There are parallels between the problems that beset emerging markets (EMs) up to and including the late 1990s, and those burdening Western Europe and the US today. Similarities start with ideology, hubris and politics: the ideology of unfettered markets, the hubris of invincibility leading to lax regulation, and the politics of too-close relationships between government and over-borrowed big business/banks, ensuring bail-outs for the largest and most reckless.
EMs are highly heterogeneous, but until the late 1990s shared the characteristic of over-dependence on foreign capital. In periods of crisis, contagion could spread from one country to another as margin calls forced highly levered investors to sell previously unaffected countries. But how did EMs come to be so vulnerable? They were persuaded as capital-scarce countries (scarce relative to the other factors of production, land and labour) that they should import capital. They were encouraged in this by the ideology (over-simplification) that open capital markets were always a good thing – one of the 10 components of the so-called “Washington Consensus”.
What they failed to understand, with devastating consequences, is that market equilibrium between supply and demand in goods markets is often not replicated in capital markets. When the price of a good goes up, this tends to increase supply and decrease demand. With financial assets, however, demand often goes up when the price rises, and vice versa, leading to instability, bubbles and systemic collapse, not least in a country’s external accounts.
The EMs learnt this the hard way through repeated balance of payments crises. After the late 1990s, Asian countries, in particular, vowed never again to be so dependent on foreign flows. Many EMs no longer are – indeed, it is quite the reverse. Most of their sovereign debt instruments and other financial assets is now owned domestically, increasingly by institutional investors. Through their large central bank reserves, and sovereign wealth funds, many EMs have become major global net creditors.
In the West, the ideology of free markets also led to a massive build up of debt and dependence on foreign capital by the developed markets – or DMs. After the Asian crisis, much of this became the counterpoint to the rapid accumulation of EM reserves. Not including money they owe to themselves (via central bank quantitative easing), the bulk of sovereign debt issued by the US, UK and other developed countries (though not Japan) is now owed to foreign investors. Yet the dominant ideology remains that they can issue as much debt as they like and that such DM debt will always be “risk free”.
For a major crisis it is not enough to be nonchalant about unsustainable external balances and debt; for a really big bang, regulators need also to be asleep at the wheel. Ideology feeds hubris.
EM hubris was partly home grown, built on real and rapid economic progress and an unwillingness to see growth slow, despite liability mismatches and problematic indebtedness. Hubris was also fuelled by the model of Western success – and a desire to “catch up”. The idea was that copying the West would lead to Western prosperity. More specifically, the “East Asian Model” drove the dangerous hubris of the late 1990s. It led countries to ignore the sound advice from the International Monetary Fund (IMF) and others that trouble was coming. According to them, the IMF didn’t understand how the Asian version of capitalism worked.
Similarly, the idea of “The Great Moderation” took hold in the West in the run-up to the 2008 crisis. With it came the idea that crisis prevention was unnecessary, as any crisis could be cleared up afterwards. Ever more financial market sophistication was believed to increase allocative efficiency and transfer risk to those who could best bear it. You can, though, have too much of a good thing: the finance beast grew too large, serving itself before the rest of the economy, transferring risk to those not best but least equipped to bear it.
If regulation has been lax, its worst omission concerns the structure of the financial industry. This is because, if not checked, the concentration of political influence (in the current case aided by simplistic free-market ideology) can effectively emasculate all other precautionary regulation. John Law’s reckless money-printing central bank devastated France in 1720, but it only achieved the height of folly because he captured political power. The pattern has repeated many times since.
Bagehot wrote the book on how to regulate banks and resolve crises in the 1870s. Knowing what to do in a banking crisis is not the problem. After a crisis breaks, government should act fast. Those failing banks that aren’t systematically important should be left to fail. Those which are should be seized, the management fired and essential lending continued, while non-essential activities are scaled down or scrapped.
It’s not always banks that are the prime focus of the problem, although banks invariably fuel it. In the late 1990s, chaebols in Korea were the ones with cozy government relationships and too much debt. Similarly in Indonesia, the large industrial groups had very close ties to President Suharto. The Korean government, though, facing extreme external pressure, did eventually tame the mighty chaebols. Powerful business groups in Indonesia were also ultimately brought to heel.
This problem has characterized various EM crises throughout history. Mexico failed to keep up with the US in the 19th century arguably because it didn’t manage to break up powerful industry and banking groups as the US did. Today, though, the tables are turned. In the US and Western Europe, banks have captured politics. Many are still deemed “too big to fail”, which means taxpayers will bail them out again in another crisis. Why have they not been split up and more firmly regulated?
When Barack Obama came to the presidency in the US he had a choice, one faced several times before by his predecessors: whether to break up powerful vested interests damaging to national interests and to the common man, or to take their advice. Unlike Jackson and Teddy Roosevelt, Obama chose the latter.
So what can we now learn?
The main thing EMs can teach DMs now is how to end denial and adjust fast. This is the reality check the IMF and others in the West gave the EMs in crisis, but which nobody is now giving the West. In the DMs, we are on our own – and it is up to our leaders and our electorates to wake up. Unfortunately it will probably take another crisis for this to happen.
New Sparta is the private office of Dr Jerome Booth – economist, entrepreneur, investor, commentator and leading expert on emerging markets. New Sparta is majority owner of bne IntelliNews. Follow him on @Jerome_Booth