The Rise and Fall of Nations: Ten Rules of Change in the Post-Crisis World

by Ruchir Sharma

The International Monetary Fund therefore defines a global recession not in terms of negative GDP growth but in terms of falling income growth, job losses, and other factors that make the world feel like it is in the grips of a recession.

The American playwright Arthur Miller once observed that an era has reached its end “when its basic illusions are exhausted.”2 Today the illusions of widening prosperity that defined the pre-crisis era are finally spent. The last to die was the faith that China’s boom would last indefinitely, lifting up countries from Russia to Brazil, from Venezuela to Nigeria, which had been thriving mainly by exporting commodities to the Chinese. Ever-growing demand from China would drive a “super cycle” of rising commodity prices and growing wealth from Moscow to Lagos. This storyline began to strain credulity by 2011, when prices for copper and steel started to fall. It collapsed completely in late 2014, when the price of oil dropped by more than half in a span of months.

A few basic principles underlie all the rules. The first is impermanence.

Recognizing that this world is impermanent leads to the second principle, which is to never forecast economic trends too far into the future.

Trends in globalization have ebbed and flowed ever since Genghis Khan secured commerce along the Silk Road in the twelfth century, and the cycles of business, technology, and politics that shape economic growth are short, typically about five years.

So the longer a streak lasts, the less likely it is to continue. When a country like Japan, China, or India puts together a decade of strong growth, analysts should be looking not for reasons the streak will continue but for the moment when the cycle will turn.

A nation’s overall rank on the HDI often aligns very closely with its ranking for per capita income, which is the result of its long-term growth record.

In general, however, if a country focuses on growth, development will follow.

Increasingly, economics is seen as an impractical science. For some academics, forecasting is an intellectual exercise, and rewards flow from publishing big ideas. The result is often a one-dimensional or ideological worldview. Some American and European intellectuals hint that Islamic culture is too backward to promote rapid growth. Some people on the extreme right believe every government action is by definition bad. Liberals often trace strong growth to democratic institutions, an explanation that can’t account for many things, including the long boom in Asia from 1980 to 2010, when most regimes in the region were illiberal.

In China, analysts skeptical of official GDP growth figures have started checking them against other indicators, such as cargo traffic and electricity consumption. That check can be pretty reliable, except that in 2015 reports emerged that government authorities were instructing developers to keep the lights on even in empty apartment complexes. The aim was to drive up electricity consumption data so that it would confirm official economic growth claims. This is a classic case of Goodhart’s Law, which says that once a measure becomes a target, it ceases to be useful, partly because so many people have an incentive to doctor numbers to meet it.

These are the basic principles: Avoid straight-line forecasting and foggy discussions of the coming century. Be skeptical of sweeping single-factor theories. Stifle biases of all kinds, be they political, cultural or “anchoring.” Avoid falling for the assumption that the recent past is prologue for the distant future, and remember that churn and crisis are the norm. Recognize that any economy, no matter how successful or how broken, is more likely to return to the long-term average growth rate for its income class than to remain abnormally hot (or cold) indefinitely. Watch for balanced growth, and focus on a manageable set of dynamic indicators that make it possible to anticipate turns in the cycle.

In three out of four of the miracle economies, the working-age population grew at an average pace of at least 2 percent a year during the full duration of a decade-long boom. A country is thus unlikely to experience a decade-long growth boom if its working-age population is growing at a rate less than 2 percent.

While population shifts gradually, measures to reshape the workforce can have a rapid impact, because you don’t have to wait fifteen to twenty years for a woman, a retiree, or an economic migrant to grow up. Providing childcare services can bring women with children back to work. Opening the nation’s doors to economic migrants can expand the working aging population virtually overnight. And reversing the twentieth-century campaign that pushed the retirement age down into the fifties in many industrial countries could bring a forgotten generation back to work very quickly.

The OECD recently estimated that eliminating the gender gap—bringing as large a share of adult women into the workforce as men—would lead to an overall increase in GDP of 12 percent in its member nations between 2015 and 2030. The GDP gains would peak close to 20 percent in both Japan and South Korea and more than 20 percent in Italy, where less than 40 percent of women are in the formal labor force. A similar analysis in 2010 by Booz and Company showed that closing the gender gap in emerging countries could yield even larger gains in GDP by 2020, ranging from a 34 percent gain in Egypt to 27 percent in India and 9 percent in Brazil.

Fear of the robotic future is now as strong as fear of migrants and refugees, and it is built on a lack of imagination.

French president Charles de Gaulle once said, “A great leader emerges from the encounter of will and an exceptional period in history,” and this is the basic dynamic linking crises to promising new reformers.

It’s worth noting that running the same analysis for developed countries revealed no clear connection between stock market returns and aging political leadership. This doesn’t mean that leaders don’t matter in rich countries, only that politics matters more in emerging ones, where institutions are weaker and new or aging leaders can have a clearer impact on the economy’s direction and therefore on the mood of the markets.

