The Rise and Fall of Nations
How, in an impermanent world, can we predict which nations are most likely to rise and which to fall? What are the most important signs that a nation’s fortunes. Are about to change, and how should we read those signs? To help navigate the normal condition of the world—an environment prone to booms, busts, and protests—there are ten important rules for spotting whether a country is on the rise, on the decline, or just muddling through. Together the rules work as a system for spotting change. They are most applicable to emerging nations, in part because those nations’ economic and political institutions are less well established, making them more vulnerable to political and financial upheaval. However, many of the rules find useful applications in the developed world.
A few basic principles underlie the rules. The first is impermanence. Forecasters tend to extrapolate from existing trends. For example, at the height of the 2000s boom, they figured that if all the hot emerging economies (i.e. BRICS) stayed hot, the average incomes of many emerging nations would soon catch up or “converge” with those of rich nations. However, today talk of BRICS fulfilling their destinies as regional economic powerhouses seems like a dim memory.
Recognizing that this world is impermanent leads to the second principle, which is to never forecast economic trends too far into the future. Any forecast that looks beyond the next cycle or two—five to ten years at most—is likely to be upended. The tendency to believe good times will last forever is magnified by a phenomenon known as “anchoring bias.” Conversations tend to build on the point that starts (or anchors) them. In general, the correct anchor for any forecast is as far back as solid data exists, the better to identify the most firmly established historic pattern. The habit of hanging on to a poorly chosen and improbable anchor is compounded by the phenomenon of “confirmation bias,” the tendency to collect only the data the confirm one’s existing beliefs. The question to ask, in any period, is not the typical one: What will the world look like if current trends hold? It is, rather, What will happen if the normal pattern holds and cycles continue to turn every five years or so? In a sense, the rules are all about playing the right probabilities, based on the cyclical patterns of an impermanent world.
Avoid straight-line forecasting and foggy discussions of the coming century. Be skeptical of sweeping single-factor theories. Stifle biases of all kinds, be they political, cultural or “anchoring.” Avoid falling for the assumption that the recent past is prologue for the distant future, and remember that churn and crisis are the norm. Recognize that any economy, no matter how successful or how broken, is more likely to return to the long-term average growth rate for its income class than to remain abnormally hot (or cold) indefinitely. Watch for balanced growth, and focus on a manageable set of dynamic indicators that make it possible to anticipate turns in the cycle. Long runs of strong growth last because leaders avoid the kinds of excesses that produce credit and investment bubbles, currency and bank crises and hyperinflation—the various kinds of busts that end economic miracles. The rules double as a rough guide to long-term economic success.
Growth can be defined as the sum of spending by government, spending by consumers, and investment to build factories or homes, buy computers and other equipment, and otherwise build up the nation. Investment typically represents a much smaller share of the economy than consumption, often around 20 percent, but it is the most important indicator of change, because booms and busts in investment typically drive recessions and recoveries.
Growth can also be broken down as the sum of production in various industries, such as farming, services, and manufacturing. Of these, manufacturing has been declining worldwide—it’s now less than 18% of global GDP, down from more than 24% in 1980—but it is still the most significant force of change, because it has traditionally been the main source of jobs, innovation, and increases in productivity.
Another simple way to define economic growth is the sum of the hours that people work plus their output per hour or productivity. But productivity is hard to measure, and the results are subject to constant revision and debate. On the other hand, the number of hours people work reflects growth in the workforce, which is driven by population growth, which is relatively easy to count. Unlike economic forecasts, population forecasts depend on a few simple factors—mainly fertility and longevity—and have a strong record for accuracy. The impact of population is very straightforward: a 1 percentage point decline in growth in the labor force will shave about 1 percentage point off economic growth. Productivity growth is the sum of hard-to-quantify improvements in the skill of workers, in the number and power of the tools they use, and in an elusive x factor that tries to capture how well workers are employing those tools. That x factor, which can be influenced by everything from experience using a computer to better management or better roads to get workers to their workplaces faster, is the fuzziest part of this difficult calculation.
While both are extremely important, it is easier to measure population growth, which has a more clear-cut impact on the economy. Fewer working people mean less economic growth, and this impact has become more visible worldwide in the past decade.
Rule 1: Is the Talent Pool Growing?
Worldwide, many fewer babies are being born, and fewer young people are entering the working-age cohort, while the overall population is growing mainly because people are living longer. This mix is toxic for economic growth. The fall in the global population growth rate was. The delayed result of aggressive birth control policies implemented in the emerging world in the 1970s, particularly the one-child policy China instituted in 1978. In emerging and developed countries, the population slowdown also fueled by rising prosperity and education levels among women, many of whom decided to pursue a career and have fewer children or none at all.
The roots of this demographic shift lie in basic changes in mortality and fertility rates over the last half-century. The overall population will continue to grow, albeit at a much-reduced rate, even as the segment that drives economic growth—working-age people—continues to shrink.
The period since 1960 has also seen a global baby bust, as the average number of births per woman has fallen from 4.9 to 2.5 worldwide. As the world’s fertility rate slips toward the critical level of 2.1, more and more countries are falling below the replacement level. Nearly one of every two people on earth already lives in one of the eighty-three countries where on average women have fewer than two children, from China, Russia, Iran, and Brazil to Germany, Japan, and the United States.
For a nation’s economic prospects, the key demographic question is: Is the talent pool growing? The first part of the rule for finding the answer is to look at the projected growth of the working-age population over the next five years, because workers (more than retirees or schoolchildren) are the drivers of growth. The second part of the rule is to look at what nations are doing to counteract slower population growth. One way is to try to inspire women to have more babies, an approach with a spotty record at best. The other is to attract adults—including retirees, women, and economic migrants—to enter or reenter the active labor force. The big winners will come from among those countries that are blessed with strong growth in the working-age population or are doing the best job of bringing fresh talent into the labor force.
While population shifts gradually, measures to reshape the workforce can have a rapid impact, because you don’t have to wait fifteen to twenty years for a woman, a retiree, or an economic migrant to grow up. Providing childcare services can bring women with children back to work. Opening the nation’s doors to economic migrants can expand the working age population virtually overnight. And reversing the twentieth-century campaign that pushed the retirement age down into the fifties in many industrial countries could bring a forgotten generation back to work very quickly. To drill down into likely changes in the size and talent of the labor pool, watch mainly for shifts in the number of senior citizens, women, migrants, and even robots entering the workforce.
In recent years countries with faster-growing populations have also tended to exhibit faster productivity growth. With more people entering the workforce and earning an independent living, a country’s income increases, and that creates a greater pool of capital, which can be used to invest in ways that further raise productivity.
Changes in the dependency ratio also say a lot about an economy’s growth potential, by revealing what percent of the population is entering its productive years, saving money, and contributing to the pool of capital available to invest rather than drawing down pension funds. Furthermore, a more experienced labor force also tends to be more productive. The best-positioned countries are those taking steps to keep older people in the workforce and out of the “dependent” population. However, in most countries, the duration of the retirement “golden years” continues to lengthen, weighing on the economy. The aging process, which has already hit most advanced countries, is expected to unfold even faster in emerging ones, again because of a sharper fall in fertility rates and a faster rise in life expectancy.
To assess which nations are best or worst positioned to grow, look first at projections for growth or shrinkage in the working-age population, to gauge the potential baseline gain for future economic growth. Just as important, track which countries are doing the most or the least to leverage whatever population gains they will enjoy. Are they opening the workforce to the elderly, to women, to foreigners? Are they taking steps to increase the talent level of the workforce, particularly by attracting highly skilled migrants? In a world facing a future of growing labor shortages, it’s all hands—human or automated—on deck.
Population decline is now high on the list of reasons, alongside its heavy debts and excessive investments, to doubt that China can sustain rapid GDP growth. To produce strong economic growth in a country with a shrinking population is close to impossible. The trick is to avoid falling for the fallacy of the “demographic dividend,” the idea that population growth pays off automatically in rapid economic growth. It pays off only if political leaders create the economic conditions necessary to attract investment and generate jobs. In the 1960s and ‘70s, rapid population growth in Arica, China, and India led to famines, high unemployment, and civil strife. Rapid population growth is often a precondition for fast economic growth, but it never guarantees fast growth.
Rule 2: Is the Nation Ready to Back a Reformer?
In the natural circle of political life, a crisis forces a nation to reform, reform leads to growth and good times, and good times encourage an arrogance and complacency that leads to a new crisis. Even the most promising reformers tend to grow stale and arrogant with time, with decisive consequences for their economies.
Pinpointing when a country is ready to make hard changes is more important than identifying the specific content of the reform. And typically, the public’s willingness to back change depends on whether it is feeling the urgency of a crisis or the laziness of fat times. A good crisis raises the probability that a nation will embrace change and new leaders, but it is very hard to say which new leaders will be successful reformers. The probability of successful, sustained reform is higher under fresh leaders rather than stale leaders, under leaders with a mass base rather than well-credentialed technocrats, and under democratic leaders rather than autocrats. Though China’s boom of the last three decades has done much to burnish the reputation of a certain brand of technocratic and autocratic economic leadership, the evidence from other countries doesn’t bear out that view.
The essential question to ask about the impact of politics on the prospects for an economy is this one: Is the nation ready to back a reformer? To answer it, the first step is to figure out which position the nation occupies in the circle of life. Nations are most likely to change for the better when they are struggling to recover from a crisis. When a country’s back is against the wall, the general public and the political elites are most likely to accept tough economic reform. On the far side of the circle, nations are most likely to change for the worse in boom times, when the populace is sinking into complacency, too busy enjoying its good fortune to understand that in a competitive global economy, the need to reform is constant. The second step is to figure out whether the country has a political leader capable of rallying the popular will behind reform.
The least auspicious periods come under stale leaders, who tend to hang on to power by passing out government largesse as a reward to powerful allies and to a complacent populace. Boom times encourage even genuine reformers to grow arrogant and hang on to power too long, so watch out for stale leaders overstaying their welcome; they foretell a turn for the worse.
The bigger the crisis, the greater the shock to the public, and the more eagerly people will support a fresh leader, even if that change disrupts the old order. The pain caused by any crisis will induce many countries to demand change—but not always to embrace hard reform. Some countries will turn to populists promising easy prosperity and a restoration of national glory, the way Venezuela embraced Hugo Chavez and Argentina turned to Nestor Kirchner after the Latin crises of the 1990s. Others will turn to real reformers, as the United States, Britain, and China turned to Reagan, Thatcher, and Deng in the 1980s.
The unusual thing about the Reagan, Thatcher, and Deng generation was how, in wildly different economic settings, they settled on similar reforms to address their crises. The low growth and high inflation of the 1970s was traceable in varying degrees to cumbersome state controls, and the solution pushed by this generation of leaders created a basic template for free market reform. In the United States and Britain, that template included some mix of loosening central control over the economy, cutting taxes and red tape, privatizing state companies, and lifting price controls while supporting the central bank policies that played the critical role in taming inflation. In China, it included freeing peasants to till their own land and opening to foreign trade and investment. Controversy over the legacy of these leaders endures, but their reforms doubtless brought a new dynamism to stagnating economies.
While reform is most likely under bold new leaders, it grows less likely as time passes, as the leader’s focus turns to securing a grand legacy or rewarding family and friends. One simple way to think about this rule is that high-impact reform is most likely in a leader’s first term, less likely in the second term, and unlikely beyond the second term, when leaders will tend to run out of reform ideas or the popularity to implement them, or both. Reagan fell victim to the “second term curse,” that recurring cycle of scandal, popular fatigue, and congressional opposition that has made it tough for American presidents to push change after their first terms. No president has accomplished what he set out to do in his second term, at least not since James Monroe, two centuries ago. In the end, said Ralph Waldo Emerson, every hero becomes a bore.
It is a bad sign for any country when its leader can’t give up the trappings of power and views himself as consubstantial with the nation. Successful leaders often share these two key attributes: popular support among the masses and a clear understanding of economic reform, or at least a willingness to delegate power to experts who do get it. In contrast, populist demagogues who artfully combine populism and nationalism can be politically successful but tend to be a disaster for their countries.
The markets also tend to cheer for technocrats, assuming that leaders with backgrounds in the finance ministry, or the World Bank, or the economics department of a prestigious university will understand the requirements of reform and strong growth. Technocrats rarely succeed in the top job, however, because they tend to lack the political flair to sell reform or even to last very long in office. On the other hand, technocratic advisers can often serve leaders well, if they are giving the right advice and leaders are willing to listen. The best way for technocrats to be successful is therefore as staff members of an authoritarian regime, which can command rather than rally popular support.
Following the spectacular three-decade boom in China, there is a strong tendency to believe that autocracies are better than democracies at generating long runs of growth, a myth that may be built not so much on the rise of China as on the coverage of the rise of China. The overreporting of autocratic triumphs may well have reinforced the general impression that Chinese authoritarian capitalism is a model worth emulating for developing countries, particularly at the early stages of development.
Autocrats sometimes do succeed. Authoritarian rulers can often ignore or overrun opposition from the legislature, the courts, or private lobbies, and that power allows visionary leaders to accomplish a lot more than democratic rivals. Autocrats can suppress special interest lobbies and any opposition to breakneck development, because the threat of the bullet keeps people in line. They can steer the population’s pool of savings toward growth industries, and they can ignore popular demands for wage hikes so those industries become and remain globally competitive. Perhaps above all, they can commandeer land to build highways and ports and other basic building blocks of a modern economy, in a way no democracy can match.
However, because autocrats face few checks and balances and no opposition at the ballot box, they can veer off in the wrong direction with no one to tell them otherwise, and they can also hang on to power indefinitely, more often than not with bad results for the economy. The threat of stale leadership looms larger in authoritarian nations than in democracies, which give people the opportunity to choose fresh leaders in fair elections every four to six years. Stale leaders tend to do the most long-term economic damage in authoritarian countries, which have much less fluid mechanisms for responding to popular demands for change or for bringing in fresh leaders. Once an autocratic regime is forced to hold elections, it loses its power to force rapid growth, but it gains an incentive to let growth rise naturally by, for example, respecting property rights and breaking up state monopolies.
Both democratic and authoritarian systems have advantages and disadvantages in the race to generate strong growth, and neither has a clear lead. During the last three decades, there were 124 cases in which a nation posted growth faster than 5% for a full decade. Of those strong growth spells, 64 came under the rule of a democratic regime, and 60 under an authoritarian regime. So there is no reason to assume autocratic regimes have generally brighter growth prospects—despite the widespread admiration for Chinese-style command capitalism. Moreover, those averages conceal the big flaw in authoritarian regimes, which is that they are much more likely to produce extreme results, meaning wilder swings between periods of very high and very low growth. Nations ruled by autocrats are also much more prone to long slumps.
