Growing pains: the outlook on development revisited.

Cooper, Richard N.

"Only time will tell whether the developing countries will regain the
economic momentum of the 1960s and the 1970s. But 1983 may well prove to
be the worst year for them since the Second World War. There are four
principal dangers.
 First, that the world depression will continue ...
 Second, that protectionist actions by the major industrialized
countries, especially the United States and the European Community, will
restrict the imports of manufactured goods from developing countries ...
 Third, that either or both of the first two dangers could
precipitate major defaults on outstanding loans. Not only would banks
lose money under these circumstances, but the strong linkages among
banks could lead in the absence of skillful management by the leading
central banks of the world to a general seizing up of the international
financial system, as happened in the early 1930's.
 Fourth, that a prolongation of the present period of low or negative
growth, against the expectations established in the pervious quarter
century for visible progress in improved living standards, will lead to
violent political change in developing countries ..."
"The Outlook on Development"
Fall 1984

Statements about the future almost always involve extensions of the past. They may be complicated extrapolations, incorporating rates of change and even identifying turning points, but they are extensions of the past nonetheless. Few individuals genuinely identify true discontinuities, and they are usually dismissed as crackpots or are admired as intellectual entertainers rather than as serious futurologists. Some extensions of the past rely implicitly on a model of the social system under consideration, with its own dynamics and constraints. Others rely on analogies across apparently different social systems at different stages of their evolution.

[ILLUSTRATION OMITTED]

However, they too implicitly (or occasionally explicitly) assume a common model for different systems, such that the observed characteristics and dynamics of one system can be informatively applied to other systems. For instance, the rise of Germany from 1870 to 1914 and its challenge to the leading power of the day, Great Britain, is said to suggest an informative warning about the current rise of China and its potential challenge to the leading power of the day, the United States.

Analogies, of course, are tricky, and it is crucial to get the matching points right. People usually neglect, in the above analogy, that the more significant rising power with respect to Britain was not Germany, but the United States, and the United States did not challenge Britain to combat, as Germany did. Analogies are colorful, and often pedagogically useful for driving a point home. But they too often substitute for serious analysis, permitting the user to avoid specifying exactly what are the key elements of similarity between the two systems or events being compared, and the dynamics that drive them--that is, without specifying explicitly the underlying model that supposedly covers both cases, even though they may be separated by a century or more in time.

With respect to developing countries in the mid-1980s, I had in mind the existence of a reasonably well-functioning (but not trouble-free) world economy with the key economic determinants being the level of economic activity in its largest national economies (the G-7 for short: United States, Japan, Germany, Britain, France, Italy, and Canada, in order of size of gross domestic product) and their policies toward imports from the rest of the world--all set within a cooperative institutional framework that was basically established after the Second World War, involving the rules, procedural frameworks, and attitudes of the International Monetary Fund (IMF) and the General Agreement on Tariffs and Trade (GATT, now transformed into the World Trade Organization).

If the G-7 economies were growing well and maintaining open markets, the world economy presented a permissive environment for growing economic prosperity in other countries. It did not, of course, assure economic prosperity; that depended as well on the institutional structures and the economic policies of other countries. Many poor countries, in fact, passed up the opportunities permitted, while others, such as Japan, South Korea, Hong Kong, Taiwan, Malaysia, Chile, Greece, Portugal, and, beginning in the early 1980s, China, exploited them.

If, however, economic developments went badly wrong in the G-7, either in terms of economic recession or heavy protection against imports, other countries would find it difficult to sustain growing economic prosperity no matter how good their institutions and their policies were. In other words, G-7 openness and prosperity were necessary but not sufficient conditions for growing prosperity in smaller, poorer economies.