Like Putin and many others before him, Erdoğan could have secured an unblemished legacy as one of his nation’s greatest postwar leaders—if he had stepped down gracefully after two terms. Instead, he is mired in controversy. In the end, said Ralph Waldo Emerson, every hero becomes a bore.

It is a bad sign for any country when its leader can’t give up the trappings of power and views himself as consubstantial with the nation.

Successful leaders often share these two key attributes: popular support among the masses and a clear understanding of economic reform, or at least a willingness to delegate power to experts who do get it. In contrast, populist demagogues who artfully combine populism and nationalism can be politically successful but tend to be a disaster for their countries.

Later, Indira Gandhi would capitalize on this nationalist mood to rule India. For close to a decade, she nationalized banks and strategic industries like coal and produced India’s worst decade of growth in the postindependence era.

The best way for technocrats to be successful is therefore as staff members of an authoritarian regime like Suharto’s, which can command rather than rally popular support.

Following the spectacular three-decade boom in China, there is a strong tendency to believe that autocracies are better than democracies at generating long runs of growth, a myth that may be built not so much on the rise of China as on coverage of the rise of China.

However, because autocrats face few checks and balances and no opposition at the ballot box, they can veer off in the wrong direction with no one to tell them otherwise, and they can also hang on to power indefinitely, more often than not with bad results for economy.

The record of extreme booms and busts should give pause to any nation that ever yearned for the firm hand of an autocrat. In recent decades, many economically troubled nations have looked to a strongman to restore prosperity. In the long run, however, stable and enduring growth is more likely under a democrat, who lacks the power to engineer spectacular runs of success or failure. Even autocrats who produce long periods of strong growth often become, in the end, predatory defenders of the status quo, trampling on property rights to enrich their own clique, discouraging anyone who is not a friend of the big boss from taking any stake in the economy.

Since the top 1 percent of Americans control 50 percent of the financial wealth, they gain most when these asset prices boom.

When changing any policy, the state has to take into account how it will affect business sentiment, as an abrupt shift can hurt the animal spirits in an economy.

China started on the road to becoming an industrial superpower only after the all-encompassing state started to interfere less in the economy. Around 1980 the Chinese government began to ease its grip, one step at a time and always in response to pressure from below. Initially, peasants demanded to sell more of their own produce, then villages sought to run their own local enterprises, and finally individuals pressed for the right to own and run those enterprises. 3

Unlike the governments of the developed world, those of the emerging world went into the crisis of 2008 with generally low levels of public debt, large reserves of foreign currency, and strong government budget surpluses or at least relatively small budget deficits. Having money to burn, they burned it, and the initial result was a great jet flame of growth.

On average, state banks control 32 percent of all banking assets in the twenty largest emerging nations. That figure is 40 percent or more in Thailand, Indonesia, Brazil, and China (where the line between state and private banks is murky and the actual number is likely much higher). It is 50 percent or more in Taiwan, Hungary, Russia, and Malaysia and a striking 75 percent in India.

As Bloomberg News pointed out in a 2015 profile, China’s financial dependence on cigarettes perhaps explains why the state tobacco company is allowed to sponsor elementary schools, where its banners proclaim, “Tobacco helps you become talented.”

Fuel subsidies also tend to widen income and wealth inequality in poor countries, because states that subsidize energy have little choice but to subsidize it for everyone, despite the fact that those benefits go to support the privileged class of car owners. According to the IMF, in emerging economies, more than 40 percent of the $600 billion in annual energy subsidies worldwide goes to the richest 20 percent of the population.

In a 2005 article titled “The Rise of Europe,” the development experts Daron Acemoglu, Simon Johnson and James Robinson set out to explain this continental boom and found that the answer was a combination of geography and a readiness to exploit it.3 Between 1500 and 1850, they argued, the boom in Europe was driven mainly by nations with two key advantages: port cities on major Atlantic trade routes, and monarchies that respected private property rights and granted merchants the most latitude to exploit growing trade channels.

In 2015 the Hong Kong–based economist Jonathan Anderson put together a “heat map” of the world’s hottest economies by plotting the location of countries that have seen manufactured exports grow significantly as a share of GDP since 1995. He found fourteen countries, confined mainly to two regions: Southeast Asia led by Vietnam and Cambodia, and eastern Europe led by Poland, the Czech Republic, and Hungary.

Strong leadership has historically played a key role in helping some regions take off. Asia’s postwar boom began in Japan, spread to a second tier of economies led by South Korea and Taiwan, then to a third tier led by Thailand and Indonesia, and a fourth led by China. A Japanese economist called this the “flying geese” model of development. As Japan rose up the development ladder to make ever more sophisticated products, the second tier learned from its example and slipped into the industries Japan had vacated, followed themselves by the third tier, and so on.

When the Internet first started to revolutionize communications in the 1990s, experts thought it would allow people to do most service jobs just about anywhere, dispersing these businesses to all corners of every country and making location irrelevant. That dispersal is happening for lower to midlevel service jobs, but as the Columbia University urbanologist Saskia Sassen has pointed out, the headquarters of service industries from finance to insurance and law are actually concentrating in a network of about fifty “global cities.” These service cities are led by New York and London but are cropping up from Shanghai to Buenos Aires.

