Some prominent institutional bond investors are shifting their focus away from traditional benchmark indices that weight countries’ debt issues by market capitalization, toward GDP-weighted indices.   PIMCO (Pacific Investment Management Company, LLC, the world’s largest fixed-income investment firm) and the Government Pension Fund of Norway (one of the world’s largest Sovereign Wealth Funds), have both recently made moves in this direction.  

There is a danger that some investors will lose sight of the purpose of a benchmark index.   The benchmark exists to represent the views of the median investor dollar.  For many investors, going with the benchmark is a good guideline - especially those who recognize themselves to be relatively unsophisticated and also those who think they are sophisticated but really aren’t.   This is the implication of the Efficient Markets Hypothesis (EMH), for example.  

On the one hand, EMH theorists are often too quick to discount the possibility of ways to beat the benchmark.   To take an example, it should not have been so hard to figure out during the 2003-07 credit-fed boom that countries with high foreign-exchange-denominated debt, particularly in Europe, were not paying a sufficiently high return to compensate for risk.  That mistake described Eastern European countries with low ratios of reserves to short-term debt as well as periphery euro members that lacked their own currency.  It probably resulted from easy money, reach for yield, and pervasive underestimation of risk.  Or, to take another example (admittedly, a tougher call), some of these countries’ deeply discounted bonds would have been good buys in early 2012, after heavy mark-downs.   

On the other hand, most investors would do better if they went with a more passive investment strategy - especially due to high management fees among actively managed funds, exacerbated by excessive turnover.   At a minimum, if one is pursuing an activist strategy such as investing more in low-debt countries, it is helpful to frame it explicitly as a departure from the view of the median investor in order to be clear in your mind as to the nature of the bet you are making.

I can think of four functions of a benchmark index.    First, investors who do not figure that they can systematically beat the median investor need to be able to hold passively a portfolio designed to track a benchmark index consisting median investor holdings.   (See Vanguard.)   The second function is to provide an objective standard by which investors can judge the performance of active portfolio-managers who claim to be able to beat the median investor, within a specific asset class like sovereign debt.  (See Morningstar.)   Third, the same weights that are used in the index can be used to compute an average interest rate or sovereign spread in the market, which can serve as an indicator as to where the median investor is currently, in the risk-on, risk-off spectrum. (See J.P.Morgan’s EMBI — Emerging Market Bond Index.)    

The fourth function of a benchmark index is to help active investors to devise a deliberate strategy to depart from the views of the median investor when they think that the latter is erring in a particular direction.  They may think that the median investor is under-estimating risk in general (spreads too low) or under-estimating the downside in countries with some particular characteristic.   Examples of such characteristics include insufficient currency flexibility, inadequate reserves, too much short-term debt, too much foreign-currency debt, too much bank debt, insufficient openness to FDI, insufficient cost competitiveness, excessive budget deficits, insufficient national saving, political risk, and so forth.

For each of these four functions of a benchmark, the correct way of weighting different countries is by market capitalization.  True, the keeper of the index will need to judge what countries and what bonds are in “the market,” i.e., are fully investable.   But this is true for any index.

The logic behind the movement away from traditional bond market indices is that by construction they give a lot of weight to countries with high debt, some of which may be over-indebted and at risk of default.  At first the logic seems unassailable.  But in theory, if the market is functioning well, it should already have factored in high debt levels:  such countries should pay higher interest rates to compensate for the risk, unless there is some special reason to think they can service their debts easily.

It is important to emphasize that many investors will want to depart from the benchmark in various directions, as indicated under the fourth motive for having a benchmark.  An investor’s belief that countries with high debt/GDP ratios are riskier than the median investor realizes would call for a strategy equivalent to moving from the market-cap benchmark in the direction of the GDP-weighted benchmark.  But one is more likely to think about the strategy clearly if it is explicitly phrased in terms of factoring in debt/GDP ratios, rather than phrased as following a new GDP-weighted index.  Furthermore the phrasing may help an investor realize that he or she might want to modify the strategy if, for example, the country in question can borrow readily in terms of its own currency (think of American exorbitant privilege or Japan’s high domestic holdings of own debt) or if, on the other hand, its debt has a particularly vulnerable maturity or currency structure (think of Hungary).

