Waving or Drowning: Developing Countries After The Financial Crisis

Yilmaz Akyuz

More than five years since the outbreak of the global financial crisis, the world economy shows little sign of stabilizing and moving towards strong and sustained growth.  Because of policy shortcomings in removing the debt overhang and providing strong fiscal stimulus to make up for private sector retrenchment, the crisis in the US and Europe has been taking too long to resolve.  While deleveraging continues to stifle private demand, economic activity is further restrained by fiscal drag in these two epicentres of the crisis as governments have turned to fiscal orthodoxy after an initial reflation.  There has been excessive reliance on monetary policy through provision of large amounts of liquidity to financial markets and institutions at close-to-zero interest rates, using unconventional means, generating financial fragility and exchange rate instability in emerging economies, as well as potential unintended and not well-understood consequences for future financial stability in AEs.

Developing countries (DCs) are not decoupled from AEs, contrary to what was widely believed during their unprecedented growth in the run-up to the global crisis.  With continued instability and downturn in AEs, the structural weaknesses in DCs are exposed.  Although conditions in global financial and commodity markets have generally remained favourable since 2009, the strong upward trends in capital flows and commodity prices that had started in 2003 have come to an end and exports to AEs have slowed considerably.  Growth in most major DCs has now decelerated significantly compared to the rates achieved before the onset of the crisis, after showing some resilience in the first couple of years of the crisis thanks to a strong countercyclical policy response made possible by their improved macroeconomic conditions during the earlier expansion.  In Asia, the most dynamic developing region, growth in 2012 was some 5 percentage points below the rate achieved before the onset of the crisis; in Latin America it was almost half of the pre-crisis rate.

The longer-term global growth prospects are clouded by persistent structural imbalances and fragilities that culminated in the current crisis.  The world economy is facing underconsumption because of low and declining share of wages in national income in all major AEs including the US, Germany and Japan, as well as China  ̶  countries that have a disproportionately large impact on global economic conditions.  There has also been an increased concentration of wealth and growing inequality in the distribution of income earned on real and financial assets largely due to finance-driven globalization.  Still, until the Great Recession the threat of global deflation was avoided thanks to consumption binges and property booms driven by credit and asset bubbles in the US and a number of other AEs, particularly in Europe.  Several Asian DCs, notably China, also experienced investment and property bubbles while private consumption grew strongly in many DCs elsewhere, often supported by the surge in capital flows and asset and credit bubbles.  This process of debt-driven expansion, in its turn, led to mounting financial fragility in the US and the EU and growing global trade imbalances, with the US acting as a locomotive to major surplus countries, Germany, Japan and China, as well as to imbalances within the EZ, culminating in the most serious post-war economic crisis with which the world is still grappling.

In none of the major AEs and China is there a tendency for a significant reversal of the downward trend in the share of wages in national income and a more equitable allocation of wealth so as to allow rapid economic expansion based on income-supported, as opposed to debt-driven, household spending.

In the US where the downward trend in wage share started in the 1980s, in the past two decades consumption and property booms and economic expansions were driven primarily by asset and credit bubbles  ̶  first the dot-com bubble in the 1990s and then the subprime bubble in the 2000s.  The current crisis has led to a greater concentration of income and wealth.  On current policies the US cannot move to wage-led or export-led growth.  Rather, it may succumb to the temptation of letting the current ultra-easy monetary policy degenerate into credit and asset bubbles and produce a rapid expansion, very much in the same way as its policy response to the bursting of the dot-com bubble gave rise to the sub-prime boom, while exploiting the “exorbitant privilege” it enjoys as the issuer of the dominant reserve currency and running growing external deficits.

Such a return to business-as-usual could be disastrous for the world economy, not just for the US.  If, on the other hand, asset and credit bubbles are not allowed to develop and boost aggregate spending, the outcome could be sluggish growth, sharply increased interest rates and stronger dollar  ̶  a combination that often breeds problems for DCs.

The EZ appears to be mired in economic weakness for an indefinite period.  The resolution of the underlying problems of debt overhang in the periphery and intra-EZ imbalances in trade and competitiveness requires a wage-led growth in Germany, but this is quite unlikely under its current policy approach.  In all likelihood, the structural reforms that are now being advocated would extend wage suppression from the core to the periphery and widen the deflationary gap.  The periphery may find it necessary to join Germany in the search for export-led growth.  Thus, the region cannot be expected to generate expansionary impulses for DCs even if it manages to restore stability in the crisis-hit periphery.

China has moved to investment-led growth as its exports slowed sharply as a result of the crisis and contraction in AEs, and this has added to credit and property bubbles already under way.  This pattern of growth cannot be sustained indefinitely.  Despite the recognition of the need to raise the share of the household income in GDP and move to a consumption-led growth, the distributional rebalancing is progressing very slowly.  Whether or not China can avoid a financial crisis and a hard-landing, over the medium-term it is likely to settle on a lower growth path with a gradual rebalancing of external and domestic sources of demand and domestic investment and consumption.  Given the central role it has played in the commodity boom in the 2000s, and as a new source of investment in resource-rich DCs, notably after the onset of the global crisis, a permanent slowdown in China, together with a strong dollar, would not bode well for commodity-dependent DCs.

All these imply that there will be no more Southern tail winds.  Even if the crisis in the North is fully resolved, DCs are likely to encounter a much less favourable global economic environment in the coming years than they did before the onset of the Great Recession, including weaker and unstable growth in major AEs and China, higher interest rates, stronger dollar and weaker commodity prices.  Indeed, they may even face less favourable conditions than those prevailing since the onset of the crisis, notably with respect to interest rates, capital flows and commodity prices.  Consequently, in order to repeat the spectacular growth they had enjoyed in the run-up to the crisis and catch up with the industrial world, DCs need to improve their own growth fundamentals, rebalance domestic and external sources of growth and reduce dependence on foreign markets and capital.  This requires, inter alia, abandoning the Washington Consensus in practice, not just in rhetoric, and seeking strategic rather than full integration into the global economy.

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