The Growth Commission has published a report (Post-Crisis Growth in Developing Countries) assessing the financial crisis and its fallout on economic growth in the developing countries. I was planning to read it last month but couldn’t do so. This report assesses if the previous recommendations in The Growth Report still holds true after the 2008 financial crisis.
The conclusion is that the recommendations are still relevant but some restraint on capital controls and financial liberalization might be fruitful. The report emphasizes the crisis does not show the failure of market-based system but that of the financial sector. The outward-looking strategy is still relevant but it may not be as rewarding as it was before the crisis because of slower growth in trade, costlier capital, and a more inhibited American consumer.
Below are notes from the report. The figures are from WEO 2010:
Economies that had sustained growth of 7 percent or more for 25 years or longer had some common features:
- Fully exploited the world economy; imported ideas, knowhow and technology; produced goods that met global demand, specialized and expanded rapidly without saturating the market.
- Maintained macroeconomic stability; inflation under control and sustainable fiscal paths.
- High rates of investment (25% of GDP), including public investment, financed by equally impressive rates of domestic savings.
- Followed the market signals while allocating resources; used industrial policy to bent the law of comparative advantage, by favoring some industries over others; the favored industries had to pass a market test by successfully exporting their products to foreign customers who did not have to buy them; relatively mobile labor; stagnant industries were allowed to fail; protected laid-off workers from economic misfortune
- Strong, committed, credible and capable governments; their macroeconomic strategies and microeconomic regulations provided the setting in which market dynamics could work; provided a range of public goods such as schooling and infant nutrition that markets under-provide.
What did the crisis teach us? The crisis delegitimized an influential school of thought, which held that many financial markets could be left to their own devices, because self-interest of participant would limit the risks they took. At a huge cost, it taught an unforgettable lesson about how financial systems really work. But, the crisis is a failure of the financial system, not the market per se.
Before the crisis (September 2008), developing countries faced very high commodity prices for eighteen months, peaking in the spring and summer of 2008. When the crisis erupted, there were declines in investment, employment and trade. The crisis spread to the developing countries through financial channel (credit tightened everywhere) and real economy channel (trade collapsed more than economic activity). China was less vulnerable to mobile investment funds because of its capital controls. China's response to this crisis was a repeat of its response to the Asian financial crisis in 1997-98, but on a much larger scale.
The government has to prevent a complete failure of the financial system and replace essential functions like credit provision until the normal channels reappear. It should also prop up economic activity and asset prices by filling the gap left by sidelined consumers and investors. Moreover, it has to act as a "circuit-breaker", interrupting the transmission of shocks from one part of the economy to the other. Fiscal stimulus reduces declines in the real economy, boosting employment, income and credit quality.
Post-crisis global economy
- The US consumer will become the US saver in an effort to repair the damage to household balance sheets. The world will also face a set of additional challenges: energy, climate and demographic imbalances, among others.
- Regulators and central banks cannot afford a narrow focus on consumer prices and employment, leaving asset prices and balance sheets to their own devices. They cannot hope to control inflation, manage growth, check overstretched balance sheets and ward off related sources of instability by manipulating short-term interest rates alone.
- The government has a legitimate reason to intervene to ensure that taxpayers' interests are safeguarded. Vulnerabilities in the financial sector represent contingent liabilities for the government and rest of the economy.
- Financial re-regulation should and will emphasize capital, reserve and margin requirements, seeking to limit the build up of systemic risk by constraining leverage.
- The cost of capital will increase, debt will be more expensive and less ubiquitous, and risk spreads will not return to the compressed levels that prevailed before the crisis.
- Joblessness in the advanced economies may not peak until late into 2010. Labor markets are still deteriorating.
- Some of the fundamental determinants of growth are relatively crisis-proof: demography or human ingenuity.
- The average rates of protectionism in the world economy, weighted by GDP, will increase as big emerging economies, which tend to have higher trade barriers on average than the industrial economies, grow in prominence.
- No magic bullet for getting out of the crisis: The economy should gradually right itself, as financial markets stabilize and the real economy follows, pulling the sea anchor of extended deleveraging along with it. Policies likely to err on the side of running short run inflation risk, rather than the reserve.
Successful economies have generally found a formula that includes a dynamic and innovative private sector supported by government investment in public goods, effective regulation, and redistribution to protect the most vulnerable. That balance varies across countries.
The crisis represents a major failure of the financial systems in the advanced countries. In particular, the lightly and incompletely regulated model that was influential in many Western economies is fundamentally flawed and in need of change. There is no evidence of a more broad based failure of the market and capitalist economies. The debate should focus on the financial sectors' stability and performance, rather than on a more sweeping condemnation of the whole market-based system.
The government should do more to protect people during times of extreme economic turbulence. Safety nets are indispensable to maintain public confidence and support for the market-led outcomes. Some countries (such as Brazil, Mexico and India) have shown that it is possible to devise more permanent programs that can serve the economy both in good times and bad, expanding during crises to meet sudden spikes in need. "Leaky" safety nets buys political support. Broader coverage may be the political price we have to pay for a well-supported safety net. Countries should prepare an inventory of well-designed projects that can be taken "off the shelf" when the need arises.
Quantitative easing, capital injections into the financial sector, bail-outs in a number of other industries, and fiscal stimulus programs have all added to the government's scope and influence. Budget deficits, if left unaddressed, will eventually raise long-term interest rates, making debts even harder to sustain.
The state's expansion needs to be reversed as the crisis subsides. Fiscal stimulus packages need to be replaced by medium-term programs to restore fiscal balance, based on realistic (and perhaps diminished) estimates of future growth. The expanded central bank balance sheets need to shrink through the sale of assets over time to the private sector.
Road ahead for developing countries
Consumption cuts and increase in savings by the American consumer could mean a $700 billion or more shortfall in global aggregate demand, relative to the world economy's productive potential. This shortfall should be filled by an increase in domestic demand in surplus countries.
To grow rapidly, countries must reallocate resources from traditional, low-productivity activities, such as agriculture, to new industries, which allow for rapid gains in productivity that often spill over to the wider economy. As countries make economic progress, their production of tradable goods tends to rise rapidly, leading to trade surpluses. There is no necessary connection between increasing the share of tradable goods in GDP and running a trade surplus. Rodrik has shown that trade surpluses do not have any independent, positive effect on growth, once you control for the share of industry in GDP. The share of "industry" captures the importance of non-traditional, high-productivity activities in a country's economy. Countries grow by promoting these activities, not by promoting trade surpluses per se.
Domestic demand is not a perfect substitute for global demand,where countries can specialize in a narrow range of products to serve specific customers. To cater to domestic demand, countries need to produce a broad range of products, so as not to saturate any particular local market niche. The limits to specialization are tighter and depend on the evolving composition of domestic demand.
Developing countries should curb financial products they may be ill equipped to handle. Several countries, including Brazil, India and China make heavy use of reserve regulatory restrictions to dampen their banks' enthusiasm. China imposes different requirements depending on the kind of assets banks hold, thereby influencing the direction of credit as well as its quantity.
Developing countries should ensure that some banks remain domestically owned, even if they are not owned by the state. The government's focus is quite understandably on the domestic economy. But foreign entities will have divided loyalties at best.