Lowy Institute

Now that the terms of the Trans-Pacific Partnership (TPP) have been agreed, the participant countries have to decide whether to ratify the deal. In assessing the benefits, where might we turn for guidance on the economics?

First thoughts might go to David Ricardo, father of one of the few ideas that economists largely agree on: comparative advantage. Countries should produce the things they do best, and trade these for things they do less well. The key insight is that countries should trade internationally, even if they are better at doing everything (they have 'absolute advantage') than their trading partners. 

The policy message is that countries should abandon tariffs and quotas and open up their markets for international trade.

This is, more or less, what Australia has done. Over 90% of Australia's imports have tariffs of 5% or less. We've done this largely unilaterally, believing it to be in our own self-interest. Can't we now just rest on our laurels, while urging other countries to follow our virtuous lead?

Economists might believe this, but they have never persuaded either the public or the politicians. The WTO has struggled in vain for the past decade to make progress at the multilateral level.

So-called Free-Trade Agreements (FTAs) such as the TPP have been the response to this failure. These are preferential agreements, so Ricardo's simple free-trade dictum doesn't apply. There is trade diversion (imports may not come from the cheapest source). Nevertheless the TPP will push some of our partners, over time, towards some reduction in quota restrictions on our agricultural exports. And having 12 TPP members (accounting for one third of world trade) reduces the trade diversion, compared with bilateral FTAs.

Thus, viewed from Ricardo's vantage point, the TPP is not ideal, but it might be the best that can be done in an imperfect world.

The main issues are however, elsewhere, in the high-level 'platinum standard' rules that the TPP imposes on participants. Most of these rules are not closely related to international trade.

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We can't object to the idea of rules, per se. Ricardo's free trade took place in a fantasy world, where cloth merchants met wine traders and agreed on price, quality, payment terms, delivery date and then everyone kept their side of the bargain. Transaction costs were ignored. In the real world, enforceable rules are needed to ensure markets work well. If there are not enough rules, uncertainty and asymmetric information raise transaction costs. If there are too many rules (or the wrong ones), there is a dead-weight cost to transactions; too much 'red tape'.

Thus we need more than Ricardo's 'free market'. But what rules are needed, who makes them, and in whose interests? 

For academic guidance on this, we might draw on the work of economic historian Douglass North (who died last week, aged 95). One of his best-known studies examined the self-imposed rules that developed between long-distance merchants during the revival of trade in the late middle ages.

North's interest was in generalising from this experience, analysing the evolution of rules of conduct. He called these 'institutions' — 'the humanly devised constraints that shape human interaction' — and likened them to the rules of sporting games.

For North, the rules evolved out of social interaction (often by the participants) rather than being imposed by governments, and in response to perceived needs. Whether a particular set of rules persisted or evolved over time depended on whether they served the objectives of the participants. 

So where does the TPP fit into North's view-of-the world? If Australia had been writing the rules from scratch to foster our international economic interaction, does the TPP represent the set we would have devised?

We're an intellectual property net importer, so have little national interest in strengthening the current IP rules, perpetuating the misconception that innovation is best fostered by awarding monopoly rights to the innovator. The same goes for foreign investment dispute resolution. As a major capital importer, we are entitled to think our own domestic laws should be enough to protect foreign investors. Labour laws, environmental issues, corruption, the role of state-owned enterprises and free capital flows are all issues we might best handle with our domestic laws and practices, which might or might not coincide with TPP requirements. In short, while acknowledging the desirability of rules-based international order, these are not the rules we would have prioritised.

Just as in football, we now have the opportunity to sign up for this TPP code which is a less-than-perfect fit with the way we would like to play. One strong incentive to sign is that this is the 'only game in town', at least at the moment. If we don't join, the TPP partners will be off playing with their own set of rules, including some which divert trade away from us. On top of this, economics isn't the only consideration: the TPP is part of our overall relationship with America.

So we will sign up. This should not, however, be the end of the story. Douglass North's narrative analyses why some 'institutions' are persistent (unchanging) while others evolve. Two paths of evolution are open. 

The first is to expand TPP membership, starting with China and Korea, but going on to include Southeast Asia and India. The biggest advantages come from enlarging the number of participants playing by the same rules.

The second is to align the rules more directly with the practical needs of international trade. The TPP rules are unlikely to evolve much, but there are opportunities outside the TPP for rule-making (and rule simplification). In the longer term, the more operational focus of the ASEAN-based Regional Comprehensive Economic Partnership (RCEP) might offer us more advantages, more analogous to Douglass North's trade-facilitating rules. It is moving slowly but is more focused on our region, where our greatest trade potential lies. 

