Myopia in the Markets

Political instability -- from Turkey to Brazil -- is unnerving investors. Could the focus on short-term gain unsettle the global economy?

It's a tough time to be investing in emerging markets. Index funds tracking their shares dropped about 10 percent in December and January, and several of their currencies are hitting the skids as well. Five mid-sized markets are in turmoil, and the signs are not good in at least two of the biggest ones. Meanwhile, the traditional economic powers are still having trouble emerging from their own slumps. But there are better times ahead, perhaps sooner than investors might think.

For the mid-sized markets, the troubles are largely of their own making, at least in terms of recent history. Egypt, Thailand, Turkey, and Ukraine are going through political crises that have polarized their populations and stoked fears -- at least among pundits -- of civil war. Argentina, like a patient with malaria, is suffering yet another of its periodic bouts of inflation and devaluation.

Together, these countries will likely account for more $2.2 trillion in output this year. That's about 2.9 percent of the global economy, but also about 7.5 percent of emerging markets' gross domestic product. Either way, it's enough to get investors' attention, and the declining value of their assets in these countries may cause them to shift their portfolios away from other developing countries as well. As some risky markets become more uncertain, the response is often to pull back from other risky markets as well.

Throw in the Federal Reserve's tapering of its cash injections into security markets, and things start to look very hairy indeed. Investors had been borrowing cheaply in the United States and plowing the money into high-return assets in emerging markets. But with interest rates rising, their ability to carry dollar-denominated debt is tapering as well. The deluge of investment into emerging markets is starting to ebb, and even to reverse itself, just when it is needed most.

As though all this weren't enough, China may be about to hit a huge speed bump. With economic growth already lagging behind expectations -- just compare the International Monetary Fund's forecast from October 2010 to the one from October 2013 -- China's shadow banking industry may be as challenging to unravel as were the bad loans in its state banks a decade ago. This matters, because China is much more than a supplier of cheap manufactured goods to the United States and Europe. It also buys billions of dollars in products and services from emerging markets, as well as sending them raw materials, intermediate goods, and money for aid and direct investment. When China gets a cold, the rest of the developing world comes down with avian flu.

Then there's Brazil. Preparations for the World Cup have hardly gone smoothly, with charges of corruption and cost overruns regularly making the news. Economic growth is expected to slow this year from a rate already far below the norm for a major emerging market. In addition, anything less than a victory in the finals of the tournament could create further discontent or depression in the soccer-obsessed nation.

Barring recessions in the United States and the European Union, things couldn't get much worse for emerging markets from the global macroeconomic perspective. But there are plenty of reasons to think they'll get better soon.

First, the program of economic reform set out by Xi Jinping's government in Beijing could lead to a new wave of investment and growth in the China. There will undoubtedly be some growing pains as capital markets are liberalized and the state's role in the economy is reduced; this process could and probably should take several years. But a streamlined and more competitive Chinese economy will be strong engine for growth around the world.

Next, the United States will soon enter what has traditionally been its most fertile economic period: the years before a presidential election. Since 1930 (the earliest year for which the Bureau of Economic Analysis provides data), the annual rate of economic growth in the two years before a presidential election has been one percentage point higher, on average, than in the two years after. More growth in the United States will mean more demand for imports from across the globe.

Europe and Japan may finally be ready to do their part, too. For the first time in three years, the European Union is on track for what qualifies as steady growth over there. If the European Central Bank finally loosens monetary policy after continually missing its inflation target, growth might even reach 2 percent after this year -- good news for imports from emerging markets. In Japan, it looks like Abenomics may be spurring demand for imports as well, belying worries about a falling yen.

Conditions may also improve within the emerging markets themselves. Argentina has presidential elections coming up in 2015; saner economic policies could come even sooner if the current government fails in its bid to rescue the peso. Turkey may find itself in a position similar to that of Brazil in 2005, when a corruption scandal failed to unseat the government in part because the economy was thriving. Thailand and Ukraine are edging closer to conflict, but Thailand, at least, has a history of keeping such episodes brief and relatively bloodless.

Could investors or their governments do anything to help resolve these crises? Don't bet on it. Most of them will simply watch and move their money elsewhere when things get too hot. Unfortunately, that withdrawal of capital will just make matters worse, potentially adding economic instability to political problems.

This is the situation that countries accept when they enter global financial markets: economic and political cycles that magnify each other. Yet it might not be so harsh if today's investors, so obsessed with short-term profits, took more of a long view. Within a couple of years, those who pull their funds out now may live to regret the decision.


Daniel Altman

The Inefficiency of Inequality

Why America's staggering wealth disparity is an economic problem -- not just a moral one.

The debate about inequality inflames many passions because of its moral and philosophical trappings. But inequality is also an economic phenomenon with enormous consequences that we are just beginning to understand. In fact, inequality's impairment of economic growth may dwarf its more apparent social costs.