In recent decades, many economically troubled nations have looked to a strongman to restore prosperity. In the long run, however, stable and enduring growth is more likely under a democrat, who lacks the power to engineer spectacular runs of success or failure. Even autocrats who produce long periods of strong growth often become, in the end, predatory defenders of the status quo, trampling on property rights to enrich their own clique, discouraging anyone who is not a friend of the big boss from taking any stake in the economy. This is why so many democratic countries have adopted term limits, in order to prevent regimes from growing stale and corrupt.
The circle of life is a rule of politics, not science. It tells you that the likely timing and direction of change depends in part on where a country stands on the circle of crisis, reform, boom, and decay. Like any other life-form, the world economy follows cycles of decay and regenerations, its energies scattering and lying formless for a time, only to gather again into new shapes. The political lives of modern economies follow a similar cycle, exploding in crisis only to re-form and revive before dying out once again. Bat times make for good policy, and good times make for bad policy. This circle of life helps explain why so few developing economies manage to grow fast and long enough to enter the ranks of the developed economies. It also helps put into perspective why those that make the leap are called “miracle” economies: They have defied the natural complacency and decay that kills most long booms.
The evidence on balance shows that politics matters for economic growth, and the fortunes of a nation are likely to turn for the better when a new leader rises in the wake of a crisis, and conversely a nation is likely to be worse off when a stale leader is in office.
Rule 3: Is Inequality Threatening Growth?
To fight inequality, a country needs to pursue two goals—redistributing the pie while growing it at the same time. All too often in the emerging world, the backlash against an. Entrenched class of well-connected tycoons has brought to power a populist firebrand who pursues redistributive policies that can burn down the economy. In the extreme cases, populist demagogues seize private businesses and farms for the state, ban foreign investors from entering the country, raise taxes to choking levels in the name of helping the poor, ramp up the size of government, and spend heavily on wasteful subsidies, particularly for cheap fuel.
Inequality starts to threaten growth in part when the population turns suspicious of the way wealth is being created. If an entrepreneur is creating new products that benefit the consumer or building manufacturing plants and putting people to work, that form of wealth creation tends to be widely accepted. However, if a tycoon is making a fortune by cozying up to politicians and landing contracts from the government, or worse by capitalizing on Daddy’s contracts, then resentment surfaces, and the nation’s focus turns to redistributing rather than creating wealth.
The long shelf life of Gini scores renders them useless as a current indicator of which nations are most threatened by rising inequality. Instead, one should use a careful read of the Forbes billionaire list as one tool to identify the outliers: countries where the scale and sources of the largest fortunes are most likely to trigger tensions over inequality, and to retard growth in the economy. To identify countries in which tycoons are taking an unusually large and growing share of the pie, calculate the scale of billionaire wealth relative to the size of the economy. To identify countries in which the tycoon class is becoming an entrenched elite, estimate the share of inherited wealth in the billionaire ranks. Most important, track the wealth of “bad billionaires” in industries long associated with corruption, such as oil or mining or real estate. It is the rise of an entrenched class of bad billionaires in traditionally corruption-prone and unproductive industries that is most likely to choke off growth and to feed the popular anger on which populist demagogues thrive. Also listen closely to how the public is talking about the nation’s leading tycoons, because it is often the popular perception of inequality, even more than the reality, that shapes the political reaction and economic policy.
The belief that inequality fades over time had been the working assumption since the 1950s, when the economist Simon Kuznets pointed out that countries tend to grow more unequal in the early stages of development, as some poor farmers move to better-paying factory jobs in the cities, and less unequal in the later stages, as the urban middle class grows. Today, however, inequality appears to be rising at all stages of development: in poor, middle-class, and rich countries. One reason for the widening threat of inequality is that the period of intense globalization before 2008 tended to depress blue-collar wages. It became much easier to shift factory jobs to low-wage countries, while continuing advances in technology and automation were replacing jobs that had earlier lifted many people into the middle class. As inequality spreads within countries, at every level of development, it is increasingly important to monitor the wealth gaps in all countries, all the time.
It is natural and healthy for a growing economy to generate wealth, so long as the tycoons are not in control of an outsize share of the nation’s wealth, are not congealing into a stagnant elite bound by family ties, and are emerging in innovative and productive industries rather than those where political connections often decide who will be a billionaire. It’s difficult to clearly define when the scale of billionaire wealth threatens to throw an economy out of balance but comparing each country to its peers throws the outliers into stark relief. Total billionaire wealth in recent years has averaged about 10% of GDP both in emerging countries and in developed countries. So, if billionaire fortunes are more than 5 percentage points above that average, as is the case today in Russia, Taiwan, Malaysia, and Chile, that seems threatening.
While some academic research shows that growth typically tends to slow when inequality is very high, it also tends to slow when inequality is very low. Though new faces on the billionaire list can be a favorable sign for the economy, this holds true only if they are good billionaires, emerging outside what economists call “rent-seeking industries.” These industries include construction, real estate, gambling, mining, steel, aluminum and other metals, oil, gas, and other commodity industries that mainly involve digging natural resources out of the ground. The competition in these sectors is often focused on securing access to a greater share of the national wealth in natural resources, not on growing the wealth in fresh, innovative ways. Major players spend a lot of time trying to win over regulators and politicians to secure ownership of a limited resource and the right to extract the maximum possible rent from that resource, by bribery if necessary. To make a rough qualitative judgment about the sources of great fortunes, compare the total wealth of tycoons in these corruption-prone businesses to the total wealth of billionaires in the country. This yields the share of the wealth generated by “bad billionaires.”
The assumption is that the rest of the billionaires make a greater contribution, but the label of “good billionaire” is reserved for tycoons in industries that are known to make the most productive contributions to economic growth or that make popular consumer products like smartphones or cars. These “good” industries include technology, manufacturing, pharmaceuticals, telecoms and retail, e-commerce, and entertainment, and they are least likely to generate popular national backlashes against wealth creation.
Bad billionaires often arise through family empires, particularly in the emerging world, where weaker institutions make it easier for old families to cultivate corrupt political ties. To identify nations where blood ties are most likely to be reducing competition and churn, use Forbes data that distinguishes between “self-made” and “inherited” billionaire fortunes. The absence of inherited wealth should be a good sign, demonstrating that new businesses can compete with entrenched ones.
The worldwide rise in inequality has produced a torrent of new research into its causes and consequences, and whatever one’s ideology, it is hard to dispute the growing view that low levels of inequality fuel long runs of strong economic growth, and that high or rapidly rising inequality can prematurely snuff out growth. The main line of the argument starts with the observation that as incomes rise, the rich tend to spend a smaller share of their additional income—and save more of it—than the poor and middle class do. The rich already buy all the basics, from food to gas, that they want and have little room to increase spending on these consumer staples when their wealth rises. On the other hand, when the poor and middle class have more cash on hand, they will spend more on clothes or food, or better cuts of beef, or on gas for that weekend trip they had been denying themselves. The way economists put it is that the rich have a lower “marginal propensity to consume” as incomes rise. As a result, during periods when the rich control a growing share of the national income, growth in total consumer spending tends to slow, holding back the economy’s growth rate.
A second line of the argument has to do with spotting change. Inequality may impede growth at least in part because it calls forth efforts to redistribute that themselves undercut growth. In such a situation, even if inequality is bad for growth, taxes and transfers may be precisely the wrong remedy. The biggest threat to growth arises when an emerging nation has already committed to heavy spending on redistribution through social welfare programs. Tossing more money at the problem of poverty can throw budgets out of balance, create an unwieldy state, and ultimately backfire by derailing the growth necessary to pay for social welfare.
The billionaire rule is growing in importance, because inequality has been rising all over the world, from the United States and Britain to China and India, due mainly to massive gains for the very rich. Measuring changes in the scale, rate of turnover, and source of billionaire wealth can help to provide some insight into whether an economy is creating the kind of productive wealth that will help it grow in the future.
It’s a bad sign if the billionaire class owns a bloated share of the economy, becomes an entrenched and inbred elite, and produces its wealth mainly from politically connected industries. A healthy economy needs an evolving cast of productive tycoons, not a fixed cast of corrupt tycoons. Creative destruction drives strong growth in a capitalist society, and because bad billionaires have everything to gain from the status quo, they are enemies of wider prosperity and lightning rods for social movements pushing predictable demands for redistributing rather than growing the economic pie.
Rule 4: Is the Government Meddling More or Less?
The question to ask for any economy is this: Is the state meddling more or less? In general, and particularly in a period like the current one, when many governments have been intervening so aggressively, less is better. Government attempts to manage economic growth come in many and varied forms, but one should watch for three basic trends: changes in the level of government spending as a share of GDP, coupled with an assessment. Of whether that spending is going to productive ends; the misuse of state companies and banks to achieve essentially political goals; and the extent to which the. Government allows private companies room to grow.
The normal postwar pattern has been that as a country grows wealthier, spending by the government has tended to grow as a share of the economy. To spot potential outliers, identify which national governments are spending much more (or much less) as a share of their economy than other nations at the same income level. The worst possible sign comes when a relatively fat state is getting fatter, compared to its peers.
The state needs to be spending at least enough to provide the essential conditions of civilized commerce, including building basic infrastructure and mechanisms to contain corruption, monopolies, and crime. One clear sign that a state is falling short is when it cannot even collect taxes, a failure that tends to expose both a general incompetence on the part of administration and a popular disdain for the state. Mexico, for example, collects taxes equal to about 14% of GDP. That is quite low for a middle-class country, and lack of revenue is making it hard for the government to maintain law and order or suppress the corrupting influence of drug cartels.
When the state is this weak, the economy runs on a paper-thin foundation and becomes particularly susceptible to the debilitating threat of civil war, with various sections of the society feeling excluded. In 2009 the U.S. Agency for International Development (USAID) studied conflicts in 62 nations between 1974 and 1997 and found that a typical civil ware lasted 15 years and reduced national GDP by around 30%. Even after peace arrived, it took a decade on average just to recover the prewar levels of income, and in four cases out of ten, violence erupted anew within a decade.
The flip side of the underfunded state is the black economy, where people do business of the books in order to evade taxers. The black economy is the ultimate expression of public disdain for the state, reinforcing not only its fragility but also its inefficiency. Jobs in this untaxed netherworld tend to be poorly paid and often dead-end career paths without benefits, and employers in this realm get the kind of productivity they pay for. The black economy can be shockingly large—running anywhere from 8% of GDP in Switzerland and the United States to more than 30% n Pakistan, Venezuela, Russia, and Egypt. It also spills into other forms of dysfunction. Tax dodgers tend to avoid banks, which reduces the pool of savings available for investment and creates an alternative and far less efficient channel for allocating capital.
Many historians have pointed out that most of the Asian miracle economies were governed, in their early years, by authoritarian, controlling states. But there is a nuance to this story. In How Asia Works, Joe Studwell writes that no nation, going back to Tudor England in the sixteenth century, produced competitive industrial companies without significant. Help and protection from the state in the initial stages. Tudor England was followed by the United States, France, and Germany. Then Germany inspired Japan, Japan inspired Korea, with Taiwan and China soon to follow. Studwell added that all these successfully activist states pursued “industrial policy” in a way that cleverly exploited market forces. In South Korea, for example, Park Chung-hee took office in 1960 and used the levers of the state to redistribute land from aristocrats to peasants, creating a broad new class of productive landowners. Rather than just favoring certain business allies, he also set up a competition among leading tycoons that would ultimately produce a few national industrial champions, like Samsung that made South Korea a leading export power.
However, no new important emerging nation has achieved this kind of success—growing rapidly thanks largely to the guiding hand of an activist state—in recent decades. Of course, many will respond, what about China? As the Nobel Prize-winning economist Ronald Coase has pointed out, the conventional story about China gets the narrative wrong. China started on the road to becoming an industrial superpower only after the all-encompassing state started to interfere less in the economy. Around 1980 the Chinese government began to ease its grip, one step at a time and always in response to pressure from below. Initially, peasants demanded to sell more of their own produce, then villages sought to run their own local enterprises, and finally individuals pressed for the right to own and run those enterprises.
Since the early 1980s, the output of private companies in China has risen by 300 times, or five times faster than the output of state companies, according to Deutsche Bank research. As a result, the share of GDP produced by the state companies has fallen from about 70% in the early 1980s to about 30% today, with most of that shift coming as market reforms picked up pace in the 1980s and ‘90s. This broad trend greatly reduced the power of the Chinese state as an employer and market trendsetter, at least until recent years.
China’s successes were less a tribute to “command capitalism” than to Beijing’s steady free market reform. Ironically, the government’s recent post-crisis activism—which provoked so much talk about the Beijing Consensus—represented at least a partial reversal of its formerly successful habits. After 2008, Chinese technocrats became increasingly obsessed with hitting unrealistic growth targets, based on the entirely political calculation of what it would take to double the size of the economy by 2020. For Beijing, the path of least resistance was to direct new public spending and state bank lending to big state-owned companies, which began to regain some of the clout they had lost. Private companies saw a slight drop in their share of industrial output and are no longer making inroads in heavy industries like mining or steel. Private companies were still growing faster than state companies in the 2010s, but only 4 percentage points faster, down from 12 percentage points faster a decade earlier.
The fact that other Asian miracle economies developed with the help of an activist state also misses a key point: The leaders of these countries had no qualms about using state power to steer funds to favored companies, but the states themselves were not particularly large. In general, government spending accounted for a relatively small share of GDP, and it still does today. Taiwan and South Korea emerge from a tradition of disciplined state spending, which helps explain why—unlike France—they produce relatively few jokes about high taxes and incompetent bureaucracy.
Lately the size of the state has been growing quickly across many nations. Particularly when a ruling regime has been in power for many years, states tend to overspend more when the economy is facing a crisis or a downturn. The incumbent rulers start scrambling to protect themselves and use the levers fo the state to promote their own popularity by attempting to generate growth at any cost. They spend heavily on make-work projects, or they order state companies to create jobs or to keep prices artificially low, in an attempt to protect their citizens from the pain of the downturn. This creeping inclination to spend heavily in hard times was very visible after the crisis of 2008.
Unlike the governments of the developed world, those of the emerging world went into the crisis of 2008 with generally low levels of public debt, large reserves of foreign currency, and strong government budget surpluses or at least relatively small budget deficits. Having money to burn, they burned it, and the initial result was a great jet flame of growth. After bottoming out at just 3% in mid-2009, the average GDP growth rate amount the major emerging economies rebounded to more than 8% in 2010. With that apparent success, a rousing cheer bubbled up from supporters of strong government. The International Labor Organization teamed up with the European Union on a report in late 2011 lauding the contribution of heavy government stimulus spending to a “spectacular” recovery in Asia and to one nearly as impressive in Latin America.