The ultimate advance would entail moving away from competing codes, towards a 'world game' where everyone plays with the same rules. International trade would benefit from both the TPP's high-level behind-the-border rules and the detailed operational facilitation that is at the heart of the RCEP.


Treasurer Scott Morrison has rejected the proposed sale of the Kidman cattle properties to foreign interests:

Given the size and significance of the total portfolio of Kidman properties along with the national security issues around access to the WPA (Woomera Protected Area), I have determined, after taking advice from FIRB (Foreign Investment Review Board), that it would be contrary to Australia's national interest for a foreign person to acquire S. Kidman and Co. in its current form.

There are some special, perhaps unique, factors in this case. The cattle properties involved are certainly exceptional, not only in sheer geographic mass (100,000 square kilometres, or 1.3% of Australia’s total land area and 2.5% of agricultural land), but in terms of their iconic historical status. In addition, one of the properties overlaps the WPA where sensitive weapons-testing takes place.

There are also some not-so-unique factors involved. Selling agricultural land to foreigners has become an emotional issue, especially for the government’s coalition partner, which represents rural interests. The prospect of selling to a Chinese firm (even privately owned) adds another layer of resistance.

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Nevertheless, in principle Australia actively encourages foreign investment. The public generally accepts net benefits have been positive. Foreign investment funds a good part of our substantial current account deficit, which for more than 200 years has allowed us to invest more than we saved, and to grow faster than otherwise.

It's not as if much foreign investment has been blocked. Outside of agriculture, much of the family silver has already been sold: 80% of our mining resources are foreign owned. In agriculture, it's just 12%, and even there we don’t have an 'in principle' objection to Chinese investment and we have accepted a rapid growth of Chinese ownership in this sector.

If we are concerned about foreigners using transfer pricing to avoiding paying a fair share of taxes, then our concerns should focus on the large-scale chronic tax avoidance practised by many multinationals operating here. The national security argument might be relevant in the Kidman property case because of the special location, but it can’t have widespread application, unless we accept the spurious argument that all Chinese investment is a 'projection of power' and that if Chinese own the electricity grid, they might turn off the lights

Past rejections don’t provide much in the way of precedents to establish clear principles. We knocked back Shell’s attempt to buy Woodside, Singapore’s bid to take over the stock exchange (ASX) and the attempted purchase of grain-handler GrainCorp. The approval process also scuppered Chinalco’s attempt to increase its stake in Rio Tinto.

It’s not as if Australia is the only country that vets foreign investors, nor are we the only country  wary of Chinese investment. The US rejected Chinese investment and the US president ticked off our prime minister for not consulting America before leasing Darwin harbour to a Chinese company. Farmland stirs patriotic fervour everywhere. New Zealand recently rejected Chinese investment in a dairy property. China itself is also very restrictive of foreign investment.

Thus just about all countries show a mix of paranoia and parochialism, perhaps with a touch of racial prejudice, in their attitude to foreign investment. But in the end Australia lets almost all of it happen. When purchases have been blocked, the public intuitively understands and largely agrees (this was the case with Woodside, Chinalco and ASX).

This ambiguity isn’t surprising; politics represents community values, which are ambivalent, even inconsistent. Governments have to dissemble, ducking and weaving to maintain sensible balanced policies, and in this case that means considering current account funding and providing a global element to investment.

It is, however, important for Australia, as a substantial capital importer, to either articulate a clear policy on foreign investment or learn to live with a smaller external deficit. It is also possible to squeeze more benefit out of the foreign investment that is coming in.

The starting point is to look ahead a few decades at what our world will look like. Asia (and particularly China) will be a substantially bigger economy. If we are to succeed, our economy will have to be much more integrated with the region. Resources (iron ore, LNG and coal) will still dominate our exports. China (and other Asian markets) will have established the stable supply relationships needed for food and resource security. Australia could provide a significant component of both.

The central policy issue is this: what is the commercial and regulatory framework that will maximise the benefit to us as a nation?

It will require specific skills, knowledge and guanxi to tap the Chinese market successfully. For agriculture, it will require scale well beyond the traditional Australian family farm (just as it does in resources). A high level of Chinese involvement in the Australian supply-source seems inevitable, even desirable. But how to ensure that the disparity of scale (they are huge and we are relatively tiny) doesn’t mean that the value add (the very considerable difference between the farm-gate price and the retail price) doesn’t all go overseas, and the choice jobs along with it?

