One upshot of the recent increase in volatility in financial markets has been a generalized return (again) into the relative safety of U.S. Treasuries: The 10-year is down 30 percent for the year (to 296 bps), and the 30-year down about half that, standing at 398 bps (see figure). A common refrain heard among market commentators is that with Europe in the throes of a sovereign debt (and now possibly full-blown financial) crisis, this is a flight to quality, and that the U.S. is remains the best of the bunch of bad options.
Source: World Bank staff calculations, from Datastream.
Over at PIMCO, Bill Gross takes the question a step further, and suggests that the rub lies in a lack of consumption demand in the developing world. Consistent with the broader PIMCO view of a new normal where global aggregate demand is anemic mainly due to shortfalls in the developed world, the claim nevertheless begs the deeper question of why consumer demand is the global South does not rise to pick up the slack. After all, if developing countries are indeed suffering from an international financing constraint, then forward-looking investors will see that sending capital their direction will ultimately translate into real growth, which in turn will support the returns to their investments.
It is easy to speculate on why this does not occur, of course. Indeed, the current phenomenon---of insufficient capital flows to developing regions where the marginal product of capital is the highest---are a reprise of the classic Lucas Paradox for our times. In order to have a sustainable reversal of the Lucas Paradox, what is really needed is a confluence of four factors. On the demand side, there needs to be both a decrease in the propensity to invest in safer developed markets, as well as an increase in the attractiveness of investing in riskier emerging markets. This then needs to be accompanied on the supply side by a decline in the ability (or at least, a decline in perceptions of the ability) of developed market issuers to credibly conduct sound policy, along with a rise in the quality of institutional and policymaking frameworks in developing ones.
Let's take these in turn. Although there is likely to be little by way of dramatic declines in the quality of policymaking in the developed world, current events make it evident that the sheen of superior policy choices in the global North is fading off. If the debt and deficit data are anything to go by, the debt outlook for developing economies is (with the notable exception of ECA) largely projected to be stable or decreasing (see top figure), while the picture is much more dismal among developed economies, with deficits not showing much of a projeted recovery (with the exception of the United States) (see bottom figure). The bottom line is that, by the debt/deficit metric at least, there is now sufficient reason to question the quality of policymaking in the developed economies.[*]
Source: World Bank staff calculations, from the IMF WEO database.
Furthermore, the quality of policymaking is improving all over the developing world. Although there are many ways to slice this pie, one readily-available metric is the cost of business start-up procedures, which captures the extent of bureaucratic and government inefficiency. By this measure, policymaking throughout the developing world has improved by leaps and bounds over a relatively short span of seven years (see figure). Africa, for example, has managed to lower such costs from in the excess of 300 percent of GNI in 2006 to 100 percent in 2009. While this is undoubtedly still extremely high, a two-thirds decline is nothing to sneer at. This trend of falling costs is replicated across the different regions, a clear reflection of the advances in policymaking in the global South.
Source: World Bank staff calculations, from the World Bank Doing Business database.
We are also seeing some tentative evidence that institutional investors are beginning to seriously consider emerging markets as the place to park the bulk of their portfolio under management. Private capital flows into emerging markets have certainly been saying the same story, and while these have moderated somewhat in the wake of the crisis, the Bank's forecasts (PDF) for 2010 through 2012 project a healthy recovery ($589.5 billion in 2010 to $770.8 billion in 2012, or 3.02 to 3.15 percent of GDP).
The final element to consider is whether global private investors and money managers are much less inclined to channel their money toward mature markets. In this case, it seems that there has yet to be a marked shift in mindset away from the safety (both financially and psychologically) of the developed world. Many portfolios still place the bulk of their assets under management in the usual suspects, and even recent retreats in the S&P 500 are insufficiently suggestive of any major changes in this respect. The flight to U.S. Treasuries (discussed above) likewise point to this fact. But the developing world has savers, too, and many are finding good reasons to keep such financial capital at home, rather than sending it to American and European capital markets. Perhaps the paradigm shift will eventually come.
While our posts here have often concluded with implications for developing countries. It is however interesting to ask, conditional on the changes described above coming to pass, what a Lucas Paradox reversal would mean for developed countries. One immediate implication is that developed economies might get a taste of what has plaugued emerging markets for decades---rapid capital flow reversal (the "sudden stop"). While any such reversal is unlikely to be as acute and sudden as they typically are for the South, policymakers in the developed world should no longer take benign credit conditions, especially those faced by sovereigns, for granted. So while it is true that yields on U.S. Treasuries remain extremely compressed, they just may go bump in the night.
*. Of course, one could make the case that the deficits are precisely a mark of good policymaking, since they were incurred in order to provide Keynesian pump-priming for what out otherwise be a depression scenario. While I have little desire to wade into the heated austerity debate, suffice it to say that had developed-country policymaking been up to the task to begin with, these countries may have avoided the worse of the financial crisis that has necessitated such a desperate fiscal response.