Alas, by that point, the flameout was already under way. China’s official growth rate slumped by more than a third between 2011 and 2013, Brazil’s by a factor of ten, and the average GDP growth rate for the emerging countries had returned to around 3.5%, about the same rate as in the 1990s, when growth was disrupted by multiple crises. The big difference in the late 1990s was that most emerging nations had no money to burn, no lenders they could turn to, and thus they could not borrow to pump up growth. They were pressured instead to reform, clean bad debts out of the system, take steps to control spending, contain inflation, and (in a few cases) make companies more competitive. That cleansing set them up for the unprecedented boom of the 2000s.
After 2008, however, the governments of the emerging world started to borrow from the future to produce that brief flash of growth in 2010. And they paid for it dearly. By 2014, the government budget surpluses of 2007 had melted into an average deficit equivalent to 2% of GDP, which was creating real worries. Burned so often in the past by crises fed in part by government spending, emerging nations had come to accept that a budget deficit equal to 3% of GDP or more was often a warning sign of serious budget problems to come.
This tale of two crises offers a stark contrast: Following the meltdown of 1998, the governments of the emerging world cut back on government deficits and debt, meddling less in private business. Five years later these countries had low debt burdens and were thus poised for an unprecedented boom. After the crisis of 2008, however, governments in many emerging nations were piling up new debts, intervening more in a failing attempt to stimulate growth, and putting their economies in a position to register weak-to-mediocre growth in the following five years.
When the state tries to roll out spending projects too quickly, much of the spending goes to waste. After 2008 the explosion of big government spending contributed to a serious decline in productivity across the emerging world. In Russia, South Africa, Brazil, India, and China, a critical measure of productivity known as the incremental capital output ratio (ICOR) rose sharply after 2008, which was a very bad sign. It meant that these countries had to borrow a lot more capital to produce the same amount of economic growth, in part because so much of the capital was going to wasteful state projects or government giveaways.
What this ratio shows is that before 2007, it took one dollar of new debt to generate on dollar of GDP growth in the emerging world, including in China. Five years after the global crisis, it took two dollars of new debt to generate one dollar of GDP growth in the emerging world, and in China it took four dollars of new debt to generate a dollar of GDP growth. The evidence for these diminishing returns was everywhere. In Russia, Brazil, India, and especially China, private companies had been cutting investment even as the state had been investing more, and this shift from private to public investment had produced more and more waste. China was the biggest spender—laying out the equivalent of 12% of GDP—and fittingly generated the most damning examples of government intervention gone wrong.
Even John Maynard Keynes, the intellectual father of government stimulus campaigns, would likely have been surprised by the scale and duration of many recent spending efforts. His advice focused on emergency spending to ease the pain of a recession, not on open-ended attempts to generate perpetual growth. That is effectively what many emerging nations, spoiled by the boom years of the 2000s, had been trying to achieve with their spending as the global recovery limped along after 2008.
In all these countries from India to Brazil, the state tried to manage the economy in a way that did nothing to promote growth in the future, so all they achieved was to delay the pain. In these cases, the spending campaigns produced just a temporary reprieve from the global slowdown, and growth in the future will be slower as a result of the debts rung up to pay for stimulus. This is what it means to say states are “borrowing from the future.”
This problem raises an interesting question: Why can’t governments spend to stimulate growth in the short term and simultaneously push reform—for example, by cutting regualtions or selling loss-making state-owned companies—to increase productivity and growth in the long-term? They could, but in practice they seem unable to work toward both goals at the same time. Perhaps this is because stimulus campaigns are motivated by an impulse to protect people from the free market, and reform campaigns are motivated by a desire to free people to compete in the market. Unfortunately, the worthy impulse to protect the people—say, by raising food or energy subsidies—often leaves the government without the resources to make necessary investments in a more competitive economy. Many emerging nations find themselves in this predicament today—with a long list of desperately needed infrastructure projects that the government can no longer afford. And once politicians dole out subsidies, they find it very hard to take them back.
Political abuse of state banks is also a peril of the state. Across the emerging world, state banks are a major impediment to the smooth functioning of the credit system. Despite several waves of free market reform in emerging economies over recent decades, the state still runs a large number of banks in many countries. If you want a loan, you ask the government. On average, state banks control 32% of all banking assets in the twenty largest emerging nations. That figure is 40% or more in Thailand, Indonesia, Brazil, and China (where the line between state and private banks is murky and the actual number is likely much higher). It is 50% or more in Taiwan, Hungary, Russia, and Malaysia and a striking 75% in India. In Russia, where twenty years after the fall of Communism, capitalism is still stymied by the difficulty of obtaining even a simple loan to start a small business or buy a house, nearly one-third of the anemic credit industry is controlled by just one bank, which is in turn run by Russia’s central bank.
The problem with state interference in the credit system is not only its scale, but also its timing. Governments are not well equipped to anticipate rapidly shifting market conditions, and this was glaringly true in the case of China. In 2014, gleaming new malls in Beijing were empty on both weekdays nd weekends. Because the state banks had made so much money ev ailable to encourage an increase in consumer spending, the real estate developers were tossing up new malls at a breakneck pace. But they were doing so at a time when Chinese consumers were moving to online retailers. That’s where all the increase in consumer traffic was. The added irony was that, for all the money the Chinese state had poured into building new highways, one of the main obstacles for online retailers was that lousy local roads still made it difficult to deliver goods to the consumer’s doorstep. The lesson here is that when the state lends in haste, it will repent at leisure.
If a state is inclined to mobilize its banks to achieve essentially political ends, it is likely to use other state companies the same way. One standard tactic to look out for is the use of state oil, gas, or electric companies to suppress prices, in a misguided effort to prevent high inflation. This only leads to less new investment in the mispriced sectors, which exacerbates shortages over time and makes for more wasteful consumption. State-owned companies are also viewed by some politicians as mainly job-creating machines. A rule of thumb is that on average, in both developed and emerging countries, jobs in the government and in state-owned companies combined amount to about 20% of all employment, based on data from the International Labor Organization (ILO). Countries with government well above that mark look bloated.
Perhaps the most self-defeating aspect of the government’s involvement in the economy is energy subsidies, which play a major role in encouraging waste and draining national treasuries. In the Middle East and North Africa as well as parts of Central Asia, many governments spend more on providing their people with cheap fuel than on schools or healthcare. Few economists in any political camp would defend this spending choice. Energy subsidies keep fuel prices irrationally cheap, encouraging people to burn too much fuel and spew more of the carbon emissions that contribute to global warming. Cheap prices strangle local energy suppliers, discouraging investment and causing shortages, which fuel inflation. They also encourage smuggling and are the reason why even in an orderly country like Canada, profiteers are smuggling in gas from the United States, where low taxes underpin low gas prices. Fuel subsidies also tend to widen income and wealth inequality in poor countries, because states that subsidize energy have little choice but to subsidize it for everyone, despite the fact that those benefits go to the privileged class of car owners.
What’s needed is a sensible Leviathan that spends its limited resources in a strategic way and acts consistently and predictably, based on a clear economic rationale. The government ought to create stable conditions in which entrepreneurial types—whether in the state sector or in the private sector—dare to invest. Int needs to create a rule of law. When the state is investing wisely and moving toward creating predictable and stable rules, good things are more likely to happen.
When commentators talk about “structural reform” in emerging countries, they are generally talking about writing and enforcing sensible rules, following the basic lessons of Econ 101. These lessons say that an economy’s output is the simple sum of basic inputs, including land, labor, and capital. So what “structural reform” often entails is the creation of an efficient legal regime governing the purchase of land to build factories, the lending of capital to finance the construction of those factories, and the hiring and firing of workers to staff them. The opposite of a rule-based system is one based on the deals cut between political bosses and their clients, which can be even more complex.
The checklist for what to watch for starts with taking a read on government spending as a share of GDP, to spot the real outliers, and checking on whether the spending is going to productive investment or giveaways. You also want to watch whether the government is using state companies and banks as tools to artificially pump up growth and contain inflation, and whether it is choking or encouraging private businesses. In recent years many countries have been raising the government share of the economy to bloated proportions, steering bank loans to the unproductive and undeserving, promoting the interest of big state companies, subsidizing cheap gas for the rich and middle class, and enforcing insensible rules in an unpredictable way that make it difficult for private companies to thrive. Many states are now managing the economy in ways that do more to retard than to promote growth. As a result, surveys in several countries show that trust in the government to do the right thing is running at very low levels and probably fueling the rise of fringe parties and radical leaders. Less meddling and more focused government spending would make for better economic and political outcomes.
Rule 5: Is the Nation Making the Most of its Location?
A geographic sweet spot is a place that makes the most of its geographic location. Geography matters for growth: Today Poland and Mexico have a big potential advantage in global competition thanks to their location on the border of the vast commercial markets of western Europe and the United States. Vietnam and Bangladesh are taking advantage of their position on existing trade routes between China and the West to take away some of the export manufacturing business that had been done mainly in China.
Nations that qualify as geographic sweet spots combine the pure luck of an advantageous location with the good sense to make the most of it by opening their doors to the world, particularly to their neighbors, and also making sure that even their own most remote provinces are entering the global mainstream. To spot likely winners, track which countries are doing the most to exploit their location by opening doors to trade and investment with the world and with their neighbors, and to balance growth in the major cities with the provincial regions.
The pressure on countries to make the most of their locations and attract a larger share of global trade is only likely to increase in the coming years. Though we live in a more connected world than we did a decade ago, the general perception that we live in an increasingly interconnected global economy no longer holds, in some crucial respects. Trade is one of them. The growth rate of global trade flows has slowed quite abruptly. From 1990 to 2008 the global economy grew rapidly, but trade grew 2 to 2.5 times faster. Then came the global financial crisis, nations turned inward, and since then global trade has been growing more slowly than the global economy. As a result, between 1990 and 2008, global trade expanded from less than 40% of GDP to almost 60%, but since then it has retreated a bit. The old consensus born in good times—that more free trade is better for all countries—has been deeply shaken in the post-crisis slow-growth world. During hard times, nations often turn inward and bar foreign businesses from competing in their home market. This is one of those times.
To get a handle on which countries are likely to thrive in export competition, the first thing to check is how open they are to global trade. Among the largest emerging nations, trade including both exports and imports amounts to 70% of GDP on average, and countries that are above average are led by major export manufacturers. At the top are countries with trade accounting. For more than 100% of GDP—which is possible since most of their consumption is imports and most of their national income comes from exports: the Czech Republic, Vietnam, Malaysia, and Thailand.
Though economies that rely heavily on exports face a hard time growing when global trade is slowing, as it has been recently, the benefits of high export income are such that in the long run, when the trade picture stabilizes, open trade powers will be more competitive than closed economies. The most closed economies, with trade at less than 50% of GDP, fall into two groups. One is a cluster of very populous countries like China, India, and Indonesia that rely less on trade simply because their domestic markets are so large. The other group includes oil- and commodity-driven economies like Nigeria, Argentina, Iran, and Peru, which have a history of protecting themselves from foreign competition and relying on high commodity price swings to generate growth. The more closed they remain, the smaller their share of newly limited global trade flows.
Taking full advantage of geography to carve out a commercial sweet spot is important for a nation’s long-term growth prospects. Export sales earn the foreign income that allows a nation to import whatever its population wants to consume, to invest in new factories and roads, and to do so without falling into the pathology of rising foreign debts and recurring currency crises. It is no accident that during their long runs of strong economic growth, the postwar Asian “miracles” in Japan, South Korea, Taiwan, and Singapore also sustained average annual manufacturing export growth of more than 10%. A nation’s chances of economic success are greatly improved by prowess in manufacturing goods for export, which highlights the importance of location. Any nation that wants to thrive as an export power has a huge advantage if it starts with a base close to trade routes that connect the richest customers to the most competitive suppliers.
In recent years it became fashionable to argue that location no longer matters, because the Internet makes it possible to provide services from anywhere. But physical goods still make up the bulk of global trade flows, and location still matters for companies that want to be close to their customers and suppliers. Worldwide, flows of goods amount to about $18 trillion a year, significantly greater than flows of both services and capital, which account for about $4 trillion each. So, for the foreseeable future at least, the exports that matter most to economic growth are exports of manufactured goods. Mexico is a good example of why proximity matters, because while its wages have been falling of late relative to China’s, its biggest gains date back further and have come from lower transport costs to the United States, particularly for heavy items that are expensive to ship, like cars.
Rule 6: Is Investment Rising or Falling as a Share of the Economy?
Two kinds of spending drive any economy—consumption and investment—and while in most economies people and governments spend more on consumption, investment is the more important driver of growth and business cycles. Investment spending is usually more volatile than consumption spending, and it helps create the new businesses and jobs that put money in consumers’ pockets. It includes investment by both the government and private business in construction of roads, railways, and the like, in plants and equipment from office machines to drill presses, and in buildings from schools to private homes. The basic question for a nation’s economic prospects: Is investment rising or falling as a share of the economy? When it is rising, growth is much more likely to accelerate.
Look at a list of the 56 highly successful postwar economies in which growth exceeded 6% for a decade or more, on average these countries were investing about 25% of GDP during the course of the boom. Often growth picks up as investment accelerates. So, any emerging country aiming to grow rapidly is generally in a strong position to do so when investment is high and rising—roughly between 25 and 35 percent of GDP. They are in a weak position to grow when investment is low and falling—roughly 20% of GDP or less. It is hard to determine whether investment is going to rise or fall, and that judgment can only be made subjectively, by looking at the scale and promise of public investment plans and by considering whether the state is encouraging private companies to invest.
Strong growth in investment is almost always a good sign, but the stronger it gets, the more important it is to track where the spending is going. The second part of this rule aims to distinguish between good and bad investment binges. The best kinds unfold when companies get excited about some new innovation and funnel money into creating new technology, new roads and ports, or especially new factories. Of the three main economic sectors—agriculture, services, and manufacturing—manufacturing has been the ticket out of poverty for most emerging countries. Even at a time when robots threaten to replace humans on the assembly line, no other kind of business has the proven ability to play the booster role for job creation and economic growth that manufacturing has in the past.
The most successful postwar development stories, starting with Japan in the 1960s, all began by manufacturing simple goods, such as clothing, for export to rich nations. As farmers moved off the land out of agriculture and into more productive factory jobs in urban areas, the factories started investing in upgrades to make more profitable exports, moving up from clothing to steel, then from steel to flat screen TVs or cars or chemicals. Then comes a major shift. As factories pop up around cities, cervice businesses from restaurants to insurance companies emerge to cater to the growing industrial middle class. Manufacturing starts to give way to services, and investment levels off and starts to shrink as a share of the economy, because services require much less investment in plants and equipment than factories do.