This needs more concerted policy thinking than just tweaking the FIRB rules in isolation. For a start, our competition authorities need to recognise that scale is often needed to compete globally. Some of the elements of a more comprehensive process are underway. The Productivity Commission is looking at the agriculture sector. DFAT has examined the trade aspects, and the China-Australia Free Trade Agreement (ChAFTA) has helped to define some of the relevant issues.

But if we don't want to run the risk of becoming 'hewers of wood and drawers of water', we will need to do more.

This might include the development of an Investors’ Code of Conduct to provide a template for a broader FIRB application process, putting specific content into the nebulous 'national interest' criterion. This could cover tax and transfer pricing. There might be a presumption there would be a substantive Australian partner. Where it makes economic sense to carry out value-add processing in Australia, this might be mandatory. There would be opportunity, too, for the foreigners to refute the more fanciful of the security concerns.

We should be able to put out the welcome mat for foreign investors while at the same time demonstrating to domestic sceptics they are not on the way to becoming mere share-croppers in their own country.

Photo courtesy of Flickr user Alex Prolmos


This week's cover-story in The Economist warns of an impending debt crisis in the emerging economies. This is seen as the third stage in the ongoing debt saga: first came the 2008 'global' crisis; then the 2010 crisis in Greece and the European periphery; now the emerging economies.

These crises are caused by total debt (both domestic and foreign), but the foreign component is always the most problematic, as it involves exchange rates, scarce foreign currency and flighty foreigners.

This latest round of hand-wringing is a reminder of the divergent opinions about capital flows. The traditional conventional view among policy and academic economists was that capital flows were unambiguously a Good Thing, a beneficial element of globalisation. The policy prescription which followed was that emerging economies should open the capital markets to foreign flows. The promise was that, provided they let their exchange rates float, things would work out well.

The experience of the past two decades has been less benign. The sloshing backwards and forwards of foreign capital has typically been driven by the abnormal circumstances in advanced economies, rather than by macro-policy mistakes in the emerging economies. A policy framework that presumes these flows to be beneficial is irrelevant to the policy challenge the emerging economies face.

Over the past decade, the policy debate has been inching forward to incorporate the inconvenient reality that the flows may be disruptive. Olivier Blanchard, recently retired as the IMF chief economist, has co-authored two papers from his new base in the Peterson Institute. As he did at the IMF, Blanchard continues to strive to bring the consensus policy framework closer to the real world.

One paper argues that capital inflows can push up asset prices in the recipient country, over-stimulating domestic demand in the process. This might seem like an obvious-enough insight, but is the opposite of the conventional academic model on which much policy prescription had been based.

The second paper argues that foreign exchange intervention can be effective in stabilising the exchange rate in the face of excessive capital flows. Again, this contradicts most academic models, which see intervention as futile or distortionary.

It is (just) possible that these two papers may shift the policy advice of the IMF in the right direction, and it would become more ready to see capital flow management and foreign exchange intervention as first-rank policy tools for emerging economies rather than last-resort measures of desperation.

Such a shift would not, however, go unchallenged.

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Coinciding with the publication of these papers, the 6000-page Trans-Pacific Partnership (TPP) draft agreement includes a Joint Declaration on macroeconomic policy that fully embodies the Old View which holds that intervention in the exchange rate will be seen as a prime facie case of 'manipulation'.

'Each Authority confirms that its country is bound under the Articles of Agreement of the International Monetary Fund (IMF) to avoid manipulating exchange rates or the international monetary system in order to prevent effective balance of payments adjustment or to gain an unfair competitive advantage.'

This Declaration, included at the insistence of some members of the US Congress, may not have much force in constraining policy-making in practice. In putting a link to the Declaration on the Australian Reserve Bank website, the RBA noted this Declaration was 'not legally binding'.

But it is a demonstration of the pathetic standard of the international economic debate, where half-learned textbook economics become the basis of strongly held policy doctrine. The Declaration requires an annual examination of member countries' macro-policies, with the detailed requirements for disclosure of foreign-exchange levels and intervention making it clear where the focus will be.

The next phase of sensible policy debate on capital flows should be to explore the practical application of Blanchard's insights. What measures of capital flow management will be effective, and in what circumstances? When is foreign exchange intervention effective? What does this say about the optimal size of foreign reserve-holdings? Can effective methods of reserve pooling (such as the Chiang Mai Initiative) be developed? Can the US Fed's swap facilities be more widely accessed? How can the Fund's role as global lender-of-last-resort be made more relevant?

These important debates are constrained because the TPP countries have now signed up to a declaration that genuflects to an old policy mindset, overtaken by reality.