To understand why, consider what happens when economic opportunities are in short supply. When any market has a shortage, not everyone gets the things they want. But who does get them also matters, because it's not always the people who value those things the most.

Economists Edward Glaeser and Erzo Luttmer made this point in a 2003 paper about rent control. "The standard analysis of price controls assumes that goods are efficiently allocated, even when there are shortages," they wrote. "But if shortages mean that goods are randomly allocated across the consumers that want them, the welfare costs from misallocation may be greater than the undersupply costs." In other words, letting the wrong people buy the scarce goods can be even worse for society than the scarcity itself.

This problem, which economists call inefficient allocation, is present in the market for opportunities as well. It's best for the economy when the person best able to exploit an opportunity is the one who gets it. By giving opportunities to these people, we make the economic pie as big as possible. But sometimes, the allocation of opportunity is not determined solely by effort or ability.

To a great degree, access to opportunity in the United States depends on wealth. Discrimination based on race, religion, gender, and sexual discrimination may be on the wane in many countries, but discrimination based on wealth is still a powerful force. It opens doors, especially for people who may not boast the strongest talents or work ethic.

Country club memberships, charity dinners, and other platforms for economic networking come with high price tags decided by existing elites. Their exclusion of a whole swath of society because of something other than human potential automatically creates scope for inefficient allocation. But it's not always people who do the discriminating; sometimes it's just the system.

For instance, consider elected office. It's a tremendous opportunity, both for the implementation of a person's ideas and, sad to say, for financial enrichment as well. Yet running for office takes money -- lots of it -- and there are no restrictions on how much a candidate may spend. As a result, the people who win have tended to be very wealthy.

Of course, political life isn't the only economic opportunity with a limited number of spots. In the United States, places at top universities are so scant that many accept fewer than 10 percent of applicants. Even with need-blind admissions, kids from wealthy backgrounds have huge advantages; they apply having received better schooling, tutoring if they needed it, enrichment through travel, and good nutrition and healthcare throughout their youth.

The fact that money affects access to these opportunities, even in part, implies some seats in Congress and Ivy League lecture halls would have been used more productively by poorer people of greater gifts. These two cases are particularly important, because they imply that fighting poverty alone is not enough to correct inefficient allocations. With a limited number of places at stake, what matters is relative wealth, or who can outspend whom. And when inequality rises, this gap grows.

And rise it has. According to the Federal Reserve's Survey of Consumer Finances, the share of American wealth held by the top 10 percent of families (ranked by net worth) climbed from 67 percent in 1992 to 75 percent in 2010. In the 2010 survey, the average net worth of the bottom half of families was $11,400. For the next quarter of families, the average was $168,900. Clearly, these two groups face vastly different economic opportunities in our society, regardless of their raw aptitude.

If you believe that poor people are poor because they are stupid or lazy -- and that their children probably will be as well -- then the issue of inefficient allocation disappears. But if you think that a smart and hardworking child could be born into a poor household, then inefficient allocation is a serious problem. Solving it would enhance economic growth and boost the value of American assets.

There are two options. The first is to remove wealth from every process that doles out economic opportunities: take money out of politics, give all children equal schooling and college prep, base country club admissions on anonymous interviews, etc. This will be difficult, especially since our society is moving rapidly in the other direction. Election campaigns are flooded with more money than ever, and the net price of a college education -- after loans and grants -- has jumped even as increases in list prices have finally slowed. Poor kids who do make it to college will have to spend more time scrubbing toilets and dinner trays and less time studying.

The other option is to reduce inequality of wealth. Giving poor children a leg up through early childhood education or other interventions might help, but it would also take decades. So would deepening the progressivity of the income tax, which only affects flows of new wealth and not existing stocks. In the meantime, a huge amount of economic activity might be lost to inefficient allocation.

The easiest way to redistribute wealth continues to be the estate tax, yet it is politically unpopular and applies to only about 10,000 households a year. All of this might change, however, as more research estimates the harm caused by inequality through the inefficient allocation of opportunities.

This kind of research is not always straightforward, since it measures things that didn't happen as well as those that did. Nevertheless, some economists have already shown how value can be destroyed through inheritance and cronyism among the wealthy. Scaled up to the entire economy, the numbers are on the order of billions of dollars.

These costs are not unique to the United States. Even as globalization has reduced inequality between countries, it has often increased inequality within them; the rich are better able to capitalize on its opportunities. Where nepotism and privilege are prevalent, the costs are amplified.

The Occupy protestors were on to something, but the economic damage caused by unmitigated inequality of wealth is at least as salient as their moral objections. This is an urgent challenge to the prosperity of the United States and the global economy. Ignoring inequality makes us all poorer.