As a nation develops, investment and manufacturing both account for a shrinking share of the economy, but they both continue to play an outsize role in driving growth. Manufacturing now accounts for less than 18% of global GDP, down from more than 24% in 1980, but it remains a key driver of innovation. In manufacturing economies at all levels of development, according to the McKinsey Global Institute, the manufacturing industries account for nearly 80% of private-sector research and development and 40% of growth in productivity, which is really the key to stable growth in the future. When workers are turning out more widgets per hour, their employer can raise their wages without raising the price it charges for widgets, which allows the economy to grow without inflation.
Today, many developing countries have come to recognize how important it is for them to boost productivity by investing in factories first, if they want growth without the crippling side effects fo inflation. It is no accident that emerging nations with the strongest records of investment growth also boast some fo the world’s strongest manufacturing sectors. Outside the lucky cases of small countries that hit the lottery by discovering oil or natural gas, most nations have found it impossible to even begin the process of breaking out from poverty without building manufacturing industries as an initial step.
While rising investment usually augurs well for economic growth, any strength taken too far can become a weakness. The trick is to stop short of overdoing it, which is why the ideal level of investment is capped at roughly 35% of GDP. Beyond that level, excess looms. This is a critical element of this rule, because the historic pattern shows that investment flows in cycles, and once it hits a peak at more than 30% of GDP and begins to fall, economic growth slows by a third on average over the next five years. And if investment peaks at more than 40% of GDP, growth slows even more sharply, by about half in the five years following the peak. The reasons for this slowdown go back to the basic nature of the economic cycles, which is that as a period of strong growth advances, people get complacent and sloppy, and more money goes to increasingly unproductive investments. The economy slows because the contribution from productivity falls.
When good investment binges start in manufacturing, they tend to become self-propelling for many years. The Harvard economist Dani Rodrik calls manufacturing the “automatic escalator” of development, because once a country finds a niche in global manufacturing, productivity often seems to start rising automatically. The early steps have always involved manufactured goods for sale to foreigners, not to locals. In a study of 150 emerging nations looking back fifty years, the Emerging Advisors Group, a Hong Kong-based economic research firm, found that the single most powerful driver of economic booms was sustained growth in exports, especially of manufactured products. Exporting simple manufactured goods not only increases income and consumption at home, it generates foreign revenues that allow the country to import the machinery and materials needed to improve its factories—without running up huge foreign bills and debts.
In short, in the case of manufacturing, one good investment binge seems to lead to another. Building factories generates funds for upgrading them, which then increases pressure to invest in improving roads, bridges, railroads, ports, power grids, and water systems—the infrastructure that allows a country to move manufactured goods from its factories onto the global export market. In the nineteenth century, the United States saw two huge railroad spending booms, followed by two quick busts, but the booms nonetheless left behind much of the basic network that helped make the country the world’s leading industrial power a few decades later.
People can move quickly from working in the fields to working on an assembly line, because both rely for the most part on manual labor. The leap from the farm to the modern service sector is much tougher, since those jobs often require more advanced skills, including the ability to operate a computer. For now, the rule is still factories first, not services first.
However, there’s an evolving challenge for countries such as India: it is tougher and tougher to get into the manufacturing game or stay in it. It has become harder and harder for established export manufacturers just to hold on to their customers, in part because the entire sector has been shrinking worldwide. It had become increasingly difficult to compete in international manufacturing even before the crisis of 2008, which subsequently made the field even tougher. In the boom years of the past decade, exports out of the big emerging economies had been growing at an annual pace of 20 to 30 percent, and that pace peaked near 40% in 2008 and again in 2010. But then global trade slowed, and export growth in these nations turned negative between 2010 and 2014. With competition intensifying as the manufacturing sector shrank, rich countries began moving more quickly to block the tricks (subsidizing exports, undervaluing currencies, and reverse-engineering Western technology) that the East Asian nations used to become export powerhouses back in the 1960s and ‘70s.
The other obstacle is automation. The current wave of new technology is not creating machines that can do one thing well, like sew a stitch; it is creating increasingly smart robots that seem capable of doing just about anything—driving a car, playing chess, running faster than Usain Bolt ,finding the box of needles in an Amazon warehouse and moving it to the shipping dock. Because modern factories employ more and more robots but fewer people, it will be more difficult for upcoming nations to move 25% of their labor force from farms to factories, the way the Asian miracle economies did. The digital revolution is now revolutionizing the factory floor, as 3D printers make it possible to conjure up products as varied as building materials, athletic shoes, designer lamps, and turbine blades without a human hand to aid in the production or assembly of the parts. Worse, for emerging nations, is the fact that developed nations led by the United States are far ahead in these advanced manufacturing techniques. As a result, emerging countries can no longer ride the manufacturing escalator for as long as they did just a decade ago.
The next form of a good investment binge, after manufacturing, is technology, but past records show that such booms have been confined for the most part to he leading industrial nations and in recent years particularly to the United States. They are exceedingly rare in the emerging world. India has made important inroads into IT services and in other specialized businesses like pharmaceuticals, but in a limited way. The leading emerging-world exceptions are Taiwan and South Korea. Both these countries have invested heavily in research and development—more than 3% of GDP a year over the past decade—in order to create technology industries from scratch.
South Korea, the most broadband-connected country in the world, has been creating globally competitive technology companies in a broad range of industries, from cars to consumer electronics. Taiwan’s companies tend to be smaller and are quick to respond to new global trends. The only other country that began developing broad strength in technology while it was still emerging is the even smaller and more unusual case of Israel, which was recently reclassified as a developed market. It is home to the second-most start-up companies in the world after the United States and spends nearly 4% of GDP on R&D.
The idea of a good binge may sound a bit like an oxymoron, but these binges are healthy because even if they lead to a crash, the country involved doesn’t emerge from the hangover with an empty wallet. It finds itself stronger than it was before the binge, with new canals or rail lines or fiber optic cables or semiconductor fabrication plants or globally competitive cement factories, which will help the economy grow as it recovers. In short, as the French economist Louis Gave has argued, an investment binge can be judged by what it leaves behind. The hangover from a binge on good investments in factories or technology tends to increase productivity for years after the boom has ended.
Still, for an emerging nation, even technology cannot play the same catalytic role as manufacturing because no country has figured out how to leapfrog the stage of building gbasic factories that make simple goods such as clothing, and that require only relatively simple skills that can be mastered by workers coming straight off the farm. It takes time to train those workers for jobs in more advanced factories or in more modern service industries. Tech booms also originate and remain centered in the leading technology powers, including Britain in the nineteenth century or the United States today.
The worst kinds of investment binges leave behind little of productive value, in part because they are not prompted by some hot new technology or innovation. Often the trigger that sends investors rushing into a bad binge is a chance to capitalize on spiking prices for a coveted asset, such as housing, or a natural resource, such as copper or iron ore. Home construction may accelerate for a bit, which is not necessarily a bad thing, particularly in a poor country that needs more housing. But real estate investment binges typically have a limited long-term return: A house will provide a home to one family but will not provide a steady boost to economic output or increase productivity. And since so many people dream of buying that perfect home or fantasy second home, the real estate market seems particularly prone to irrational manias.
The quality of an investment binge—whether it is good or bad for the economy—also depends heavily on how businesses pay for it. If they aggressively borrow money, whether from banks or through other forms of debt like bonds, the usual outcome when the bubble bursts is a drawn-out mess. As businesses try to renegotiate their debts and banks are forced to write off the bad loans, the credit system is paralyzed, and the economy slows down for years. But if businesses instead raise money for their investments by selling equity on the capital markets, the market sorts out the mess much faster. Stock prices fall, and owners are forced to take the hit, no fuss and no negotiation. The best way to fund a binge is by foreign direct investment, which often flows to emerging markets in the form of foreigners building or buying direct states in new factories or other businesses. As owners, they tie themselves to the fate of these projects for the long haul. This very stable source of financing can’t flee easily in a crisis.
Another kind of bad binge flows from the well-known “curse” of natural resources. Most emerging countries that invest heavily in the production of raw materials are unable to grow rapidly for nay long stretch of time, whether it is Nigeria in oil, Brazil in soybeans, or South Africa in gold. No other investment target inspires such consistently high hopes and deep disappointments. The way the curse works is that the production of oil sets off a scramble among elites to secure shares of the profits rather than invest to build roads, power plants and factories. In oil-exporting countries, the leardership becomes decreasingly reliant on revenue from taxpayers, then less inclined to listen to them as voters; instead it quites their rumblings by spending part of its oil revenue on subsidized gas, cheap food, and other unproductive freebies. Meanwhile other industries suffer. Foreigners pump in money to buy the oil, which drives up the value of the currency, in turn making it difficult for local factories—what few exitst—to export their goods. The oil windfall tends to undermine every local industry other than oil.
For richer commodity countries, the new resource is not the only source of wealth and so does not become an irresistible lure to corruption. Stronger growth follows a commodity boom if antaion manages either to save the windfall in a rainy day fund, which it can use to counter cyclical collapses in commodity prices, or to invest in industries that turn petrol into petrochemicals, or iron ore into steel, or rough diamond rocks into polished stones.
This highlights the limits of the widely hyped “renaissance” in Africa, where many economies grew rapidly in the last decade. Investment rose from 15 to 22 percent of GDP on average across the continent, but much of the money flowed into services and commodity industries. The economies that picked up speed, including Angola, Sierra Leone, Nigeria, Chad, and Mozambique, did so in large part due to rising prices for their most important commodity exports. To the extent that they attracted foreign investment, it came mainly from China and went largely into oil fields and coal or iron ore mines. Manufacturing shrank as a share of Africa’s exports, and millions of Africans actually moved backward, out of industrial jobs and into less productive work in informal shops.
There is one caveat to the curse of oil, which is that commodities can be a blessing in the short term, even for less diversified countries. The long-term “miracles” are all manufacturing companies, but on the list of 56 countries that saw at least a decade of very rapid growth, 24 are commodity economies, including Brazil and Indonesia. This is not surprising. The two-hundred-year history of commodity prices is that, in inflation-adjusted terms, the average price of commodities is unchanged. Upswings tend to last for a decade but then prices drop like a rock and stay low for around two decades, taking a number of steel- or oil- or soybean-driven economies with them, unless the leadership has taken steps to break the curse.
If manufacturing binges tend to fuel other good binges in infrastructure or technology, commodity investment binges tend to fuel equally bad binges in commercial or residential real estate. This makes it all the more important to look under the hood of any investment binge, to see where the money is going. When investment rises steadily as a share of GDP for many years, it often begins to shift from good targets to bad ones. In the late stages of a good boom, the number of opportunities to invest in high-return factories or technologies will diminish before the optimism does. That’s when people turn to investing or speculating in houses, in stocks, or in commodities like oil and gold, and the binge starts to go bad.
Of course, the worst-case scenario is little investment growth. If investment is way too low as a share of GDP—around 20% or less—and stays low for a long period, it is likely to leave the economy full of potholes and other glaring gaps. The damage inflicted by weak investment is the opposite of the damaged one by binges—a story not of excess but of stagnation and errors of omission. Countries that invest too little leave roads unpaved, schools unbuilt, the police ill-equipped, and factories suspended in the blueprint stage. This link between weak investment and weak growth is very clear because unfortunately it is so common. The number of success stories—countries that maintained a high rate of investment and thus generated strong GDP growth for a decade or more—is very low. The number of failures is very high, so the sample size is large enough to show an obvious pattern. In the postwar era, if the average rate of investment remained below 20% of GDP for a decade, the nation had a 60% chance of growing at a paltry rate of less than 3% over the course of that decade.
Crippling traffic jams in the major cities are a warning that the supply network is too weak, which is very dangerous to the economy. When it rains in Sao Paulo or Mumbai, traffic screeches to a halt because the sewers overflow. If a nation’s supply chain is built on shoddy road, rail, and sewer lines, supply cannot keep up with demand, which drives up prices. In this way, weak investment is a critical source of inflation—a cancer that has often killed growth in emerging nations.
Investment is the ccritical spending driver of growth, and a high and rising level of investment is more often than not a good sign. But high and rapidly rising investment can go to waste, so one has to watch carefully where the money is going. The quick rule of thumb is that the best investment binges are those that go toward manufacturing, technology, and infrastructure, including roads, power grids, and water systems. The worst binges tend to be in the property sector—which provide little enduring boost to the economy and often leave countries dangerously in debt—and in commodities, which tend to have a corrupting influence on the economy. Although a cas can be made that services will come to rival manufacturing as a catalyst for sustained growth; that day has yet to arrive. For now the rule is still factories first.
Rule 7: Is Inflation High or Low?
People often say that high inflation is to be expected in a developing economy. The thinking is that when a young economy is growing fast, its people will have more money to spend, and with more money chasing the available goods, prices will rise. This view follows from the standard classroom lessons, which teach that consumer price inflation can be driven by positive demand shocks such as consumer euphoria or excessive government spending, or by negative supply shocks like a sudden rise in oil prices. In practice, however, a young economy is most vulnerable to demand-driven inflation when it has invested too little in its supply networks. The supply network includes everything from power plants and factories to warehouses, and the communication and transport systems that connect them to consumers. If these supply channels fall short of meeting demand, consumer prices start rising.
High inflation is always a bad sign, and low inflation is often a good sign. In general, an economy is in a sweet spot when inflation is low and GDP growth is high, especially when growth has recently started to take off—because the absence of inflationary pressures may suggest it is the beginning of a long run. If GDP growth is picking up but inflation is rising with it, the boom can’t last long because at some point—sooner rather than later—the central bank will have to respond by raising interest rates, in order to dampen demand and subdue inflation. This increase in borrowing costs may also choke off growth. The worst case, however, is high inflation with low or falling growth, because in these conditions the central bank will still have to raise rates to control inflation, effectively putting the brakes on an economy already at risk of stalling. This can lead to stagflation, an extended period of low growth and high inflation.
The question to keep in mind: Is inflation high or low? And one way you can tell whether consumer price inflation is high or low is by comparing the rate in any one country to the recent average for its peer group. As of 2015, the recent average for emerging countries is about 6%, and the average for developed countries is about 2%.