They say that the challenge for academic economists is to prove that what happens in the real world could also happen in theory. Blanchard and his colleagues have taken a useful step in this direction, reconciling theory with inconvenient reality. This might be seen as progress, if only the political-economy of international economics were not still in the hands of Keynes' 'madmen in authority … distilling their frenzy from some academic scribbler of a few years back'.

Photo courtesy of IMF


With the text of the Trans-Pacific Partnership (TPP) finally revealed, commentators, specialists and interest-groups can immerse themselves in the 6000 pages (with important side-letters still to come) of the agreement. But the nature of the discussion will change now that the negotiation is finished.

The time for influencing the outcome with threatening rhetoric, position-taking and negotiation tactics is over. It's now a binary choice: join or don't join. Industry lobbyists will have to decide whether their non-negotiable positions are so immutable after all. Politicians will have to weigh up the pros and cons, and how to explain it all to voters. While Congress might yet prove to be a deal-breaker, it's time to look beyond the negotiations, assuming the deal will be ratified and that a quorum (including Australia) will sign up.

Peter Petri, Michael Plummer and Fan Zhai  of the Peterson Institute in Washington have attempted an econometric assessment of the TPP’s impact. There is a powerful message from this model-based analysis: the TPP by itself has modest benefits, but if all the Asian countries worked towards TPP-style rules and eventually joined up in an over-arching, all-inclusive Asia/Pacific framework, the benefit would be very much greater.

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The Peterson Institute authors estimate that world income would rise by US$295 billion per year on the TPP track, and by US$1.9 trillion if the Asian/Pacific countries ultimately combine to achieve region-wide free trade. To put this in more perspective, the world gains about 0.3 % of GDP through implementing the TPP, but an inclusive pan-Asia/Pacific agreement would raise incomes by nearly 2%.

You can argue the methodology of these model-based results, but the message is powerful. The TPP's current membership will yield a modest benefit: widen the membership and the benefits would dramatically multiply.

The problem here is that there is very little enthusiasm among key players for enlarging the TPP. South Korea might join on the basis of its recent bilateral trade deal with Canada. Indonesia might enter into negotiations, but has big domestic hurdles in terms of both opinion and existing policy. More importantly, the big non-starter — China — is neither eager to pursue membership nor welcome if it does. 

The position of China, both before the agreement and now, is probably the single most important issue and is surrounded by more ambiguity than the negotiations themselves.

The TPP draft contains other provisions that will make China feel unwelcome. It requires each TPP member to 'foster an exchange rate system that reflects underlying economic fundamentals,' 'avoid persistent exchange rate misalignments' and 'refrain from competitive devaluation.' Two veterans of the Peterson Institute, Fred Bergsten and Jeffrey Schott, applaud this revival of the hoary old canard of 'currency manipulation', aimed at China. They say it 'should strengthen the US Treasury Department's ability to deter currency manipulation by our trading partners, including future members of the TPP'. Other countries are mentioned, but China is the clear target.

Currency manipulation was always over-hyped and is yesterday's issue. Even one of its strongest protagonists accepts that there is not much relevance to today's US economy. Just about everyone (including the IMF) agrees that the renminbi is not over-value now, whatever the arguments of five years ago. But these provisions are a reminder of the deep-seated antipathy to China. 

This blinkered vision needs to be addressed. The Peterson Institute study mentioned above notes that: 'Given China's scale and strategic role in the region, it is difficult to envision the future of the Asia-Pacific trading system without a central role for China'.

For its part, China might make use of the study to remind the world (and US commentators) that these preferential trade agreements are distortionary, and are estimated to cost the Chinese economy 0.3% in income through trade diversion.

The way forward is to offer a less ambivalent welcome to China, encouraging it to begin a dialogue with TPP partners that would lead towards the greatly augmented benefits that would come from wider membership. 

With neither the US nor Japan likely to initiate this more welcoming attitude, there might be a role for Australia,  not only to encourage China to seek membership, but to address the obstructive attitudes found in the US (and probably Japan as well). Economics offers no reason to exclude China. If keeping China out of the TPP is strategically smart, let's hear this argument articulated clearly.

Photo courtesy of Flickr user TPP Media Australia.


The negotiators have finally reached agreement on the Trans-Pacific Partnership (TPP). The US Congress might yet be a stumbling block, but the many US interest groups which stand to benefit will influence that outcome. Other TPP countries have to get legislative approval too.

Whatever the deficiencies of the deal, it is better to be in rather than out. It's time to starting thinking about what steps could be taken to increase the benefits that will flow.