Investors are reacting to what has turned out to be default risk that was higher than they had expected, among some high-debt countries.  Taking greater note of high debt levels last decade would have warned investors away from countries like Greece and Hungary.   But there is always a danger of fighting the last war.   Middle-income countries have paid down much of their debts over the last decade, attaining debt/GDP ratios far below those of advanced economies.    As the chart shows, major emerging markets have relatively low debts [first bars, for each country] compared to GDP [second bar].  That is, their debt/GDP ratios [third bar] are now much lower than in advanced countries.  (Russia’s sovereign debt is now below 7 per cent of GDP.)  As a result, there is only a limited supply of their bonds left to hold.  If the global investor community switches from market-cap-weighted to GDP-weighted investing, the high demand and low supply of bonds from low debt/GDP countries may drive their interest rates to unnaturally low levels, setting off new credit-fed boom-bust cycles in their economies.  

Of course, as a country’s international debt approaches zero, the keepers of the index might drop it altogether.  But the fall in demand for that country’s remaining international bonds from the investment funds that are following the benchmark could then produce an undesirable discontinuous jump in the interest rate.

Many emerging market countries have paid down debt denominated in dollars or other foreign currencies, while continuing to borrow in their local currencies.  (See the table at bottom.)  Such relatively large countries as Thailand, Malaysia, Indonesia, South Africa and Russia, for example, have little dollar-denominated debt left - 3% of GDP or less (shown in the chart as the dark bottom of each first bar).   If an international bond benchmark is to be limited to dollar-denominated debt, then GDP weights could imply a severe imbalance between international investor demand for these countries’ bonds and the small supplies available. 

Accordingly, local currency denominated debt must be included in the most useful benchmarks.  But then a portfolio reallocation away from traditional benchmark indices such as the EMBI would imply a big shift in allocations away from simple credit risk toward currency risk.   True, the ability of emerging market economies to attract foreign investment in their local currencies represents an important strengthening of the global financial system, relative to the currency mismatch and balance sheet vulnerabilities of the 1990s.  Nevertheless, an investor switching from one “benchmark” to the other needs to be aware of the extent to which the reduction in default risk comes at the expense of heighted exposure to currency risk.

In short, it is not crazy for an investor to depart from the market-cap-weighted benchmark in the direction of putting more weight on debt/GDP countries and less weight on high debt/GDP countries.   But the GDP-weighted index should not be mistaken for a neutral benchmark.

[A version of this post originally appeared at Project Syndicate, Feb. 11, 2013.  Comments can be posted there, or at Seeking Alpha.]

Table:  Sovereign debts as a percentage of GDP

     I recently visited Cuba for the first time, to participate in scholarly meetings.  For an American citizen this short voyage requires a leap through hyperspace.   It was my third attempt over ten years to get there.  Obstacles had included both the US government and the Cuban government.

     This was a trip back in time, to 1959.   For one thing, a majority of the (few) autos on the street in Havana are large American cars from the 1950s.  Most are beautiful.   One hears about the cars, but I had thought the reports must be exaggerated.   

     Cuba’s economic system is out of Alice in Wonderland.   It has one of the world’s longest lasting dual exchange rate systems.  Currently the cost of dollars in the market is 25 times higher than the official rate of one peso per one dollar.  This means that a worker in the hotel sector or restaurant sector who is able to keep dollar earnings has an income 25 times higher than one who must turn them in to the government.

      The island long ago developed an advantage in skilled services such as medicine and education.  But doctors and professors earn far less than those who join the fledgling private economy.  The latter features 178 possible approved jobs.  The possible choices on the list by design make no use of an educated person’s skills.   They include waiter, bathroom attendant, taxi driver, automobile battery repairman, mule driver, and wheel barrow operator.   Most people are still employed by the state, however.