In the postwar era, low inflation has been a hallmark of every long run of strong economic growth. Nations that post long. Runs of strong growth are almost always investing a large share of their national income, and that investment creates the strong supply networks that keep inflation low. China, Japan, South Korea, and indeed all the Asian miracles followed this model: Heavy investment drove economic growth while inflation was kept in check. The miracle economies like South Korea, Taiwan, Singapore, and China, which saw booms lasting three decades or more, rarely saw inflation accelerate to a pace faster than the emerging-world average. Although in some of the Asian miracle economies inflation was high at the start of the boom, it fell during the course of the boom. Moreover, one of the signs heralding the end of these booms was a flare-up in inflation, like sparks from a sputtering engine.
A high rate of inflation is a cancer that kills growth, attacking the living organism of the economy through several channels. Inflation discourages savings, because it erodes the value of money sitting in the bank or in bonds, in turn shrinking the pool of money available to invest. Eventually, high inflation will force the central bank to take action by increasing the price of money through higher interest rates, which will make it more expensive for businesses to expand and for consumers to buy homes and cars; as a result, the growth boom will stall. When inflation is very high—say, in the double digits—it also tends to be volatile, dropping suddenly or accelerating into hyperinflation, adding new hurdles to growth in the economy. In an environment where prices are prone to wild swings, businesses find it difficult to get financing for their projects and also can’t be confident in the likely return on their investments. If businesses are afraid to build new supply networks or improve old ones, those networks continue to fall short of meeting demand, which keeps driving up prices. The economy then becomes permanently inflation prone.
The general rule—high consumer price inflation is a bad sign—is particularly useful for spotting outliers in a world where most countries have won the war on inflation. In the 1970s the OPEC embargo sent oil prices skyrocketing. Food prices rose sharply too. As workers came to expect spiking prices at the gas pump and grocery store, they began demanding regular wage hikes to meet their basic needs, which pushed companies to hike prices for all kinds of consumer goods. The vicious “wage-price” spiral began, driving the inflation rate into the double digits in rich countries like the United States, and stagflation set in. However, the U.S. finally did whip double-digit inflation, owing to the neck-snapping interest rate hikes imposed by Fed chief Paul Volcker in the early 1980s (a move that was nearly matched at the time by the Bank of England). The U.S. economy fell into a painful recession, but this turned out to be a small price to pay, because it. Led to a long period of strong. Growth with little or no inflation.
It’s hard to overstate what beating consumer price inflation can do for political and economic stability. There is never one cause of a social revolt, but food prices in particular have played a role in many. Though the revolutions of 1848 are often attributed to the spread of democratic ideas in Europe, recent research has argued that the main catalyst was a spike in food prices, which led to the emergence of more liberal regimes in what are now Germany, Austria, Hungary, and Romania. In more recent decades Latin America has been a cauldron of inflation-driven regime change. These regime changes hit countries from Mexico to Chile and Brazil to Argentina and Paraguay. Rising prices for wheat and other grains also contributed to the 1989 fall of the Communist regime in the Soviet Union.
Before turning to deflation, it’s worth examining how the war on inflation was won, because the weapons used in that victory remain vital to preventing its return. In part, the victory was a product of opening to global trade. In the 1980s, the ‘90s, and deep into the 2000s, booming global trade fueled explosive growth in international transport, communication, and financial networks. Starting in 1980, the share of imports and exports in global GDP rose steadily from 35 to 60. Percent in 2008, when it stopped growing and even retreated a bit due to the shock of the financial crisis. Still, we live in a much more globalized world than we did before 2008, and the integration of cheap labor from China and other big emerging nations continues to put heavy downward pressure on both wages and consumer prices around the world. It is now difficult for local prices to rise quickly, because if they do, local wholesalers are no longer yoked to local suppliers. They can shop around overseas for cheaper suppliers of clothes or hammers or TV sets. For similar reasons, it is difficult for local wages to soar because producers can shut factories at home and contract production out to countries with lower wages. These are market forces, largely beyond the control of political leaders. Central bank independence has also become an important measure of a national commitment to containing inflation.
For much of the postwar era, in the political battles over central banks and easy money, the cause of fighting inflation often lost. Even in many emerging countries where the central bank was nominally independent—and the central bankers well understood the threat of inflation—they were not independent enough to resist public or private political pressure to keep interest rates and borrowing costs low. But the crises of the 1970s showed political leaders how painful inflation can be, particularly for poor- and middle-class voters, who are hit hardest by rising prices for basic staples. Those crises turned many politicians into anti-inflation warriors.
Inflation targets are effective if the central bank manages to prove to the public that it is serious—that it is prepared to increase e the price of money and induce the pain necessary to control inflation. This proof has the effect of anchoring inflation expectations, meaning that people no longer fear prices will spiral out of control, so businesses can plan for the future and workers don’t feel compelled to demand high wage raises, just to keep up with rising consumer prices. If inflation expectations are not anchored, a vicious cycle can grip a country in which rising inflation undercuts the value of the currency, making imports more expensive and further driving up both prices and expectations of inflation.
Inflation is now widely seen as an inevitable part of life, like death and taxes. But before the 1930s inflation was not the norm. According to historical records from the Global Financial Database, which go back to the thirteenth century, the global average annual inflation rate between 1210 and the 1930s was only 1%. This long-term global inflation rate is not only surprisingly low, at just 1% over more than seven centuries, it is even more striking for what the average conceals: sharp and frequent swings between periods of inflation and periods of falling prices, or deflation. Those swings ceased after 1933, when periods of global deflation disappeared and were replaced by an unbroken and unprecedented string of inflation that has lasted more than eighty years. In many countries, inflation has been as inevitable as death for only one lifetime. Before that, deflation was just as common.
The unshakeable persistence of global inflation in the second half of the twentieth century has many explanations. The growth of the banking industry and the wider availability of credit, with consequently more money chasing the available goods, probably played a major role in driving up prices. Another is that the end of the gold standard in the 1970s made it easier for central banks to print money. The result was that as periods of worldwide deflation disappeared after 1933, the average global inflation rate rose, peaking at 18% in 1974, then falling sharply over the course of the following decades to around 2% by 2015.
To reconstruct the path of inflation and deflation before modern record-keeping began in the twentieth century, investigators reconstruct price changes from sources as varied as government surveys, farm ledgers, doctors’ office records, and even nineteenth-century sales catalogs from Seers, Roebuck and Montgomery Ward, the American department stores. The measurement of price changes likely gets a bit less accurate as researchers push the story backs toward the Dark Ages, but the basic pattern of a widespread disappearance of deflation in most countries after the 1930s has been confirmed by many sources. A recent Deutsche Bank analysis of the Global Financial Database showed that before 1930, it was common for more than half of all countries in this sample to be experiencing deflation in any given year. After 1930 it was rare for even one country in ten to be experiencing deflation. And in the postwar period, only two economies have experienced an extended period of deflation—defined as one lasting at least three years. Those are the little-known case of Hong Kong—which experienced deflation for seven years, between 1998 and 2005—and the infamous case of Japan.
It is the Japan case that has given deflation a particularly bad name. Japan’s experience helps explain why the world took such a scare when deflation appeared to be rearing its head after the crisis of 2008. The world seemed to face a combination of deflationary threats similar to what had undone Japan, including heavy debt, which depresses consumer demand, and supply overcapacity. By 2015, with inflation falling to an average rate close to zero in the developed nations, the fear was that much of the world could fall into the kind of classic deflationary spiral that gripped Japan after its bubble burst in 1990.
When deflation sets in, prices don’t just rise more slowly, they actually fall. Consumers start to delay purchases, waiting for the price of the TV or cell phone they want to become even cheaper. As consumer demand stagnates, growth slows, which adds to the downward pressure on prices. Like other Asian miracle economies, including South Korea, Japan had also overinvested at the height of the boom in the 1980s, creating. An oversupply of everything—factories, office space, apartments—that had the effect of depressing price increases when growth slowed. But of the postwar miracles, only Japan fell into an extended period of outright deflation: Conumer prices fell steadily for more than two decades after the boom ended in 1990, and economic growth sputtered along at 1% during this period.
The bad deflationary spiral can be very hard to stop. As prices fall, people come to expect prices to fall further, and the only way for officials to get consumers to start spending again and halt the deflationary spiral is for the central banks to somehow flush enough money into the economy to persuade the public that prices and markets are going to rise again. That is what Japan’s central bank struggled to achieve for years during its war on deflation.
Another reason bad deflation is so hard to stop is the effect falling prices have on debtors. As prices fall, every dollar or yen or renminbi is effectively worth more, but the totals that debtors owe remain the same. The perverse result is that hard-pressed borrowers are forced to pay down loans in an increasingly valuable currency. As the American economist Irving Fisher put it at the height of the Great Depression, “The more debtors pay, the more they owe.” The deflationary spirals that struck much later in Japan and Hong Kong were similarly sustained by strong currencies and mounting debt burdens.
The problem with worrying too much about the lessons of Japan, however, is that not all deflationary cycles follow this scenario. There. Are plenty of cases of good deflation too. In The Great Wave, the Brandeis University historian David Hackett Fischer traced the records for the United States and various European countries as far back as the eleventh century and found long “waves” of time in which prices were either stable or falling, and numerous isntances in which the deflationary periods were accompanied by a high rate of economic growth. In these long periods of good deflation, the fall in prices was driven not by a self-reinforcing shock to consumer demand, but by a positive shock to supply.
These long periods of good deflation all date from before the 1930s, and they were driven by technological or institutional innovations that lowered the cost of producing and distributing consumer goods, driving down the price of those goods for long periods of time. Often, in fact, these bouts of good deflation have coincided with beneficial investment binges in new technologies like the steam engine, the car, or the Internet.
To site just a few cases of good deflation: In seventeenth-century Holland, a new opening to trade and innovations in finance sparked a golden age of inflation-free growth that tripled the size of the economy over the course of that century. A similar period unfolded during the Industrial Revolution in late eighteenth- and nineteenth-century England, where technological breakthroughs such as the steam engine, railroads, and electricity were steadily lowering the costs of making everything from flour—which could now be ground in mechanized mills—to clothing. During this era, consumer prices in England fell by half, while industrial output rose sevenfold. Falling consumer prices in this era were interrupted only by heavy state spending on the Napoleonic, Crimean, and Franco-Prussian wars.
Good deflation broke out in the United States during the early 1920s, when the economy was expanding at a near 4% pace annually, and the invention of new labor-saving devices such as the car and the truck were driving down prices for consumer goods such as food, apparel, and home furnishings. In more recent times, though deflation in general has largely disappeared at the global and national level, there have been powerful examples of good deflation in specific industries, including in the tech sector, where the innovations coming out of Silicon Valley were by the mid-1990s reducing the prices consumers paid for increasingly powerful and mobile computing power. That too was having a restraining effect on overall consumer prices.
The takeaway here is that, while low inflation is often a good sign and high inflation is almost always a bad sign, there is no simple deflation rule. One can’t say that deflation in prices for consumer products is in itself a good or bad sign. Nothing highlights this fact better than the long boom that the United States enjoyed between the late 1870s and the outbreak of World War I in 1914. During the first half of this period, deflation averaged 3% a year, and during the second half, inflation averaged 3% a year. Throughout that time GDP growth averaged a robust 3% a year.
The obvious question then is: Can you tell when consumer price deflation is the good, supply-driven kind, or the bad, demand-driven kind? The honest answer is that this is an extremely difficult task, which requires parsing conflicting forces of supply and demand. The point here is simply that since deflation became a bad word, there has been a bias toward assuming that any hint of deflation is bad for the economy, and that is not borne out by historical evidence. In 2015, for example, consumer demand was weak around the world, and debts were rising in China and other emerging countries—both signs of bad deflation. But there were also signs of good deflation. Despite the mixed signals, many voices began to argue that it was time for the world to abandon the fight against the old and clear threat of inflation in order to target the new and debatable threat of deflation.
This argument ignored how much the world has changed in recent decades. The old waves of inflation and deflation have been replaced in the postwar world by steady—but also increasingly contained—inflation. Consumer prices are generally less volatile than they once were, and compared to other kinds of prices, they are laos relatively less important as signals of sharp turns in the economy. Today changes in asset prices, particularly prices for stocks and houses, are just as important, because there is an increasingly clear link between real estate and stock market busts and economic downturns.
The rising importance of asset prices is rooted in the recent period of rapid globalization, before 2008. As a result of rising global trade and technological progress over the last three decades, producers can shop around the world for the lowest-wage factories in which to make consumer goods. And consumers can shop around the Internet for the lowest price on everything from T-shirts to chainsaws. These forces tend to stabilize consumer prices.
But globalization has had an opposite effect on asset prices, by opening up local markets to a vastly larger pool of potential buyers from abroad. With more buyers bidding for assets such as stocks and houses, prices tend to rise and to be less stable. Today foreigners are the main owners of stocks in Korea’s largest companies, including Samsung and Hyundai. And foreign buyers are one of the main drivers of escalating prices for high-end real estate in cities like Miami, New York, and London. These forces tend to destabilize asset prices and lead to more frequent boom-bust cycles, with a boom in asset prices often signaling a coming economic crash.
Every major economic shock in recent decades has been preceded by an asset bubble. Prices for housing and stocks both spiked before Japan’s meltdown in 1990s and before the Asian financial crisis of 1997-98. The stock market mania of the late 1990s in the United States signaled the coming stock market crash of 2000-1, and a brief global recession followed. In the ensuing recovery, America led a booming world economy that saw prices for both houses and stocks skyrocket, until both those markets crashed again in 2008. The world economy suffered a recession then and has been struggling to recover ever since.
Often a crash in prices of houses or stocks will depress the economy, because when those asset prices fall sharply, the result is a real decline in wealth. When people feel less wealthy, they spend less, resulting in lower demand and a fall in consumer prices as well. In other words, asset price crashes can trigger bouts of bad consumer price deflation. This is what happened in Japan, where the real estate and stock market bubbles of the 1980s collapsed in 1990 and led to the long fall in both asset and consumer prices. It is also what happened in the United States during the Roaring Twenties, when the runaway optimism of the age drove up stock prices by 250% between 1920 and the peak in 1929. Then the market crashed and was followed by consumer price deflation in the early years of the Great Depression.
The key question for our purposes: When do rising asset prices reach the bubble stage and start to threaten economic growth? One rule of thumb is that the bigger the run-up in home or stock prices, the more likely a crash. History shows that many long runs of economic growth ended in a housing price bust, so the real estate market is worth especially close watching. In general, if for an extended period of time home prices grow at a faster annual rate than the economy, be on the alert. In a 2011 paper looking into potential causes of the global debt crisis, the IMF studied seventy-six cases of extreme financial distress across forty countries and found several key indicators that seem to rise before these meltdowns, including home prices. While home prices typically rise by about 2% a year, that pace speeds up to between 10 and 12 percent in the two years before a period of financial distress.
