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Chapter 22 Developing Countries: Growth, Crisis, and Reform 125
Chapter 18
Developing Countries:
Growth, Crisis, and Reform
.1 n Chapter Organization
Income, Wealth, and Growth in the World Economy
The Gap Between Rich and Poor
Has the World Income Gap Narrowed Over Time?
Structural Features of Developing Countries
Developing-Country Borrowing and Debt
The Economics of Financial Inflows to Developing Countries
The Problem of Default
Alternative Forms of Financial Inflow
The Problem of “Original Sin”
The Debt Crisis of the 1980s
Reforms, Capital Inflows, and the Return of Crisis
East Asia: Success and Crisis
The East Asian Economic Miracle
Box: Why Have Developing Countries Accumulated Such High Levels of International Reserves?
Asian Weaknesses
Box: What Did East Asia Do Right?
The Asian Financial Crisis
Spillover to Russia
Case Study: Can Currency Boards Make Fixed Exchange Rates Credible?
Lessons of Developing-Country Crises
Reforming the World’s Financial “Architecture”
Capital Mobility and the Trilemma of the Exchange Rate Regime
“ Prophylactic” Measures
Coping with Crisis
Case Study: China’s Undervalued Currency
Understanding Global Capital Flows and the Global Distribution of Income: Is Geography Destiny?
© 2012 Pearson Education, Inc. Publishing as Addison-Wesley
126 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Ninth Edition
Summary
© 2012 Pearson Education, Inc. Publishing as Addison-Wesley
Chapter 22 Developing Countries: Growth, Crisis, and Reform 127
.2 n Chapter Overview
This chapter provides the theoretical and historical background students need to understand the macroeconomic
characteristics of developing countries, the problems these countries face, and some proposed solutions to
these problems. Students should be aware of the general events of the East Asian financial crisis. The chapter
covers the East Asian growth miracle and subsequent financial crisis in depth. First, though, it introduces
general characteristics of developing countries and the economics of their extensive borrowing on world
markets, as well as the inflation experiences, debt crisis, and subsequent reform in Latin America.
The chapter begins by discussing how the economies of developing countries differ from industrial economies.
The wide differences in per capita income and life expectancy across different classes of all countries are
striking. Some economic theories predict growth convergence, and there is evidence of such a pattern among
industrialized nations, but no clear pattern emerges among developing countries. Some have grown rapidly
while others have struggled.
There are important structural differences between developing economies and industrial economies.
Governments in developing countries have a pervasive role in the economy, setting many prices and
limiting transactions in a wide variety of markets; this can contribute to higher levels of corruption.
These governments often finance their budget deficits through seigniorage, leading to high and persistent
inflation. The economies of developing countries are typically not well diversified, with a small number
of commodities providing the bulk of exports. These commodities, which may be natural resources or
agricultural products, have extremely variable prices. Finally, economies of developing countries typically
lack developed financial markets and often rely on fixed exchange rates and capital controls.
There is a discussion of the use of seigniorage in developing countries in the text. You may want to use the
discussion of seigniorage in the text as a springboard for a more in-depth discussion of this topic. In particular,
you could present a model of where seigniorage revenue is a function of the inflation rate chosen. The function
is concave, at first increasing but eventually decreasing as high inflation leads people to hold less money
(see Figure 22-1 below). It is much like the Laffer curve for taxation. This helps explain how similar
seigniorage revenues may come from widely different inflation levels.
Figure 22-1
In principle, developing countries (and the banks lending to them) should enjoy large gains from
intertemporal trade. Developing countries, with their rich investment opportunities relative to domestic
saving, can build up their capital stocks through borrowing. They can then repay interest and principal
out of the future output the capital generates. Developing-country borrowing can take the form of equity
finance, direct foreign investment, or debt finance, including bond finance, bank loans, and official lending.
These gains from intertemporal trade are threatened by the possibility of default by developing countries.
