Guest Author: Jeffrey Frankel is James W. Harpel Professor of Capital Formation and Growth at Kennedy School of Government, Harvard University. He directs the program in International Finance and Macroeconomics at the National Bureau of Economic Research, where he is also a member of the NBER Business Cycle Dating Committee, which officially declares recessions. He served on the Council of Economic Advisers under President Clinton and is on advisory panels for the Federal Reserve Banks of New York and Boston, the Peterson Institute for International Economics, and the Bureau of Economic Analysis. Complete Curriculum Vitae. He writes at Jeff Frankel’s Weblog.
In 2008, the global financial system was grievously infected by so-called toxic assets originating in the United States. As a result of the crisis, many have asked what fundamental rethinking will be necessary to save macroeconomic theory. Some answers may lie with models that have in the past been applied to fit the realities of emerging markets — models that are at home with the financial market imperfections that have now unexpectedly turned up in industrialized countries. The imperfections include default risk, asymmetric information, incentive incompatibility, procyclicality of capital flows, procyclicality of fiscal policy, imperfect property rights, and other flawed institutions. To be sure, many of these theories had been first constructed in the context of industrialized economies, but they had not become mainstream there. Only in the context of less advanced economies were the imperfections undeniable. There the models thrived.
An analogy can capture the apparently novel suggestion that emerging markets may have important lessons for advanced countries. In the latter part of the nineteenth century most of the vineyards of Europe were destroyed by the microscopic aphid Phylloxera vastatrix. Eventually a desperate last resort was tried: grafting susceptible European vines onto resistant American root stock. Purist French vintners initially disdained a strategy that they considered would compromise the refined tastes of their grape varieties. But it saved the European vineyards, and did not impair the quality of the wine. The New World had come to the rescue of the Old World.
The academic literature on macroeconomics and finance in developing countries hardly existed 30 years ago. But by now it has grown very large — large enough to deserve a survey of its own. I review much of this research in a survey titled “Monetary Policy in Emerging Markets.” It appears as a chapter in the Handbook of Monetary Economics, edited by Ben Friedman and Michael Woodford, which has just this week become available from Elsevier Publishing. Among the hundreds of authors represented in the survey are Caballero, Calvo, Dooley, Dornbusch, Edwards, Reinhart and Velasco, as well as many younger scholars. Again, although financial opening gave capital flows a central role in the emerging market models, the need to allow for imperfections in these markets has always been clear. It is also what gives the models so much relevance today, not just for theory but for policy as well. Raghu Rajan and Simon Johnson point out that some of the institutional failings that we associate with financial sectors in developing countries, such as distorted incentives and undue political influence, also apply to the United States and other advanced countries. Among other areas of economic policy where the North could draw useful lessons from small countries in the South as to how to address the problems, in earlier blogposts I have given the example of the procedures that Chile has used over the past decade to achieve countercyclical fiscal policy.