Breakout Nations: In Pursuit of the Next Economic Miracles [Hardcover]

The average length of time investors hold stocks has been falling from a peak of 16 years in the mid-1960s to under 4 months today. In the 1970s it took $1 of debt to generate $1 of U.S. GDP growth; by the last decade it took $5. Real GDP growth in developed nations is expected to fall this decade to about 2-2.5%. Author Sharma is head of emerging markets at Morgan Stanley and as such spends one week each month visiting other nations looking for the best places to invest. He believes it's no longer possible as in 2003- 2007 to simply bet on rapid growth in any emerging market - those years average 7.2% returns. The amount of funds flowing into those stocks grew 92% between 2000 and 2005, and another 478% between 2005 and 2010. His 'Breakout Nations' provides quick overviews of more than two dozen of the currently most interesting economies for the next decade.

His first major conclusion is that China's growth will slow sharply. Total debt as a share of GDP is rising, its cheap labor advantage is rapidly disappearing, its consumers are already strongly participating in its new economy - spending has increased nearly 9%/year for 30 years, and some estimate China already has a 25% share of the world's luxury market, its 'one-child' policy is now bringing an aging population (average age 37 in 2020, vs. 29 in India and 49 in Europe), its highway network is already second only to the U.S., slightly more than half its population is now city-dwelling (691 million), developers have built 'ghost cities' and malls, and its economy is already quite large - the world's second largest.

Sharma is even more negative on India. Major problems include its bloated government, crony capitalism, a general reluctance of farmers to leave their land, a state much less able than China to provide world-class infrastructure (it's struggling to arrange sufficient grain storage capacity while people are starving, cannot provide reliable power to existing businesses), investment by Indian businesses have decline from 17% GDP in 2008 to 13% and their overseas operations now account for over 10% of overall corporate profitability, public debt/GDP has reached the 70% level, and there are high demands for social welfare.

Brazil, like India, also has high expectations for state-provided social welfare, its currency has risen sharply, growth has fallen to 4% GDP/year during the 2003-07 period, and to combat inflation, Brazil has one of the highest interest rates in the world - leading to an influx of even more currency. Government spending has risen from 20% of GDP in the 1980s to 40% in 2010, while productivity grew at only 0.2% between 1980='08, vs. 4%/year in China. Trucks carrying sugar to Sao Paulo's port wait 2-3 days for lack of space and unloading equipment. Investment levels are only 19%, vs. China's 50%, the average student leaves school after 7 years, vs. 8 in China. New infrastructure spending averages 2% GDP in Brazil vs. 10% in China. The 'good news' is that it now produces 2 mbd of oil and this is expected to reach 6 mbd by 2020.

Mexico's top ten business families control almost every industry in Mexico, with market shares ranging between 60 - 80%. U.S. corporate profits average about 12% GDP, in Mexico they're 25%. Economic expansion there in the last decade averaged 3%/year, students there rank near the bottom in international comparisons, and drug violence has been endemic since 2007. China's average wage was about one-third Mexico's in 2002, now is about 13% less. A new antitrust law was passed in 2011, and resulted in a $1 billion fine levied on Carlos Slim's America Movil over termination fees - it remains to be seen whether he'll pay.

Russia's government closely controls what is said on TV, but not in the papers. Despite a relatively high per capita income, citizens incur frequent power outages. Moscow and St. Petersburg are connected by a modern rail system from Germany, but the average age of the rest of its rail system is 20 years old, and runs quite slowly. Roads and airports are old. Oil comprises about half of the government's income. Personal income tax rates have been lowered to 13%, and average income is up from $1,500 in the late 1990s to $13,000 currently - double that in China. Between 2003 and 2007 growth averaged 8%/year, with Russian companies doing the best. Pensions were raised from 25% of income to 40% after oil hit $140/barrel; state-owned companies account for 56% of the stock market. (Russia owns 51 - 60%.)

