Next week it will be time for another meeting of G20 leaders, this time in Los Cabos, Mexico. The meeting will follow key elections in Greece this weekend, with financial markets fearing that the polls could be the trigger for an intensification of the eurozone crisis.

Indeed, there's a sense that the eurozone is approaching yet another potential tipping point, as was the case towards the end of last year, before the ECB stepped in with what ended up being almost one trillion euros of support. Since a eurozone disaster could be calamitous for the world economy, markets will be looking to the G20 to help calm the situation.

Unfortunately, as I noted in the aftermath of last year's Cannes Summit, while it's inevitable that the eurozone crisis will dominate G20 discussions, saving the euro is an incredibly tough ask for the group. My view hasn't changed.

Sure, there are useful and important things the G20 can do: the pledge by central bankers to step in and stabilise financial markets if needed is one example; doing a better job in pushing through the combined deal on IMF funding and representation would be another; and there is real value in keeping the pressure on the Europeans to do the right thing. But the solution to the eurozone crisis lies with Europe's leaders, and at Cannes, the G20 demonstrated its limited ability to force common sense on Berlin, Athens and the rest. Indeed, some are already writing off the G20's chances this time.

Still, while it's important to be realistic about what the G20 can deliver, it's also true that the group cannot afford for Los Cabos to be seen as a failure, if it wants to maintain its claim to be the world economy's pre-eminent international economic body. That's because the stakes are so high. 

There's an interesting op-ed in the FT arguing that Europeans should learn the lessons of the 1997-98 Asian financial crisis. Since one result of the eurozone experiment has been to trigger what looks very much like a classic emerging market crisis around the European periphery  an overvalued exchange rate, balance of payments strains (albeit partially disguised by the Target2 settlement system), and a sovereign debt problem – its certainly appropriate to look at what other emerging market crises might teach us.

But what makes the piece particularly interesting is what it does and doesn't say. So it seems to me that the authors are right to remind us again of the very different kind of policy response advocated in both cases, and are likewise correct to urge more policy pragmatism on the part of European policymakers.  And it's also noteworthy to see some worries expressed about the seniority of Chinese creditors in the event of further debt restructuring: yet another telling indicator of our changed world economy that emerging economies are worrying about their credit exposure to the developed world.

But two other things struck me about the piece.

First, the rapid speed of adjustment in East Asia in the late 1990s was greatly assisted by the role played by large real exchange rate depreciations in producing a rapid turnaround in external imbalances, and by a relatively benign external environment.   Those real depreciations were delivered by major swings in the region’s nominal exchange rates: something which is, of course, not on offer for individual member economies stuck in the Eurozone.   And the current external environment is very far from benign.

Second, the Op Ed’s authors talk approvingly of the way in which in Asia the 'people had to tolerate hardship, and they did not believe in the magic of street demonstrations.' Really? I must have imagined the protests in Indonesia opposing increases in the price of gasoline and electricity, not to mention the May 1998 riots and the whole fall of Soeharto thing (which had its fourteenth anniversary last month). Even the Koreans, cited approvingly in the piece for their self-sacrifice of gold) to support their government, still got around to registering their dislike of IMF-imposed austerity measures.

Photo courtesy of Wikipedia.

In a couple of earlier posts, I've noted that right now it's possible to tell two quite powerful but also quite different stories about life in the middle in the world economy. One of these is a depressing tale about a squeezed developed-country middle class; the other is a much more positive narrative about the transfer of hundreds of millions of people out of poverty in the developing world.

Inevitably, the fact that these stories are occurring concurrently raises the question of whether there are links between the two. More specifically, is an expanding middle in the developing world coming at the expense of a shrinking middle class in the developed world?

Yes, this is yet another variation on the familiar question as to whether globalisation in general and liberal trading regimes in particular have been good for workers in the developed world. One early version of this debate was fought out in the 1980s and 1990s, when economists argued over the relative roles played by technology and trade in explaining disappointing labour market outcomes (broadly speaking, high unemployment in Europe, greater wage inequality in the US). Back then, the professional consensus tended to be that technology was much the more important factor.