As a general principle, large trade groupings are better than smaller: there is less trade diversion. Multilateral is, of course, optimal, but the World Trade Organisation shows no signs of being able to make progress, so our starting point is with the 12 countries that reached agreement on the TPP in Atlanta last month.

From Australia's viewpoint, this group is light on Asian members, but this could change. Indonesian President Joko Widodo expressed interest in joining when he was in Washington last week. South Korea is also a likely joiner (its existing bilateral agreement with the US makes negotiation easier). The US is working on Thailand and the Philippines as well.

While the US worked assiduously to encourage countries like Indonesia to join, the position on China is less clear. For its part, China has shown no great offense at being excluded, perhaps guided by the Marxist doctrine (Groucho, not Karl) that you wouldn't want to be a member of any club that would let you in.

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There might have been an argument (as made in this post: 'The TPP is not a Containment Strategy')for leaving China out of the initial negotiations in order to make it easier to get a set of rules in place. But to go on leaving China out does look like a containment strategy. Certainly, its economic model is different from America's, with a command economy and many state-owned enterprises. But this is true, too, for Vietnam, which seems to see the way clear to sign on as a founding member.

Who might set this process underway? Japan is unlikely to be an advocate. Given the lukewarm attitude of some US commentators, an early initiative from that quarter seems unlikely. This might be an opportunity for Australia to take the lead. This would fit a sensible overall strategy of pushing back where China is over-reaching (for example, in the South China Sea), but at the same time offering China opportunities to integrate itself more fully with the rules-based international economic order.

Would this Asian-oriented effort to expand the TPP undermine the alternative Asian-based trade groupings, particularly the ASEAN-focused Regional Comprehensive Economic Partnership (RCEP), which includes China and India? Fortunately the RCEP and the TPP largely work at different levels. The TPP tries to put in place high-level general rules which will govern world trade (intellectual property, dispute settlement, labour-market issues and the environment) while the focus of the RCEP is on specific operational issues that hinder trade.

Until Indonesia showed some interest in the TPP, there was the possibility that ASEAN might see these two trade approaches as rivals, but with Jokowi's positive response to TPP, the opportunity is open for all the RCEP countries to do what Australia has done from the start; take part in both streams of negotiation because it believes the two are complementary.

Here's the brief. We could open a dialogue with China to encourage it to seek membership, while at the same time arguing its case among the existing members. A parallel dialogue with Indonesia would attempt to reinforce its interest in joining, as some offset to the inward-looking, more nationalistic voices now much louder in Jakarta. Again, we would support their case among the current TPP membership.

Perhaps more clearly than Australia, the US sees the TPP as having substantial diplomatic and strategic content. Now the economic rules have been established, our job as a foundation member is to make sure the wider strategic aspects are in our interests, and remain so.

Image courtesy of Flickr user Caleb and Tara VinCross


The 'China slowing' story has dominated the financial markets' gloomy commentary for the past few years, so the recent official GDP growth figure of 6.9% for the year to the September quarter gave commentators another opportunity to find the dark cloud in every silver lining. The figure met the official target of 'around 7%', but it was greeted with widespread scepticism. Last week’s monetary tweak is an acknowledgment that growth is slower than the authorities would like.

What should we make of all this? To put this into perspective, we need to address the specific issues one-by-one:

  • Are the GDP figures reliable?
  • Isn't 7% a lot slower than China's normal breakneck pace of growth?
  • Is 7% growth sustainable?
  • Is a smooth transition from double-digit to 7% feasible?

Can we rely on China's GDP measure?

In a narrow sense, GDP figures are bound to be unreliable.

Let's leave aside the natural scepticism generated by the Chinese statistics that are published so promptly and which always meet the official target. Instead, let's just note that even in mature economies, there is a lot of guess-work, approximation, extrapolation, dodgy deflators and uncertain quality-adjustments in every country's GDP figures. But outside China, there is less pressure to meet a target growth-rate.

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There is also a long history of incredulity, although nearly all observers accept China has done well since the 1980s and had a stunning burst of growth this century. Recent growth estimates, however, have raised more-than-usual doubts. Anecdotal reports cite manufacturing overcapacity and limp property markets. But ad hoc indices based largely on real production (such as the 'Li Keqiang' index) would not capture the transition from an economy driven by steel and concrete production to one where services (education, schooling, health, travel and so on) play a dominant role: services now account for more than half of recent growth and are notoriously hard to measure in GDP.

Perhaps the best response is to remain agnostic about the quarter-by-quarter figures, and accept that China (like other countries) will have economic cycles during which growth slows temporarily. We should, instead, focus on the underlying growth dynamic.

