08 01 2011

Is there a fast track to economic development?

Joining a stronger currency as the dollar or the Euro seemed for a moment to create economic miracles for many small countries in Europe and Latin America. Now after the financial crisis, this looks more as a road to trouble.

The recent troubles in the countries on EU's periphery (Ireland, Portugal and Greece) pose some more profound questions regarding economic development. The question is, how a small, relatively backward economy, lying in the periphery of a bigger more developed economy, can best achieve economic development. This is the problem for the smaller countries around the EU, for the smaller Latin American economies, and for some small Asian countries also.

During the nineties, the so-called Washington consensus dictated that what was needed was macro-economic stability, privatization of state owned enterprises, liberalization of foreign trade and making the country attractive for foreign direct investment. Some doubts remained about the exchange rates – should the countries peg their currency to the developed economy (US dollar or Euro), or should they maintain a floating currency?

The Latin American experience, as well as that from some Aisan countries, has not been good. The pegging of the currency in Argentina and Brazil led to a big inflow of cheap but volatile capital leading to an increase in relative prices and hence an overvalued currency, and low growth. Finally the currencies had to devalue, for Argentina accompanied by a traumatic economic collapse. Others, as El Salvador, which was dollarized a decade ago, are trapped in low growth and kept afloat only by massive remittances from people who have immigrated from the country.

But what about the experience from the Euro zone? It looked much more successful and seemed to contradict the belief that simply integrating into the bigger and more developed economy would not lead to economic development. Just look at Spain. Spain had 30-40 years ago more traits of a developing economy than that of a developed one. The transformation has been breath-taking – not always to the better, but there is no way denying that it is much more prosperous and modern than before. One possible interpretation is that if the economy is relatively diversified and developed before the integration, in the bigger economy is undertaken, as was the case of Spain in 1986, there is a higher probability of success.

The cases of Greece and Portugal are more doubtful. These two countries were integrated in the EU in 1981 and 1986 respectively, and in the Euro zone in 2001 and 1999. Historically laggards in Europe, in 2008 Greece had almost reached the EU average income, and Portugal is not far behind. So they certainly look as success stories? Well, perhaps not. It seems that at least part of these achievements are illusions. In the case of Greece, it has been growing fast, but based on unsustainable government spending and a huge balance of payment deficit. This had to come to an end, and now it has. And in the case of Portugal, where fiscal policy has been much more prudent, the country has been caught in low growth during the last decade. This looks more as Argentina in the nineties, than as the Asian tigers.

What these cases seems to tell us is, that there is no fast and easy way to achieve economic development. The quick fixes, as joining the Euro or adopting the US dollar as currency can do miracles in the short term. It can bring a high inflation rate down, give sudden access to cheap loans, inducing a real revaluation of the currency as local prices continue to increase, even if more moderately, despite the new currency, increasing property prices, create an illusion of a prosperous economy. Rapid growth in construction of housing or shopping malls, a credit fuelled boom in consumption – it has all the traits of an economic miracle. But is is something very different, and that becomes clear when the boom comes to an end, even if - as in the case of Portugal - there has been no spectacular burst of a bubble.

Doubts start to surge also about the foundations for the apparently more successful Spanish economy. It does look more solid. There are big Spanish multinational firms in high tech areas. The banking sector looks more solid and apparently less vulnerable to the burst of the housing bubble as lending policies have been prudent. However, the property bubble was enormous and there is still a big overhang of empty houses. Reportedly, property prices have only fallen with 11% since the peak in 2007. If true, the fall in property prices still has a long way to go before the market is in balance. As the economic downturn continues (the outlook for 2011i for very modest growth after negative growth in both 2009 and 2010) and is exacerbated by the recent austerity packages, this may lead to a vicious circle where falling incomes and housing prices brings more mortgages in peril, and finally endanger the banks. To this comes that much of the growth in Spain in the last decade has actually been a product of the property boom. Now that the boom is over, Spain looks uncompetitive with the present level of prices and incomes. Things may turn nasty before they start to improve.

If we look at the “tiger economies” in Asia, some of these showed off some the same traits before the Asian financial crisis in 1998. But that was temporary, and the more successful of them have based their economy on more solid foundations: heavy investment in education, industrial policies to promote industrial development including state owned enterprises in key areas of the economy, high domestic savings, government owned banks to channel savings into industrial investment, control of capital flows – particularly inward flows – and competitive exchange rates.

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Thorbjorn Waagstein

Thorbjørn Waagstein, Economist, PhD, since 1999 working as international Development Consultant in Latin America, Africa and Asia.

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