Since then, however, international economic integration has continued to grow, and the debate has been re-opened. So, for example, Nobel Prize winner Michael Spence recently argued that the impact of globalisation has changed over time. Up until about ten years ago, he reckons its effect on the distribution of wealth and jobs was largely benign, but as emerging economies have become both larger and richer, the consequences for the rich world have changed. And yet, other economists continue to see technology, not trade, as the dominant factor.

In my previous post I outlined some of the angst in the developed world regarding the future of the middle class. There is, however, another compelling story to tell about life in the middle, and it's much more upbeat. The same period that has seen the middle squeezed in the developed world has witnessed a dramatic expansion in the global middle class, driven by economic progress in emerging economies.

Of course, this second story is heavily coloured by the chosen definition of 'middle class', and there are plenty of choices on offer. One approach is to adopt a relative definition and classify the middle class as comprising those with incomes between 75% and 125% of the median income in each country. Alternatively, other researchers have used absolute definitions, such as those living between the mean incomes of Brazil and Italy, or those living on between $2 and $10 per day.

Martin Ravallion of the World Bank has defined the developing world's middle class as those who live in a household with consumption per capita between PPP$2 and PPP$13 a day (at 2005 prices). This captures those who are no longer poor by developing country standards but are still poor by rich country standards.

One close relation to the current debate over inclusive growth and inequality that I highlighted in a previous post is a parallel discussion regarding the fate of the middle class. A particularly noteworthy feature of this second debate is that perspectives on the issue are highly conditional on just which middle class is under discussion.

Thus, in significant parts of the developed world, the story is about a middle class under sustained pressure. This applies to Europe, where life has become much tougher in recent years, even for the relatively affluent. But it's a view of the world that has gained particular traction in the US, where the post-GFC period has  brought much angst regarding the supposed hollowing out of the  American middle class:

(Source: Reuters.)

Several analysts have worried about the potential negative consequences of this trend. For example, back at the start of this year, Francis Fukuyama had an essay in Foreign Affairs wondering whether liberal democracy could survive the decline of the middle class. Fukuyama has joined a growing number of pundits in arguing that a combination of technological change and globalisation had served to undermine middle class incomes in the developed world.

As well as this negative story about life in the middle, however, there is also a much more positive story to be told. That's the subject of my next post.

Back when I was trying to find a silver lining to the great GFC cloud, I used to cheer myself up by arguing that at least we had learned the lessons of the Great Depression and weren't about to re-run the disaster that was the 1930s.

Reading some of the commentary over the past couple of days makes me wonder whether I was too optimistic. Martin Wolf:

Before now, I had never really understood how the 1930s could happen. Now I do. All one needs are fragile economies, a rigid monetary regime, intense debate over what must be done, widespread belief that suffering is good, myopic politicians, an inability to co-operate and failure to stay ahead of events. Perhaps the panic will vanish. But investors who are buying bonds at current rates are indicating a deep aversion to the downside risks. Policy makers must eliminate this panic, not stoke it.

I'm just back from a research trip that took in a couple of conferences and a bunch of meetings with think tanks. I'm still digesting the various messages (aside from the blindingly obvious one about the grim outlook for the world economy), but one thing I did notice was the ubiquitous rhetoric about the need to deliver 'inclusive' growth alongside an intense focus on the political and economic costs associated with rising inequality. 

Given the current state of play, that's not really a surprise. But it does mark a change in the rankings of policy priorities relative to the pre-GFC status quo.

Calls for a shift to more inclusive growth are particularly loud in the developed world right now. Part of this reflects concerns about a long-running rise in inequality. As a recent OECD study sets out, in the three decades leading up to the GFC, income inequality had increased across the majority of OECD member countries, rising to its highest level in more than thirty years (see also OECD video above).

Greek voters delivered a dramatic protest vote against austerity on 6 May as support for the country's traditional parties collapsed. The Greeks have not been alone in venting their frustrations: of 17 governments in the eurozone, ten have been thrown out of office in the past year or so, mostly as a consequence of the crisis. 

Voters are, of course, dead right in their view that the current policy approach has not only been a failure, but an extremely painful one. The problem is, despite some signs of a rethink in Germany, it's still not clear that there is a viable alternative on offer.

