The force of the US Federal Reserve (Fed) has awoken and it is set to increase its interest rates for the first time since 2008. And if it doesn’t do it today, it will in the course of 2016.
Many commentators are focusing on the implications of this for the US and Europe. But the main impact is likely to be on developing countries: Brazil and Turkey, for example, having been facing sizeable capital outflows in anticipation of the Fed’s interest rise, and are on the verge of recessions. This comes in the context of low commodity prices – on which many developing countries rely for their export revenues – and other macroeconomic imbalances. The interest rate hike, albeit small, will aggravate existing problems in the developing world.
What we are likely to witness is the third episode of “the three part crisis trilogy”, which originated in the US in 2008, migrated to the Eurozone, and is now moving to the developing world.
In the aftermath of 2008, the Fed lowered its interest rates in order to avoid a replay of a 1929-like deep depression. Prolonged quantitative easing and low interest rates may have prevented the worst in developed countries, but they also had a side effect: investors turned their eyes to emerging countries, in search of higher returns.
Capital, including speculative “hot money”, started flowing into emerging economies – increasing dollar-denominated private indebtedness in those countries. While developed countries were stagnating, it was emerging economies that kept global growth going.
Alas, what we are witnessing here is nothing but a mere replay of previous episodes: since the beginning of the era of financial globalization, every time interest rates have been low in the US, capital has flown into developing countries creating excessive leverage – indebtedness.
And then, when the Fed decides to increase its interest rates, capital is pulled back to the US, in search of safer returns. Capital outflows then trigger public and private debt crises in the most vulnerable countries. Despite differences, this scenario played out in Latin America in the 1980s, then again in Mexico in 1995, in East Asia and Russia in the end 1990s, and in Turkey and Argentina in the early 2000s. In short, this is a typical “boom and bust” pattern driven by external indebtedness, and “this time is [not] different”, again.
In the current context, crises are likely to be triggered through private debts: emerging economies corporations have been borrowing in US dollars on international markets for financing domestic investment projects. But if capital starts flowing out, currencies depreciate (or the USD dollar appreciates) and corporations are left with revenues denominated in a depreciated currency and debt liabilities in USD dollars.
In countries where leverage is high and currency reserves are low, this will lead to private sector defaults, and then cascade to governments – which will have to cover the losses. Those that are more shielded from this evolution will still get a bumpy ride, and will have to tap into their currency reserves.
Have we learnt anything?
As expected, both policy-makers in developing countries and some influential commentators are blaming the Fed’s monetary policy for this outcome. But others consider the forthcoming crises to be largely self-inflicted.
Dani Rodrik and Arvind Subramanian, for example, argue that the risks of financial liberalisation in an imbalanced global economic structure are well-known; those policy-makers in developing countries now contemplating a “bust” scenario willingly embraced financial openness. After all, they are the ones who allowed the inflow of foreign capital after 2008, and took the risks this entailed if capital was to flow back out – as now happening. Unconstrained by policy action, the “animal spirits” of investors did the rest.
What is striking in this story is not the capacity of the Fed’s monetary policy- be it expansive or restrictive – to determine the fate of other countries’ economies; rather, it is that many developing economies fell into the same old-trap.
But there are other lessons too:
First, the strong similarities among the crises occurring since the beginning of the era of globalization suggest that the problem is with financial liberalisation itself. The idea that unhindered capital flows would lead developing countries towards economic glory has been proven to be a fallacy. Reliance on external finance has often been a destabilising force, creating unsustainable growth booms – which eventually bust – inflicting social misery along the way. In fact, most successful developing countries followed unconventional policies precisely to shield themselves from the “irrational exuberance” of global financial markets.
Second, bad ideas die hard. Despite cautionary footnotes, mainstream policy making has been taking for granted that financial liberalization would enhance growth, allocate capital across the world “efficiently” and provide much-needed access to finance for poorer countries. This was notably the prescription adopted by institutions such as the IMF (at least until 2012): financial liberalisation became the “gold standard” and capital controls – to limit external vulnerability – the “villain” in the piece. Developing countries were urged to liberalise their capital accounts and let financial markets “allocate capital” freely. And most did. But, it turned out that the theories put forward by the mainstream have no empirical basis: financial openness did not translate into higher growth rates or better development outcomes. Quite the contrary.
The crisis of 2008 killed off many “certainties” in economics. The latest episode of the crisis should empower us to challenge another key policy assumption of the pre-crisis world: that of deregulated financial globalisation as a positive driving force. In the meantime, there are tools for preventing destructive boom and bust cycles. The force is with policy-makers to use them.
— source neweconomics.org