      Perhaps American consumer society has too many goods available; but Cuba has far too few.  Most things that one would want — a toaster to make breakfast, leather to make shoes, tools for auto repair, software to upgrade a computer, spare parts to keep all those appliances from the 1950s running, …everything - is only available either by rationing, waiting in line, or going to the black market.  Many are not available at all.    

      How can such a system have persisted for so long?   Why doesn’t everyone see the folly?  

      Repression and fear don’t explain it.  The fact is that the advantages of the market system are not hard-wired into human brains — not anywhere, and especially not when they have been portrayed as the allies of selfishness and corruption, in opposition to such noble ideals as cooperation, fairness, and equality. 

     When the Soviet Union was collapsing, Robert Shiller and co-authors surveyed residents of Moscow and New York regarding their attitudes toward free markets.   Unsurprisingly, many of the Russians gave answers that strike an economist as failing to appreciate adequately the virtues of the marketplace as a mechanism to bring supply and demand into equality.  For example 66% of the Russian respondents thought it was unfair of flower-sellers to charge higher prices on holidays.  The surprising finding, however, was that just as high a percentage of Americans thought it was unfair of the flower-sellers to raise prices!  (Economists, of course, point out that  demand is much higher on holidays, and that without the higher prices flower-growers would have no incentive to increase the supply at such times.) 

      People in Eastern Europe eventually figured out that communism does not work and that the market system does.  If the United States of America did not exist, or if the embargo did not exist, Cubans could do likewise: infer that there is something fundamentally wrong with an economic system that involves so much time wasted and so many simple desires frustrated.  But in the case of Cuba, there is an alternative explanation right at hand.  Many of these goods would be imported from the United States, or produced at home with inputs from the United States.  Therefore it must be the US and its embargo that is to blame.  So it seems to many Cubans.

      When makers of foreign policy ”get tough” with another country, they often under-estimate the extent to which the opponent’s government can derive long-lasting legitimacy by pointing to the external threat to rally its people.   The citizens of the last two countries still clinging to communism, Cuba and North Korea, both vividly remember military conflict with the United States (the Bay of Pigs and the Korean War, respectively) and both countries have long been subject to American sanctions.   The first communist country to experiment with market reforms, Poland, was one that never came into military conflict with the West.    Lesson:  the US should end its obsolete embargo against Cuba.  Let those private-sector auto mechanics have their spare parts!

      Harvard’s Jorge Dominguez likens the Cuban reform path to an accordion that alternately goes in and out.  Liberalization took hold out of the desperate economic situation (”special period”) that followed the 1991 collapse of the Soviet Union, Cuba’s long-time benefactor.  The reform process was then slowed from 1996 to 2005 — even stopped altogether — in part because Venezuelan support made it less necessary.  

     Reforms have been renewed in recent years– now under “los lineamientos,” translated as “the guidelines.”  For example, the government announced in 2011 it would let people buy and sell houses. Farmers can sell directly to the market, to hotels and restaurants, rather than just to the government.  One explanation for the recent reforms is that the more pragmatic Raul Castro took over after his brother became ill in 2006.  But another explanation is that money from Venezuela has lately begun to level off and appears uncertain in the future.  (For one thing, Venezuela’s oil production has declined during a period when everyone else’s has boomed, due to mismanagement by Hugo Chavez of his own economy.)  

      Referring to the heavy economic dependence on the US that had ended abruptly after the 1959 revolution and to the heavy dependence on the Soviet Union that had ended abruptly after the 1989 fall of the Berlin Wall, Cuba’s Minister for Heavy Industry in 1995 vowed, “We will never let this happen to us for the third time.” (Jatar, 1999, p.38).  Yet that is what is now happening with respect to dependence on Venezuela.

      For now, Cuba is casting about for a model to follow.  The example of Sweden shows that it is possible to combine a strong social safety net with a strong private economy.  But what Cuba seeks is a model of transition out of communism.   

