Why Advanced Economies Need to Learn From Developing Nations
Since the onset of the global financial crisis, I have pointed out that advanced economies should learn policy lessons from the experience of the developing world. This argument has been reinforced by two developments last week: the destabilization of the pound after the Brexit vote in the U.K., and indications that the U.S. now has less influence over the yield curve for its government bonds.
For decades, three key beliefs structured our understanding of the economic and financial underpinnings of most advanced countries: that underlying structural forces had matured into understandable, transparent and very gradual drivers of change; that institutions were stable and well-functioning, and that these two solid foundations could withstand the vagaries of short-term political cycles. This meant that advanced economies were believed to inhabit an analytical “cyclical space,” where secular and structural changes occurred extremely slowly.
This characterization made the job of analysts and policy makers a lot easier, at least on the surface. Rather than having to deal with significantly more complex structural issues, the main task of these experts boiled down to understanding and managing business cycles. With time, even the dynamics of the business cycle were perceived to be conquerable, giving raise to the notion of persistent “goldilocks” (neither too hot, nor too cold) economies and a “great moderation.”
This framework, however, has proved both misleading and dangerous, particularly as it played down or ignored four important underlying developments:
1. The ever-increasing levels of debt and leverage needed to maintain the sense of economic and financial stability, however superficially
2. Greater and more distorting malinvestment in artificial rather than genuine drivers of growth and prosperity
3. A worsening trifecta of inequality (income, wealth and opportunity), and
4. Growing political polarization that fuels and is fueled by a widening distrust of the political establishment, business elites and expert opinion
It is clear that over the preceding decade, structural foundations of advanced countries started to revert to features that are more prevalent in emerging economies, particularly those with weak institutions, insufficiently deep economic and financial underpinnings, fluid social fabrics and messy politics. Yet much of the decision-making mindset continued to cling to a cyclical understanding of the economy.
Excessive reliance on a cyclical approach is the main reason that analysis and policy making in advanced economies have disappointingly lagged reality, especially in the aftermath of the global financial crisis. This also explains why most Western governments have been let down repeatedly by economic outcomes, why they frequently have been forced to revise their expectations downward and why outcomes have so often fallen short of even these lowered expectations.
The adverse consequences were not limited to overly unbalanced analysis and partial economic management responses. Consistently disappointing economic conditions also have fueled political polarization, which, in turn, has complicated economic management.
It’s no wonder that advanced economies have experienced the kind of events that are unfamiliar (and in some cases, deemed improbable or even unthinkable), but are quite common in the emerging world. The most striking of these include:
- The stubbornly persistent new normal of unusually sluggish economic growth despite huge monetary policy stimulus
- High levels of underemployment and/or unemployment
- The risk that an alarming number of young people could go from being unemployed to joining the ranks of the unemployable
- The euro zone’s debt crisis
This is why officials from advanced economies would be well-advised to be more open to the lessons from the developing world. Indeed, last week provided yet more illustrations of the unusually fluid structural conditions in the West and, therefore, the need for greater intellectual and analytical curiosity.
The shock Brexit vote brought volatility to the pound, unanchored by fluidity in both the current and capital account of the U.K.’s balance of payments. It suddenly introduced structural complexity to the U.K.’s commercial relationships with its most important trading partners, which, combined, also constitute the largest economic area in the world. Simultaneously, a central attraction for companies to set up shop in the U.K. -- the ability to serve the whole EU -- also is in play. This raises questions about the future of foreign interests implanted in Britain and, more immediately, will slow inflows of direct investment and portfolio capital.
This kind of uncertainty, which is more common to developing than advanced economies, can severely destabilize the currency. What’s more, these developments are taking place as the Bank of England -- unusually -- lacks feasible and effective interest-rate measures to stabilize its foreign exchange markets.
The U.S. also finds itself in an unusual situation, though it is a lot less extreme.
As a large country, the U.S. traditionally has had control over both its economic and financial destinies. Although it still can determine its economic future, it has less control when it comes to the yield curve on its Treasuries, which has been exceptionally subject to influences from abroad.
The consequence is that neither the level of U.S. interest rates nor the relative valuations of various Treasury bond maturities is now closely linked to domestic economic fundamentals. Instead, rates and relative prices are more indicative of the economic and policy prospects in Europe (and, to a lesser extent, Japan). That means the Fed must spend an unusual amount of time assessing external developments and the way they affect domestic variables.
None of these developments is likely to go away soon. In fact, we are likely to see an even longer list of improbables and unthinkables come to pass in the advanced world. And Western policy makers will have an even more urgent need to supplement their conventional economic understanding with insights from the experiences of the developing world.
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