Lowy Institute

Mark Thirwell Lowy Institute 2008

When I joined the Lowy Institute a little more than a decade ago, the price of iron ore was below A$30 per tonne; the Australian dollar was worth around US$0.65; the cash rate stood at 4.75%, a little way into a gradual tightening phase that would take it up to 7.25% by early March 2008; Australia's GDP per capita was still a bit below 70% of US levels; and less than 9% of our exports went to a Chinese economy, which back then had an overall GDP of about US$1.6 trillion. 

A bit more than 10 years on, as I say farewell to the Institute, things have changed.

Despite falling from its 2011 peak, when it flirted with A$200 per tonne, the price of iron ore still remains more than A$100 higher than it was when I started; the dollar is currently worth around US$0.92 after breaking through parity in late 2010 for the first time in the post-float era and going on to hit a record high of more than US$1.10 in 2011; the cash rate is now down at 2.5%, its own record low; as of last year, our GDP per capita had climbed to about 135% of US levels; and in the same year, more than one quarter of our exports went to a Chinese economy with a GDP that had expanded to about US$8 trillion. 

The intervening period has seen both the biggest, broadest and longest commodity boom in at least a century and the deepest and most dangerous international economic and financial crisis since the 1930s. Meanwhile, the Australian economy has kept on growing, turning in a period of recession-free economic growth that's unprecedented not just for Australia in modern times, but for any other developed economy too. 

These developments have been more than enough to keep me deeply engaged with our shifting international economic environment.

However, as long-term readers of The Interpreter will know, for much of my time here at Lowy I have been focused on the prospects for, and implications of, what I call the Great Convergence.

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The onset of rapid, sustained catch-up growth in the big emerging markets has arguably done more than any other single development to shape our current international economic and strategic environment. Of course, this convergence story has had its ups and downs: the debates over decoupling during the depths of the GFC were one manifestation of doubts about its durability, and the current angst over emerging market growth prospects is a more recent one. Correctly calling the next phase of that convergence story is going to be crucial in understanding the probable shape of our future international environment and should continue to offer the Institute a fruitful research agenda.

A critical aspect of this debate is what often appears to be a continuing tension between the economic and strategic/security views of where the convergence process is likely to take us. The former view of a successful convergence story tends to end up in a rather optimistic place — an 'Asian century' world of increased prosperity and deeper international engagement. Embedded in the more thoughtful forecasts is a careful recognition that reaching this destination will first require navigating some tricky territory including, but not restricted to, stresses on environmental and resource sustainability and social and political strains triggered by big shifts in income and wealth. 

Yet this successful economic convergence story is often seen as contributing to a more unstable security environment, in a kind of reverse-Pax Mercatoria.

Indeed, over the past year or so, I have been struck by the number of times I have participated in discussions about the future outlook for the region which have managed to combine firm optimism about the predicted medium-term economic trajectory with marked pessimism about the likely security environment. Sometimes these have been in separate but successive sessions in seminars, and sometimes (even more strikingly) they have occurred in conversations with the same analyst, investor or businessperson. 

While it's possible to think of scenarios that combine these two features — deepening economic engagement with intensifying security competition — it's not clear that this would represent a sustainable equilibrium.

The kind of international economy we have constructed, with its global supply chains and complex, highly connected trade and financial networks, is not one that's obviously compatible with major and sustained increases in international tensions. Wouldn't the good economic story tend to disarm the security competition (that is, move us back to the Pax Mercatoria)?

Or, less attractively, mightn't an adverse security environment end up undermining the positive economic one?

To put it a bit differently: who is going to be (most) right about the future: the economists or the security analysts? Interrogating these two competing views should provide some interesting and important territory for the Lowy Institute to cover.

Issues such as these, along with the big shifts and shocks to hit the global economy over the past decade, mean that it's been a fascinating time to be an international economy watcher, and Bligh Street has offered a terrific vantage point. As I move on, I wish the Institute, The Interpreter, and its readers, all the best.

Election Interpreter 2013

Short posts from Lowy Institute experts on what they regard as the most important international policy issue of this campaign. See the Election Interpreter 2013 archive for the whole series.

How we plan to steer the Australian economy and the expectations that help shape it between the Scylla of unfounded complacency and the Charybdis of excessive pessimism.

Sometimes we seem to suffer from a kind of economic bi-polar disorder. We're either happily surfing the Asian Century to everlasting prosperity or we're facing imminent doom from the collapse of the mining boom and the end of Chinese growth. Of course, we shouldn't ignore the possibility of important tail risks, but reality is likely to be both less dramatic and more complex.