Is the current underlying trend much lower than usual?

Here is the context. China had a period of double-digit growth in the decade leading up to the 2008 financial crisis. Such growth is unusual, but by no means unprecedented: Japan, South Korea, Taiwan and Singapore have all had such growth spurts. All these countries had extraordinarily high saving and investment. The most important common factor is that they started from a low GDP base, giving them great potential for a quick catch-up. You don't have to invent better ways of doing things; you only have to borrow from rich countries which are ahead on the technological frontier. This is the 'convergence' story referenced in 'The End of Economic Convergence? Not Quite'.

China had other things going for it as well. These included a huge pool of surplus labour in agriculture, which could be shifted into manufacturing and other urban jobs, a transfer that in turn created a great need for urban dwellings and infrastructure.

But these double digit growth spurts could not (and did not) persist in any of these countries. China's point of inflection came in 2008-09, coinciding with the global financial crisis. This slowing was hidden, temporarily, by a policy stimulus far larger than in any other country, which pushed growth back into double digits in 2010 and 2011. This was artificial and unsustainable.

Thus, in underlying terms, the growth inflection should be dated at 2009. The catch-up on urban house construction was showing signs of satiation. The seemingly endless supply of rural labour was looking less limitless (the 'Lewis turning point' was beginning to impinge). A recession-hit global economy was no longer able to take up China's manufacturing surplus, which is why the current account surplus, after peaking at over 10% of GDP in 2008, fell rapidly

The Chinese authorities recognised this quickly enough, and started talking about growth rates starting with a '7'. For the past three years, this is what the GDP growth figures have shown. This 'new normal' is a lot less than pre-2008 growth, but the big shift in the underlying rate occurred five years ago. It is now an old story, with a good part of the adjustment already made. This new normal would still be enough to double China's GDP every decade. It's also worth noting 7% growth on today's higher GDP represents a bigger increase in physical production than the double-digit annual expansions before 2009, when GDP was much lower.

Let's just accept, then, that whatever the variations in the quarterly figures, the underlying trend growth may well be somewhere around 7%. Is this sustainable?

How long can the new normal last?

Given China's starting point — per-capita income is still only around one-seventh of the US — it still has a lot of potential catching up ('convergence') to do.

On the supply side, there is still potential for shifting surplus agricultural labour into more productive work. Certainly there seems no shortage of investment entrepreneurship. There are plenty of inefficiencies (especially in the state-owned enterprises) to be ironed out, to the benefit of GDP.

On the demand side, dismantling the 'hukou' system restrictions would give all those involved more incentive to demand the urban facilities they are currently denied (housing, health services and education). Whatever the temporary over-building of dwellings or infrastructure, China needs to build perhaps 200 cities the size of Singapore, with all the deep infrastructure and modern dwellings seen in that country.

Certainly, there are challenges. China can't go on stimulating demand by fast credit growth and profligate budgets. But the nature of the transition required seems feasible: the task over the next decade is to shift around 10% of GDP from investment into consumption. Most countries have the opposite problem; the politically far more intractable challenge of stimulating investment and restraining consumption. For this purpose, the Chinese have a singular advantage over Western countries: a command economy which can 'think big', take risks, absorb losses without losing momentum and push through the necessary transformation.

Will it be a bumpy ride?

This leads to the last issue: will this transition be smooth? Even an authoritarian administration has political constraints. And policy-makers will no doubt make some errors. Growth is, intrinsically, a syncopated process, with spurts and reversals. But 7% growth is not such a high bar. Indonesia, hampered by weak micro-economics and poor governance, averaged 7% annually during Suharto's three decades. China, with its imperfect but comparatively superior administration and entrepreneurial dynamism, should be able to do at least as well as that.

Why, then, are seasoned observers like John Garnaut praising the forecasting abilities of the chief growth sceptic Michael Pettis? We'll have to wait longer to see who was most prescient about China's growth path. We are, however, already half-way through the decade in which Michael Pettis said average growth would barely break 3% (see his bet with The Economist). It would take not just a dip in GDP growth but a sustained recession of negative growth for the rest of this decade before that bet pays off.

Eventually China must follow the pattern of those countries which have converged onto the technological frontier, where growth no longer depends on 'catch-up' and the far more difficult task of technological innovation must be faced. But China has many years of convergence before it arrives there.

In the meantime, for all the financial-market alarm about the latest blip in the production managers' index (PMI), the gyrations in equity markets and a minor exchange rate adjustments, China is likely to grow around twice as fast as the mature economies. The current IMF forecast is for numbers starting with a '6'.