As I first suggested in a series of posts back in 2010, one way to view the euro is as a particular European response to the problems involved in establishing a fixed exchange rate regime.

One of these problems involves establishing the credibility of an exchange rate peg. By opting to fix the exchange rate, a government is simultaneously promising to abandon a great deal of policy flexibility. Most obviously, it's giving up the ability to devalue the nominal exchange rate. Slightly less obviously, and assuming a high degree of capital mobility, it's surrendering the option to run an independent monetary policy. And, as established by the repeated failure of currency pegs across emerging markets triggered by budget deficits incompatible with macro stability, it's also promising to adopt some constraints on the operation of fiscal policy.

Giving up these policy options comes at a cost. If and when things get bad – say the economy is hit by a nasty shock – there's going to be a strong temptation for government to rethink those earlier promises. This is where the credibility problem comes in. 

Back in February I highlighted a short paper written for us by Alistair Thornton, arguing that we shouldn't be too sanguine about Chinese growth prospects this year.

On last week's evidence, Alistair was right to be cautious, as the data delivered a swathe of soft economic readings for April. Thursday brought news of weaker than expected export growth and a stall in import growth for that month. Then Friday delivered the weakest reading for industrial production in three years and also saw fixed-asset investment rising at its slowest level since 2002.

All up, pretty much every indicator for April came in below market expectations, sounding a loud warning about weakening growth prospects. Beijing took notice and the initial policy response has already arrived: on Saturday the PBOC cut the commercial banks' reserve requirement ratio by half a percentage point.

How much more policy action will be forthcoming? It depends in part on the extent to which the dip in growth represents China's transitioning to the slightly lower growth trajectory that the authorities have announced for this year, and which is therefore part of Beijing's economic strategy, and how much is the product of the tough external environment and the authorities' overdoing their earlier efforts at domestic tightening.

And, of course, its not irrelevant to the policy process that this bad economic news has arrived at a time when political risk has also been on the rise.

Meanwhile, with more bad news coming out of Greece, including renewed speculation about a euro exit, the global outlook is once again looking decidedly cloudy. As I wrote back in February, living with a world economy that seems to be operating according to Murphy's Law is going to be an uncomfortable experience.

Photo by Flickr user Dennis Kruyt.

In his post on the contest for the leadership of the World Bank, Steve Grenville wonders whether Australia will 'want to stay close to our great and powerful friends and reaffirm that "he who pays the piper calls the tune", or cast our vote for different succession processes which reflect the changing world?'

To give Canberra its due, I reckon Australia has already passed this test. If I recall correctly, along with Canada (and of course Mexico), Australia was one of the very few countries on the IMF Executive Board to offer its support to the candidacy of Agustin Carstens for leadership of the IMF. Pretty much everyone else — including most of the emerging market heavyweights like China – ended up supporting France's Christine Lagarde.

Sure, it might be different this time. But based on past performance, if there's any criticism of Australia warranted, it would have to focus on supporting an emerging market candidate when most of the emerging markets themselves weren't terribly keen on the idea, rather than on Canberra somehow trying to cling on to the old order.

As I've argued before here on The Interpreter, getting global economic governance to work in the G20 era is no easy task. So, could think tanks make a contribution?

Well, the Mexican Government believes they can. Think-20 is an initiative of the Mexican G-20 presidency, organised in collaboration with COMEXI, the Mexican Council on Foreign Relations, and at the end of February I attended the inaugural meeting in Mexico City. This  brought together representatives from a selection of think tanks (see graphic below) to discuss Mexico's plans for its presidency of the G-20 this year, in the run-up to the leaders' meeting scheduled for Los Cabos in June.

This was the first time think tanks have been invited to take part directly in the discussion of a G-20 presidency, so it marked a significant recognition of the potential contribution that think tanks can make to global governance. The agenda covered economic stabilisation and reform, the future of the international financial architecture, food security and green growth, and the effectiveness and productivity of G-20 summits. Despite a healthy diversity of opinion, the group agreed on a range of suggestions.

