Emerging market stock markets, bond markets and currencies have suffered much more than developed country markets during 2008, in spite of the original real estate bubble and credit disaster having been contained almost entirely in rich countries. That suggests that globalization, by which emerging markets gain capital and access to developed markets for their goods and services exports, may be something of a Faustian bargain.

There is no question that the decline in some emerging markets’ stock markets and credit ratings was justified. When oil drops from $147 to $70 a barrel, it is reasonable to expect Russia and Venezuela to be hit badly, even if those countries had been well run. However given the spectacular refusal by both the Putin/Medvedev team in Russia and Hugo Chavez in Venezuela to recognize the validity of economic laws, it is not surprising that those countries have run into big trouble, which is likely to get bigger.

Argentina too has been exhibiting its usual poster-child-for-lousy-economic-policy status ever since 2003, and those of us who value sound economic policy more than the welfare of the Argentine people are duly cheering now that the chickens are coming home to roost. (Sorry amigos, but you guys elected these bozos. Indeed it’s a great relief that the good guys didn’t win the 2007 Presidential election; otherwise, as after the late unlamented Juan Peron, it might have been another 50 years or more before you finally figured out that populist-leftist economics doesn’t work. This way, you’ll have your chance to straighten up and fly right in a couple of years.)

However most emerging markets are not all that badly run. Indeed, given the abysmal performance of a number of Western governments in recent weeks, the case can be made that many emerging markets are well run by Western standards, avoiding obvious mistakes that are common in the West. Brazil for example is fighting inflation the right way, with a Selic short-term interest rate of 13.75%, double its rate of inflation. South Korea (almost graduated from “emerging market” status) has a new government that is properly committed to the free market, and a level of government spending far below even current levels in the US and Europe, let alone the heights to which those unfortunate countries may climb. Vietnam and a number of African countries are at least competently run, which given their immense wage cost advantages ought to allow them a lengthy period of rapid growth.

Traditionally, emerging markets have suffered from a higher cost of capital than the rich West. This compensates for their lower labor costs, allowing Western companies to survive in an environment of free global competition. Thus it would normally be expected that when the rich world caught a cold, emerging markets would suffer from pneumonia, as capital sources dried up and they found it impossible to fund new investment.

However there is currently one flaw in this picture: emerging markets today have much higher savings rates than the rich West. The United States in particular and the West in general have gone on a spending binge that has left the majority of the world’s foreign exchange reserves in the hands of Middle Eastern and Asian governments. Far from emerging markets suffering from a smaller pool of capital, many of them today have a much healthier capital position than their Western competitors. Thus a sudden capital shortage should have affected them less than their Western counterparts, not more.

That suggests that competently run emerging markets should regard this crisis as a temporary hiccup, not a reason to despair, and certainly not a reason to jettison wholesale an economic model that has worked generally well for them and retreat into Third World autarky and socialism. Countries that default owing to global conditions should not regard it as the end of the story; if they remain competently run they will quickly be allowed back into the international financial arena (countries like Argentina that default through sheer incompetence and hatred of the global investing class are a different matter, and deserve no help.)

In the long run, emerging markets’ advantages of labor costs will still be there, and if they preserve the essentials of a free market system they will have in their domestic economies much of the savings base they need to succeed. The main need will be to keep open the flows of international trade, so that global markets are available to expand their businesses.

Conversely, the prospects of Western economies would appear dismal. With inadequate savings bases, they are going to be permanently capital-short in a world where capital is both scarce and more expensive. Their labor costs will remain relatively high, yet they will no longer have the advantage of capital availability over competently run emerging markets. Eventually growth will return, but it may be at a considerably less comfortable equilibrium than today in terms of living standards.

As for emerging markets themselves, it is now clear that the advice they have received from Western institutions such as the World Bank has been largely misguided, and ill-suited to a world in which the global stability they had been promised proved so ephemeral. They need to establish quickly a new consensus that will enable them to prosper in a world where capital is no longer so abundant and Western countries are no longer a cornucopia of wealth and foreign investment:

• Solid property rights. For domestic and international reasons, emerging markets need to establish solid property rights. Apart from being immoral, the Russian/Argentine approach to property destroys capital formation domestically and in a world where global capital is scarce will quickly discourage foreign investors. Emerging markets will during the crisis see Western countries carrying out actions that damage property rights; that makes their own respect for such rights more not less essential
• Encourage middle class savings. If capital is not readily available internationally, it must be found domestically. The principal source of capital formation for small businesses in almost all societies is the capital accumulated by the entrepreneur’s relatives and friends. Interest rates need to be kept significantly above the rate of inflation to encourage saving and discourage borrowing-fueled consumption, banking systems must be protected from collapse, taxation of capital must be kept at a low level, inflation must be suppressed to prevent capital erosion for those on fixed incomes and a “level playing field” must be established as far as possible for domestic investment so that modest savers can invest on the same terms as the big boys. Encouragement of middle class savings is the #1 requirement for economic development; it has been disgracefully neglected by the index-linked bureaucrats of the aid agencies.
• Interest rates need to be kept high, for two reasons. First, high interest rates encourage capital formation and discourage saving. Second, they keep inflation under control. Big businesses will whine at the high real cost of capital; the recent crisis has demonstrated that capital that is cheap is far less important than capital that is always available.
• Government spending must be tightly controlled at all times. The temptation will be to indulge in government handouts or worse still Keynesian spending programs (where the government rather than the recipient determines the goods on which money is spent) to counter the effects of economic downturns. International aid bureaucrats will encourage these – it’s all they know. The fact remains that over a long period, it has been demonstrated that high government spending (as a percentage of Gross Domestic product) or rapidly rising government spending are the principal factors suppressing economic growth; for OECD countries since 1960 variances in government spending account for more than half the observed variances in growth rates.
• The capital markets must be free for retail investment, but there is no hurry to remove restrictions on retail borrowing. Investors who have the option of investing freely internationally will keep the bulk of their money at home; those who are restricted by exchange controls will find ways to hide it abroad, preventing its use for small business formation. Conversely, an over-active mortgage market diverts scarce savings into housing, while an over-active credit card market destroys savings altogether and will undermine the capital base of a country that has not yet achieved wealth.
• If population increase is too rapid (above 1% per annum approximately) steps should be taken to reduce it. The capital cost of building facilities for a rapidly expanding population, and the education cost of a bloated youth cohort are too large for a poor economy to absorb, particularly if capital and aid flows are less bountiful than formerly. Rapid population growth is incompatible with increasing living standards, and hence should be sharply discouraged.
• Finally, foreign companies and private equity operations should be free to purchase domestic companies – their capital and expertise are important in allowing local companies to grow and bringing their operations up to the best international standards. However, exceptions should be made, not for strategic industries (there is no economic reason why foreigners should not own energy and mining companies) but for companies where domestic companies are already globally competitive and the country has established itself as pole of sectoral excellence. If a country has special expertise in a particular industrial sector, it is important that training for that sector, job opportunities for new entrants, advancement opportunities for more experienced staff and sectoral entrepreneurial opportunities for the adventurous and capable be retained domestically. There are disadvantages both economic and political to being a “branch plant” economy; it’s inevitable in most sectors but should be avoided in at least a few for each country.

In the long run, well-managed emerging markets will emerge from this downturn with increased strength, both absolutely and relative to the West. New tricks will have to be learned, however.

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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)