Sharma believes it is common for authoritarians in developing countries to extend their power, citing as examples Cameroon, Nigeria, Bolivia, Venezuela, Argentina, and now Russia. (But not China.) Despite Russia having been first into space and has produced 27 Nobel winners in science, mathematics, and economics, it has no global manufacturing companies on its stock exchange. One of its disadvantages is that it is one of the 20 least populated nations in the world, creating logistics challenges, especially for retailing. Nearly 80% of its 100 billionaires (115 in China) reached that status in commodities. Most Russians pay cash to buy a house, small business interest rates run 15 - 20%, its currency was devalued in 1991 and 1998. Bribery is rampant, and direct foreign investment in 2010 was negative. It has one of the world's worst aging problems, and about 40,000 inflow of immigrants/year (mostly Russian-speaking from former satellites).

Where are the best places to invest? Sharma's analysis and reporting continues, and he eventually concludes that the Czech Republic, South Korea, Turkey, then possibly Poland, Indonesia, and Turkey are the best candidates. As for the U.S. - he sees a good possibility of a manufacturing revival in lower wage states after 2015, and believes Germany is also well positioned because it has invested in facilities in low-wage European nations.

Bottom-Line: 'Breakout Nations' provides interesting introductory material. However, readers should recognize that even if China slows down 3 - 4 percentage points as Sharma predicts, it has become so large that even that will represent sizable aggregate progress. Further, China has been making major strides to move up the value chain - buying Western firms (eg. Volvo), locating facilities in the U.S. (Haier America) and Europe, encouraging/forcing American technology firms to locate R&D and manufacturing in China as a condition for selling in China (G.E., Caterpillar, Intel, etc.), is moving into more complex manufacturing (now the world-leading ship builder, producing heavy construction equipment, wind-power generation, developing CPUs; is a leader in biotechnology research), and dominates the solar power industry. It's not going to fade away, even if its growth rate declines.

The book is poorly sourced and wrong in so many areas. For example:

Page 41: "In 2002 Google purchased a California-based social networking site called Orkut, to compete with Myspace and Facebook in forty-eight languages..."

FACT: In 2002, Facebook and Myspace did not exist. Facebook, founded in Feb. 2004, and Myspace, founded in Aug. 2003, came between Google's in-house launch of Orkut in June 2004. Yup, Google didn't even buy a "California-based social networking" company called Orkut. Orkut Büyükkökte, an employee at Google, built the site while working for the company during his free time in 2004 (not 2002).

Page 109: "In the early years of the Depression the United States followed the advice not of Keynes but of the then-more fashionable Austrian economist Friedrich Hayek, who counseled that the job of government in the face of a downturn was to stay out of the way and let market forces liquidate the deadbeats and deadwood in the economy. The result was a severe U.S. contraction and 25 percent unemployment rate, but by 1950 the economy had nearly doubled in size compared with the 1929 peak. The pain had unleashed a boom, just as Hayek said it would. Contrast that to Japan, which responded to its severe recession in 1990 with every possible stimulus and bailout known to Keynesians (and then some), and today has an economy only 20 percent larger than it was in 1990."

FACT: He's a Hayek apologist! Where he gets it so wrong: "...but by 1950 the economy had nearly doubled." Sharma credits this "doubling" to Hayek counseling the government to stay out of the way, but in reality, the economy recovered after the government increased spending (a Keynesian idea) to support World War II between 1939 to 1945. It was government spending from World War II, not Hayek who spurred the economy after the Great Depression.

FACT: Japan followed the economic advice of Milton Friedman, not John Maynard Keynes, to solve the nation's imbalances in the 90s. It's important to understand the difference between monetary stimulus and fiscal stimulus in order to catch the lie in this case. In the 90s, as Japan's economy started to tank, the government, instead of boosting government spending, resorted to lowering the interest rates and using other monetary stimulus (not more spending) to control the supply of money. This failed. As a result, Japan's government proposed irrelevant Thatcherite supply-side changes, including privatizing the post office. This also failed. In fact, Japan is only now starting to grow, at a rate of 4.1 percent as of May, after the nation ignored Friedman and listed to Keynes by boosting fiscal spending.

These discrepancies, in some cases small (like Orkut) and others large, make me not trust the author one bit. The entire book is poorly sourced, and misinformed. It makes me question his credentials to work for Morgan Stanley because he's clearly and poetically dumb.

I read the book on the two legs of a recent transcontinental flight and liked the content, the method and most of the arguments. It is a well written, but not so well edited text. The book claims that China and Taiwan separated at the end of WWII. While the Japanese left China in 1945 the territories did not separate till the end of the civil war in 1949 when Chiang Kai Shek fled the mainland. On the Chapter on India he cites the example of Bihar and uses the term "lawless Biharis" which was not in good taste. While the recent state of affairs in the state has not been good this way to uniformly brush the citizens of a state does not add value to the book or its message.