Before World War II, only seven of fifty-two recessions followed to collapse of a bubble in the stock market or the housing market. This link has tightened dramatically since World War II, with forty out of sixty-two recessions—nearly two-thirds—following on the heels of a collapse in the housing or stock market. In general, housing bubbles took longer to reach a peak than stock market bubbles, largely because stock prices are more volatile than home prices. Housing bubbles were much less common than stock price bubbles, b ut when they did occur, they were much more likely to be followed by a recession. And once prices for either houses or stocks rise sharply above their long-term trend, a subsequent drop in prices of 15% or more signals that the economy is due to face significant pain.
But—and this is important—that pain will be much more severe if borrowing fueled the bubble. Debt magnifies these recessions. When a recession follows a bubble that is not fueled by debt, five years later the economy will be 1 to 1.5 percent smaller than it would have been, if the bubble had never occurred. However, fi the bubble is debt driven, the losses are worse. In the case of a stock market bubble fueled by debt—meaning investors were borrowing heavily to buy stock—the economy five years later will be 4% below its previous trend. A debt-fueled housing market. Bubble will have an even uglier endgame, with the economy shrinking as much as 9% compared with where it otherwise would have been, five years on.
The need to keep an eye on asset price inflation is particularly important in 2015, when many economists are warning that the world faced the opposite concern: Japan-style deflation. In response to the falling rate of consumer price inflation, they say, central banks including the U.S. Federal Reserve should keep interest rates at near-zero levels, to avoid falling into a deflationary spiral from which it could be very hard to escape. To skeptics, who respond that inflation is still the main threat, these economists argue—along with leading central bankers—that the glacial rise in consumer prices prove there is no inflation.
But there is an inflation risk, if one recognizes the threat of asset price inflation. Going back two hundred years, no major central bank had ever set short-term interest rates at zero, before the Fed did it in the 2000s, and other central banks around the world followed. These easy money policies fueled a wave of borrowing to buy financial assets, and today the United States is in the midst of an unusual synchronized boom in prices for the three major asset classes of stocks, bonds, and housing.
In the past fifty years, valuations of U.S. stocks surpassed current levels less than 10% of the time, and prices for bonds and housing are now at similar historic highs. A composite valuation for the three major financial assets in America—stocks, bonds and houses—is at a fifty-year high. In short, if one considers all these markets, this bubble has reached heights well above those hit during the bubbles of 2000 and 2007, both of which led to recessions. Yet the Fed’s argument back in 2000 and 2007 was the same as it is now: The absence of consumer price inflation means there is no inflation risk to the economy.
The Fed now leads a global culture of central bankers who see their jobs as stabilizing prices, but for consumer goods only, come what may in the asset markets. This needs to change. Today the high level of trade and money flows—compared to the early postwar period—tends to restrain consumer prices but magnify asset prices, so central banks need to take responsibility for both. It’s time to recognize that sharp shifts in prices of stocks and houses can foreshadow imminent turns in the economy.
The general rule is that low consumer price inflation is an indispensable buttress of steady growth. Any period of high growth may be doomed if it is accompanied by rapidly rising inflation. High growth is far more durable if consumer prices are rising slowly or even if they are falling as the result of a positive supply shock or good deflation. However, deflation in asset prices is almost always a negative sign for the economy and is usually preceded by a rapid run-up in the price of houses and stocks. In today’s globalized world, in which ross-border trade and money flows often tend to restrain consumer prices but magnify asset prices, watching the price of stocks and houses is as important as tracking consumer prices.
Rule 8: Does the Country Feel Cheap or Expensive?
This is a critical question for understanding a nation’s economic prospects: Does the country feel cheap or expensive? If the country has an overpriced currency, it will encourage both locals and foreigners to move money out of the country, eventually sapping domestic economic growth. A currency that feels cheap will draw money into the economy, through exports, tourism, and other channels, boosting its growth.
This rule continues to elude many political leaders, who are quick to celebrate a strong currency as the byproduct of a strong economy, which is drawing in money from all over the world. That is true—right up to the point when the country starts attracting speculative “hot money” looking to make a quick profit from gains in the currency. Local and foreign speculators will start buying assets like stocks or bonds not because they believe in the strength of the national economy or its companies, but because they believe the rising currency will increase the value of those assets, at least temporarily. For a while this bet is a self-fulfilling prophecy, as hot money adds to upward pressure on the value of the currency. This in turn tends to undermine exports and to discourage companies from making long-term investments, which soon enough hurts the overall prospects of the economy. The country will be poised to grow not when the currency starts falling but when it has stabilized again at a cheaper and more competitive value. In many countries, nonetheless, the tendency to equate currency strength with a bright economic future persists.
Framing the key question about a currency in terms of how cheap it “feels” may sound vague, but there is no better way to compare its value to other currencies. The process of measuring the value of currencies is much more nebulous than it appears. If it takes three Brazilian reals to buy a dollar today and four reals next year, it appears that one real is buying less and less, meaning its value is falling. But that is not necessarily the case, because that fall may be partly or fully countered by inflation. If prices are rising much faster in Brazil than in the United States, then the real will feel more and more expensive.
It is thus impossible to accurately measure the value of currencies unless you correct for relative inflation rates. The task grows even more difficult when measuring the value of the real compared not just to the currency of one trade partner but to all its trade partners, from the United States to China, and correcting for different rates of inflation in all these countries. Such a calculation is complex, and the resulting currency values can be confusing and contradictory. Even the most experienced currency experts will admit that there is no consistently reliable meaure. In fact, in the global foreign exchange markets, where on average over $5 trillion are traded on any given day, currency valuations don’t even feature in the conversations of most traders, who often favor buying the currencies of nations with high interest rates. As one veteran analyst put it, “In valuing currencies, nothing works.”
The most common measure is the Real Effective Exchange Rate (REER), which attempts to adjust the value of a nation’s currency for the rate of consumer price inflation in its major trading partners. There are also competing measures that try to adjust the value of the currency based on different measures of inflation, such as producer prices, or labor costs, or the rate of increase in per capita income. The minutiae of the different methods aside, the point here is that an analyst’s choice of method is subjective, and the results erratic. For instance, in early 2015, as oil prices were falling sharply, the Russian ruble collapsed in value by most of these measures, except for the one that uses labor costs, which made the ruble look expensive. This is the normal state of confusion about the value of currencies.
In an effort to improve clarity, a number of expert sources have attempted to rank how expensive countries are by creating indexes, comparing current prices for things everyone can relate. To. The granddaddy of this category is The Economist’s Big Mac Index, but as McDonald’s fall out of style, other analysts have started comparing prices for Starbucks coffee or other globally available goods. Deutsche Bank’s annual “Mapping the World’s Prices” report uses multiple categories, from the local price of the iPhone and Levi’s 501s to the cost of a weekend getaway, a date, and a haircut, but its conclusion still acknowledges the basic subjectivity of the exercise.
Getting a feel for the value of currencies is an unavoidably subjective exercise; practical people are wise to be wary of the misleadingly precise numbers that abstract models can produce. Some people may object that th prices in any country will feel different depending on where the traveler came from. Brazil may feel less expensive to Americans paying in dollars than to Europeans paying in euros or Japanese paying in yen. That can be true at times, but in general a rising currency tends to be rising against most major currencies.
Also, in a world still dominated by the dollar, the most important perspective on any currency is how it feels relative to the dollar. Even though the United States has slipped a bit as an economic superpower—it accounts for 24% of global GDP, down from 34% in 1998—it is still the sole financial superpower. The dollar is still the world’s favorite currency. One-half of the world’s economic output comes from countries that use the dollar or have currencies that are closely tied to the dollar, including the Chinese renminbi. And because the Federal Reserve controls the supply of dollars it is, now more than ever, the central bank of the world. Nearly two-thirds of the world’s $11 trillion of foereign exchange reserves are held in dollars, and that proportion has barely changed for decades. According to the Bank for International Settlements, 87% of all global financial transactions conducted through banks use the dollar on one side. That share may sound impossibly high, but it is accurate, because most global commercial deals are conducted in dollars, even if the deal does not involve an American party. A South Korean company that sells smartphones to Brazil will likely request payment in dollars, because most people still prefer to hold the world’s leading reserve currency.
The subjective feel of a currency opens up the whole question of how competitive (read: cheap) the currency is to manipulation by politicians. In the absence of an accepted standard for comparing currency values, politicians can pick a yardstick to make any case they want. Outsiders need to rely on faith that they will know an expensive currency when they feel it. The truth is that if a cup of coffee at the corner café feels overpriced, big business deals are likely to feel expensive as well.
A second and related question to ask when gauging a country’s prospects is: Is money flowing into or out of the country? If the currency feels cheap and the economy is reasonably healthy, bargain hunters will pour money in. If the currency feels cheap, yet money is still fleeing. The country, something is seriously wrong. For example, the Russian ruble had collapsed by late 2014 due to the falling price of oil, but Russians were still pulling tens of billions of dollars out of the country every month, fearing that the situtaiont would only get worse. In this case, cheap was not yet a good sign, because it was not yet cheap and stable.
The key to tracking cross-border flows of money can be found in the balance of payments, which is tracked by the IMF and which records all the legal flows of money into and out of a country. With the balance of payments, the critical category to watch is the current account, which captures how much a nation is producing compared to how much it is consuming. For most countries, by far the biggest entry in the current account is the trade balance, or the money earned from exports minus the money spent on imports. However, the trade balance alone is too narrow a measure to capture the full extent of a nation’s international obligations. For that one has to watch the broader current account, because it includes other flows of foreign income that can make those import bills easier or harder to pay, including remittances from locals working abroad, foreign aid, and interest payments to foreigners. The current account thus reveals whether a country is consuming more than it produces and whether it has to borrow from abroad to finance its consumption habits. If a country runs a sizable deficit in the current account for too long, it is going to amass obligations it can’t pay and run into a financial crisis at some point. What then is the tipping point?
In a 2000 paper, the Federal Reserve economist Caroline Freund, in a study of advanced economies, found that the current account tends to rise and fall in a somewhat predictable pattern: Signals of a turn for the worse flash when the current account deficit has been rising for about four years and hits a single-year peak of 5% fo GDP. Soon after exceeding that level, the deficit typically tends to reverse and to fall naturally, simply because businesses and investors lose confidence in the country’s ability to meet its obligations, and they pull out money. That undermines the value of the currency and forces locals to import less. The current account deficit then starts to narrow, and the economy slows significantly until falling imports bring the current account back into balance. When the current account deficit runs persistently high, the normal outcome is an economic slowdown over the next five years. If the deficit averages between 2 and 4 percent of GDP each year over a five-year period, the slowdown is relatively mild. If the deficit averages 5% or more, the slowdown is significantly sharper, shaving an average of 2.5 percentage points off the GDP growth rate over the following five years.
This research thus adds supporting evidence for the 5 percent rule. Since 1960 there have been forty cases in which a country saw its current account deficit expand at an average annual rate of at least 5% of GDP for as long as five years, and in these cases an economic slowdown was all but certain. Of the forty cases, 85% ended in a growth slowdown over the next five years, and in around 80% of the cases, there was a crisis of some kind. The growth slowdown hit many countries rich and poor, including Norway, South Korea, Peru, and the Philippines in the 1970s; Malaysia, Portugal, Brazil, and Poland in the 1980s; and Spain, Greece, Portugal, and Turkey during the period of exuberantly excessive spending in the last decade.
The bottom line: If a country runs a current account deficit as high as 5% of GDP each eyar for five years, then a significant economic slowdown is highly likely, and so is some kind of crisis. Any nation on that path is clearly consuming more than it is producing andm ore than it can afford, and it needs to dial back. Running sustained current account deficits of more than 3 or 4 percent of GDP can also signal signs of coming economic and financial trouble, just less urgently.
Below the 3% threshold, however, a persistent current account deficit may not even be a bad thing depending on where the money is going. Though any deficit shows that money is flowing out of the country, this outflow can be a plus if the money is being spent on productive imports—for example, machinery and equipment to build factories. In that case, the loans financing those purchases are supporting productive investment in future growth. The risks posed by a current account deficit depend on what kind of spending the country is engaging in. If the spending is mainly on imports like luxury goods, which do not fuel future growth, it will be much more difficult for the country to pay the import bills and loans when they come due. One quick way to check where the money is headed is to see if the deficit is rising alongside an increase in investment as a share of GDP. If investment is rising, it is at least circumstantial evidence that the money is not flowing out for frivolous consumption.
A current account deficit becomes a clear concern when it has been rising as a share of GDP for many years, and the accumulated bill grows too big to pay. Yet time and again in recent decades, the world has been gripped by currency contagions, in which investors start pulling money out of one troubled country, triggering a pullout from countries in the same region or income class even though those nations can pay their bills. In a way, the serial crises that have rocked the emerging world since the 1970s are one rolling crisis built on the recurring fear that. Poor nations won’t have the money to pay their bills. The Mexican peso crisis of ’94 begat the Thai crisis of ’97 begat the Argentine crisis of 2002 and many others, trampling more than a few innocent-victim nations along the way. At. The first signs that one emerging-world currency is faltering—as the Thai baht did in 1997—investors often flee from emerging markets in general. They do not pause to distinguish between countries that face a serious current account deficit problem and those that do not.
There is an important caveat to this rule: The definition of what constitutes a dangerously high current account deficit may well be changing. The five-year, 5% threshold is based on the pattern of currency troubles in recent decades but in a world disrupted by the global financial crisis of 2008, which ahs brought global trade growth to a hlat and led to a sharp contraction in global capital flows, that pattern may shift. Though we live in a highly interconnected world, growth in global trade flows has slowed quite abruptly. The impact of slowing global trade might not have been big if other global money flows were not in retreat, but they are. Because a current account deficit generally reflects excessive consumption of imports, any country running one has to find foreign currency to pay its import bills, and that currency can enter the country in the form of foreign bank loans, foreign purchases of stocks or bonds, or direct foreign investment in local factories. These flows show up in a separate section of the balance of payments, the capital account, and have dried up even more dramatically than trade since 2008.
The capital account includes just about every imaginable channel people can use to move money across borders, from bank loans to money secreted away in the Cayman Islands. Normally, analysts and newspaper headlines focus on one aspect of capital flows, the money invested by foreigners in local stock and bond markets, which are technically part of “portfolio flows” but are often referred to as “hot money” because stocks and bonds can normally be sold off very quickly. These flows involve trading in public markets, so they are highly visible. However, this hot money is in fact only one part of overall capital flows, and it is not the most volatile part. Alongside portfolio flows, the other main capital flows are foreign direct investment and bank loans, and in recent decades bank loans have been the most volatile of all the capital flows. Bank loans are the real hot money. They are also the key to the recent overall shrinkage in global capital flows. The main reason global capital flows reversed after 2008 is that big banks in the United States, Europe, and Japan are pulling back to their home markets, offering fewer loans overseas. This retreat was driven to some extent by concern about risks in the emerging world but mainly by new regulations imposed after the 2008 crisis. These regulations include requirements that banks hold more capital so that, at least in theory, they can better weather the next big global crisis.