Back in 2010, I wrote a piece called Our Consensus Future, which tried to set out what I thought represented a fairly broad consensus forecast for the global economy over the medium term. It was a view of the world underpinned by the idea of the Great Convergence, and which was reflected in range of publications and policies, including the recent Asian Century White Paper.

Yet, as I noted on The Interpreter at the time, the widely shared confidence in this 'consensus future' across international financial institutions, investment banks, governments, consultancy shops and, yes, think tanks, was actually a bit surprising given that the financial crisis had only recently delivered a stinging reminder to us all of the perils of forecasting in a world of black swans and fat tails. In particular, while I agreed that some version of this future was the most likely scenario for the global economy, I also argued that the probability then being assigned to this particular set of scenarios might well turn out to be too high.

All of which is a roundabout way of saying that I have a slightly different take to Steve Grenville as to why the current growth travails in emerging markets have been garnering so much attention. In particular, I wonder if what we are seeing might represent a fundamental reassessment of the risks and probabilities associated with a whole range of forecasts about likely emerging market performance, rather than just the latest anxiety attack to grip market participants (although I can't rule out the latter, either).

It was notable, for example, that the IMF, in the latest update to its world economic outlook, both cut its forecasts for emerging market growth and warned that 'risks of a longer growth slowdown in emerging market economies have now increased, due to protracted effects of domestic capacity constraints, slowing credit growth and weak external conditions.'

In other words, this bout of angst over emerging market prospects suggests to me that 'our consensus future' may no longer be the shared view it once was, and that as a result I might now have to retire the term.

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Of course, some of the current gloom reflects transitory factors including the impact on market sentiment of the June-July mini sudden stop in capital flows to emerging markets, triggered by the Fed's musings on whether to taper its program of asset purchases, as well as the ongoing run of weak growth data out of emerging markets, led by China. In addition, however, investors seem to have (re-)discovered a whole list of risks to the underlying emerging markets growth story, including fears about the impact of an international environment that's less friendly to emerging economies (less rich-world demand, softer commodity prices), the need to reinvent national growth models accordingly, worries about social and political stability and, of course, the difficulties involved in escaping the middle income trap.

Some of the current reassessment is probably overdone, but some of it is probably overdue as well. Certainly, taking a more cautious view on the likely trajectory for emerging markets as a group seems reasonable, given the scale of the challenges many of these countries still face.

Meanwhile, for now I am going to stick with the view I've set out before on The Interpreter: that it's still far too soon to write off the catch-up growth story for emerging markets, but that it does seem that the overall environment is no longer as convergence-friendly as it used to be. Hence the average future pace of convergence may well be slower than we've been used to.

Photo by Flickr user United States Government Work.


Last week, the IMF made its contribution to the ongoing debate over Chinese economic performance. The growth forecasts included in the Fund's latest Article IV Staff Report on China – which see growth this year at around 7.75% and at 7.7% in 2014 – are right up at the optimistic end of current forecasts, most of which see the government struggling to hit its 7.5% target this year. Indeed, Beijing recently signaled that 7% is the new official 'floor' for growth this year, and Finance Minister Lou Jiwei had earlier indicated that a 6.5% rate might be tolerable.


Move away from the guessing games over growth numbers and the Fund's report becomes useful in giving a sense of the challenges now facing Beijing. Thus the IMF points out that 'progress with rebalancing has been limited and is becoming increasingly urgent', that 'the heavy reliance on credit and investment to sustain activity is raising vulnerabilities', that 'fiscal space is considerably more limited than headline data suggest' and that 'vulnerabilities have increased in the financial, government and real estate sectors'.

This is sobering stuff from an organisation often seen as having an embedded bias to optimism. In fact, the Fund does still conclude that 'China has the resources and capacity to maintain stability even in the face of an adverse shock', although it also adds 'the margins of safety are narrowing.'

This latest Fund assessment, combined with my own impressions from a recent visit to China, suggest the following:

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1. It's clear that China's growth momentum has slowed. That slowdown is both the inevitable consequence of the current growth model running into sharply diminishing returns and a product of the current cyclical conjuncture. Certainly, the symptoms pointing to structural problems with the growth model (weaker productivity estimates, lots of excess capacity across a range of industries, sustained PPI deflation, and a declining rate of return on investment) are easy to find.

2. Working out what China's new potential growth rate might be is still very much a guessing game. The Fund thinks that average GDP growth could fall to around 6% over 2013-30, with growth driven by a combination of investment (2.3 percentage points) and productivity growth (3.3 percentage points):


But the IMF also uses its report to warn that if China sticks with its current growth model the 'convergence process would stall, with the economy slowing to around 4 per cent':


3. Even a China that is growing significantly slower than the double digit pre-crisis average still has the potential to be a major source of global and regional demand. The US dollar size of the Chinese economy in 2007 was about $3.5 trillion; last year it was about $8.2 trillion. In other words, lower growth rates could in theory be comfortably offset by a much larger base effect, assuming that the adjustment to the new, lower growth path is relatively smooth.