It will come as no surprise that, in a gathering of think tankers, the area of greatest consensus was on the role of think tanks themselves. Participants highlighted several ways in which a network of G-20 (and non-G-20) think tanks could make an ongoing contribution. Three of the most important were:

• By serving as an ideas bank, and providing new ideas and policies for G20 governments.
• By providing a potential source of accountability, though monitoring how well G20 governments delivered on their commitments.
• By working to deliver buy-in to the G20 process, through helping to explain the importance of the G20 and of (at least some of) the policies it is trying to promote.

The main day of meetings was held under the Chatham House role, but here's a recording of the press conference in which four of the participants (including this somewhat jet-lagged Australian) had a go at summarising the discussion. 

I've noted before on The Interpreter the dramatic shift in the nature of the world economy from the 2003-2007 mini-golden age to something that is currently much less congenial.

In a new paper, I suggest that one way to think about the post-crisis world economy is to see it as at times involving the prolonged and vicious application of Murphy's Law: in other words, whatever can go wrong with the world economy, has. Every time we think that we are about to see the onset of a sustained recovery, another shock comes along – with the Eurozone crisis now the pick of the bunch.

One bright spot in this gloom has been the relatively robust performance of emerging market economies in general and of China in particular. But are we getting China right? In a new International Economy Comment, Alistair Thornton, a China economist at IHS Global Insight, sounds a note of caution. Here's Alistair:

Hardly a day goes by without headlines declaring a soft or hard landing for China. It's one of those topics that everyone seems to have a strong opinion on, and there is little consensus. For obvious reasons, it is of critical importance to the global economy, particularly at a time when advanced economies face significant headwinds.

Digging past China's headline numbers is essential in this regard, not least because of the skepticism surrounding official data. The numbers are of notoriously poor quality, largely because China is a large fast-moving economy with a relatively young bureaucracy, rather than because it suffers from overt political manipulation, although that has certainly happened in the past.

In this International Economy Comment, I try and dig a little deeper, using the Chinese premier-in-waiting's preferred method for gauging growth, and I find evidence of an ongoing slowdown. This is not to call a hard-landing – because in that eventuality a policy response would be aggressive – but to highlight that things are not as stable as they may seem.

Let's hope this isn't going to be another case of Murphy's law in action.

Photo by Flickr user Mal.Smith.

According to the FT, Germany's Finance Minister has suggested that Greece might want to postpone April's elections and instead install a technocratic government which would not have room for any of the pesky politicians who have so far failed to deliver enough austerity. This is, of course, the Italian model, which saw Silvio Berlusconi replaced by Mario Monti.

Given the mess the previous bunch of politicians delivered, it's no surprise that markets appear to like the idea of rule by technocrat. Certainly, the current direction of policy seems to be based around a determined effort to limit Greece's room for manoeuvre.

I discussed the possibility of this kind of development in a couple of Interpreter posts back in 2010 in which I wrote about the golden straitjacket and Dani Rodrik's idea of a political trilemma for the world economy. Rodrik argued that one way to escape from the trilemma — his term for the proposition that countries can choose a maximum of two out of the three options of democratic politics, national sovereignty and international economic integration — was that countries could choose to don some version of the golden straitjacket, thereby removing economic policymaking from the political sphere.

So, one potential solution to the Eurozone's woes is to (temporarily) take economic policy out of the hands of the politicians and voters and give it to a bunch of experts.

I'm sympathetic to the distinction Michael Beckley raises between GDP and GDP per capita in his post on defining decline; it's a point I also focused on in my original post. Each gives us different readings about national capabilities.

But the other question I raised concerned comparisons over time. Specifically, I was surprised by Beckley's contention that the economic gap between the US and China had grown since 1991, and I plotted some GDP and GDP per capita data to suggest that the gap looked like it had shrunk. Beckley disagrees and the source of this difference is that, while I focus on ratios, including the ratio of GDP per capita, Beckley looks at the absolute difference in GDP per capita between the two economies.

It certainly makes sense to look at the absolute difference when comparing the two economies at a given point in time. But absolute differences do not do a good job of capturing changes over time. That's why we should normalise the data when making these kinds of comparisons – for example by constructing ratios or indices.

