|source: OECD, open-thinking.com|
Global growth has experienced what economists call a ‘structural break’: the centre of growth is moving steadily toward final demand in the developing world. This is a profound change. Unlike most episodes of broad growth in middle- and low-income economies, the developing world’s growth today is not limited to one region. It is generalised even to the poorest continent, Africa. The investment industry now compiles league tables of ‘frontier markets’, which will soon take the place of today’s emerging markets, and will cede their own spots to countries not yet on the radar.
How should rich countries cash in? Finance is one answer. Pension funds and other institutional investors in the rich world should be, and increasingly are, investing in the growth of the developing world. This approach has limits. The ascendant development model emphasizes a role for national savings. Its appeal is that it has proven resilient to shocks, whereas previous models — emphasizing not national savings but imported capital — have often collapsed in the face of a shock. The new development model is at minimum ambivalent to the role of imported capital. Best practice is to accumulate reserves to maintain a competitive currency and to ‘self-insure’ against crisis. Obviously, a lot of these countries need imported capital to grow. But they can now find it from the developing world itself, on terms the rich countries cannot match, whether for political or other reasons. Some of the biggest investors in Africa are Chinese, Indian and Brazilian private and state-owned multinationals. Their impact on the poorest economies is unmistakable.
If finance is not the West’s path to capitalising on the new centre of gravity in global growth, then what is? Trade. What should a rich economy trade with the developing world? Centuries of consideration on this topic yield the conclusion that the economy should sort out its own specialisation. Failures in the industrialised world’s efforts to ‘pick winners’ in the 1970s and 80s are a recent vindication of this viewpoint. Yet specialisation does not occur in a vacuum; policies play a role. South Korea had no particular endowment when it emerged from the Korean War in 1953, least of all in human capital (education), in which it is currently very well endowed. It was a poorer country than Ghana in per-capita GDP. The United States was founded with a stupendous resource endowment. Yet it did not specialise in this, as did a similarly endowed, similarly wealthy economy at that time: Argentina. As it happens, the US from an early stage as a new republic eschewed comparative advantage and pursued industrialisation behind the highest tariff walls anywhere in the world. It arguably set an example for Germany and for the industrialisation of economies down to the Asian NICs of today.
Here’s the thing. Specialisation is shaped by ‘relative prices’. This mundane term hides one of the most powerful analytical tools in international finance. Relative prices are the comparison of prices exhibited in the non-traded sectors of the economy to those in the traded sectors. The latter are pinned down by global trade, meaning that the two categories can follow sharply divergent price paths. This matters for specialisation because prices dictate resource allocation. Growth in non-traded prices relative to traded prices is a type of ‘real’ appreciation in the currency, i.e. an appreciation in terms that matter for the economy, i.e. price signals and resource allocation. An important nontraded (NT) sector is construction. Its relationship to relative prices is symbiotic. Construction, like other NT sectors, thrives on appreciated real currency values, in part because this keeps a lid on traded prices and wages, including inputs into the NT activity. Yet the rising resource allocation to construction in turn abets overvaluation, by raising prices in NT relative to traded sectors. The latter are left to cope with a chronically overvalued currency, and often wither.
Finance is another key NT sector. Like construction, it thrives under conditions of real currency appreciation. This is in part because the real appreciation gives it an advantaged cost of capital. Growth in financial services relative to other sectors in the economy also abets the real appreciation, as an increasing proportion of resources are diverted to the sector, pushing up its prices. The housing bubble in the most overbuilt OECD economies has burst. And, notwithstanding administrative efforts to keep it aloft, further price declines are likely. Only in Ireland has this sector retrenched appreciably from its peak. The financial sector appears to be a different story. There is a sense in which the policy consensus favours reinstatement of the status quo ante. The social sciences concept of path dependence seems apropos here: shifting the economy away from the heavy emphasis on financial services faces extreme inertia.
Bear with me. The Netherlands discovered the Groningen gas field in 1959, currently the tenth-largest in the world. As its export basket became dominated by gas, its terms of trade (i.e. the price of exports relative to imports) rose steadily. A rise in the terms of trade, like a rise in relative prices, is a real appreciation of the currency. There is, in fact, an interplay between them. A consequence of the rising terms of trade is that only sectors sheltered from global trade are able to thrive at the appreciated real exchange rate. Resources are then disproportionately allocated to non-traded activities, further exacerbating the currency overvaluation. Traded sectors, starved of resources, shrink or disappear entirely. The Netherlands was not the first to experience this phenomenon, but it is now generally termed ‘Dutch disease’.
Dutch disease is afflicting economies with outsized exposures to the financial services industry. Rather than gas or oil, the natural resource being exploited is ‘reserve currency’. Countries which issue a currency in whose value investors set some store, particularly central banks, are able to exploit this demand for the currency through financial intermediation. The United States and United Kingdom have both had or are having a long spell of issuing the world’s reserve currency. It is not possible to say anything empirically sound about the consequences of this status, because there are so few data points. (In the twentieth century there were really only two: the dollar and sterling.) But the growth in size of financial services in these countries is unmistakable.
The upshot is this: the rich countries which have avoided Dutch disease (of whatever origin) are in a good position to gain from the unprecedented growth of the developing world. Most specialise in manufacturing or other value-added activities. The United States and Britain, as heavily externally indebted economies, need to do likewise. A necessary start is to get relative prices right. To do that, financial services need to shrink. Politically, that is going to be tough.