4. A potential complicating factor here is that maintaining macro stability might become increasingly challenging. This reflects the imbalances that are a byproduct of the old model, the challenges involved in the rebalancing process itself, and the consequences of a move (sometimes deliberate, sometimes inadvertent) to an economy subject to significantly less direct state control. June's 'Shibor shock' was a telling symptom of this development. Reforming the growth model requires pushing ahead with liberalisation, but that in turn may well involve some short-term loss of policy control.

5. Hence China risk right now is not just about working out how much slower economic growth is likely to be, but also about the potential for a significant increase in macro volatility as the economic transition proceeds. As the single largest contributor to global growth, a slower-growing and potentially more volatile Chinese economy will inevitably have important implications for China's trading partners. Australia is one of those most exposed on this metric (albeit less than many of the regional members of 'Factory Asia'):


One consequence is that we might be coming to the end of what has until recently been something of a free (Chinese) lunch for Australia.

Think of it this way. Back at the tail end of the previous century, we might have expected that deepening trade ties with China would deliver stronger growth (and higher incomes) but at the price of increased volatility. This would reflect the stylized fact that emerging market growth typically tends to be both higher than that of our developed country trading partners, but also more variable.

Yet what we actually ended up with was faster growth and relatively low volatility – the big growth shocks in recent years have occurred in the crisis-hit economies of the developed world. China, by contrast, has managed to deliver an extremely impressive combination of rapid growth and low volatility (admittedly, some of this low measured volatility might reflect the well-known quirks of Chinese data. But that seems unlikely to have been the whole story):


Unfortunately, there now seems to be a significant risk that our free lunch of higher growth at no cost in extra volatility might be coming to an end. China still seems likely to end up growing faster than our trading partners in the developed world, albeit at a rate much lower than in the pre-crisis period. But the ride may also be about to get a lot less smooth. In the future, Australia's Chinese takeaway may come with a higher price attached.


This week saw the US and EU agree to launch talks on what has been described as potentially the 'biggest bilateral trade deal in history.'

The proposed Transatlantic Trade and Investment Partnership (TTIP) is the latest in a series of so-called 'mega-regional' trade arrangements. Australia is a participant in negotiations over two other mega-regional deals, the Trans-Pacific Partnership (TPP), which recently completed its 17th round of negotiations in Lima, and the Regional Comprehensive Economic Partnership (RCEP), which held its first round of negotiations last month.

As Geoff Miller pointed out on The Interpreter yesterday, if both the TTIP and the TPP were successfully concluded, there would be a case for arguing that the global rules of 21st century trade would no longer be set within the multilateral trading system. That would represent a major shift away from the system which has helped support global prosperity – and global peace – for more than half a century.

This week also brought the release of the ninth in a series of reports by the WTO on trade policy measures taken by G20 members. These reports have been produced since G20 leaders at the April 2009 London Summit asked the WTO and other international organisations to monitor their pledge (the 'standstill') to refrain from trade and investment protectionism.

According to the WTO's latest assessment, over the past seven months more than 100 trade-restrictive measures were implemented by G20 economies, covering around 0.5% of all G20 merchandise imports, or about 0.4% of world imports.

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It's true that over the same period some G20 economies also introduced trade liberalisation measures, but these were outnumbered by the restrictive ones. Moreover, this latest set of restrictions comes on top of a series of measures taken since the WTO's monitoring began. Since many of these earlier measures are still in place, this translates into a slow but steady increase in the cumulative share of trade subject to restrictions or distortions, which since October 2008 account for around 4.6% of G20 imports or around 3.6% of total world imports.

The good news is that, as the WTO points out, these numbers are still low enough to suggest that 'most countries have on the whole resisted resorting to protectionism'. The not-so-good news is that the same numbers also confirm that G20 members have nevertheless been prepared to break their promises on the standstill.

Some more unpleasant news on trade policy arrived last week, when another monitoring exercise – this one conducted by the independent Global Trade Alert (GTA) – released its 12th report on protectionism. According to this report, 'the past twelve months have seen a quiet, artful, wide-ranging assault on free trade.' The GTA emphasises that much modern protectionism is hard to detect and is designed either to exploit the gaps in existing rules or to focus on areas not covered by the rules at all. As a consequence, the GTA report argues, monitoring exercises that concentrate on traditional trade policy measures may significantly underestimate the 'true' amount of trade intervention underway.