To see why, take the following (deliberately simplistic and extreme) example. Suppose that, at the start of our comparison period, GDP per capita in the US was $1000 while GDP per capita in China was just $1. Then assume that by the end of our comparison period US GDP per capita had risen to $1.001 million while Chinese GDP per capita had risen to $1 million. So China has grown much faster than the US over this period, but the US remains the wealthier economy: 

By the end of this simplistic example, has China shown signs of catching up with the US or not?

If we look at absolute values, we would have to say 'no'. In fact, the gap between the two countries has increased, rising from $999 at the start to $1000 at the end. And yet the message that China has gone backwards relative to the US is incredibly counter-intuitive.

As a follow-up to my earlier post on the limits to growth, it's worth noting this report released late last year by the McKinsey Global Institute. The report is an extended discussion on some of implications of the first of the two points on which I ended my post – that after a long period of falling prices appearing to signal easing resource constraints, recent trends look quite different:

There's a lot of material here, including some interesting bits relevant to the race between the cost-increasing effects of resource depletion and the cost-reducing effects of innovation: read more

Andrew Shearer's recent post on US-China comparisons prompted me to take a look at the paper by Michael Beckley he recommended. While I don't have anything useful to contribute on the specific subject of the US military/security edge over China, a couple of things did strike me.

First, I would summarise many of Beckley's points regarding the clear superiority of the US in measures of innovative capacity such as R&D spending and patent citations as reflecting the big difference in GDP per capita between the two countries. Given the close correlation between the level of a country's development and many of these variables, these results are exactly what we should expect when comparing a developed and developing economy. 

Or, to put it another way, countries at the economic frontier are likely to grow more through innovation while countries involved in catch-up growth will rely on a different growth model. 

This difference is one of the factors that lie behind concerns about so-called 'middle-income traps': the policies and institutions you need to deliver the growth that get you from low- to middle-income status may not map all that well onto those that get you from middle-income to high-income status. So while it's quite possible that the gap with the US on these innovation-style indicators will narrow as China develops and its GDP per head rises, it's not a foregone conclusion.

Second, I was surprised by the claim – at least with regard to economic variables – that the US lead over China has grown since 1991. That's certainly not what I would take away from the data. Of course, there are lots of potential variables to consider, and there are probably some data points that would support this story. 

Since some of my colleagues have been  setting out their thoughts on the Asian Century White Paper, I thought I might chip in with my two cents. I have three opening questions.

1. Shouldn't we try to go beyond old-school geography?

Granted, we know that there's lots of globaloney out there. Distance isn't really dead, the world’s not flat, and geography certainly isn't history. The real estate agent's mantra – location, location, location – remains an important feature of our world and of Australia's place in it.

Still, restricting ourselves to thinking about the world in old school geographical terms, especially when it comes to the international economy, seems just, well, overly restrictive. Perhaps, instead of starting from artificial geographic designations like 'Asia', we could start by mapping the evolving flows of goods, services, capital and people within which we are enmeshed, and then see where that takes us. At a minimum, in a world of international supply chains where traditional trade statistics capture only a small part of the underlying reality and which is characterised by increasingly complex financial networks, we need to supplement our traditional models with new ways of understanding our environment.

2. Can we find appropriate benchmarks?

It's probably inevitable that any study on our economic relations with a given region is going to generate claims that our ties with one country or another – or even the region as a whole – are underdone, or alternatively, that certain markets or modes of exchange are less developed than we might expect (I'm not immune to this kind of temptation). After which assertion we immediately and naturally skip on to the question, 'what is to be done to alter this deplorable state of affairs?'

I ended my earlier post by pointing out that economists typically think about resource scarcity differently than those who take a more pessimistic view, such the authors of The Limits to Growth and New Scientist magazine, which recently gave Limits a 40th anniversary appraisal. A neat way of explaining the difference is set out in this paper by John Tilton, which outlines two alternative models. 

Model one is the fixed stock paradigm. It starts with the common-sense observation that the earth is finite, from which it follows the supply of resources must also be finite, and hence can be represented as a fixed stock. Since the demand for those same resources is a constant flow variable, the flow must eventually deplete all of the fixed stock. Moreover, if demand growth then turns out to be exponential, depletion could occur quite quickly. This is a Limits-style world.