Today the Internet is making geography irrelevant neither for manufacturing industries nor for service industries. People still meet face to face in order to manage and build service companies that provide everything from Internet search engines to cargo logistics, and new companies in these industries typically set up in the same town to tap the same expert talent pool.

Still, for an emerging nation, even technology cannot play the same catalytic role as manufacturing because no country has figured out how to leapfrog the stage of building basic factories that make simple goods such as clothing, and that require only relatively simple skills that can be mastered by workers coming straight off the farm.

The worst kinds of investment binges leave behind little of productive value, in part because they are not prompted by some hot new technology or innovation.

The way the curse works is that the production of oil sets off a scramble among elites to secure shares of the profits rather than invest to build roads, power plants and factories. In oil-exporting countries, the leadership becomes decreasingly reliant on revenue from taxpayers, then less inclined to listen to them as voters; instead it quiets their rumblings by spending a part of its oil revenue on subsidized gas, cheap food, and other unproductive freebies. Meanwhile other industries suffer. Foreigners pump in money to buy the oil, which drives up the value of the currency, in turn making it difficult for local factories—what few exist—to export their goods. The oil windfall tends to undermine every local industry other than oil.

The two-hundred-year history of commodity prices is that, in inflation-adjusted terms, the average price of commodities is unchanged. Upswings tend to last for a decade but then prices drop like a rock and stay low for around two decades, taking a number of steel- or oil- or soybean-driven economies up with them, unless the leadership has taken steps to break the curse.

It is not yet clear how the China story will end, but this process of decay in the quality of a binge—from good investments in factories or roads to questionable ones in real estate megaprojects—often results in a meltdown of some kind. Thailand is a classic case, because its long record of strong investment—in the roads and factories that transformed its eastern seaboard—got derailed in the late 1990s. The optimism of the preceding boom inspired many Thais to begin borrowing heavily to buy real estate, creating a bubble that when pricked helped trigger the Asian financial crisis of 1997–98. The same story unfolded in Malaysia, where at the peak of its boom in 1995, investment reached 43 percent of GDP, the second-highest level ever recorded in a large economy, behind only China today.

In practice, however, a young economy is most vulnerable to demand-driven inflation when if it has invested too little in its supply networks. The supply network includes everything from power plants and factories to warehouses, and the communication and transport systems that connect them to consumers. If these supply channels fall short of meeting demand, consumer prices start rising.

Today the high level of trade and money flows—compared to the early postwar period—tends to restrain consumer prices but magnify asset prices, so central banks need to take responsibility for both.

The country will be poised to grow not when the currency starts falling but when it has stabilized again at a cheaper and more competitive value. In many countries, nonetheless, the tendency to equate currency strength with a bright economic future persists. These misunderstandings are not as violent as they were in the twelfth century, when King Henry I ruled England. In 1124, alarmed by the falling value of the English sterling and suspecting a conspiracy, he chose to address the problem by summoning nearly one hundred royal money changers to the palace at Winchester and, in what historian Nicholas Mayhew described as “a very public occasion designed to bolster confidence,” subjected the entire lot to castration or, for the luckier ones, amputation of the right hand.1 Today the understanding of why currencies move the way they do, and what to do about it, has advanced a bit but perhaps not as much as you might expect.

The bottom line: If a country runs a current account deficit as high as 5 percent of GDP each year for five years, then a significant economic slowdown is highly likely, and so is some kind of crisis.

Because a current account deficit generally reflects excessive consumption of imports, any country running one has to find foreign currency to pay its import bills, and that currency can enter the country in the form of foreign bank loans, foreign purchases of stocks or bonds, or direct foreign investment in local factories.

To start with, nationalist attacks on immoral foreign speculators imply that locals are loyal and patriotic, while outsiders are flighty and exploitative. This narrative ignores the Lucas paradox, named after the Nobel laureate Robert Lucas, which questions the assumption that money flows tend to move from rich countries to poor ones, driven by wealthy American or European investors seeking high returns in hot growth markets. Lucas pointed out that rich locals in emerging nations also have a strong incentive to move their money to richer countries with more trustworthy institutions and safer investment options, such as U.S. Treasury bonds.

For a nation that does slip into a currency crisis, the strongest sign of a turnaround is when the current account rebounds from deficit into surplus. That surplus shows the currency is likely stabilizing at a competitively low rate, boosting exports while forcing locals to cut back on imports. The crisis is passing, and the economy can dust itself off and start growing again.

The only way they could regain a competitive position to generate more export income and reduce their dependence on foreign capital was by making painful choices to cut wages and bloated public payrolls. Economists call this dreaded belt-tightening process “internal devaluation,” and it achieves much the same end as a currency devaluation, by restoring export competitiveness. Only it is slower and more politically difficult, particularly in labor-friendly Europe, since it involves tough union negotiations. Five years after the crisis, Europe’s peripheral economies were still struggling to recover.