Both sets of developments – the rise of mega-regional deals and the spread of murky protectionism alongside G20 backsliding on trade policy promises – are symptoms of a multilateral trading system in decline. There are other symptoms, too, of which the most obvious is the long-running failure to complete the Doha Round of trade negotiations, despite repeated pledges to do so by the world's leaders, including in the G20.

Does any of this really matter? Optimists can mount a fairly respectable case that there's nothing much to worry about. The forces of technology and the logic of global supply chains will continue to bind the global economy together and place strict limits on the case for protectionism, they might argue. After all, the world economy has recently negotiated the biggest slump in international trade since the Great Depression, and done so without the protectionist excesses that disfigured the 1930s. And if the multilateral system is now unable deliver the kind of deep economic integration that the global economy requires, then new initiatives such as the TPP and the TTIP will do so instead.

Under these circumstances, why would G20 leaders want to spend valuable political capital on yet another attempt to conclude a Doha Round that's already well past its expiry date?

The optimists may turn out to be right. But they may also underestimate the dangers and costs involved if the multilateral system continues to decline. That system has its origins in the chaos of the interwar period and the lesson that the world would do well to avoid the fragmentation of trade and competing blocs which characterised that period.

In our world of shifting economic power, fears over resource security and concerns about geo-economic competition, that lesson remains relevant. In a new Lowy Institute Analysis paper, I argue that opting to stand by while the multilateral system unravels is precisely the kind of risky, high-stakes gamble that the G20 in particular should be working hard to avoid. As the world's premier international economic forum, the G20 should have a keen interest in supporting a robust multilateral system, and in the paper I suggest several steps G20 leaders could take to help restore its flagging fortunes.

Photo by Flickr user MorBCN.


The global economy is in the midst of an unprecedented macroeconomic policy experiment based on unconventional monetary policy marked by a combination of high public debt, near-zero interest rates and aggressive quantitative easing.

As a recent IMF policy assessment pointed out, the initial deployment of those policies appears to have been quite successful in restoring market functioning and reducing tail risks. There may also have been some benefits for growth and price stability, although here the Fund admits that the evidence is rather less clear cut.

The same paper goes to caution that the growing scale of central bank activities brings with it some significant risks. In particular, there are huge uncertainties around both the medium- and long-run implications of the current period of historically low policy interest rates, and around the mechanisms for, and consequences of, exit strategies from these extreme policy settings. 

In the first chapter of its April 2013 World Economic Outlook, the IMF issued another reminder of the medium-term dangers associated with the developed world's monetary policy experiment. The Funds worry list included the possibility of ultra-low interest rates encouraging excessive risk-taking, balance sheet mismatches, high leverage, and asset price bubbles. In addition, asset price collapses, sovereign debt stress, banking sector crises, large destabilising global capital flows and exchange rate movements are all possible outcomes should the exit from the current experiment go pear-shaped.

The last couple of weeks have given us a taste of how some of this could play out. Back in late May, when Ben Bernanke gave markets a signal that the Fed might consider slowing the pace of its current US$85 billion-a-month program of asset purchases, the following days brought a spike in US bond yields and the worst monthly loss for bond investors since December 2010. And yesterday saw emerging market assets undergo a sharp sell-off, once again sparked in part by the prospect of changes in Fed policy.

Markets' current obsession with the potential timing and scale of the Fed 'tapering' its asset purchases are a reminder of some of the big uncertainties surrounding the economic outlook. There's no doubt that the monetary experimentation of the past few years has been warranted by the nature of the crisis confronting policymakers (although failure to deliver adequately on other fronts has probably placed excessive pressure on the monetary authorities to accommodate shortcomings elsewhere). But we still don't know what the fallout of all that experimentation will be.

The global economy's rollercoaster ride looks far from over.


So Brazil has triumphed over Mexico in the contest to provide the next Director-General of the WTO. Roberto Azevedo (pictured) beat Herminio Blanco to take over from Pascal Lamy, who will step down on 31 August after serving two terms as DG.

Brazil's President Dilma Rousseff declared that Azevedo's win was 'not a victory for Brazil, nor for a group of countries, but a victory for the World Trade Organization.' But as I noted last week, there are several possible ways to characterise the result:

  • Despite Rousseff's conciliatory words, as a triumph for Brasilia over Mexico City in the continuing tussle for 'leadership' in Latin America, and for international diplomatic clout more generally.
  • As a win for the preferred candidate of the BRICs and developing countries over the preferred choice of the US, the EU and the 'trade establishment'.
  • And (perhaps) as a symbolic victory for Brazil's more restrictive approach to trade policy as opposed to Mexico's relatively more liberal one.