      The Chinese economic miracle is the obvious model, beginning with the reforms of Deng Xiaoping.  This judgment assumes that income equality is in reality not as important to Cuba as the requirements that the Communist Party maintain control and the country’s leaders never have to say they were wrong.  The Cuban slogan has long been “Socialism or death!” Cubans are proud, and mindful of their history of ill-treatment by larger powers.  In this they resemble the Chinese, who have converted to capitalism more energetically than the capitalists while yet leaving the giant picture of Chairman Mao up in Tiananmen Square.  

      But when the Chinese and Soviets split in the 1960s, Cuba went with the latter.  Only in some American college dorm rooms did posters of Mao and Che appear side-by-side.   So for now the model is Vietnam, rather than China.  (Unfortunately, the Vietnamese economy has been troubled of late.)

      Four things will happen soon, probably at approximately the same time:  the aging generation of Cuban émigrés who have dictated American policy on Cuba will give way to the next generation; the Castros will pass from the scene as well; American-Cuban relations will be normalized; and the world’s 2^nd-to-last museum of communism will spontaneously convert to a rapidly growing service-exporting economy.   Lineamientos and models will no longer seem so necessary. 

      I just hope that before the wave of American money and tourists arrives on its shores, the government of Cuba undertakes the appropriate regulatory intervention:  a zoning law that all car bodies in some designated part of Old Havana must date from 1959 or earlier.

 References 
•·   Jorge I. Dominguez “Hello from Havana,”  Harvard Magazine, July-August 2009.
•·   Dominguez, et al, eds., Cuban Economic and Social Development (Harvard University Press), 2012.
•·   Anna Julia Jatar-Hausmann, The Cuban Way (Kumarian Press), 1999.
•·   Robert Shiller, Maxim Boycko & Vladimir Korobov, “Popular Attitudes Towards Free Markets: The Soviet Union and the United States Compared,” American Economic Review 81, no.3, pp.385-400, June 1991.

[A shorter version of this column was published by Project Syndicate. Comments may be posted there.]

Emerging markets have performed amazingly well over the last seven years. They have outperformed the advanced industrialized countries in terms of economic growth, debt-to-GDP ratios, and countercyclical fiscal policy.  Many now receive better assessments by rating agencies and financial markets than some of the advanced economies.

As 2012 begins, however, emerging markets may be due for a correction, triggered by a new wave of “risk off” behavior among investors. Will China experience a hard landing? Will a decline in commodity prices hit Latin America? Will the sovereign-debt woes of the European periphery spread to neighbors such as Turkey in a new “Aegean crisis”?

Engorged by large capital inflows, some emerging market countries were in an overheated state a year ago. It is unlikely that the rapid economic growth and high trade deficits that Turkey has experienced in recent years can be sustained. Likewise, high GDP growth rates in Brazil and Argentina over the same period could soon reverse, particularly if global commodity prices fall - not a remote prospect if the Chinese economy falters or global real interest rates were to rise this year. China, for its part, could land hard as its real-estate bubble deflates and the country’s banks are forced to work off their bad loans.

The World Bank has now downgraded economic forecasts for developing countries in 2012 (Global Economic Prospects, Jan.18, 2012).    Brazil’s economic growth, for example, came to a halt in the third quarter of 2011 and is forecast at only 3.4 percent in 2012 …well below the rapid 2010 growth rate of 7.5 percent.  Reflecting a sharp slowdown in the second half of the year in India, South Asia is coming off of a torrid six years, including 9.1 percent growth in 2010.  Regional growth is projected to ease further to 5.8 percent in 2012.

But will economic slowdown turn to financial crash?   Three possible lines of argument support the worry that emerging markets’ performance are fated to suffer dramatically in 2012: empirical, literary, and causal. Each line of argument is admittedly tentative.

The empirical argument is just historically based numerology: emerging-market crises seem to come in 15-year cycles. The international debt crisis surfaced in Mexico in mid-1982, and then spread to the rest of Latin America and beyond. The East Asian crisis erupted 15 years later, in Thailand in mid-1997, and then spread to the rest of the region and beyond. We are now another 15 years down the road. So is 2012 the time for the third round of emerging markets crises?