In the event, the world economy generally avoided truly bad outcomes in the post-1984 period. The G-7 were doing well economically in the period from 1984 to 1990, when a minor recession occurred in the United States. This recession was precipitated by Iraq's invasion of Kuwait in August 1990, leading to a sharp increase in the price of oil to over US$40 a barrel, reminding the US public of similar increases in 1974 and 1979-80, each of which was followed by severe recession. That association in turn precipitated a sharp drop in consumer confidence and in consumer spending, leading the United States into recession (a downturn in total production for two or more quarters), albeit one that was much shallower than the oil-shock recessions of 1975 and 1982. The policy mistake by the administration of US President George H.W. Bush was to not make clear at once that if necessary the Strategic Petroleum Reserve (built up to deal with a significant interruption of oil supplies) was available and to take publicly visible steps to activate it. That might not have been enough to avoid a recession, but on the other hand it might have been--we will never know.

Predicted Protectionism

Serious protectionist policies were avoided during this period, but pressures for protectionist actions were strong in the United States, as foreshadowed in the 1984 article. The dollar had strengthened greatly against other leading currencies during the period from 1979 to 1985, and US manufacturers were feeling strong competitive pressures from imports--especially in automobiles, when then, as now, US manufacturers strove to sell large cars with high unit profits, just when the US public, driven by the high oil prices of 1980-81, shifted their demand to smaller, more fuel efficient cars.

[ILLUSTRATION OMITTED]

Reading the hostile congressional sentiment, Japan imposed restraints on its auto exports to the United States, and Japanese auto firms began to invest in the United States. The Plaza Agreement among finance ministers of September 1985 reflected an effort to head off protectionist legislation by depreciating the dollar, and the administration of US President Ronald Reagan had to beat off many Congressional protectionist proposals in what became the Trade and Competitiveness Act of 1988. Even then, "super 301" of that Act pushed the Administration into threatening countries that were deemed, on a variety of criteria, to be engaging in "unfair" trade with the United States. This provision was later weakened with the conclusion of the Uruguay Round of multilateral trade liberation in 1994.

While Americans talk as if they merely want a "level playing field" in international trade, several aspects of US policy are heavily stacked in favor of US producers (a similar claim can be made with respect to the European Union and, with different mechanisms, to Japan). So-called "anti-dumping" duties, conceptually designed to prevent predatory pricing by individual foreign firms, have been turned into devices for wholesale selective protection on particular products against not just one firm, but many from several countries at the same time. Any sales in the United States below "fair market value," an artificial construction of dubious merit, are actionable if material injury is threatened against a US "industry," which is inappropriately defined narrowly to be virtually the same as a product. Once anti-dumping duties are imposed, they are difficult to remove despite a five-year sunset provision. In short, "fair trade" is too often a euphemism for protection, protection that on any layman's use of the word "fair" would be judged extremely unfair.

Decades of Debt

The debt problems of the early 1980s gradually receded, as the commercial banks rebuilt their capital and sold off their claims on the governments of developing countries, particularly in Latin America, and as new loans and rescheduling occurred along the lines discussed in my 1984 article. By 1988 US Secretary of Treasury Nicholas Brady could propose a selective reduction in debt burden, and starting with Mexico a series of "Brady bonds" were issued to extinguish some of the bank debt at discounted rates; such bonds continue to trade today, 15 years later. Even so, Latin Americans speak of the "lost decade" of the 1980s, a period of low economic growth attributed to their attempts to deal with the heavy debt burden inherited from the 1970s and early 1980s. Asian economies, in contrast, performed much better, partly because of lower debt, partly because of better export performance, rendering it easier to service their external debts.

More debt crises occurred during the 1990s, this time, to the surprise of many, extending to Asian countries. But the first banking and foreign exchange crises of the 1990s occurred in Europe, starting in Finland and Sweden and then quickly spreading to countries that signed the Maastricht Treaty to create a common European currency--Italy, Spain, and Britain were especially affected. Then it was Mexico's turn from 1994-95. In 1997, a crisis erupted in Thailand and quickly spread to Malaysia, Indonesia, and other countries of Southeast Asia. Korea's turn came in December 1997, Russia in August 1998, and Brazil in October 1998 extending into 1999. The details differed in important ways in each country. Some, such as Thailand, had exemplary fiscal policies but far too lax supervision of its banks, which borrowed extensively abroad and in foreign currency to finance domestic real estate development.