Regardless of the spin one chooses to put on the result, there is no doubt that the challenge now facing Azevedo is immense: to restore the clout of an organisation that has been losing credibility since shortly after the launch of the Doha Round back in 2001.

Doha now spans four failed WTO Ministerials (five if the failure to launch a round in Seattle in 1999 is included) and as each year has gone by, the degree of ambition has faded. The upcoming Ministerial in Bali in December will see WTO members make yet another push to deliver what is now a radically pared-down agreement (basically a deal on trade facilitation). Yet recent months have seen signs that even this might be out of reach. 

Mr Azevedo must be hoping that this isn't the case. Although the outcome is largely out of his hands, another failed WTO Ministerial would signal the WTO's continued slide into irrelevance as a negotiating body and represent a disastrous start for his term at its helm.

Photo by Flickr user Ana de Oliviera.


And then there were two.

The process of selecting a new Director-General for the WTO is heading to a conclusion, with the third and final round of consultations with members scheduled to start today. After the previous two rounds, the original nine-person shortlist has been whittled down to just two candidates: Mexico's Herminio Blanco and Brazil's Roberto Azevedo, meaning that a Latin American will get the top job for the first time. None of Asia's candidates, including Indonesia's Mari Pangestu, made the final cut, prompting some speculation that this showed the region's declining interest in the organisation.

For the next week or so, the focus will be on the differences between the Brazilian and Mexican candidates. For example, one view sees Azevedo as the preferred candidate of the BRICS and Blanco as that of the US and the 'trade establishment'. Another looks to the quite different trade policy stances of their respective nations. 

Whichever candidate wins is going to face an uphill task to restore the health of a body which, back at the turn of the millennium, was seen as the 'Great Satan' of globalisation but which now appears to be slipping into irrelevance.

The signs are not hard to find. Back in 1999, the prospect of another global trade round was enough to turn the streets of Seattle into a battleground. Today, more than a decade on from its launch in 2001, the Doha Round remains moribund – the trade round that time forgot. Just last month, the US warned that even the current attempts to salvage small elements of the Doha Agenda were going nowhere and that the WTO was headed for 'irrelevance' as a negotiating forum. 

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The warning came as the WTO reported that world trade growth in 2012 had slumped to just 2% and was likely to remain similarly sluggish through this year, and as the current Director-General Pascal Lamy cautioned that the 'threat of protectionism may be greater now than at any time since the start of the crisis'. 

Critics increasingly argue that the WTO's negotiating agenda seems to be stuck in the 20th century and is failing to grapple with the pressing issues of today's global economy. As a result, the trade policy agenda appears to be moving further away from Geneva and towards so-called 'mega regional' agreements such as the TPP and the proposed Transatlantic agreement linking the EU and US.

Taken together, these trends feed a growing sense that the multilateral trading system is in trouble. The new DG, whoever he is, will have to work hard to save it. More importantly, so will the world's leaders, who at times have shown an almost cavalier disregard for the importance of maintaining a robust multilateral trading system.

Photo by Flickr user Andrew Ressa.


A quick addendum to my earlier post. In that piece, the penultimate para is my best go at an objective (or at least as close as I can manage) assessment of the economic legacy of Thatcherism. It's also a classic economist's two-hander.

My own personal opinions on Thatcher's legacy have been shaped both by where I grew up and by where I live now. I did a fair bit of my growing up in what used to be a steel town in the Northeast of England. It's a part of the UK that's an example of the wrong side of that 'deep divide' in regional performance that I mentioned in my previous post. It's also not somewhere you would find many fans of Mrs Thatcher (in fact, it's a constituency that has never returned a Conservative MP in the postwar period). That environment has inevitably coloured my own memories of growing up in Thatcher's Britain.

Yet my overall assessment of Thatcherism today is probably more influenced by living here in Australia. In particular, when I look back to the economic reforms that this country underwent in the 1980s and 90s, it seems to me that Australia managed to deliver a similar (and similarly needed) economic transformation, but did so with what appears to have been rather less of the harshness and divisiveness that accompanied Thatcherism in the UK. Of course, that assessment might well be different if I'd lived through it here rather than through its British counterpart. And sure, there were obviously important differences in national circumstances that I'm almost certainly not taking into account. 

Even so, my impression is that Australia's experience suggests it was possible to get many of the benefits of major economic reforms without suffering from quite as many of the downsides associated with the Thatcher years. That seems to me to have been the better deal.