The hypothesis of regular boom-bust cycles is supported by a long-standing scholarly literature, such as the writings of Carmen Reinhart. But I would appeal to an even older source: the Old Testament - in particular, the story of Joseph, who was called upon by the Pharaoh to interpret a dream about seven fat cows followed by seven skinny cows.

Joseph prophesied that there would come seven years of plenty, with abundant harvests from an overflowing Nile, followed by seven lean years, with famine resulting from drought. His forecast turned out to be accurate. Fortunately the Pharaoh had empowered his technocratic official (Joseph) to save grain in the seven years of plenty, building up sufficient stockpiles to save the Egyptian people from starvation during the bad years. That is a valuable lesson for today’s government officials in industrialized and developing countries alike.

For emerging markets, the first phase of seven years of plentiful capital flows occurred in 1975-1981, with the recycling of petrodollars in the form of loans to developing countries.  The international debt crisis that began in Mexico in 1982 was the catalyst for the seven lean years, known in Latin America as the “lost decade.” The turnaround year, 1989, was marked by the first issue of Brady bonds, which helped write down the debt overhang and put a line under the crisis.

The second cycle of seven fat years was the period of record capital flows to emerging markets in 1990-1996.  Following the 1997 “sudden stop” in East Asia came seven years of capital drought. The third cycle of inflows, often identified as a “carry trade,” came in 2004-2011 and persisted even through the global financial crisis. If history repeats itself, it is now time for a third sudden stop of capital flows to emerging markets.

Are a couple of data points and a biblical parable enough to take the hypothesis of a 15-year cycle seriously?  We need some sort of causal theory that could explain such periodicity to international capital flows.

Here is a possibility: 15 years is how long it takes for individual loan officers and hedge-fund traders to be promoted out of their jobs. Today’s young crop of asset pickers knows that there was a crisis in Turkey in 2001, but they did not experience it first hand. They think that perhaps this time is different.  

If emerging markets crash in 2012, remember where you heard it first - in ancient Egypt.

[This article was published in Project Syndicate, which holds the copyright.]

    
      In 2008, the global financial system was grievously infected by so-called toxic assets originating in the United States.  As a result of the crisis, many have asked what fundamental rethinking will be necessary to save macroeconomic theory.  Some answers may lie with models that have in the past been applied to fit the realities of emerging markets — models that are at home with the financial market imperfections that have now unexpectedly turned up in industrialized countries.  The imperfections include default risk, asymmetric information, incentive incompatibility, procyclicality of capital flows, procyclicality of fiscal policy, imperfect property rights, and other flawed institutions.   To be sure, many of these theories had been first constructed in the context of industrialized economies, but they had not become mainstream there.   Only in the context of less advanced economies were the imperfections undeniable.  There the models thrived.     
 

     An analogy can capture the apparently novel suggestion that emerging markets may have important lessons for advanced countries.   In the latter part of the nineteenth century most of the vineyards of Europe were destroyed by the microscopic aphid Phylloxera vastatrix. Eventually a desperate last resort was tried: grafting susceptible European vines onto resistant American root stock.   Purist French vintners initially disdained a strategy that they considered would compromise the refined tastes of their grape varieties. But it saved the European vineyards, and did not impair the quality of the wine. The New World had come to the rescue of the Old World.

     The academic literature on macroeconomics and finance in developing countries hardly existed 30 years ago.  But by now it has grown very large — large enough to deserve a survey of its own.  I review much of this research in a survey titled “Monetary Policy in Emerging Markets.”  It appears as a chapter in the Handbook of Monetary Economics, edited by Ben Friedman and Michael Woodford, which has just this week become available from Elsevier Publishing.   Among the hundreds of authors represented in the survey are Caballero, Calvo, Dooley, Dornbusch, Edwards, Reinhart and Velasco, as well as many younger scholars.  Again, although financial opening gave capital flows a central role in the emerging market models, the need to allow for imperfections in these markets has always been clear.   It is also what gives the models so much relevance today, not just for theory but for policy as well.   Raghu Rajan and Simon Johnson point out that some of the institutional failings that we associate with financial sectors in developing countries, such as distorted incentives and undue political influence, also apply to the United States and other advanced countries.  Among other areas of economic policy where the North could draw useful lessons from small countries in the South as to how to address the problems, in earlier blogposts I have given the example of the procedures that Chile has used over the past decade to achieve countercyclical fiscal policy.  

