Ever since the fall of Communism and the rise of the Internet, future growth has appeared to lie in emerging markets. Modern communications have made it much easier for multinationals to run international supply chains that take advantage of their abundant resources and cheap labor, while emerging markets people have become far more connected to the world economy, to their great advantage. Yet just as globalization itself has begun to reverse, as I discussed last week, so the era of emerging markets emergence may be coming to a close – at least for the next decade or so.

Contrary to the belief of many emerging markets politicians, the sudden acceleration in emerging markets performance was not the result of a sudden improvement in their governance. While the collapse of Communism provided a nasty shock to the worst emerging markets regimes, even such convinced statists as China and Vietnam had already before 1990 come to realize that market forces could produce an improvement in economic performance. While there was a certain “virtuous circle” effect in the late 1990s and early 2000s, from countries seeing their neighbors improving policy and thereby performance, it wasn’t very strong.

For one thing, the East Asian tigers, the most capitalist of emerging markets, suffered a devastating economic crisis in 1997-8 which retarded their progress by around a decade and gave pause both to other emerging markets and to their bankers, who ceased for several years providing that flood of credit which facilitates the easiest consumption-led development. As for Western advisors, by the late 1990s they had come to agree on a watered down “Washington Consensus” version of capitalism which tended to reduce trade barriers and brought some (mostly crony capitalist) privatizations, but did nothing to reduce the size of government or make it more efficient.

There were two factors making emerging markets richer from 1990 onwards. The first, and by far the most important, was the emergence of cheap cellphone technology and the Internet. Suddenly it became possible for multinational companies to run worldwide supply chains and, eventually, for citizens even in the backwoods of emerging markets to connect themselves to the world market, and discover what the local factor should be paying them for their maize, for example.

The result has been an immense arbitrage between rich and poor countries, whereby all but the most skilled and well-connected citizens of rich countries have seen a halt to the steady rise in living standards they had enjoyed for the last half century, as they have started competing in a worldwide market for manufacturing and traded service labor. Meanwhile the inhabitants of poor countries have seen a massive influx of manufacturing and service jobs, raising their living standards at unprecedented rates. China, as the largest available pool of cheap labor, already tolerably well run by 1990 under Deng Xiaoping, was the first to benefit from this effect, with rising living standards moving steadily inwards from the coastal cities, while Africa, with poor local infrastructure and especially poor governance, was the last continent to benefit. However after 2000 even Africa, which had stagnated for 40 years, began to take off.

The second and less benign factor favoring emerging markets was the easy money policies of the Fed, the Bank of Japan, the Bank of England and eventually the European Central Bank that have prevailed since 1995. These have made it much easier for emerging markets to raise bond market money, since they have driven investors on a semi-permanent search for yield and higher tolerance for risk. By compressing the risk differentials in capital costs between emerging and developed markets, they have lowered the cost of outsourcing to cheap labor markets, accelerating the global restructuring that was happening anyway. Only for brief periods, in 2001-02 and again in 2008-09, did investors’ risk aversion return to normal levels and the flow of capital to emerging markets dry up.

The two factors combined after 2000 to increase commodity prices, as higher emerging market demand combined with funny-money-fed bubbles. This further spread economic growth to countries without efficient cheap labor or decent governance, but with ample supplies of resources of one kind or another – the likes of Brazil and Russia, nobody’s ideal of cheap-labor manufacturing locations, but prospering nevertheless.

The 2001 Argentine crisis showed what could go wrong. Argentina had pegged its currency to the dollar, then in the late 1990s (when commodity prices were still low) relaxed its never very stringent discipline on the public sector, covering ever enlarging deficits by gigantic dollar bond issues for maturities as long as it could get. I was at that time advising the Croatian Ministry of Finance; when we saw Argentina’s 20-year bond issues we briefly wondered whether we should be doing similar deals, until we realized that the high interest rates and relaxed fiscal discipline made disaster inevitable long before 20 years were up.