In the years of economic turbulence that have followed the onset of the global financial crisis, a common lament has been the absence of effective economic leadership and an unwillingness to take tough decisions. The early obituaries and assessments of Margaret Thatcher offer a potent reminder of what determined economic leadership actually involves, along with the associated benefits and costs.

A quick scan of the pieces by Martin Wolf and Chris Giles in the FT, Larry Elliott in The Guardian and Nicholas Crafts at VoxEU, for example, brings home just how dramatic were the changes Thatcher brought to the UK economy: the liberalisation of exchange controls; financial deregulation and the 'Big Bang' that transformed the fortunes of the City of London; labour market reform and the effective defeat of the trade union movement; the taming of inflation; large-scale privatisation; the rejection of old-school Keynesian fiscal policy; an abortive experiment with monetarism; major tax reforms, including a significant shift in the income tax regime and a rise in the VAT; opening up to foreign investment; deregulation of the housing market, including the sale of council housing stock; and wide-ranging and often painful industrial restructuring, along with a retreat from traditional-style industry policies and subsidies.

The results of these policies were equally dramatic: on the one hand, a marked and positive transformation in the UK's relative economic performance that lasted almost three decades. On the other, big increases in inequality, deep divides in regional economic performance, and – looking back from our post-GFC world – a dangerous over-dependence on what turned out to be a risky financial sector.

No surprise, then, that to this day she remains a deeply divisive figure in UK politics.

Photo by Flickr user cseeman.


In a blog post earlier this year I asked whether emerging economies had been lucky or smart. I also suggested that one way to start answering this question was to look at their performance during the major stress test provided by the global financial crisis.

Of course, it's possible to ask much the same question about Australia's economic performance. Is our incredible run of more than 21 years of economic growth the result of good policy or just a product of good luck? In an essay for the new issue of Pacific Standard magazine, I suggest that there are two ways of thinking about Australia's relative economic performance over the past couple of decades.

First, there is the 'Australian model' approach. This view says that Australia offers a good example to the rest of the world of how to thrive in turbulent global economy. Then there's the alternative interpretation which says that Australia has done little more than ride its luck and a temporary (but very large) boom in global commodity markets. Eventually and inevitably, the boom and the luck will run out. You could call this view the Australian bubble.

My essay looks at which view is closer to the truth. Given the popular stereotype about economists, you probably aren't going to be surprised to learn that I end up giving some credit both to good policy and to good luck. However, I also take some comfort from the fact that we have survived three major economic and financial stress tests in our recent history. To me, that suggests we must be doing something right.

Photo by Flickr user tarotastic.


We now have a new deal for Cyprus, one that looks a fair bit closer to what the first deal should have been and what the IMF originally proposed. In particular, it backs away from the attempt to impose a levy on depositors covered by the EU-wide €100,000 deposit insurance and instead puts the burden on large depositors and also bails in bank bondholders.

Despite this belated shift to a — relatively — more sensible plan, the outlook for the Cypriot economy remains grim, with forecasts of GDP losses of 10% or possibly much more.

Moreover, in a now familiar pattern, not content with stuffing up the original deal, the authorities seem to have once again managed to bungle the message accompanying the new deal. Initially, the head of the Eurogroup of eurozone finance ministers, Dutch Finance Minister Jeroen Dijsselbloem, said that the Cyprus agreement would serve as a model for dealing with future banking crises. Then he quickly changed his mind, deciding that Cyprus wasn't a model after all. So much for policymakers delivering a clear and consistent line.

Meanwhile, the debate has moved on to the implications of Nicosia's (almost inevitable) decision to impose capital controls in an effort to stem depositor flight. 

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In particular, several observers have already noted that the introduction of capital controls undermines the concept of European monetary union and indicates that the value of a euro in Cyprus is no longer the same as that of a euro held elsewhere in the eurozone. Seen in that light, it's possible to argue that, at least technically, Cyprus has become the first country to be forced out of the eurozone.

During the first half of last year, there was a big debate over whether Greece would have to exit (remember 'Grexit'?) and if so, whether this would topple the first domino in a chain that would ultimately unwind the single currency. In the event, Greece stayed in, not least because Berlin was eventually convinced that the risk of allowing that first domino to fall was too great. Instead, it looks like it will be Cyprus that gets the role of the first domino.

Brussels is now betting that Cyprus is too small and too much of a special case to set the other dominoes falling. The good news is that, so far at least, the evidence is that financial markets seem to agree. Of course, some of Brussels' other bets haven't worked out that well.


Cyprus, Aphrodite's Island, is in trouble. And it's trouble that could further set back sentiment in a eurozone that's already been damaged by last month's inconclusive Italian elections. Now Cyprus' parliament has rejected the terms of a €10 billion bailout from Brussels and instead may have turned to Russia for financial assistance.