A second approach is what Tilton calls the 'opportunity cost paradigm', which assesses the availability of resources by thinking about what society has to give up to secure another barrel of oil or ton of copper.

In this model there are two forces at work. First, there is the same story of the depletion of existing stocks of a given commodity. This means producers must find new stocks which will often be harder to access or of lower quality, tending to push up costs and hence prices. Second, however, is the introduction of new technology which can offset this upward pressure on prices by economising on the use of an existing resource, by finding substitutes, or by reducing the cost of acquiring new stocks. 

Recently, New Scientist magazine ran an article (subscription required) marking forty years since the publication of The Limits to Growth. The piece both echoes and cites earlier positive re-appraisals of Limits, including this one by the CSIRO's Graham Turner, and shares a similar pessimistic tone.

Many (most?) economists have tended to have a fairly problematic relationship with this kind of thing, particularly when it comes to the supply of so-called non-renewable resources. When we start off as little, baby economists, we are frequently introduced to the Reverend Thomas Robert Malthus as a cautionary tale about resource pessimism. 

In 1798, Malthus published An Essay on the Principle of Population. Famously, he wrote about the inability of agricultural productivity to keep pace with population growth. Equally famously, he got his forecast wrong. As many subsequent critics have pointed out, Malthus turned out to be writing at a time just before a series of major developments. The acceleration of the Industrial Revolution, a dramatic expansion of international trade, the emergence of new agricultural producers in North America, Argentina and Australia, and the onset of the demographic transition allowed a series of countries, led by his own, to break free from the trap Malthus had just identified. 

Similarly, when Malthusian-style fears about binding constraints to growth reappeared in the late 1960s and early 70s as the world economy experienced a period of rising food prices, the Green Revolution and rising world agricultural productivity ended up allowing food output to run comfortably ahead of population growth, setting food prices off on a decades-long fall in real (inflation-adjusted) terms.

Economists often cite both Malthus' original predictions and the failure of the pessimistic forecasts of the early 1970s like The Limits to Growth as cautionary lessons about what happens when forecasters fail to account properly for the impact of technological change and the power of the price mechanism.

Part of what's going on here is that the economists and those who take a more pessimistic view typically think about resource scarcity in quite different ways. More on that in a follow-up post.

I've mentioned before on The Interpreter that I find reading science-fiction an interesting and enjoyable way to get some ideas about future trends, and here is Bruce Sterling, one of the genre's leading futurists, in his annual state of the world discussion. 

For a pithy view of the future around mid-century that brings together climate change, the demographic transition, and urbanisation, it's pretty hard to beat Sterling's 'old people in big cities afraid of the sky.'

And here is Charles Stross keying off Sterling to think about what the world might look like in 2032 and 2092.

Photo by Flickr user Ruff Made Art.

I'm in complete agreement with Steve Grenville's overall point — there is precious little evidence to suggest that the US blog debate has done much to 'winnow out dodgy arguments or produce a policy consensus.' But while that's probably pretty depressing for those who would like to think of macro as a purely technocratic business, I also don't find it particularly surprising.

As I've noted before, I think that political beliefs (and other values) have a significant influence on where many economists stand on some of these issues. And given that there is often a hefty political element to at least some of the policy choices involved, this also should be no surprise. What's perhaps more depressing is that — so far, anyway — the gradual accumulation of empirical evidence on some of these debates (few signs of so-called expansionary austerity; the absence to date of an inflationary surge) seems to be doing little to change minds, either.

It follows, then, that I don't think this lack of consensus is a particular failure of economic blogging: I am quite confident that the same inability to reach consensus would have prevailed (and indeed does prevail) in debates fought out in newspaper op-ed columns or policy briefs or wherever.

Moreover, I also think there is still some value in the debate. So, I would guess that economics students must find it quite useful (not to mention highly entertaining) to see policy arguments among the profession's great and the good diced and dissected: for a recent example, here is Brad DeLong taking on John Cochrane's views on fiscal stimulus.