These small mistakes apart there are a couple of underlying themes that I felt are important for anyone considering buying the text. Though the book claims to be looking at the long term returns from different economies and the author's predictions about the same he presents a very narrow view of looking at policies and tools.

Let us look at something of relevance to the American audience. The book claims that in the aftermath of the Great Depression the US followed Hayek's paradigm to let the markets clear out ill resources and return to health and the result was that the US economy doubled in size in the next 20 odd years. While it is true that the government or the Fed intervened very little in the early part of the recession in 1929 the recession did not end till 1933 and by then a few things had happened:

1. The Fed intervened and brought more liquidity into the system.
2. The dollar was devalued (by almost 75%) essentially creating inflationary expectations in a deflationary economy.
3. The New Deal was brought in.

The first two steps clearly are monetary stimulus, and the last one is nothing but a fiscal stimulus. The real growth that brought US to the forefront of the world was the war fueled spending during WW II. None of this is a free market and invisible hand policy approach. So the claim that the US economy doubled in size because the policy makers of the day left the market fend for itself are on vary shaky grounds. Putting that as a matter of fact is in my opinion outright peddling of ideology.

The book further claims that the reason for Japan's lost decades even in the midst of one of the largest fiscal and monetary stimuli was that Japan did not let markets correct the problems in the economy. Japan managed to grow out of the ravages of WW II and managed to produce numbing growth with the same model and no natural resources to speak of for more than 4 decades! How come the model is good when it works, and not good when it does not? I think a much better analysis of the Japanese story is in Richard Koo's The Holy Grail of Macroeconomics: Lessons from Japan's Great Recession [HOLY GRAIL OF MACROECONO].

One other point that he does not take into account is that though Japan's economy has not grown at a rapid rate in the last 20 years its per-capita income is very much at par with other developed nations. With the population virtually stagnant and a high standard of living an argument can be made that the people do not care what international investors think of! The difference between Japan and China (or for that matter India) is that China has 4 times as many people as the US: it is not a small state. So the sheer size of the Chinese economy is bound to grow and become larger than the US in our lifetime.

The book insists on using market exchange rates to make comparisons. It makes sense as a selling point if one can use it to paint a more contrasting picture but for a book on international economies not bothering to mention PPP rates does not seem to be an oversight. On the basis of market exchange rates the developing economies may look smaller, but market exchange rates include a lot more information than just the cost of goods and services. So his insistence on using market exchange rates was a bit off-putting.

What I loved about the book was the frequent reminders that leadership matters, and good leaders produce good results. I will talk about the country I know the most of: India. The growth rate of the nation as a whole has come down to about 6-7%, but there are states within the country that are growing at or above double digits: most notably Bihar and Gujarat. The reason I chose these states are that the state leaders are by all counts the most enterprising of all state leaders in the country, but the contrast is that Bihar is the poorest state in the nation, and Gujarat is the richest. But they are both growing at more than 10%. So the small base story does not seem to be very valid on the face of it. Good leaders on the other hand are important. One of the biggest arguments for the slowdown of the national economy has been that the central leadership has been mired with socialist ideals and leaders. One of the most commonly used term in the country today is Policy Paralysis. Time magazine's Asia edition even carried a cover story with the Indian prime-minister on the cover with the title "The Underachiever."

The other thing I loved was a very concise description of modern economic histories of all major developing economies in the world. I am inclined to include the text in my reading list for my International Finance students.

Read the book. It is fun, but take some of the claims with a pinch of salt. When I read something I keep the person's position in mind and make appropriate deviations from the claims. Do the same with this book: the author is a major investment banker! When reading anything from Stiglitz or Reich or Krugman I make it a point to look to the right for better analysis, and when reading Friedman or Hayek or anything from Wall Street I look to the left. I do not claim to be anywhere close to any of these guys but it just makes better sense to keep people's ideological positions in mind when reading their work. As is said there are lies, damned lies, and then there are statistics. We can crank up numbers to prove anything but if we have an idea of where the person is coming from it makes it easier to take a more balanced view of things on hand.