock markets
and credit ratings was justified. When oil drops from US$147 to $70 a barrel,
it is reasonable to expect Russia and Venezuela to be hit badly, even if those
countries had been well run. However given the spectacular refusal by both the
Vladimir Putin/Dmitry Medvedev team in Russia and Hugo Chavez in Venezuela to
recognize the validity of economic laws, it is not
surprising that those countries have run into big trouble, which is likely to
get bigger.
Argentina too has been exhibiting its usual status as
poster-child-for-lousy-economic-policy ever since 2003, and those of us who
value sound economic policy more than the welfare of the Argentine people are
duly cheering now that the chickens are coming home to roost. (Sorry amigos,
but you guys elected these bozos. Indeed it's a great relief that the good guys
didn't win the 2007 presidential election; otherwise, as after the late
unlamented Juan Peron, it might have been another 50 years or more before you
finally figured out that populist-leftist economics doesn't work. This way,
you'll have your chance to straighten up and fly right in a couple of years.)
However, most emerging markets are not all that badly run. Indeed, given the
abysmal performance of a number of Western governments in recent weeks, the
case can be made that many emerging markets are well run by Western standards,
avoiding obvious mistakes that are common in the West.
Brazil for example is fighting inflation the right way, with a benchmark Selic
short-term interest rate of 13.75%, double its rate of inflation. South Korea
(almost graduated from "emerging market" status) has a new government that is
properly committed to the free market, and a level of government spending far
below even current levels in the US and Europe, let alone the heights to which
those unfortunate countries may climb. Vietnam and a number of African
countries are at least competently run, which given their immense wage-cost
advantages ought to allow them a lengthy period of rapid growth.
Traditionally, emerging markets have suffered from a higher cost of capital
than the rich West. This compensates for their lower labor costs, allowing
Western companies to survive in an environment of free global competition. Thus
it would normally be expected that when the rich world caught a cold, emerging
markets would suffer from pneumonia, as capital sources dried up and they found
it impossible to fund new investment.
However, there is currently one flaw in this picture: emerging markets today
have much higher savings rates than the rich West. The United States in
particular and the West in general have gone on a spending binge that has left
the majority of the world's foreign exchange reserves in the hands of Middle
Eastern and Asian governments. Far from emerging markets suffering from a
smaller pool of capital, many of them today have a much healthier capital
position than their Western competitors. Thus a sudden capital shortage should
have affected them less than their Western counterparts, not more.
That suggests that competently run emerging markets should regard this crisis
as a temporary hiccup, not a reason to despair, and certainly not a reason to
jettison wholesale an economic model that has worked generally well for them
and retreat into Third World autarky and socialism. Countries that default
owing to global conditions should not regard it as the end of the story; if
they remain competently run they will quickly be allowed back into the
international financial arena (countries like Argentina that default through
sheer incompetence and hatred of the global investing class are a different
matter and deserve no help.)
In the long run, emerging markets' advantages of labor costs will still be
there, and if they preserve the essentials of a free-market system they will
have in their domestic economies much of the savings base they need to succeed.
The main need will be to keep open the flows of international trade, so that
global markets are available to expand their businesses.
Conversely, the prospects of Western economies would appear dismal. With
inadequate savings bases, they are going to be permanently capital-short in a
world where capital is both scarce and more expensive. Their labor costs will
remain relatively high, yet they will no longer have the advantage of capital
availability over competently run emerging markets. Eventually growth will
return, but it may be at a considerably less comfortable equilibrium than today
in terms of living standards.