With this sort of growth, Australia is still the lucky country, well located to be pulled along on China's coat-tails (see 'How Dependent is Australia on China's Economic Growth'). We might, however, have to do our own transformation: less resources and more food and services. Are we as capable of transition as China?

Image courtesy of Flickr user Matthlas Mendler


I'm a Tyler Cowen fan, but this China presentation (see above, and on The Interpreter yesterday), is pretty sloppy.

Let's take debt-to-GDP (about 6 minutes in). The background graph shows China's debt ratio at 230-300% of GDP, which is probably about right for total debt (official plus private, including households). But the graph shows the US at just over 100%, which is about right for official debt, but way too small for total debt. The same graph shows Japanese debt at 60%, which is just outlandishly wrong (government debt alone is around 250% of GDP).

Probably the best data source for comparable global total debt-to-GDP is from the McKinsey Global Institute. The chapter on China's debt puts its debt-to-GDP at 282% in mid-2014, with the US at 269%. The study puts Japan's debt at 400% of GDP. China comes in at number 22 on McKinsey's global ranking of debt by country.

China's economy certainly has many challenges (including debt), and this leaves room for wide differences of outlook. I tend towards the optimistic end of the spectrum, but I readily acknowledge that China could have a cyclical period of below-trend growth (ie. below 7%). Tyler Cowen, however, goes much further. He says 'China is running a very serious risk of a recession which will be deep and also may last really quite some number of years'.

Let's try to put a bit of precision around this prediction by turning it into a falsifiable hypothesis. A recession entails negative growth, and Cowen's prediction is for a 'deep' one. 'Quite some number of years' might mean, say, five, perhaps even more.

Let's then do what The Economist did with Michael Pettis' prediction that China's annual growth would barely break 3% on average this decade. Here's the bet: 'That China has negative growth for five years, starting soon'. I'll put a few dollars on the other side. Or should we follow the Keen-Robertson tradition, with the loser wearing a T-shirt saying 'I was hopelessly wrong on China growth'?


Financial markets are prone to public hand-wringing about impending dangers, not least because this creates more volatility, with its profit-making opportunities. As well as worrying about China, world commodity prices, and US monetary policy tightening, markets are concerned about disruptive capital outflows from emerging markets.

It is no comfort that this volatility is caused by the market itself: it results from each player's attempt to shift investment funds ahead of the rest. When some investors decide it's time to leave, this quickly turns into a lemming-like rush. Bonuses depend on being first in the exodus.

With the increased integration of global capital markets, capital flows readily in response to interest differentials between countries, and in large volume. The flows also reverse, much more suddenly, in response to changes in sentiment. One moment, market participants are 'risk on': prepared to take a chance on investing in countries about which relatively little is known. Then, always with one eye on their rivals, investors can switch overnight to 'risk-off': suddenly fully aware of their ignorance about the fundamentals of the investment and concerned only to get out ahead of the pack.

The sequence since the financial crisis of 2008 goes like this: at first, foreign investors fled emerging markets as part of the generalised panic. Then, when they saw most emerging economies had come through the crisis rather well and, encouraged by the large interest differential created by the near-zero rates in the crisis economies, investors shifted more of their funds into emerging markets – the 'search for yield'. Of course not all investors did this. But global investors' portfolios are huge compared with the size of financial markets in emerging economies, so the flows pushed up exchange rates in the recipient economies (which of course reduced the international competitiveness of these economies), thus encouraging current accounts to move into deficit.

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Compared with the pre-crisis period, the composition of these flows has changed. Global banks, chastened by their 2008 experience, have not participated much. Bond markets have taken their place. Emerging-economy companies have shifted towards foreign-exchange-denominated bond issuance, making borrowers vulnerable when exchange rates shift.

Such inflows sow the seeds of a subsequent damaging reversal. Exchange rates in emerging countries start to look overvalued, and current account deficits cause concerns. Then some trigger, often arbitrary, sets off a rush for the exits.

In emerging economies with small financial markets and a relatively short history of exchange rate flexibility, these volatile flows can cause substantial damage (as was demonstrated in the 'taper tantrum' in May 2013).

So where are we at now? If markets worked in accordance with the text-books, investors would have already incorporated all the likely risks (ie. China slowing; Fed interest rate changes and so on) into today's prices, and investors with above-average concerns about such eventualities would already have taken their money out. But markets don't work like that. Correlated expectations (meaning everyone changes their minds at the same time) lead to volatile flows that local authorities can't do much about because the main drivers are external.

