By Simon Johnson
The next financial boom seems likely to be centered on lending to emerging markets. Sam Finkelstein, head of emerging markets debt at Goldman Sachs Asset Management, summed up the prevailing market view – and no doubt talked up his own positions – with a prominent quote in Monday’s Financial Times (p.13, front of the Companies and Markets section):
“Debt-to-GDP ratios in the developed world are about double those in emerging markets and they’re growing. This makes emerging markets interesting because you’re pick up incremental spread [higher interest rates compared with developed world rates], and in return you’re actually taking less macroeconomic risk.”
This is a dangerous view for three reasons.
First, against all historical evidence, it assumes that the only macroeconomic risks we should worry about – in general or for emerging markets – are related to standard measures of government fiscal policy. “Less risk” and “more yield” was exactly what securitized subprime mortgages and their derivatives were purported to offer; this combination typically proves illusory.
Second, emerging markets got into serious trouble through private sector overborrowing both in the 1970s (Latin America, communist Poland and Romania) and in the 1990s (many parts of Asia). In some crises, the government stepped in and ended up holding a great deal of debt – but this does not change the fact that the exuberance was all about private sector banks (in the US and Europe) lending to private sector corporations (financial and nonfinancial) in a mispricing of risk that started out at modest levels but grew over the cycle.
Third, when your ability to borrow depends in part on the value of your collateral – see the academic work of Ben Bernanke and the experience of Japan in the late 1980s (e.g., the classic Hoshi-Kashyap volume) – then rising asset prices enable you to borrow more. This does not necessarily have to go bad in a macroeconomic sense, but experience over the last 30 years is not encouraging. Global moral hazard – the idea that someone will provide a bailout – does not mix well with free capital flows and this kind of financial accelerator.
Goldman Sachs knows all this, of course. But, as they will tell you correctly, reforming incentives or even discouraging this kind of cycle is definitely not their job. Their role is to make money, pure and pretty simple given their market share.
It’s the responsibility of government to make the world financial system less dangerous. Judging from the G20 summit (see my comments on the communique) this weekend, we are making no progress at all in that direction.