Creative destruction on Wall Street

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Get ready to hear it ad nauseum: creative destruction! If you're an ardent supporter of the free market, there is little else to fall back on in the face of today's events on Wall Street. In fact, one might even be pleased about the turn of events, given that financial authorities allowed Lehman Brothers to fail. Avinash Persaud sums up this perspective in an op-ed today in the Financial Times:

[T]here is the subject of moral hazard. While central banks have been offering liquidity on generous terms and stopping institutions from going bankrupt, some banks were not engaged in hard restructuring but gaming the system. They were busy hoarding liquidity and pushing risky instruments into the hands of the authorities... the game is not about luring sovereign wealth funds to invest before markets recover but about how to restructure for a brave new world in which the financial sector is smaller.

According to this reading, it's good that Lehman fell - an inefficient firm has been destroyed, and capital will be freed to migrate to new, better managed institutions. But while all of this may be true, the next few weeks and months will certainly not be pretty for the U.S. economy. I noticed one thing missing from most of today's coverage in the press and (surprisingly) in the blogoshere: What will the effect be on developing economies? 

Undoubtedly, there will be many knock-on effects that are hard to predict. But here are the two issues I see as most important for developing economies:

  1. The end of export-led growth: Just last week, Dani Rodrik wrote an article suggesting that the export-led growth that was typical of many Southeast Asian countries will no longer be nearly as viable for the developing world. As he points out, "[t]he most immediate threat is the slowdown in the advanced economies." The collapse of Lehman, the emergency sale of Merrill Lynch, and the troubles of AIG will only exacerbate this slowdown. I suspect Rodrik will look prescient on this one. (China, it seems, is already taking action to deal with an expected drop in demand for exports.)
  2. Financial sector regulation: Stock markets in many emerging markets are becoming increasingly democratized, as the middle class has seen greater access to equities as a vehicle for investment. However, these markets don't yet offer the kind of complex financial instruments seen on Wall Street. Financial authorities in the rest of the world will be watching closely. If U.S. financial markets rebound relatively quickly, the failure of Lehman will be seen as a triumph for creative destruction. The lesson will be that light regulation is best (even though, as Tyler Cowen points out in this NYT's article, Wall Street is not, in fact, as unregulated as is sometimes supposed). If the U.S. sees a prolonged recession, however, I would wager that we will see an impetus for greater regulation of the financial sector in many parts of the world as more complex financial instruments are introduced to emerging markets.

Thoughts on this one? What else will creative destruction on Wall Street mean for the developing world?

Update: With the bailout of AIG, it looks increasingly like the rest of the world is seeing the financial crisis as a clear lesson about the need for financial regulation (Hat tip: Tyler Cowen).

Update II: Joseph Stiglitz adds his two cents. Money quote:

The globalization agenda has been closely linked with the market fundamentalists -- the ideology of free markets and financial liberalization. In this crisis, we see the most market-oriented institutions in the most market-oriented economy failing and running to the government for help. Everyone in the world will say now that this is the end of market fundamentalism.

In this sense, the fall of Wall Street is for market fundamentalism what the fall of the Berlin Wall was for communism -- it tells the world that this way of economic organization turns out not to be sustainable. In the end, everyone says, that model doesn't work. This moment is a marker that the claims of financial market liberalization were bogus.


Ryan Hahn

Operations Officer

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