[Comments can be posted on the Belfer Center site.]

During much of the last decade, U.S. fiscal policy has been procyclical, that is, destabilizing.   We wasted the opportunity of the 2003-07 expansion by running large budget deficits.   As a result, in 2010, Washington now feels constrained by inherited debts to withdraw fiscal stimulus at a time when unemployment is still high.   Fiscal policy in the UK and other European countries has been even more destabilizing over the last decade.  Governments decide to expand when the economy is strong and then contract when it is weak, thereby exacerbating the business cycle.    

Meanwhile, some emerging market and developing countries have learned how to run countercyclical fiscal policy - saving in the boom and easing in the recession - during the same decade that we advanced countries have forgotten how to.    

The frenetic debate at any moment for or against “fiscal conservatism” is artificial.  It is not the right answer always to shrink any more than it is the right answer always to expand.  Americans should take a perspective longer than the annual budget cycle or the bi-annual electoral cycle, let alone the daily news cycle.   When the United States was able to take advantage of the long 1992-2000 boom to eliminate its budget deficit, the key legislation had been enacted in 1990 and 1993.   Similarly, the big deficits of the last ten years were created by the legislation of 2001 and 2003.   Bringing back far-sighted fiscal policy would mean taking steps today to lock in long-term progress toward fiscal responsibility (such as enacting social security reform) but at the same time extending last year’s short-term fiscal stimulus so long as the economy is still weak.

It might help to have ways to insulate fiscal policy from some of the wilder vagaries of politics.    I came away from a conference in Chile recently, impressed anew by that country’s accomplishments.  It has achieved countercyclical fiscal policy over the last ten years by means of some innovative institutions.   Chile has a rule that targets the structural budget balance.  In other words, it can only run a deficit to the extent that GDP and the price of copper are below their long-run trends.  But a structural budget rule is not enough in itself.   Who is to say which deficits are structural and which are temporary?  Chile’s key innovation ten years ago was to vest responsibility for determining the long-run trends in GDP and copper prices in two panels of independent experts.   Why does this matter?   One reason that politicians spend too much in booms is that they convince themselves that deficits are temporary even when they are really structural.  Officials in the US and Europe made overly-optimistic forecasts of future growth rates and tax revenues during the 2001-07 expansion.  Research shows that this is a systematic pattern.  The biased forecasts contributed to unaffordable tax cuts and accelerated spending, which in turn spelled excessive deficits and debts.  Today we are living with the consequences of this procyclicality.

Perhaps we should look South, in order to re-learn how to run countercyclical budgets. 

[For comments, go to SeekingAlpha.]

         My last blog post listed some policies and institutions with which various small countries around the world have had success — innovations that might be worthy of emulation by others.  Of course there are plenty of other examples of policies and institutions that have been tried and that are to be avoided.    The area of agricultural policy is rife with them.   Many start with a confused invoking of the need for “food security.”

          The recent run-up in wheat prices is a good example.   Robert Paarlberg wrote an excellent column in the Financial Times recently, titled “How grain markets sow the spikes they fear.”   Grain producing countries point to the high volatility of prices on world markets and the need for food security when imposing taxes on exports of their own grain supplies, or outright bans, as Russia did in July.    The motive, of course, is to keep grain affordable for domestic consumers.  But the effect of such export controls is precisely to cause the price rise that is feared, because it removes some net supply from the world market.    (The same could be said when grain importing countries react to high prices by enacting price controls, because that adds some net demand to the world market.)   

            The current run-up in grain prices is reminiscent of the even higher spike in food prices in 2008.   As Paarlberg argues, many of the other explanations that were put forward for that episode don’t fit this time.   The importance of export controls is now clearer.

