BLINDED BY OUR SUCCESS AND FREE-MARKET IDEOLOGY, WE’RE DESTROYING THE DEVELOPMENT WE’RE TRYING TO FOSTER: WORLDWIDE LIQUIDITY A THIRD WORLD DISASTER

It took a few financial hurricanes, but there is growing doubt about the case for investing in emerging markets — even among people who are making a living at it. If there was any complacency in the field, the past 18 months have erased a lot of what looked liked certainties. The role of the International Monetary Fund, the importance of currency convertibility and open markets, the ability of free markets to foster development — all have come under scrutiny in the wake of what has seemed like catastrophe after catastrophe.

The central illusion of emerging markets investing is that rapid improvement in economic growth is possible in a developing country simply because the level of investment has increased. The truth is that no economic jump-start — from foreign aid to Opec petro-windfalls to Korean-style debt leverage — has ever led to balanced economic growth over any sustained period of time. Indeed, emerging market investing, touted throughout the 1990s as the right path for Third World development, may be doing more harm than good in emerging market countries.

Over the past several decades, despite economic aid and investment equivalent to several times the gross domestic product of the entire developing world in 1970, the absolute and relative position of that sector has continued to decline. For example, in 1973, the average annual income of a person in Africa was 14% of that of an individual in a member nation of the Organization for Economic Cooperation and Development. Today it is less than 7%.

Despite the oil boom, median per capita income in dollars in the Opec countries is now lower than before the oil embargo. Average income is higher, but that includes such statistical aberrations as Kuwait and Brunei. Generally speaking, not even the gusher of oil wealth was able to take the majority of these economies to a higher economic level.

And we all know the situation in the so-called “Second World” of the former Soviet Union and its satellites and imitators. If one accepts the figures of Dmitri Volkogonov, director of the Moscow Institute of Military History, on the extent of sale of gold and precious metal over the period of Bolshevik rule, it appears that economic growth, excluding the destruction of World War II, was somewhere in the region of negative 2% to negative 3%.

You can get quite a bit grislier — Mao was such a great economist that as late as 1959, during the “Great Leap Forward,” there were widespread reports of babies being sold as food in Northern China’s public markets.

Obviously, there have been exceptions. Even with the recent collapse in equity markets, Southeast Asians are clearly better off than in the recent past, and Japan has been utterly transformed from a poor backwater to the world’s second-largest economy. But if one looks at the broader developing world, they are exceptions, though ones we’ll come back to.

The generally poor results have followed a seemingly iron path of progression. First the exciting new theory, then the application, followed shortly by the collapse, as a previously misunderstood factor rears its ugly head.

In today’s Southeast Asia, the culprits are “crony capitalism” and “lack of transparency,” which used to be known as “state capitalism” and the “Asian way” when the excitement was blowing in the other direction.

But the cycle goes way back. Following World War II, the cure was supposed to be anti-colonialism. In the 1960s, it was development aid plus import substitution economics. In the ’70s, it was “appropriate technology” and rural subsidies. Only the cycle of hope and disappointment has seemed permanent.

At the beginning of this decade the mantra was capitalism, free trade and free capital flows. It’s hard sometimes now to recapture the sense of triumph that accompanied the fall of the Soviet empire. There was a euphoric belief that in a matter of decades, if not years, the world would be unified under one economic system, with foreign capital launching all countries onto growth plans that could only previously be dreamt of.

It was a remarkably generous vision, but it was just that — a vision. I can remember in my own case when it became obvious to me that the real situation might be more complicated.

About eight years ago I was in Peru, which at the time was a fairly hellish place. The airport was fortified with machine gun nests. All the taxis had armed escorts. The Sendero Luminoso — Shining Path — guerrillas had taken several towns in the Andes around Arequipa and were rumored to be near Lima.

When I stepped out of the hotel the next morning, there wasn’t a single car moving. During the night the Sendero had entered the city and hanged from the lampposts dozens of dogs, all with signs criticizing Deng Xiaoping, the Chinese leader, as a “revisionist dog.” Nobody really said anything or moved — the only sound was isolated people suddenly sobbing. It really seemed like a place about to have a nervous breakdown.

And it suddenly occurred to me: There’s something going on here that isn’t going to be fixed by a few investment bankers and portfolio managers.

Now, of course, Sendero was eventually destroyed and the market rallied off its lows. But the original wound continues. Peru is a largely Indian country where until 1956 Indians were legally considered non-human and lumped in with pack animals. It simply doesn’t have the making of sustainable economic development.

And that’s the underlying problem with the open capital-market approach to emerging market investing and with emerging markets in general. We’ve made the ideological commitment to the idea that capitalism is the only conceivable economic model, while at the same time committing ourselves to specific actions, such as portfolio investment and open capital markets, that are creating chaos and destroying the very development we are trying to foster.

To put the matter simply: Capital is not the crucial element of capitalism. The developed countries of Europe and the United States acquired the characteristics of a successful capitalist society over a very long period of time. And most people would agree on the basic list of requirements for economic success: property rights, freedom of contract, a neutral government, an independent judiciary and reasonable tax laws that don’t create incentives against individual achievement.

In many cases in emerging markets, we are putting capital into countries that have none of these characteristics, such as Indonesia, and then acting surprised when it doesn’t work. As a way of thinking, it’s radically ahistorical, and it undervalues the achievement of our own societies, as well as the economic achievements that our ancestors have built up over centuries.

A society is capitalist and economically successful because its people and institutions share certain characteristics — and even in the West these characteristics were achieved at an enormous cost.

