Emerging markets: economic policy for the next cycle

At the original Bretton Woods conference in 1947, one of Keynes' proposals for the new financial architecture was for an adjustment mechanism that would penalise persistent creditor nations. Keynes was acutely aware of the problem that emerges when one set of countries run huge surpluses. This is the problem of adjustment - at turning points in the cycle, adjustment is always mandatory for debtor nations but optional for creditor nations. It is this basic fact that renders any free international financial system inherently political. When the debtor nations are small and lacking systemic influence, they typically find themselves at the mercy of the big boys (e.g. Asian financial crisis, Mexico 1994, Latin America 1982 etc.). When the debtor nation is large and systemically indispensible (i.e. the US now), adjustment can be delayed for a long time. But it must occur eventually, and given recent newsflow and datapoints it would seem a good bet that this adjustment will now happen over the next 1-2 years.

So what? Why does this matter for emerging markets? It seems almost certain now that the US is going start saving considerably more. Over the past cycle the excess savings stemmed from emerging markets, which were in turn lent out to the US to finance the leveraged boom. Emerging markets were essentially following an export-led growth model: keep exchange rates down, prioritise investment over consumption, promote exports. This is fine so long as there is demand for your exports. Unfortunately in the new world of a thrifty US consumer, there is going to be no marginal buyer for these exports. Therefore, if emerging markets try to adopt the same export led growth strategy as they have over the past cycle, we risk drifitng into a low-level equilibrium. We would have a global paradoox of thrift - increasing savings in both the US and emerging markets, but lower overall demand for goods. Clearly this would be a disaster.

History has shown that the best way out of these situations is for the creditor nation to embark on domestic fiscal expansion in order to stimulate domestic demand - see Martin Wolf's recent article on this point. I am increasingly coming round to the view that this could be the single most important macroeconomic challenge over the next cycle. If emerging market policy makers can get it right, then we could revert to the 3-4% global economic growth rates of the past. But if they try to follow the policies of the past cycle then I fear we could be in for a seriously pro-longed slump. The world has changed, and policy needs to change with it. In this regard, China's stimulus package is very encouraging, but there will need to be a lot more where that came from.