            In 2008 Argentina imposed export tariffs to prevent its grain farmers from taking advantage of high world prices.   (This case seemed particularly irrational in that, unlike the usual case, the strongest political pressures came from the growers, not the consumers.)    At the same time, on the other side of the world, India put on export controls to prevent its rice farmers from selling their product on world markets to take advantage of high rice prices.   Controls imposed by Argentina, India, and others were important contributing factors to the global spike in food prices.

            Are governments indeed being completely irrational?   The commodities we are talking about are staples in the consumption of ordinary households.   For simplicity, let’s assume it is an absolute constraint that governments cannot allow grain prices to go above a certain threshold.    Perhaps there will be riots in the streets otherwise.  In this case might it make sense to put on export controls when the price threatens to go above that level?   One can see the motivation in the short run.   But, thinking in the long run, across complete cycles, controls are not a good answer.  

            One can imagine various sensible long-term policies that might assure that this constraint is not violated, such as stockpiling, although in practice many policies sold as “food security” are not in fact applied in a sensible way.

            One solution may be for major countries that are active in the market for wheat or rice to get together and agree not to impose controls.   The result would be to stabilize prices: no more alternation of price spikes and price collapses.  Each country could then rely more on the world market to cover shortfalls than it can now, when trade is made less dependable by the threat of controls by others.   The case of rice controls was nailed in a paper on food security written last year by two students in Harvard’s MPAID program (Masters in International Development), Naoko Koyama Blanc and Diva Singh.  In their model, it can indeed under certain conditions be rational for India to follow the practice of imposing controls when the price goes up, under a regime where volatility is high because others impose controls.  But it would be more rational for India to negotiate a no-controls regime with other countries, because under that regime volatility would be lower, the controls would not be needed, and everyone would be better off.   

     Two decades ago, many thought the lesson of the 1980s had been that Japan’s variant of capitalism was the best model, that other countries around the world should and would follow it.   The Japanese model quickly lost its luster in the 1990s.  

     One decade ago, many thought that the lesson of the 1990s had been that the US variant of capitalism was the best model, that other countries should and would follow.   The American model in turn lost its attractiveness in the decade of the 2000s.   

     Where should countries look for a model, now, in 2010?  Many small countries on the periphery have experimented with policies and institutions that could usefully be adopted by others.  

     A panoply of innovations has helped Chile to outperform its South American neighbors.   Chile’s fiscal institutions - structural budget balance with the parameters estimated by independent expert panels — insure a countercyclical budget.  They are among the mechanisms that are particularly worthy of emulation by other commodity exporting countries, to defeat the Natural Resource Curse.  

     Costa Rica in Central America and Mauritius in Africa each pulled ahead of its peers some time ago.  Among many other decisions that worked out well for them, both countries have foregone a standing army. The result in both cases has been histories with no coups, and financial savings that can be used for education, investment, and other good things.  Singapore achieved rich country status with a unique development strategy.  Among its many innovations were a paternalistic approach to saving and use of the price mechanism to defeat urban traffic congestion (now emulated by London). 

     Some small advanced countries also have lessons to offer.   New Zealand led the way with Inflation Targeting, along with many liberalization reforms in the late 1980s.   (Perhaps its Labor Party should even be given credit for pioneering the principle that left-of-center governments can sometimes achieve economic liberalization better than their right-of-center opponents.)   Ireland showed the importance of Foreign Direct Investment.  Estonia led the way in simplifying its tax system by means of a successful flat tax in 1994, followed by Slovakia and other small countries in Central/Eastern Europe and elsewhere (including Mauritius again).   