Global cross-border bank flows peaked before the crisis at roughly 4% of world GDP in 2007, then swung sharply negative the next year, indicating that banks not only stopped lending but started liquidating loans to bring money home. These flows have yet to recover, and this “deglobalization of banking” will make it increasingly difficult for the United States and Britain to borrow money to support their taste for imported goods. It will also be much more difficult for them to finance their persistent current account deficits, which have averaged about 3% in the United States and 2.2% in Britain since 1990. The same hurdles now exist for any country that runs a high current account deficit and may be living beyond its means.
Countries will likely find it increasingly difficult to attract the foreign capital flows necessary to pay for their lifestyles, which means they could run into trouble in financing their current account deficits much sooner than they would have in the past. With global trade stagnating, it may be getting tougher for any country to keep its current account in balance by earning export income and easier to fall into a crisis. In the pre-2008 era, the tipping point came when the deficit had been increasing by 5% of GDP for five years in a row. In the post-crisis era, the tipping point may come faster and at lower deficit levels—perhaps at the 3% mark that central bank officials from India to Indonesia have been increasingly citing as threshold level.
Even before the optimism of the globalization era gave way to concern about deglobalization, the general consensus among economists was that most nations had gained from opening up to trade, whereas opening up to global capital flows produced mixed results. At the peak of the globalization boom, rising capital flows made it all too easy for countries to spend beyond their means and drift into financial crises. Back in 1980, how much a country saved and how much it invested had been very closely linked: If investment was growing at a steady pace, then for most countries, savings were also growing at a steady pace. But by the 2000s, that relationship had changed. Rising global capital flows had made available trillions of dollars in new funding each year. Countries no longer needed to save hevily in order to spend or invest heavily, because they could so easily tap the savings of other countries, the basic source of global capital flows. In short, countries like China, where the current account surplus peaked at 10% in 2007, were saving enough extra income to finance the often unproductive consumption habits of countries like the United States, where the current account deficit peaked at 6% in 2006. The risk was that this torrent of global capital was allowing many countries to spend more than they saved by running up foreign debts.
The old virtues of domestic thrift are now returning. This revival of national savings shows up clearly in the current account, which measures the difference between consumption and production, and that difference reveals how much nations are saving. If nations are consuming more than they produce, running up a current account deficit, they are effectively cutting into savings. Now, with global trade receding, the world’s current account imbalances, defined as the absolute value of all current account deficits and current account surpluses, has fallen by $600 billion to $2.7 trillion, or by about a third as a share of global GDP. This shows that a lot less money is sloshing across borders. After having collapsed by 2007, the link between domestic saving and domestic investment has also returned to where it was in 1980. Once again, to the extent countries are investing at all, most are funding that investment largely from their own savings.
The concern in the post-crisis era is an emerging “savings glut,” created by the lack of investment opportunities. A number of forces are contributing to this glut, but two of the most important are slower growth in the emerging world and the related slump in commodity prices. Though these forces point to slower economic growth in the new era, they also point to more stability. Many countries are relying less on strangers overseas to finance their spending habits, which may be a stabilizing force in a world where rising capital flows—particularly of the hot money variety—had been feeding the magnitude and frequency of currency crises.
It is a common perception that the large shifts in money flows that can cause currency crises are dictated by global players, many of whom emerged on the international scene during the recent decades of go-go globalization. The most powerful among these players are hedge fund moguls, fund mangers at various investment. Firms, sovereign wealth funds that invest the oil profits of petro-states like Saudi Arabia, and pension funds that handle savings for hundreds of millions of working people all over the world. However, to spot the beginning or the end of currency trouble in emerging markets, follow the locals. They are the first to know when a nation is in crisis or recovery, and they will be the first to move. The big global players mostly follow.
Often crises erupt in emerging coun tries when investors lose confidence in the economy and start pulling out their money, which undermines the value of local currency and leaves the country incapable of paying its foreign debts. The country then has to run to the IMF for a bailout. Blame often quickly falls on fleet-footed foreigners for triggering the capital flight. This natural reflex misses a few key steps in the normal sequence of events. To start with, nationalist attacks on immoral foreign speculators imply that locals are loyal and patriotic, while outsiders are flighty and exploitative. This narrative ignores the Lucas paradox, named after the Nobel laureate Robert Lucas, which questions the assumptions that money flows tend to move from rich countries to poor ones, driven by wealthy American or European investors seeking high returns in hot growth markets. Lucas pointed out that rich locals in emerging nations also have a strong incentive to move their money to richer countries with more trustworthy institutions and safer investment options, such as U.S. Treasury bonds.
Locals have been moving money out of emergin stock markets since the records began in 1995. The data on cross-border flows for twenty-one big emerging countries show that local investors were net sellers in the local stock markets every single year. Though locals in emerging economies did tend to invest the bulk of their money at home, they always sold more local stock than they bought. At the same time, foreigners almost always bought more stock in emerging markets than they sold and were net buyers every year but the crisis year of 2008 and again during the mass exodus of 2015. This should not be that surprising: Both groups were diversifying their bets, with developed world bueyrs seeking to invest part of their wealth in high-return emerging markets, and emerging-world buyers seeking to invest part of their wealth in safe developed markets. The lesson is that people move their own money mainly out of self-interest, to make more money, and not in order to prove their patriotism or to act out some evil plan to sabotage foreign natures.
In ten out of the twelve major emerging market currency crises over the past two decades, local investors headed for the exits well before foreigners. As the value of the currency reached its low point, foreigners did capitulate and move much larger sums of money than locals, but they did not lead; they followed on the heels of an earlier exodus. In eight out of those twelve major currency crises, foreigners started pulling out of local investments—calling in loans and dumping stocks and bonds—as the currency was hitting its low point. Instead of anticipating the crisis and making a killing, foreigners sold out at the bottom and lost a fortune.
Capital flight begins with locals because they have better access to intelligence about local conditions. They can pick up informal signs—struggling busiensses, looming bankruptcies—long before these trends show up in the official numbers that most big foreign institutions rely on. Savvy locals are also often the first to return. In seven of the twelve major emerging-world currency crises, locals started bringing money back home earlier than foreigners and acted in time to catch the currency on its way up. Another way to think about this pattern is that big global players know a lot less than they like to imagin, and locals are a lot smarter than foreigners give them credit for.
The capital account in the balance of payments also offers telltale signs of when local money is exiting the country in large amounts. As locals begin draining their bank accounts at home, moving cash to the Bahamas and employing other exit channels, the money will show up in the balance of payments as heavy capital outflows. Rich locals and corporations can also slip money out of troubled countries through illicit channels that show up only in the “errors and omissions” column of the balance of payments.
Even though the central message of this rule is that a cheap and stable currency is good, currency crises have been a larger part of the discussion because those periods indicate that a country has reached a turning point. For a nation that does slip into a currency crisis, the strongest sign of a turnaround is when the current account rebounds from deficit into surplus. That surplus shows the currency is likely stabilizing at a competitively low rate, boosting exports while forcing locals to cut back on imports. The crisis is passing, and the economy can dust itself off and start growing again.
If political leaders often fall prey to the illusion that a strong currency is a symbol of national strength, technocratic leaders who understand that cheap is good at times succumb to the opposite fallacy: that they can make their economy stronger by simply devaluing the currency. However, interfering to fix the price of a currency is like interfering to fix any other price in the market, which often punishes such attempts.
Markets can punish these attempts to manage currency values in many ways. The most important is that if a country has borrowed heavily in dollars or euros or some other foreign currency, then devaluing its own currency by, say, 30% is going to raise its payments on those foreign loans by an equal margin. For countries that do this, the drop in the currency will do as much damage as good to the economy; private companies will spend more for servicing their debt and less on hiring workers or investing in new plants and equipment. They also will likely end up pushing many of their citizens into default on foreign loans.
Devaluations can do other unintended damage as well. In a country that lacks strong manufacturing industries, the cheaper currency can do little to promote exports, earn foreign currency, and help balance the current account deficit. This is the classic vulnerability of commodity-exporting countries, though recent research shows that, compared to ten or twenty years ago, it is getting more difficult even for manufacturing powers to capitalize on a cheap currency. The reason is the recent global integration of supply chains, which means that many manufacturers buy a significant share of their parts and raw materials from abroad. As a result, exports now contain a larger share of imports, and if manufacturing powers try to gain an export advantage by devaluing their currency, they end up raising the price they have to pay for these imports. If a country is also highly dependent on imports of basic staples like food and energy, a cheaper currency will make it more expensive to import these essentials, in turn driving up inflation, further undermining the currency and encouraging capital flight. This is a recurring syndrome in, for example, Turkey.
These bouts of capital flight put the government in an awkward position. As foreigners start to follow locals out the door, the central bank often tries to prevent capital flight. These bouts of capital flight put the government in an awkward position. As foreigners start to follow locals out the door, the central bank often tries to prevent capital flight from precipitating a sudden and destabilizing collapse in the value of the currency. The banks spends billions of dollars from its reserves to buy its own currency, hoping to “defend” the currency, but this ends up draining the reserves and achieving only a temporary pause in the currency’s slide. That gives investors a chance to flee the country with partial losses, but their flight keeps exerting downward pressure on the exchange rate. Many currency traders joke that “defending the currency” really means “subsidizing the exit” of foreign investors. Better, from the start, to let the market decide what price it wants to pay for the currency.
It is the rare country that can deliberately devalue its way to prosperity. The pivotal devaluation in China in 1993 was one of those rare cases that led to stronger economic growth with no pain, even in the short term. China had little foreign debt, it did not rely too heavily on imported goods, and most important, it had a strong manufacturing sector, which grew even faster after Beijing devalued the renminbi. This strategy won’t work so well in Brazil or Turkey or Nigeria or Argentina or Greece, which have little or no manufacturing base. A cheaper currency in these countries will make imports morer expensive and fuel inflation but will do little, or will take a very long time, to encourage growth in exports and jobs due to the lack of export industries.
One way to think about this rule is that the less developed an economy is, the more sensitive it is to “cheap is good.” If a country exports raw materials or, for that matter, very simple manufactured goods such as garments, shoes, or processed foods, for which low prices are often the critical selling point, the more its economic fate will swing with the value of its currency. But if the country makes more expensive goods—particularly branded goods for which customers are willing to pay a premium—then the currency still matters, but less so. The classic cases are Germany and Japan, which managed to sustain their long runs of strong growth in the 1970s and ‘80s despite massive currency appreciation, because “Made in Germany” and “Made in Japan” ahd come to be seen as synonymous with exacting standards and precise engineering. The same story has played out in Switzerland; no currency has appreciated more over the last decade than the Swiss franc, yet the country’s share of global exports has remained steady when most other developed countries have seen declines. The national bank and others have studied “why Switzerland is special” in this regard, and the answer is that the country makes a broad array of exports—including drugs, machinery, and of course watches—that are so high in quality, customers stick with Swiss models even when a stronger franc drives up the price.
The way the world has been turned on its head since the crisis of 2008 suggests that the scope for devaluing your way to prosperity is even more limited now. Global trade is no longer expanding, and emerging nations battle one another for finite shares of the fixed trade pie. This si a world in which cheap currencies lone are unlikely to produce many economic stars. Playing games to devalue a currency in this environment could easily backfire. It may still work for a relatively small economy such as Vietnam, in which trade accounts for 170% of GDP, and consequently even a small increase in its share of global trade can have a sizable positive impact on economic growth. But in big economies trade matters less than the domestic market.
These growing hurdles are not likely to stop governments from trying to devalue their way to success, but at a time when the global economy is weak, globalization has stalled, and competition is growing more intense, the gambit is increasingly likely to come up empty. Even in China, devaluation is not likely to have the same impact it had in 1993. Since then China has grown to command 12% of global exports, the largest share any economy has reached in recent decades, and it is simply too big to expand much further. In fact, because China is so large, when it devalues, the ripple effects tend to force currency falls across the emerging world. In late 2015, when China devalued the renminbi by 3%, hoping to revive sagging exports, almost instantaneously the currencies of many other emerging markets fell even more sharply, more than wiping out any competitive gain Beijing might have achieved by the devaluation.
The value of a currency is best determined by the market and can be the simplest real-time measure of how effectively a country can compete on price with its main rivals for international trade and investment. If a currency becomes too expensive, it can lead to a large and sustained increase in the current account deficit, and money will start to flow out of the country. The risk of an economic slowdown and a financial crisis is extremely high when the current account deficit has been growing at an average rate of 5% of GDP for five years running. But in a world increasingly marked by “deglobalization,” the threshold level for a manageable current account deficit could be moving lower, possibly to 3%. It is still important to understand whether money is flowing out to finance productive purchases like factory equipment or frivolous ones like luxury goods.
To spot the beginning or the end of currency trouble, follow the locals. They are often the first to know when a nation is in crisis or recovery, and they will be the first to move. The big global players will mostly follow. When the current account is back in surplus, and the country is once again pulling in enough money from abroad to cover its foreign bills, it’s a sign of an impending turnaround in a country’s fortunes. Usually it takes a very cheap currency to facilitate this process. Of course, a free fall in a currency is not a good sign, particularly if the country has substantial foreign debt. And does not have a manufacturing base for exports that can benefit from a cheap exchange rate. The ideal mix is a market-determined cheap currency in a stable financial environment underpinned by low inflationary expectations: That combination will give local businesses the confidence to build, banks the confidence to disburse loans at reasonable rates, and investors the confidence to make long-term commitments to the rise of a nation.
Rule 9: Is Debt Growing Faster or Slower than the Economy?
There is a key warning signal of economic trouble: a period when borrowers and lenders get caught up in a credit mania, and the total amount of private loans grows significantly faster than the economy. It is obvious that credit crises are linked to debt, but there are infinite ways to parse the multitrillion-dollar debt markets, based on who is giving the loans (foreign or local sources) and who is receiving the loans (government or private companies and individuals), as well as how large debt burden is and how fast it is growing and over what period of time. The possible combinations are limitless. The key thing to zero in on is that financial crises are often preceded by a sustained boom in borrowing by the private sector, meaning companies and individuals.