The origins of the problems facing Cyprus have some striking similarities with the events that brought down Iceland and Ireland during earlier phases of the global financial crisis. More specifically, Cyprus is yet another example of a small economy made vulnerable by an outsized financial sector. As of mid-2011, the assets of the Cypriot banking system were the equivalent of 835% of GDP, while the assets of commercial banks with Cypriot parents amounted to some 500% of GDP. What made matters worse was the large exposure of those same banks to the crisis-hit Greek economy, in the form of holdings of Greek government bonds as well as loans to Greek residents, which stood at an impressive 160% of Cypriot GDP. Oops.

A further — and it turns out, rather important — part of the story is the fact that Cypriot banks have relied heavily on overseas deposits to fund their operations, with a hefty chunk of that money coming from Russia. Some estimates put the sums involved at considerably more than the current value of Cypriot GDP.

Last weekend, the EU and the IMF agreed a bailout deal with Nicosia which managed to leave nobody happy. The big problem was the proposed treatment of depositors, with the plan stitched together in Brussels providing not only for large depositors (that is, those with deposits bigger than the €100,000 deposit insurance cut-off) to be subject to a one-off 9.9% levy but also — and much more surprisingly — for small depositors (whose money is covered by the insurance scheme) to pay a 6.75% levy. Bailing in of small depositors has been widely and in my view quite rightly seen as a potentially dangerous policy blunder.

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The backlash against the deal came both from small depositors — and Cypriot voters — who would have seen a share of their savings confiscated under the plan, as well as from Moscow, which expressed its own deep unhappiness with the proposed measures. This despite the common view that one reason for bailing in small depositors in the first place was Nicosia's own reluctance to levy an even greater impost on its foreign depositors.

Mind you, it's also widely believed that EU and in particular German determination to see depositors make a contribution came in no small part from Berlin's view of the politics of having German taxpayers bail out those same Russian investors. Der Speigel, for example, cites a German intelligence assessment claiming that the main beneficiaries of any European bailout would be rich Russians who had invested illegal funds. In the event, and despite talk of watering down the provisions affecting small investors, the terms of bailout failed to gain parliamentary approval and there's now widespread speculation that Nicosia will seek help from Moscow.

While this story still has some distance to run, there are already a couple of important lessons that can be drawn from events so far.

First, the original bailout package was a disaster-in-waiting. By in effect deciding to confiscate a proportion of insured deposits, the measure risked generating bank runs in Cyprus as depositors (once banks reopened) would try to pull their money out in order to escape any future confiscations. This would be bad enough if it were restricted to Cyprus, but the bigger risk is it could cause depositors in other vulnerable European countries to do the same, prompting a bout of destabilising contagion.

European authorities have asserted that Cyprus is a special case (much as they did with the different terms of the Greek bailout), and that there are no implications for other member economies. It's also true that Cyprus only accounts for tiny proportion of EU GDP. But even if any immediate contagion turns out to be limited, the measures could nevertheless produce an important change in expectations which risks complicating policy choices in the event of future crises elsewhere. More generally, the bungling of the deal has done nothing for confidence in the eurozone and its officials more generally.

Second, the nature of the bailout negotiations is yet another stark reminder of the limits to European solidarity. Given the ultimate solution to the eurozone's problems is going to involve significantly closer fiscal, financial and hence eventually political union, that's a potentially critical constraint.

Remember, one of the developments that eventually helped settle sentiment last year was the view that Germany had switched its position from being happy to see Greece exit the eurozone in order to 'punish' profligate Greeks and protect German taxpayers, to accepting that such a move would be a disaster for the eurozone as a whole. The treatment of Cyprus is in some ways reminiscent of the tougher line initially taken with Athens (perhaps aided in this case by the idea that the small scale of Cyprus lent itself to experimenting with a tougher stance, with only limited downside), and domestic political constraints have once again been shown to play an important role in constraining policy choices.

Photo by Flickr user @Poricinio


Earlier this month I noted that, after several years dominated by bad economic news, the start of the current year had brought hopes that we might finally see a degree of stability return to what has been a demonstrably unstable global economy. While some of this shift in sentiment could be put down to sheer 'risk fatigue', it also reflected a sense of bullets dodged and pitfalls avoided, as some of the most feared tail risks facing the world economy have (so far, at least) failed to materialise.

This view is broadly consistent with the latest IMF assessment of global economic prospects as presented to the recent meeting of G20 finance ministers and central bank governors in Moscow. In particular, while noting that 'important downside risks remain', the Fund judges that (p.6):

Risks have become more symmetric in the short term. The ECB’s OMT has lowered important tail risks relating to the viability of euro. The US fiscal cliff has largely been avoided, while latest developments suggest that the risk of a hard landing has receded in China. Accordingly, the improved financial conditions and confidence could trigger stronger-than-projected global investment and growth.

