Emerging Markets Are Here to Stay

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Essay

Dutch Tulips and Emerging Markets: Another Bubble Bursts

Paul Krugman

After the Cold War, everyone believed the world was going capitalist in a hurry. Developing countries followed America's advice to them--"free your markets and strengthen your money." In fact, the gains from both free trade and sound money were overstated. But the force of conventional wisdom ostracized cautious voices. The result was a speculative binge in emerging markets. With the Mexican crisis, the bubble has burst. Politicians in developing countries could continue their reforms only so long as investment poured in. Sooner or later, a reality check was inevitable. Disappointing growth and statist retrenchment may lie ahead.

Paul Krugman calls into question the future of emerging markets ("Dutch Tulips and Emerging Markets," July/August 1995). He argues that the efficacy of the "free markets--sound money" model--the so-called "Washington consensus"--was oversold, leading to foreign investments based on hope rather than performance. The recent successes of the emerging markets, he argues, are a "classic speculative bubble," possessing no more substance than the seventeenth-century investment craze in Dutch tulips. The Mexican crisis that began last December is, Krugman concludes, "likely to be the trigger that sets the process in reverse," with "a downward cycle of deflating expectations" in store for the rest of the decade.

The fundamental flaw in Krugman's argument lies in equating the future of emerging markets with the accuracy and longevity of the Washington consensus. Certain recommendations of the consensus, such as trade liberalization, may not immediately result in growth, but underlying economic, political, and social forces have irreversibly transformed the countries usually referred to as "emerging markets." Despite predictable setbacks in the development process and some experimentation with alternative policies, these broad forces will drive continued reform, growth, and investment in emerging markets.

In his desire to make a sweeping generalization, Krugman fails to differentiate among emerging markets--the very error made by the market optimists he so correctly criticizes. But the problems Krugman trumpets are limited to certain countries recovering from the debt crisis in Latin America. While Mexico's annual real growth in GDP over the last few years has been undeniably low, increasing less than 1 percent in 1993, Thailand's has increased between 8 percent and 13 percent each of the last eight years. Indeed, Asian emerging markets have performed spectacularly over the last 20 years, going back to before the Washington consensus was even thought of; annual increases in real GDP averaged more than 6 percent between 1975 and 1982 and 7.5 percent thereafter, according to the International Monetary Fund. Chile and Colombia have also experienced steady growth over a sustained period. Even the overall long-term growth rate for emerging markets has been much higher on average than rates in the countries Krugman highlights, and the IMF and the World Bank as well as leading private sector economists predict these high rates will continue.

Krugman assumes that all emerging markets are equally dependent on a monolithic "world market" for funds, with equally devastating implications. In reality Mexico was uniquely dependent on external capital flows, which made it extraordinarily vulnerable. The beginning of the decade marked a critical transformation: the cumulative net outflow of approximately $15 billion from 1983 to 1989 became a cumulative net inflow of $102 billion from 1990 to 1994. During the same periods, capital flows into all of Asia went from $117 billion to $261 billion. In 1993 Mexico attracted $31 billion, 20 percent of net capital flows into all emerging markets combined.

Latin America, and Mexico especially, have been more vulnerable than Asia not only because of the sudden reversal in capital flows but also because of the composition of investment. Between 1990 and 1994, 66 percent of net capital flows to western hemisphere countries were concentrated in yield-sensitive and liquid portfolio investments, compared with 24 percent in Asian countries. The greater long-term stability of foreign direct investment, which dominates in Asia, has been proven conclusively, as multinational corporations seek out new markets and low-cost manufacturing. Krugman's scenario of a monolithic market retreating worldwide because of disappointing economic performance in certain countries is simplistic conjecture, not based on hard evidence.

The adoption of free market reforms around the globe is explained not by any Washington or New York group's policy recommendations but by fundamental forces in international economics and politics. The demise of the Soviet Union created an economic crisis, as exports and foreign exchange plummeted overnight in states representing the majority of the world's emerging market population, from the former Soviet republics and East European countries to India and China, Cuba and Vietnam. Worldwide, pragmatic economic priorities rather than East-West political alignments formed the new basis for relations between states. After the Cold War, governments find their policy choices almost without exception confined to a set of options that promote growth and global integration.

Inside the emerging market countries, radically and irreversibly transformed economic policies have in turn given rise to new internal economic forces, new political interest groups, and that tremendously powerful social force, consumerism. The new groups reinforce the new policy choices. Established business leaders have been co-opted as well, as some profit from the policy changes by selling off businesses to new investors, expanding into new export markets, or developing businesses previously prohibited. A fresh dynamic has been established in each country, working to further integrate economic interests across national boundaries. While this still allows for a range of policies, as evidenced most clearly in Asia today, all are variations on the basic principles of the Western free market model.