Over the last three decades, the world has been subjected to increasingly frequent financial crises, each one setting off a hunt for the clearest warning sign of when the financial mine is about to blow again. Every new crisis seemed to produce a new explanation for crises in general. The postmortems after Mexico’s “tequila crisis” of the mid-1990s focused on the dangers of short-term debt, because short-term bonds had started the meltdown that time. After the Asian financial crisis of 1997-98, it was all about the danger of borrowing heavily from foreigners, because foreigners had suddenly cut off lending to Thailand and Malaysia when their problems became clear. These varying explanations resulted in much confusion and contributed to the general failure of most big financial institutions to see the credit crisis looming before 2008.
In studies of major credit crises going back to the Great Depression in the 1930s and in some cases even to the “tulip mania that tripped up Holland in the 1600s, the precursor—and thus the most powerful indicator of a coming crisis—was that domestic private credit had been growing faster than the economy for a significant length of time. This is a very important clue.
Although the total size of a nation’s debt—meaning the total of government and private-sector debt—does matter for the economy’s prospects, the clearest signal of coming financial trouble comes from the pace of increase in that debt. Size matters and pace matters more. It was a bad sign for Thailand that by 1997, private debt amounted to 165 percent of GDP, but a debt burden of that size would not necessarily have signaled a crisis if the debt had not also been growing significantly faster than the economy for a sustained period of time. Thailand’s debt had been growing steadily even in the late 1980s, but then it took off after 1990. In the five years before 1997, the Thai economy was growing at an annual rate of about 10%, but private debt was growing at a rate of around 25%. That runaway pace of credit growth reflected overoptimistic mood and increasingly bad lending and borrowing decisions, and it revealed that Thailand’s debt burden was increasingly likely to spark a crisis. So the clearest signal of the coming crisis was not that private debt hit 165% of GDP in 1997 but that it had risen sharply from 98% in 1992, an increase of 67 percentage points. For the purpose of spotting coming trouble, that is the magic number: the five-year increase in private credit as a share of GDP.
For the thirty most severe five-year-long credit binges going back to 1960, private credit grew significantly faster than the economy for five years running and increased private credit as a share of GDP by a total of at least 40 percentage points. In all these cases, a consistent turn for the worse came following the fifth year of the cycle, after the increase in private credit hit the 40-percentage-point threshold. Once they crossed that line, most of these countries—eighteen out of thirty—went on to suffer a financial crisis within the next five years. These slowdowns came when the period of manic optimism gave way to the realization that borrowers and creditors had overindulged at the height of the boom and now faced a painful period of penny-pinching to work off those debts and loans.
The critical question to ask about debt: Is private debt growing faster or slower than the. Economy for a sustained period? A country in which private credit has been growing much faster than the economy for five years should be placed on watch for a sharp slowdown in the economic growth rate and possibly for a financial crisis as well, because lending is running out of control. On the other hand, if private credit has been growing much slower than the economy for five years, the economy should be put on watch for a recovery, because creditors likely have cleaned up their books and are near ready to lend again.
The private sector is where debt manias typically orginate. Some trigger—often an invention or innovation—persuades people that the economy is entering a long period of rapid growth, that their future income prospects are bright, and that they can handle more debt. In the United States, credit booms have been triggered by the invent tion of the driving bell, the opening of canals and railroads, the advent of television, the arrival of powerful fiber optic networks, and the appearance of new kinds of lending tools that allowed people to borrow against the value of their homes.
At first, the impact of the new innovation does in fact boost economic growth and incomes, inspiring bright forecasts that inspire even more borrowing. This cycle of optimism can continue long after the practical impact of the initial innovation has worn off, and economists can tell that impact is wearing off because productivity growth begins to slow. Many businesses will be so caught up in the mania, however, that they will keep building railways or fiber optic lines past the point when current demand for those products justifies investing more in supply. Others start borrowing to build homes and offices, also on the assumption that the boom in demand will continue. Still others jump in offering new kinds of loans to keep the party going.
When debt is growing significantly faster than the economy, even well-run banks cannot possibly dole out so many loans so quickly without making big mistakes. The longer the binge continues, the bigger the errors, as ever dodgier private lenders get in the game, extending credit to increasingly ill-qualified private borrowers and investors. When an economic growth spurt is powered by ecredit excesses, it is prone to crumble.
Eventually, the party comes to an end due to some major financial accident, which typically occurs after the central bank is forced to increase the price of money aggressively to clamp down on the excesses. The economy then slows down sharply, and the authorities begin working to ease the ensuing credit crisis by shifting the debt of bankrupt private borrowers onto the government’s books. The government’s debt also increases as it often attempts to soften the impact of the economic downturn by borrowing to increase public spending. The idea that financial crises typically have their roots in government borrowing problems is not supported by history. The origin of the trouble is normally found in the private sector, though countries that enter the crisis with heavy government debt will suffer from a longer and deeper recession, simply because the government will find it hard to borrow to finance bailouts or stimulus spending.
The decay produced by debt is a progressive disease. Its symptoms become gradually more intense, depending on how fast the debt is growing and for how long. When a credit crisis hits, the psychology that drove the boom shifts into reverse. People lose faith in the growth prospects of the economy, in their future income, and in their ability to pay off debts. That uncertainty leads to belt-tightening, further slowing the economy. An economic slowdown after a debt binge can follow a variety of scenarios, involving some combination of a short-term pullback in the economy and a long-term fall in the trend growth rate. The standard scenario is a sharp contraction followed by a recovery to the previous trend growth rate, which was what happened to Sweden after its financial crisis in the early 1990s. The worst cases involve a contraction and then a recovery but to a new, lower trend growth rate, which will in the long run leave the economy significantly smaller than it otherwise would have been. That unfortunately appeared to be the scenario unfolding in the Eurozone after the debt crisis of 2010. It was also the path followed by Japan after its debts peaked in 1990, and by Taiwan after its debts peaked in 1992. The path a country takes depends in large part on how quickly the government can address the basic debt-to-GDP balance, either by slowing the pace of growth in debt or by reviving GDP growth, or both.
History shows that when massive credit binges start to unwind, and credit growth falls below the rate of economic growth, the immediate result is often a recession. But that is a necessary cleansing step, before a new period of healthy credit growth can begin. However, not all increases in debt are for the worse. Capitalism can’t work without a credit system that allows small entrepreneurs to borrow to fund big dreams, and there have been many good credit booms, in which credit grew—but not too fast—as a share of the economy and went to fund projects that could boost future growth. Steady credit booms can leave banks with more capital, because they earn a good return on their loans, and with improved lending practices, they offer legitimately creative credit products.
So now to the upside rule: If credit has been growing slower than the economy for five years, it suggests that the banking system is healing, creditors are getting ready to start lending again, and a period of healthy credit growth is in the offing. In fact, the more slowly debt has been growing as a share of GDP over a five-year period, the more likely it is that the economy will witness an increase in growth, boosted by healthy credit, in the ensuing years.
To restart a banking system from zero, two steps are critical. The bad loans need to be recognized and removed from the books, or the debt burden will act as a drag on lending for years; and the banks need to be “recapitalized,” which means provided with fresh capital, which can be done either by the government or by new owners, so that they have money to start making new loans.
Dealing with bad loans always poses a political problem in deciding who will suffer the pain. Authorities can make the borrowers take the hit, by forcing them into default or bankruptcy or by allowing the lender to seize their cars or homes. Or they can press lenders to forgive the debt of the borrower either in its entirety or by offering some relief in the form of easier repayment terms or lowering the total amount owed. After 2008, one reason the United States bounced back faster than Europe is that in most states U.S. law makes it relatively easy for homeowners to default on their mortgages. This helped clear bad debt from the system. One way or another, the beginning of the end of a credit crisis often arrives not when the debts start to be repaid but when they begin to be resolved through forgiveness and relief, or foreclosure and default.
Another strong signal that a debt crisis is bottoming out can be found inside the banks. Typically, when a bank is disbursing more money in loans than it holds in deposits and relying on outside funding to fill the gap, it could face trouble. If its loans amount to more than 100% of deposits, the bank enters a risky zone, and past 120%, it faces a crisis warning. After the crisis hits, the ratio of loan to deposits will start falling, as the bank curtails lending, writes off bad loans, and eventually begins to attract deposits again. In general, when total loans fall back under roughly 80% as a share of total deposits in the banking system, banks will be poised to start lending again. This return to banking system balance—with deposits in healthy proportion to loans—has marked the revival in credit and economic growth in many post-crisis countries.
After the humiliation of a debt crisis, badly burned borrowers and banks often fall prey to “debtophobia”—the fear of taking on debt or giving out credit. Consumers and businesses want only to retire their debts, not to embark on new ventures, while banks are afraid to lend to these shell-shocked customers. Without credit, a recovery will generally be very weak, with GDP growth rates around one-third lower than in a normal credit-fueled recovery. It takes a trigger to restart a credit boom, some new innovation or change in the economy that gives people reason to believe that that their incomes will go up in the future so they can afford to take on debt and business risks.
Rising debt levels can be a sign of healthy growth, so long as debt is not growing too much fster than the economy for too long. The level of debt may matter at some unknown point, but the pace of increase in debt is the most important and clear sign of a shift for the better or worse, and the first signs of trouble often appear in the private sector, where credit manias tend to originate. The psychology of a debt binge not only encourages lending mistakes and borrowing excesses that will retard growth and possibly lead to a financial crisis, but also leaves a mental scar that can last long after the crisis has passed. Once the symptoms of debtophobia start to lift and banks are ready to lend again, the country will feel free of debt burdens and be ready to grow again.
There are four basic signs of a stock market bubble: prices rising at a pace that can’t be justified by the underlying rate of economic growth; high levels of borrowing for stock purchases; overtrading by retail investors; and exorbitant valuations.
Rule 10: How is the Country Portrayed by Global Opinion Makers?
The question to ask of any country: How is it portrayed by the global media? The longer an economic boom lasts, the more credible a country’s track record appears to the media and the more warmly they embrace it as the economy of the future. The more this love deepens, the more alarmed one should get. Long runs of sustained growth are rare. And the faster an economy booms, the shorter its growth run is likely to be.
If a period of strong growth approaches the five-year mark, the default assumption should be that the growth spurt is nearing its end. And yet, many observers assume that strength will build on strength. The praise they shower on economies in the midst of growth booms only sows the seeds of collapse—it makes national leaders too complacent to keep pushing reform and attracts more foreign capital than the country can handle. When a crisis hits, the media’s love turns to hate.
The next stars often emerge from among countries that have fallen off the media radar—or were never on it in the first place. They start to flourish—or recover momentum—when left alone to put their economic house in order, and it is only after they record several years of strong growth that the media discover them. By then, the run may be nearing exhaustion. The basic rule: the global media’s love is a bad sign for any economy, and its indifference is a good one.
The single strongest conclusion of postwar research on economic growth is that all economies tend to “regress to the mean,” or fall to the historic mean GDP growth rate for all countries. (That mean rate is about 3.5%, or 1.8% for per capita income growth.). Forecasters seem to ignore the tendency of economies to regress to the mean. Institutions like the IMF and the World Bank have been issuing forecasts that feed positive media hype for emerging economies, whether they were hot or not, and have an especially difficult time predicting turning points.
Although the fortunes of commodity economies have strong links to volatile price swings, the hype for them is often driven by an emotional form os straight-line thinking derived from the Malthusian disaster scenario. Ever since the English scholar Thomas Malthus first predicted in the early nineteenth century that rising lgobal population would outpace farm output and lead to mass starvation, experts have put forth pessimistic theories every few decades, if not every few years, despite Malthus’s prediction never having been realized. These scenarios keep getting it wrong for the same reason that Malthus did. They underestimate the capacity of farmers, or oil and steel magnates, or producers of any other commodity to innovate and increase supply. In the post—World War II era, global food prices adjusted for inflation have fallen at an average annual pace of 1.7%, in large part because when prices rise, farmers earn more income and invest in better fertilizers and more efficient combines and tractors—to increase supply. The biggest enemy of high prices is high prices, as producers ramp up investment in new supplies.
Why is it so difficult for any economy to sustain strong growth? One popular explanation is the middle-income trap, which holds that a poor nation can grow at catch-up speed by making simple improvements such as paving roads but will find it difficult to sustain rapid growth when it hits a middle-income level and needs to develop more advanced industries. The truth, however, is that “development traps” can knock countries off track at any income level. The challenges of creating productive industry—backed by better banks, schools, and regulators, and fueled by steady infusions of investment and credit—do not accumulate and confront an economy all at once. They hound an aspiring nation at e very step of the development ladder. The task of generating brisk growth is easier in a poor country, where just building decent roads and other simple steps can boost the economy.
The list of the world’s fastest-grwoing economies by decade is remarkable for its number of unsung stars, and for the rate of churn. Rarely did economies stay on the list for two decades in a row. Few expected Brazil to fall off the list after 1980, or for China to jump on. Hardly anyone expected Japan to drop off after 1990, or for Russia to climb aboard to the following decade. And every decaded tossed up new names—from Iraq in the 1950s to Iran in the ‘60s and Malta in the ‘70s—that flamed out in the next decade. More often than not, countries are at the verge of disappearing from the list when the global media are most in love with them, and they are preparing to join the list when they are in the shadows. The next leaders typically emerge from among the past laggards: During this decade the Philippines became the hottest economy in the emerging world, and now formerly stagnant Mexico is the Latin American economy most likely to accelerate in the near term.
Indifference is also a good sign, because when booms go bust, the media come in and conduct an autopsy on the bloated corpse of the economy, laying bare all the excesses of overspending and unpayable debts that a country racked up in the late stages of its boom. The government sets up commissions to close banks and dispose of bad loans, replace corrupt and incompetent figures at leading state companies, and push reform designed to make sure the same crisis doesn’t recur. The house cleaning can take several years, depending on the scale of the crisis. One should act on the advice first offered by Baron de Rothschild in the 1870s and repeated by others many times since: The best time to buy is “when there is blood in the streets” and prices are presumably at rock bottom. The problem arises when the bloodied country stays that way for some time. Economies are most likely to turn for the better not during. The period of hate but when. The media have moved on to the next story, leaving the crisis-hit country alone to work on cleaning up its mess.
In conclusion, remember that the longer a growth spurt lasts, the less likely it is to continue. The most-loved nations will rarely have the best economic prospects in the next five to ten years. The most-hated nations, on the other hand, are often the object of widespread criticism for a reason, generally an outbreak of political protest or financial crisis that has exposed genuine vulnerabilities and will take some time to address. It is after these crisis-struck nations fade from the media glare and join the ranks of the forgotten countries that they are likely to emerge as the nest success stories. The most promising form of hype for any country is none at all.