Back when I first studied macro, I was taught about fiscal stimulus, the debate over the Treasury View and so forth in some rather dusty lectures on the history of economic thought. Now these debates are being fought out in real time against the backdrop of contemporary policy decisions. Again, this is perhaps (rightly) depressing for those who would like to think of macro theory as involving the forward march of a pure science. But if nothing else, at least it offers a much more interesting and engaging pedagogical tool.

Finally, there is some evidence that economic blogs do have some measurable positive effects. This series of posts at the World Bank from last year discusses some researchers' attempts to measure the influence of econoblogging: their final paper is available here.

Cartoon by XKCD.

Over 2003-2007 the world economy enjoyed something of a mini golden age. Economic growth was high, macroeconomic volatility was low, financial markets were buoyant, and the apparent probability of crisis was low. 

Since 2007, however, that mini golden age has been transformed into something that feels altogether more leaden: economic growth has slumped, macro volatility has soared, markets have turned manic depressive (with the emphasis frequently on the latter phrase) and the probability of crisis seems to be worryingly high. It's been a potent example of reverse alchemy – turning gold into lead.

Some of this was depressingly predictable: one lesson from past financial crises has been that the post-crisis period is typically one of sub-par economic performance. But there's little doubt that post-crisis economic malaise has been exacerbated by an extremely disappointing performance on the part of policymakers.

The consequence is that it's hard get too optimistic about a short-term economic outlook that is dominated by unfinished business from this year. On the other hand, the long-term outlook for the world economy continues to be shaped by the Great Convergence and remains very much the consensus view of the future.

Which raises an interesting question about the medium-term prospects for the world economy: just how are we going to transition from a gloomy short-term outlook to a much more optimistic long-term one? Well, as the old joke says, I wouldn't start from here...

Back in early 2010, I suggested that a key theme for the year ahead should be the pressing need for a range of economic actors to rebuild the credibility that had been so badly damaged by the financial crisis. In particular, I suggested that the image of competent Western economic management had been trashed, and was now in urgent need of repair.

Not quite two years on, and sadly, policy credibility remains in short supply. The debt ceiling debacle in Washington and subsequent sovereign ratings downgrade provided a sort of symbolic confirmation that the US could no longer boast AAA-quality policymaking. Meanwhile, developments in the eurozone over the past two years have signalled an even greater degree of policy failure, with expressions of disappointment and frustration with Europe's drift towards disaster now commonplace.

As a result, rebuilding policy credibility should – again – be a key theme for next year. Here's hoping the world's leaders do a better job of it this time.

Photo by Flickr user davidz.

There's been a depressing sense of déjà vu about the world economy over the past week. Once again, we are worrying about policymakers in the core developed economies failing to get to grips with a financial crisis; and once again we are fretting about the adverse spillover effects to the key emerging markets that have helped support Australian growth.

We know that our region will not be immune from developments in Europe. In this regard, it's important to remember that the key lesson from the previous global financial crisis was not that the emerging markets of Asia and elsewhere were safe from a downturn in the developed world: in fact, when the crisis went critical after the collapse of Lehman Brothers, both economic activity and financial markets crashed right across the world.

Rather, it was that the affected emerging markets were nevertheless able to aggressively use fiscal and monetary policies to offset the worst effects of the downturn, and had the policies and institutions in place that were able to deliver an impressive degree of resilience in the face of a severe external shock.

As the crisis in the Eurozone deepens, that resilience is now facing another major test. According to the World Bank's latest regional assessment for East Asia and the Pacific, weaker growth in the EU (and the US) will once again have a significant impact on the region, given continued high direct trade exposures to developed markets:

Euro-pessimism has taken (yet) another steep rise over the past few days: this week's Economist magazine asks whether this is the end for the euro; in the FT Gavyn Davies outlines some possible post-crisis scenarios; and the Wall Street Journal ponders some of the possible implications of 'eurogeddon'.

What's striking about this is that the degree of policy failure implied here is of truly epic proportions. After all, if just leaving the euro would prompt the 'mother of all financial crises' in the exiting country, consider the calamity that a full-scale collapse risks triggering.