Take the idea of the state as a neutral arbiter in matters of religion. The West didn’t suddenly decide that freedom of belief was a great idea. The idea came about after a century of the Wars of Religion, after the leaders of the various factions literally couldn’t bring themselves to continue decades of mass murder and chaos.

When we almost randomly pump money into emerging markets regardless of the context of the societies we’re underwriting, we’re acting against our own interests — these places will not work out as investments over the long term — and against the interests of the people in the places we’re investing.

For the fun of it, I went back and compared economic and quality of life statistics for all countries that have reported them to the United Nations for at least 40 years. Plotted on a graph against forward gross domestic product growth, it turns out that the two best indicators of a market emerging successfully are female participation in the workplace (which of course would be an indicator of general modernity) and the ratio of a primary schoolteacher’s salary to that of a bus driver (a ratio above 1.25 indicates at least the potential for sustained GDP growth).

Investors don’t count

Surprisingly, the number of investment bankers and portfolio managers drinking in the bars in the hotels of the capital city was not much of an indicator.

At this point I’d like to circle back to those emerging markets that have been successful, particularly Japan, the mother of all success stories.

If one looks at the economic history of Japan in the postwar era, it’s striking what you don’t see. You don’t see much in the way of foreign aid (there was no Marshall Plan for Japan at any point). You also see very little in the way of foreign investment.

What you do see is a society organized, until the late ’80s anyway, around the assumptions of a scarcity of capital, a need to grow through exporting and a suppression of domestic consumption, as well as programmatic emphasis on ever greater levels of investment.

In some ways, Japan is the only true development success story, with Korea its closest imitator. But Korea is fatally harmed by being second in the race after Japan, and has not up until now been able to create enough value-added in what it produces to offset a truly scary balance sheet. Having five car companies cannot offset the disadvantage of never inventing anything fundamentally new in either how cars are designed or how they are produced.

Similarly, Southeast Asia is in many ways just a reflection of the incredible investment bubble in Japan. It simply got to the point for Japanese manufacturers that they had to invest abroad because they simply lacked the labor to run any additional capacity in Japan itself. Or so it seemed to Japanese corporate managers in the late ’80s.

The vaunted Asian miracle was always a bit of fraud. Consider Malaysia. In a country where one foreign company — Matsushita Electric — accounts for 6% of GDP, you have to wonder whether you’re looking at a developed nation or a tropical industrial park.

And Malaysia made the ideological mistake of global capitalism in reverse. Just as there has been a lot of investment in places like Malaysia without much examination if it really had the makings of a developed capitalist society, Malaysia thought it could import wholesale the technology of the West without adopting many of the values that underlie the creation of the technology. It’s a common delusion throughout the Third World, particularly at the government level. I would guess the next society that will confront the issue is China — and much sooner than many people believe.

There is another factor that needs to be considered, even if any conclusions at this point have to be fairly tentative. Put simply, it may well be that the type of society we’ve become, with the “free market” seemingly the ideological answer for every dilemma, has made it difficult to see the reality on the ground in emerging markets. Our own success as a society may well make it more difficult for us to understand the complex problems and choices of less-favorably situated nations.

don’t blame victims

Clearly, the present system is broken regardless of the cause of investors’ shortsightedness and herd behavior. And blaming the locals is both silly and cruel. How were the Southeast Asians to know that they were exceeding prudent guidelines, when they could pick up virtually any Western business magazine and read about the triumph of their approach?

Even technically to blame Southeast Asians for the currency crisis is ridiculous. When the situation imploded, both the International Monetary Fund and the World Bank were increasing their loans to the region, so why should the locals have been concerned? Similarly, when the reversal happened, Asian central bankers were faced with an exodus of funds that, were Southeast Asia the size of the United States, would be equivalent to $800 billion.

Trust me: If $800 billion left the United States in the next six months, our economy would collapse every bit as spectacularly as Southeast Asia’s did, despite our infinitely greater resources.

The painful truth: The only route to sustained growth is improvement in human capital and input — and such changes are measured in decades, not quarterly portfolio reports.

North America, according to U.N. statistics, has 126,200 technical and scientific workers per million population. The average emerging market has 8,263. The writer Manuel Castells reports that North America in 1990 accounted for just under 43% of all research and development carried on worldwide, while Latin America and Africa together accounted for less than 1%. Until these types of disparities are addressed, sustained economic growth in the emerging markets is a chimera.

What will continue are boom and bust cycles based on labor-cost arbitrage and levels of Western enthusiasm for emerging-market speculation — none of which will give the vast majority of the world’s population living in developing countries a lasting foothold on the path to economic growth.

The solution, to the extent that there is one, is to readjust our expectations for liquidity as investors. Enough barriers to the flow of capital have to be created that the scope of investment is either long-term or non-existent.

I’m not even remotely concerned about the decline these sorts of barriers would cause in overall investment levels. As the case of Japan proves, scarcity of capital is actually preferable in many instances to abundance, particularly for a developing society. Both Taiwan and Chile, for example, have sharply controlled their inflows of capital for well over a decade — and both have far outperformed the average developing country in terms of sustained development.

More important, we have to see the IMF and U.S. program to liberalize capital markets as both excessive and ideologically inspired. It’s an error that its perpetrators literally cannot see.

The ideological blinders have caused investors to underestimate the horrific damage their activities in emerging markets can do to the countries involved. Certainly, investors in emerging markets are nursing significant wounds, and I don’t minimize the distress these markets have caused. But in Indonesia, which tried to follow IMF mandates, approximately a third of the population is now facing severe hunger, with some subsisting on boiled tree cellulose.

Our weak asset class is their end of the world. We must take a hard look at what we think we’re doing.