Developing countries have defaulted in many situations over time, from 19th-century American states to
most developing countries in the Depression to the debt crisis in the 1980s. If lenders lose confidence,
© 2012 Pearson Education, Inc. Publishing as Addison-Wesley
128 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Ninth Edition
they may refuse further lending, forcing developing countries to bring their current account into balance.
These crises are driven by similar self-fulfilling mechanisms as exchange rate crises or bank runs (and are
often referred to as “sudden stops” when financial flows stop running to developing countries seemingly
without warning), and the discussion of debt default provides an opportunity to revisit the ideas of
currency crises and bank runs before a full-fledged discussion of the East Asian crisis.
It is important to recognize the different types of financing available to countries. Bond funding, bank
borrowing, or official lending can all provide debt-oriented funding, while foreign direct investment or
portfolio investment in firms can provide equity financing. In addition, countries can borrow in their own
currency or in another currency. The chapter discusses the problem of “original sin” where many countries
are unable to borrow in their own currency due to both problems in global capital markets and countries’
own histories of poor economic policies.
The next section of the chapter focuses on the experiences of Latin America. In the 1970s, inflation became
a widespread problem in Latin America, and many countries tried using a tablita, or crawling peg. The
strategy, though, did not stop inflation and large real appreciations were the result. Government guaranteed
loans were widespread, leading to moral hazard. By the early 1980s, collapsing commodity prices, a rising
dollar, and high U.S. interest rates precipitated default in Mexico followed by other developing countries.
After the debt crisis stretched through most of the decade and slowed developing country growth in many
regions, debt renegotiations finally loosened burdens on many countries by the early 1990s.
After the debt crisis appeared to be ending, capital began to flow back into many developing countries.
These countries were finally undertaking serious economic reform to stabilize their economy. The chapter
details these efforts in Argentina, Brazil, Chile, and Mexico, and also discusses how crisis unfortunately
returned to some of these countries.
Next, the chapter covers the success and subsequent crisis in Asia (Chapter 11 also touches on this subject).
The causes of success, such as high savings, strong education, stable macroeconomics, and high levels of
trade are considered. Some aspects of the economies that remained weak, such as low productivity growth
and weak financial regulation are also discussed. The crisis, beginning in August 1997, is explained in
detail along with its spread to other developing countries. The lessons of these years of growth and crisis
are summarized as: choosing the right exchange rate regime, the importance of banking, proper sequencing
of reforms, and the importance of contagion. A box then considers whether currency boards can make
fixed exchange rates more sustainable.
A box on international reserves and a case study on China addresses two connected issues which are often
controversial politically: the mass accumulation of international reserves (largely in the form of U.S.
Treasury Bills) by developing countries and the attempt by China to limit the appreciation of its currency.
The box points out that much of the reserves accumulation is connected to insuring against shifts in financial
flows (such as sudden stops of external financing) more than trying to insure against excess needs based
on trade flows (as was the case when financial flows were quite small). In addition to self-insurance, though,
some of the reserves accumulation is a by-product of sterilized intervention. The clearest example of this is
China. China has tried to limit appreciation of its currency to encourage export-led growth. This is done
in part with capital controls, but also through purchasing dollars and selling yuan to prop up the value of
the dollar. As we know from the II-XX model in Chapter 19, at some point, China will likely need to
appreciate or experience inflation. Limited appreciation has been allowed in the last two years, perhaps
as the start of this transition.
These experiences have emphasized the policy trilemma discussed in Chapter 20 and led to calls for reform
of the world’s financial architecture. The chapter next considers some of these, from preventative measures
to reduce the risk of crises, to measures that improve the way crises are handled (such as reforming the IMF).
Finally, the chapter concludes with a section on current debates in the growth literature, chiefly a discussion
of the relative importance of geography and institutions in driving income growth and levels.
© 2012 Pearson Education, Inc. Publishing as Addison-Wesley