After a period of prolonged gloom, we have started to see the emergence of some cautious optimism about the world economy. Still, as I pointed out in that earlier piece, it's important not to underestimate the persistent nature of many of the risks still facing the global outlook.

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For a couple of examples, it's worth returning to my list of things to look out for the in global economy in 2013. The first two items on that list were US fiscal follies (where I stressed that, although we'd 'sorta, kinda' avoided the fiscal cliff, there were plenty of other tripwires ahead) and the longevity of eurozone optimism (where I pointed to the importance for sentiment of upcoming elections in Italy and Germany). We've recently seen significant developments in both areas.

First, in the US, the seemingly endless political fight over budgetary policy has now moved on to the sequestration, which comprises some US$1.2 trillion of automatic spending cuts scheduled to take place over the next ten years. Absent a last minute agreement, the sequestration process will kick in this Friday. That would to add to the fiscal drag already acting on the US and global economies this year, and could shave perhaps an additional half percentage point from US GDP growth (assuming no future adjustments were forthcoming). On top of that, there's the corrosive effect a failure to reach compromise would have on markets' already fragile confidence in Washington's ability to conduct sensible fiscal policy. And then there's the looming 27 March deadline for a possible government shutdown to worry about.

Meanwhile, in the eurozone, Italy's election results earlier this week delivered a sharp warning to investors inclined to become complacent about developments in the European periphery in general and the willingness of European voters to live with sustained austerity in particular.

So, while its true that this year started off on a relatively positive note for the world economy, the message from recent developments is that those inclined to cautious optimism need to keep the emphasis on caution.

Photo by Flickr user Mark Sinderson.


Last December, in a post on the future of global growth, I posed a set of questions related to the future performance of emerging markets. Will catch-up growth be sustained at pre-GFC rates or will it continue but at a slower pace, reflecting a tougher external environment? Or will the 'convergence' process stall altogether? The future of emerging market growth is also a recurring element in my 13 for 2013 series on the outlook for the world economy.

One way to approach these questions is to think about the difference between good luck and good policy. If emerging markets' success in the pre-GFC period was mainly a product of good luck (for example, due to an unusually convergence-friendly international environment) then we might expect that a less friendly international environment will see that luck run out, with growth suffering accordingly. 

Alternatively, if strong performance was largely driven by good policies, then provided those policies are sustained, we should be more optimistic about emerging markets' growth prospects in the post-crisis era.

This important distinction between good policy and good luck is highlighted in a nice paper by Easterly, Kremer, Pritchett and Summers published in the early 1990s. Country characteristics and policies such as educational attainment and political stability are often thought to be among the key determinants of economic growth.

But the paper's authors pointed out that, while all these factors have tended to be relatively stable over time, growth rates have tended to be much more volatile, making it less likely that the former were key drivers of the latter. Instead, they found that shocks (especially shocks to the terms of trade) tended to be as important as policy in determining growth performance.

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More recently, economists at the IMF have looked at the resilience of emerging markets and developing economies over the past two decades. The good news is that they find that resilience – as measured by the ability both to sustain economic expansions and to recover rapidly from recessions – has increased markedly in these economies. In particular, for the first time, the past decade saw emerging and developing economies spend more time in expansion and have smaller downturns than advanced economies. 

The Fund economists have a go at estimating the source of this improved resilience, and put it down to a combination of better policymaking and increased 'policy space' (that is, more room to respond to adverse shocks via fiscal and monetary policy) as well as to less frequent shocks. They estimate that better policies and more policy space account for about three-fifths of the improved performance in emerging markets, and fewer shocks for about two-fifths. In other words, both good policy and good luck have played a role, with the former being more important.

The same message comes from the observed response of emerging markets to the shock of the crisis itself. So, for example, these World Bank economists point out that, although the GFC saw emerging economies suffer declines in real GDP growth that were as large or even larger than the falls in developed economies, this was actually good news, as in the past, emerging economies have typically fared much worse than their developed economy counterparts. Again, they identify one of the reasons for this shift as an improvement in the quality of economic policymaking.

The good news, then, is that there is evidence of an improvement in the quality of emerging market policies, and this is reflected in increased economic resilience. However, the same evidence also confirms that emerging markets remain vulnerable both to external shocks (such as slower growth in the developed world or spikes in global uncertainty and risk aversion) and to homegrown problems including credit booms and banking crises.

Photo by Flickr user sean_carney.