     Mexico pioneered the idea of Conditional Cash Transfers (the OPORTUNIDADES program — originally PROGRESA, launched in 1998).  CCT programs have subsequently been emulated by many developing countries.  This was two revolutions in one:  (1) the specific idea of making poverty transfers contingent on child school attendance (which has been emulated even in New York City) and (2) the methodological idea of conducting controlled experiments to find out what policies work or don’t work in developing countries (which has fed into the exciting Randomized Control Trials movement in development economics).  Also in the 1990s, largely thanks to the leadership of President Ernesto Zedillo, Mexico adopted non-partisan federal electoral institutions that were subsequently in 2006 able to resolve successfully a disputed election.   (In contrast, it turned out in November 2000 that the United States had no mechanism to resolve such disputes, other than the preferences of political appointees.)  Mexico undertook health reform in 2004.  More recently, President Felipe Calderon has shut down the entrenched electric utility and pursued much-needed reforms in tax, pension, and other areas.

     In highlighting some very specific institutions that could be usefully applied elsewhere, I don’t mean to suggest that they can be effortlessly translated from one national context to another.   Nor do I mean to suggest that these examples are entirely responsible for the success of the economies identified.  (Indeed a few of these countries have recently been wrestling with severe problems.)  But a country doesn’t have to be large like the United States to serve as a model for others.  Small countries tend to be trade-dependent, and open to new ideas.  They are often more free to experiment than are large countries. The results of the experiments include some useful lessons.

[TV interview on BNN.]

            As Chile’s President Michelle Bachelet prepares to hand over power to her newly elected successor, she remains extraordinarily popular.  It is worth reflecting on the fiscal aspects of her term in office, as Chile has important lessons for other countries struggling with fundamental long-term budget problems, which includes a lot of countries right now.

             As recently as June 2008, President Bachelet and her Finance Minister, Andres Velasco, had the lowest approval ratings of any President or Finance Minister, respectively, since the return of democracy to Chile. (See graphs below.) There may have been multiple reasons for this, but perhaps the most important was popular resentment that the two had resisted intense pressure to spend the receipts from copper exports, which at the time were soaring along with world copper prices.  One year later, in the summer of 2009, the pair had the highest approval ratings of any President and Finance Minister since the return of democracy.  Why the change?  

   (more…)

Nicholas Kristof’s column in the New York Times today, “Better Roses than Cocaine,” says it all. There is no good reason for the US Congress to continue to hold up the free trade agreement that the Administration has negotiated with Colombia.

Free trade with Colombia can’t have anything to do with loss of US jobs: Colombia’s exports already enter the US duty-free. Rather, the Free Trade Agreement would reduce remaining Colombian barriers to imports from the US. It could contribute (a bit) to a surge in US exports worldwide, which in turn could once again become the engine of US growth that it was in the 1990s.

Nor would free trade with Colombia be bad for human rights in that violent country. No government is perfect. But the Uribe government offers the best hope of bringing some measure of peace, prosperity and justice to Colombia. It is fighting against the guerillas and drugs. It wants to give farmers some security, for example, so that they know they have an assured US export market in cut flowers to replace the risky business of growing coca for cocaine. It deserves our support.

American labor unions raise the issue of killings of Colombian union leaders. But this is a weak reason to oppose the FTA. For one thing, the odds of being killed if you are a union leader in Colombia are now less than the odds of being killed if you are a regular citizen.

It is hard to escape the conclusion that the main reason Congressmen are opposing the Colombian free trade agreement is to pander to ill-informed American public opinon. (Of course the White House would have been better-advised to concentrate its energies and political capital on the multilateral level, the WTO, rather than on the negotiation of myriad bilateral FTAs with small countries. But this is an argument of economists and policy wonks. No politicians are opposing the Colombian agreement on these grounds.)

Kristof concludes with a challenge to Democrats. “Democrats instinctively criticize Bush when he harms America’s standing in the world.” I assume he has in mind Kyoto, Guantanamo, Abu Graib, land mines treaty, International Criminal Court, nuclear weapons policy, energy policy, steel tariffs, and other economic missteps I could list (see The International Economy). He continues, “But a test of intellectual honesty is your willingness to hold your own side to the same standard and to point out pandering in those politicians you normally admire.”

He is right. Hillary and Barack: if you are listening, SUPPORT THE COLOMBIAN FREE TRADE AGREEMENT! Everybody else: read Kristof.