When the real estate bubble burst, loans went bad, foreign interbank loans could not be repaid, and a foreign exchange and banking crisis erupted. Pressure of foreign bank withdrawals spread to other Southeast Asian countries, slowly at first, later with greater virulence. Korea had its own dynamic, which occurred shortly afterward but basically independently of the Thai crisis. The Korean government early in 1997 withdrew its implicit guarantee of bank loans to large, heavily indebted Korean conglomerate firms, called chaebol. This radically changed the condition of Korea's financial structure, making its banks much more vulnerable than before.

In sharp contrast to the Asian countries, the governments of Russia and Brazil were heavy borrowers, both domestically and internationally, and their fiscal positions were not in good shape. The source of their crises lay largely in undisciplined fiscal policy, aggravated by the impact of higher interest rates (to defend the exchange rate) on the need to service large amounts of short-term government debt.

Each of these crises was eventually resolved, often with large programs of international support, although in the end Russia defaulted on its government obligations, to the distress of domestic and international creditors alike. The crises typically produced sharp and painful economic downturns, but in most cases these proved to be relatively short-lived as recovery proceeded relatively quickly. Indonesia was the major exception, where the economic crisis produced a political crisis with the resignation of Soeharto, Indonesia's effective ruler for over 30 years, and the uncertain beginnings of a functioning democracy.

Despite the financial crises, the 1990s was a relatively good decade for development, thanks not least to the outstanding performance of the world's two most populous countries, China and India, both of which felt some impact from the Asian crises but were spared an acute contraction. Both grew robustly during the past 15 years, India enjoying its best economic performance since independence in 1947.

It has become fashionable to blame the financial crises of the 1990s on the world economic system. It is true that foreign capital was involved in all of them and that attempts to withdraw foreign capital aggravated financial pressures on the countries in crisis. But, in general, foreign capital did not precipitate the crises. Indeed, typically foreign capital was slower to leave the crisis countries than funds owned by residents of those countries.

Characteristics of Crisis

If we can judge from the history of the United States and the leading European countries, financial crises seem to be an intrinsic characteristic of economic development, a kind of adolescent growing pain. The United States had a serious financial crisis roughly once a decade from the 1830s to the financial catastrophe of the 1930s. While foreign capital was sometimes involved, most were purely domestic in origin. As the real economy does well and as banking and other financial institutions develop, euphoria sets in. Lending the money of other people into a booming market is an excellent way to become rich.

As booms continue, especially in real estate but also in commodities, caution is increasingly shed, and many investors join the bandwagon, preferably with borrowed money. Eventually the bubble bursts, and those who joined late often face bankruptcy. New prudential rules are imposed on financial institutions. But after a decade or so, innovation around the rules has occurred and new players enter who lack the experience of those who were burned the last time. So the process is repeated, with the same underlying dynamic, but with different details. This process occurs in each growing country, independently of the international environment, although foreigners may be drawn in by the same irrational exuberance.

The principal role of the international community is thus not to prevent crises, since that is probably impossible, but rather to prevent unwarranted contagion of each crisis to economic neighbors, to help minimize the damage of the crisis through financial support, and to help head off crises through broadcasting the experiences of others in similar situations and through the identification of early warning signs and conveyance of early warnings. Even so, these things may be helpful, but they are unlikely to prevent crises. Thailand, for instance, had ample early warning from the IMF one year before its foreign exchange crisis broke, but simply ignored the warnings. Things were going too well for any politician to want to bring them to a halt, or even to slow them down.

Finally, this analysis obviously involves extrapolating from the past experience of now rich countries to the contemporary and future experience of emerging market--an example, of course, of the analogistic reasoning mentioned at the outset.

[ILLUSTRATION OMITTED]

RICHARD N. COOPER is the Maurits C. Boas Professor of International Economics at Harvard University.