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.

Changes in the structure of domestic production, with a shift from agriculture to services and industry, along with the trend toward urbanization will continue over the long term. Emerging market cities with populations over five million increased from 11 in 1970 to 20 in 1985 and, the United Nations estimates, will number 34 by the year 2000. Multinationals worldwide have targeted the rapidly growing consumer populations in emerging markets, reaffirming the projections of continued significant growth coming from the World Bank, the IMF, and leading economists.

Social and political indicators, along with the revolution in technology, also point to irreversible and sustained changes in emerging countries. Between 1970 and 1985 enrollment in secondary schools increased from 22 percent to 38 percent among youths aged 12 to 17, and the United Nations predicts a jump to 48 percent by 2000. Leading policymakers in emerging markets now have similar educational backgrounds, many having attended American and European universities. Communications technologies have also altered the economic and social landscape. For example, telephone lines per 1,000 people have increased 242 percent over the last 20 years in emerging countries, and households with television 219 percent over the last 15 years. These technological changes have opened up political systems, heightened awareness of the wider world, created new expectations, and advanced the globalizing creed of consumerism.

While Krugman may be correct in claiming that some free market reforms--trade liberalization, for instance--do not always result directly in growth, many reforms undoubtedly do. Across the emerging markets, productivity as well as domestic and international investment have risen as a consequence of measures enacted to strengthen local financial systems, reduce burdensome regulations, and provide access to foreign exchange. In addition, virtually all emerging markets have adopted policies to augment internal public and private savings. Krugman's argument assumes capital is critical to growth, but in his focus on the international market he neglects to mention the equally important role of domestic savings and investment--key to the growth of the successful Asian countries.

Krugman states, "In sum, the real economic performance of countries that had recently adopted Washington consensus policies, as opposed to the financial returns they were delivering to international investors or the reception their policies received on the conference circuit, was distinctly disappointing." But international investors represent a distinct minority of the total investment in these countries' stock markets, and any profits the foreigners enjoy are presumably enjoyed in spades by local investors. In fact, the principal threats to economic reform lie in the internal dislocations caused by the shifts in economic and political power; witness the widespread debates on the need for social safety nets.

Krugman argues that after Mexico, "markets will no longer pour vast amounts of capital into countries whose leaders espouse free markets and sound money on the assumption that such policies will necessarily produce vigorous growth." Again, the evidence proves him wrong. The Organization for Economic Cooperation and Development reports that developing countries in Europe and Asia continued to raise international capital in the form of bonds and loans at approximately the same rate in the first quarter of 1995--post-Mexico--as during the previous five quarters. Even in Latin America, the drop in capital has not been as conclusive as in Mexico, nor has it had the far-reaching impact Krugman suggests. While the OECD reports a tremendous decline in Latin America's access to the bond and loan markets, a KPMG Peat Marwick study notes $1.9 billion in U.S. direct foreign investment in Latin America in the first quarter of this year, up 50 percent over the first quarter of 1994. Despite volatility due both to developments in specific countries and to cyclical factors such as interest rates, multilateral institutions and international brokers all cite the resurgence of portfolio investment after Mexico, albeit with greater discrimination between countries and with changes in regional allocations.

Studies including the IMF's August 1995 International Capital Markets note a gradual but persistent trend toward greater international diversification of the institutional portfolios where savings increasingly are going. The five major industrial countries had close to $13 trillion under management in 1993, but a mere 1 percent is currently invested in emerging markets, significantly below the emerging market's 12 percent share of total world equity market capitalization. Given diversification policies and the consensus forecast that emerging markets will grow approximately twice as fast as the industrial economies between 1995 and 2000, further increases in portfolio investment from the developed world as well as from other emerging countries are considered likely by the World Bank and other experts. In fact, industry surveys suggest that emerging markets have become a respectable asset class, joining real estate and high-yield bonds on the standard menu available to investors. Emerging markets were not created by, nor are they dependent on, decisions made in Washington. They will undoubtedly prove to be much more durable investments than Dutch tulips.


By Paul Krugman

Barbara Samuels and I probably do not disagree as much as her comments might suggest.

Two years ago, anyone who talked to investors about Latin America encountered a sort of unquestioning enthusiasm about the whole region, including Mexico. There is an influential body of opinion that still sees the Mexican crisis as an anomaly. My point is that the same overstatement of the likely impact of reform that led to Mexico's boom-bust cycle has occurred for a number of other important developing countries. Even now, I believe investors have failed to think seriously about the policy dilemmas that major emerging market nations face. How, for example, will Argentina, which has 18 percent unemployment, be able to engineer a recovery while committed to its one peso--one dollar policy? (Alternatively, how could it abandon this policy without a crisis of credibility?) Can Malaysia really continue a growth path based on enormous inflows not only of capital but of labor, and what will happen to its ambitious public investment plans if it cannot?

One institutional investor told me about a presentation by a rating service on Indonesian bonds. Along with others in the audience, the investor was disturbed by the evident unreliability of Indonesia's data. The presenter responded with an analogy to Indonesian puppet shows, in which one looks at the shadows rather than the puppets; in other words, investors were being asked to be optimistic based on the general idea that developing countries have great prospects rather than on a careful examination of this specific country's macroeconomic situation. That kind of sloppy thinking led to Mexico's crisis, and may well lead to comparable crises in other countries.

Does that mean there are no investment opportunities in emerging markets, or that there will be no national success stories? Of course not. Perhaps the best way to put it is to quote a senior Mexican official who remarked in 1993, "You know, four years ago, when we couldn't attract any money, we really weren't that bad. But right now, when everyone wants to give us money, we really aren't that good."

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