After Argentina’s default, the country ended even its sloppy self-indulgent version of free-market policies, and since 2003 has pursued a policy mix very similar to that it followed in the 1940s, unlearning the lessons of the previous six decades. However commodity prices rose and, with the country relieved from most of the costs of debt service, prosperity followed. Consequently the Argentine people have been taught that free-market policies lead to poverty and crisis, while autarky works – a repeat of the similar lesson taught by the political/economic cycle of the 1930s and 1940s. Argentine supporters of the current regime refer to the 2003-13 period as the “Miraculous Decade” and to the capitalist but impoverished 1930-43 period as the “Infamous Decade.” In terms of results, they have a point; in terms of sound policy, the names should be reversed.

Argentina hit the wall early, because of the commodity cycle, but that wall is now approaching emerging markets in general, and will cause their current prosperity to come to a painful end.

First, emerging markets’ cost advantage over Western competitors has been reduced. This has already been noticed with respect to China, which is now running a balance of payments deficit. Much production has been moved from the expensive coastal regions to the hinterlands, but the additional transportation and logistics costs make it barely worth the trouble to do so. At the same time, production has been moving to other emerging markets such as Vietnam, which have themselves begun to see rapid wage increases.

The wage arbitrage between rich and poor countries will not continue smoothly until wages have been equalized altogether, because the inefficiencies of emerging markets have not greatly diminished. While billions have been spent on infrastructure, the level of corruption in these markets remains very high, the education level of the populace as a whole remains fairly low and the systems for getting things done remain imperfect.

With the exception of a few small countries like Estonia, Macedonia and Chile, which have brought their systems, education levels and integrity more or less up to Western levels and are benefiting thereby, this won’t change in a hurry. In a large country, vested interests opposing integrity, fool-proof systems and better education remain powerful, and change is thus glacially slow. Both China and India, for example, have been “reforming” their institutions for a generation yet have made very little progress even though both countries are much richer than they were.

In a well-run world, we would expect the example of successful emerging markets to spread to unsuccessful ones, so that governance improved, state inefficiencies were trimmed back, macroeconomic policies were optimized and corruption was cut back at least to the more or less tolerable levels of New Jersey or Chicago. However the Argentine example shows us that this is not currently happening to any significant degree, largely because of funny money.

Commodity prices have risen to unsustainable levels, propping up commodity producing economies and allowing them to prosper without becoming better governed. Overspending governments have been allowed to borrow in international markets at costs far below those they had ever dreamed possible, so corruption and waste have flourished like weeds. International institutions have imposed no discipline on their clients, instead encouraging them to undertake wasteful “stimulus” public spending.

Foreign and trade policies have been feeble, allowing regional bullies to prosper and harass their more virtuous neighbors, imposing no meaningful sanctions on economic or political bad behavior, and discouraging the kind of steady growth-oriented public sector restraint that allows the private sector to flourish. In some countries, such as Colombia, policies have been decent in spite of the incentives for overspending and foreign borrowing; in other countries, such as Brazil and Russia, they haven’t. Africa in particular has this year engaged in an orgy of foreign borrowing, almost all of which has flowed into public sector deficits and balance of payments deficits – thus doing nothing to grow the economy at all, merely enriching government officials with sticky fingers as it cycles back out of the country.

In the current environment in the majority of emerging markets debt and corruption have been increasing while governance has been deteriorating. Since the arbitrage pushing manufacturers towards emerging markets is getting weaker, their superior growth will soon disappear. Needless to say, when the crunch comes it will be a painful one, with credit drying up and bankruptcies proliferating.

While emerging markets investors did quite well in the early 1990s and the middle 2000s (suffering a bad relapse in 1997-98) they haven’t gained much recently. While the MSCI World developed markets index has returned an annual 10.1% over the last 5 years, the emerging markets dollar index has returned investors less than half that, at only 4.7% annually. Given the “frictions” that prevent international investors getting the full benefit of the profits earned by their emerging markets holdings, it’s time for them to look elsewhere.

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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.)