Many features of developing economies’ recent evolution, and of their prospects, can only be fully grasped if one understands the rise of the global financial dynamics based on securitization. The boom-and-bust of housing finance, shadow banking, and the myriad of financial innovations provided the turning point of an evolutionary process in finance. This process built a powerful liquidity-generating machine, whose apparently smooth handling of risks reduced financial intermediation costs but in fact blew serial bubbles in asset markets.
First, the liquidity-generating machine inflated US asset values and fed the exuberant growth of US household spending. US consumers have accounted for more than one-third of the growth in global private consumption since 1990. Increasingly, their spending was made possible by the wealth effect generated by the rising prices of housing and household financial assets and stocks, whose values were in turn expected to more than outstrip those of household debt. It was this upswing in consumption by US households, and others as debt-based consumers-of-last-resort in the global economy, that essentially made possible the extraordinary structural transformation and productivity increases experienced by some manufacturing exporters and commodity producers among developing economies.
Also relevant to developing economies were the easier and cheaper capital inflows that were a by-product from the liquidity machine. These flows supported not only domestic investments in developing countries but also the accumulation of reserves, especially in those countries that maintained current-account surpluses. Of course, the recycling of developing countries’ reserves through US financial markets helped to lubricate the liquidity machine—which partly explains the “Greenspan conundrum,” i.e. the perseverance of low US long-term interest rates while US monetary policy was gradually tightening. But the point to emphasize is that the piling up of reserves, growth of current-account surpluses, and emergence of “savings gluts” that took place in some developing countries would have been less significant were it not for the liquidity machine operating at full steam in core developed economies.
Looking ahead, the agenda regarding developing economies has several parts. One is urgently to reinforce global financial safety nets, in time to mitigate the effects of the sudden unwinding of leveraged positions in these economies that has accompanied the new financial introspection in developed countries. Even if corporate and sovereign liabilities can be rolled over and/or replaced by new sources of finance, thus avoiding additional rounds of negative feedback in the global economy, there remains the question of how to leverage investments in developing economies without the support of the previous liquidity machine. One can ensure that the string is not pulled apart, but not that it can be pushed.
For the time being, no new virtuous cycle of rising demand and matching productivity increases is likely to fill the void left by the evaporation of global growth. Given the tendency to reconstitute household savings in crisis-afflicted developed economies, as well as the temporary character of the aggressive counter-cyclical fiscal policies being implemented, the best hope is that these countries will sustain their aggregate demand above stagnation levels. Thus we are unlikely to see a resumption of the past pattern, of absorption growth above Total Factor Productivity increases in developed economies coupled with supply expansion in fast-transforming developing economies.
In fact, the best opportunities for sparking virtuous cycles in the global economy now lie within the realm of developing economies, where the scope for gains from structural transformation and technological catching-up is still substantial. Investments in infrastructure and other capital-intensive industries, for instance, are strongly needed in order to overcome bottlenecks, while the equivalent investments in already-better equipped economies may be partially redundant. Faster catching up of consumption in developing economies would help to absorb the increases from this expanded production capacity. After World War II, Europe and Japan sustained a long growth cycle through a process of technological and mass-consumption catching up with the US frontier. And from the 1990s until recently, many developing economies achieved high growth as the result of innovations in IT and other fields (including finance), combined with globalization—notwithstanding their ultimate dependence on developed countries for absorption of their output.
The time may now have come for better matching of increases in production and consumption within developing countries. This is not to be confounded with pursuing isolationism through higher local integration per se. Channels for international trade and investment need to be kept wide and open, so that growth-spurts, including the eventual revival of economic dynamism in developed economies, can complement each other. Programs of investment in infrastructure and human capital, poverty reduction, and social inclusion in developing countries would stimulate local consumption and investment, producing positive feedback loops. As long as countries stay committed to economic openness, gains of scale and scope can be accrued, and such a process might take place in all economies regardless of their size. This will not be easy. Most developing economies lack the fiscal space and the flexibility in the balance of payments that they would need to ignite their own growth spurts. The liquidity machine might eventually join in, benefit from, and support such a developing country-led process, but it is likely to remain impaired for some time, given the current attitudes of investors and lenders.
How then to tap the potential for virtuous dynamics? How to reanimate and redirect “animal spirits” in that direction? To escape from a global scenario of mediocre growth may require a successful multilateral effort to address these issues.
First appeared at Roubini EconoMonitor