As for emerging markets themselves, it is now clear that the advice they have
received from Western institutions such as the World Bank has been largely
misguided, and ill-suited to a world in which the global stability they had
been promised proved so ephemeral. They need to establish quickly a new
consensus that will enable them to prosper in a world where capital is no
longer so abundant and Western countries are no longer a cornucopia of wealth
and foreign investment:
Solid property rights. For domestic and international reasons,
emerging markets need to establish solid property rights. Apart from being
immoral, the Russian/Argentine approach to property destroys capital formation
domestically and in a world where global capital is scarce will quickly
discourage foreign investors. Emerging markets will during the crisis see
Western countries carrying out actions that damage property rights; that makes
their own respect for such rights more not less essential
Encourage middle class savings. If capital is not readily
available internationally, it must be found domestically. The principal source
of capital formation for small businesses in almost all societies is the
capital accumulated by the entrepreneur's relatives and friends. Interest rates
need to be kept significantly above the rate of inflation to encourage saving
and discourage borrowing-fueled consumption, banking systems must be protected
from collapse, taxation of capital must be kept at a low level, inflation must
be suppressed to prevent capital erosion for those on fixed incomes and a
"level playing field" must be established as far as possible for domestic
investment so that modest savers can invest on the same terms as the big boys.
Encouragement of middle class savings is the #1 requirement for economic
development; it has been disgracefully neglected by the index-linked
bureaucrats of the aid agencies.
Maintain high interest rates. Rates need to be kept high for two
reasons. First, high interest rates encourage capital formation and discourage
saving. Second, they keep inflation under control. Big businesses will whine at
the high real cost of capital; the recent crisis has demonstrated that capital
that is cheap is far less important than capital that is always available.
Tight government spending. Government spending must be tightly
controlled at all times. The temptation will be to indulge in government
handouts or worse still Keynesian spending programs (where the government
rather than the recipient determines the goods on which money is spent) to
counter the effects of economic downturns. International aid bureaucrats will
encourage these - it's all they know. The fact remains that over a long period,
it has been demonstrated that high government spending (as a percentage of
gross domestic product) or rapidly rising government spending are the principal
factors suppressing economic growth; for countries that belong to the
Organization for Economic Cooperation and Development, variances in government
spending since 1960 account for more than half the observed variances in growth
rates.
Investment. The capital markets must be free for retail
investment, but there is no hurry to remove restrictions on retail borrowing.
Investors who have the option of investing freely internationally will keep the
bulk of their money at home; those who are restricted by exchange controls will
find ways to hide it abroad, preventing its use for small business formation.
Conversely, an over-active mortgage market diverts scarce savings into housing,
while an over-active credit-card market destroys savings altogether and will
undermine the capital base of a country that has not yet achieved wealth.
Population growth. If population increase is too rapid (above 1%
per annum approximately) steps should be taken to reduce it. The capital cost
of building facilities for a rapidly expanding population, and the education
cost of a bloated youth cohort are too large for a poor economy to absorb,
particularly if capital and aid flows are less bountiful than formerly. Rapid
population growth is incompatible with increasing living standards, and hence
should be sharply discouraged.
Mergers and acquisitions. Finally, foreign companies and private
equity operations should be free to purchase domestic companies - their capital
and expertise are important in allowing local companies to grow and bringing
their operations up to the best international standards. However, exceptions
should be made, not for strategic industries (there is no economic reason why
foreigners should not own energy and mining companies) but for companies where
domestic companies are already globally competitive and the country has
established itself as pole of sectoral excellence. If a country has special
expertise in a particular industrial sector, it is important that training for
that sector, job opportunities for new entrants, advancement opportunities for
more experienced staff and sectoral entrepreneurial opportunities for the
adventurous and capable be retained domestically. There are disadvantages both
economic and political to being a "branch plant" economy; it's inevitable in
most sectors but should be avoided in at least a few for each country.
In the long run, well-managed emerging markets will emerge from this downturn
with increased strength, both absolutely and relative to the West. New tricks
will have to be learned, however.
Martin Hutchinson is the author of Great Conservatives (Academica
Press, 2005) - details can be found at www.greatconservatives.com.
(Republished with permission from PrudentBear.com.
Copyright 2005-07 David W Tice & Associates.)
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