Of course, if history is to repeat itself, then now is the time to start thinking about what the next phase of European currency cooperation might look like: and indeed Paris and Berlin are reportedly setting out their ideas. But after this latest debacle, will Europe's voters once again let their leaders play double or quits with the region's currency arrangements?

As is now commonplace to point out, Australia's alliance preferences link it to the US, even as its economic ties with China are dense and growing. 

Since Washington and Beijing are increasingly viewed as strategic rivals, this is supposed to present policymakers in Canberra with a potentially difficult trade-off – do you cuddle up closer to your most important customer and risk losing your lovely security blanket? Or do you chance diminishing your economic welfare by sticking with your traditional allies? 

Australia's situation seems tailor-made for testing this purported pull between matters of economics and security. If one were to look only at the increase in Australian-Chinese economic ties over the past few years, then these would seem to predict that Australia would also be pulled geopolitically towards China.

Under the Howard Government, Canberra clearly remained a close ally of the US, to the extent that Australia famously earned for itself the description of US 'deputy sheriff' in the region. But after some early diplomatic pain, the same government also worked hard to keep China onside: a recurring theme in Prime Minister Howard's speeches was that Australia could maintain good relations with both Washington and Beijing (a theme that is still familiar today). Meanwhile, analysts carefully watched ministerial pronouncements for any signs that economic gravity might geopolitically tilt Australia towards China.

In the years following the Howard Government, China's relative importance to Australia as a trading partner has grown, even as that of the US has declined. Granted, the US remains a far more important investment partner. But even there, China's status as an overseas investors has risen sharply from what used to be negligible levels. And of course, at least to date, the aftermath of the GFC has served to reinforce perceptions that there has been a big shift in relative economic fortunes between the two great powers in favour of Beijing.

In response to Anton's Reader Riposte, I'm not sure Mrs Thatcher's macro policy makes for a good case study in support of the existence of the confidence fairy. 

The early years of her first term saw the implementation of very tight fiscal and monetary policies, and the result was a severe contraction. When macro policy was then loosened, economic recovery followed. When looking at the fiscal position over this period, it's important to look at the cyclically adjusted fiscal stance to see whether policy was stimulatory or contractionary.

Two other quick points.

First, Mrs T was happy to use tax increases to get her fiscal consolidation. In particular, she hiked VAT to such an extent that it's been estimated the overall tax take levied on labour increased relative to the previous government and stayed above it until the late 1980s. Indeed, noted supply-sider Arthur Laffer took to the pages of the Wall Street Journal to denounce her approach.

Second, the success in restoring fiscal health to the UK economy over the period owed more than a little to the good luck of a nicely timed windfall from North Sea oil.

Photo by Flickr user cseeman.

It's hard to stay optimistic about the G20.

Getting a big success out of last week’s summit was always going to be a tough ask and in the end, the initial take on Cannes has been that it largely lived down to expectations. Some have gone further and described the meeting as 'comically irrelevant'.

Initially, pessimists had worried about the ambitious agenda of the French presidency and whether, as a result, the G20 was in danger of heading down the APEC route of combining a rapidly expanding agenda with a failure to deliver. But as the crisis in the eurozone deepened, it became clear that the meeting would end up being judged on its contribution to dealing with Europe's overlapping debt, banking and growth problems.

To a large extent, this was inevitable: after all, it would be very strange if the self-designated 'premier forum' for international cooperation did not having anything to say about one of the most pressing challenges to global economic stability. In this regard, criticisms of the euro crisis 'hijacking' the G20 rather miss the point. 

The introduction to Arvind Subramanian's new book Eclipse begins with a description of international economic events taking place during a future February 2021.

In a story designed to illustrate the changing balance of financial power in the global economy, Subramanian imagines a newly inaugurated US president en route to a meeting with the Chinese director of the IMF, where he will sign an agreement to get US$3 trillion in emergency financing in return for the US submitting to Fund conditionality.

Meanwhile, back in today's world, Eurozone leaders are reportedly hoping to set up a special fund, possibly managed by the IMF, to attract investment from cash-rich countries like China and Brazil to help out with the current crisis.

As William Gibson said, the future is already here, just unevenly distributed.