Over time, policy responses are developing. In the past 10 years, the consensus (as represented, say, in IMF documents) has shifted from believing that free markets would sort out an optimal solution to acknowledging a problem exists. There is, however, still no convincing policy solution. The current panacea is 'macro-prudential controls', which are various kinds of financial market intervention (loan/valuation ratios; loan/deposit ratios; restrictions on bank balance sheets; and additional bank capital). This takes us back to the pre-deregulation world when authorities tried to steer bank behaviour, but managed only to shift the financial action away from the regulated banking sector and toward non-bank institutions (this process used to be called 'disintermediation', now it's referred to as 'the rise of the shadow banking sector').

The recent IMF Global Financial Stability report addresses all this, without any real hope that financial markets will remain sanguine during the Fed's 'will it, won't it', tightening phase. The IMF's concern focuses on lack of market liquidity: investor portfolios are distorted by the extreme policy settings of the post-crisis period, so rapid changes in balance-sheet holdings will cause big shifts in bond prices and exchange rates.

The IMF's prescription doesn't get much beyond urging vulnerable countries to run impeccable domestic policies. Most emerging economies in Asia, imperfect though their macro policies may be, are in reasonable shape to ride this out. But there are exceptions elsewhere: Brazil is now mired once again in the chaotic under-performance that has characterised this economy. It seems destined to remain the 'country of the future'.

Hanging like a dark cloud over market sentiment, China's mild slowing is being overplayed. Journalists can — and no doubt will — continue to give air time to those predicting a repeat of the 1997-98 Asian crisis, but there is an excellent chance that these economies (including China) will continue doing quite well, particularly when judged against the disappointing performance of most of the mature economies.

Image courtesy of Asian Development Bank


Thomas Piketty might be the rock-star of the income-inequality debate, but Angus Deaton has won the Nobel Prize for economics, and deservedly so. 

Perhaps you first heard about his impending fame here on The Interpreter: his book, The Great Escape, was my book of the year in 2014 and I thought he got the better of the income inequality debate with Piketty. The Nobel, however, demonstrates that his contributions go back a long way, and cover much wider ground. You can read the short version of his contributions here and the long version here.

Most of his early work at the World Bank is quite technical, setting up the means for measuring and comparing income across disparate countries and over time, solving difficult issues of income aggregations and comparison. This analysis provided the bedrock data to support his various arguments. He provided a bridge between the arm-waving debate on poverty and the rigour of the academic world.

Tyler Cohen describes Deaton's contribution in more practical terms: 'understanding what economic progress really means'. 

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While Piketty was largely focused on rising inequality in mature economies, Deaton was telling a parallel story of a billion people in emerging economies (notably China and India) shifted out of poverty, dramatically reducing income disparities between rich and poor countries. Hong Kong, Singapore, South Korea and Taiwan demonstrated what a couple of decades of fast growth can do to raise living standards. China, India, Indonesia and a raft of others followed.

Instead of making comparisons of income, Deaton focused on the specifics of consumption measured in intuitively understandable terms: the spectacular general improvements in health and education:

The world is a healthier place now than at almost any time in the past. People live longer, they are taller and stronger, and their children are less likely to be sick or to die. Better health...allows us to do more with our lives, to work more effectively, to earn more, to spend more time learning, and to spend more time with our families and friends.

Not every country is succeeding, and inequality within the success stories is typically getting worse. Deaton captures this diversity with the image of a crowd running forward, holding national flags. Some advance faster than others. Some country groups start behind others. Within each country group the fastest runners are getting well ahead of their compatriots and steadily catching up to those who started in front. The overall result: fewer left behind in abject poverty but many still quite poor; a huge increase in the world's middle class; and a rapid expansion in that small group of the super-rich, holding an assortment of country flags.

Deaton accepts 'the deep conflict between incentives and inequality', but he reminds us that there is more to a better life than just income. Technology, dissemination of knowledge and improved social structures have dramatically raised living standards and life expectancy, making us healthier (and thus probably happier). In the past half-century, the poor have largely caught up with the longer life expectancy that the rich have enjoyed for more than two centuries. Life expectancy in India is now the same as it was in the UK in 1850, when UK income was far higher than India's today.

The foreign-aid industry may have mixed feelings about this award. Deaton was sceptical that foreign aid does much good. Particularly in Africa, fiscal dependence on aid flows has undermined the development of domestic tax administration and institutions.

While Piketty caught the zeitgeist of increasing concern about growing income inequality in mature countries, Deaton added a more cheerful and perhaps more important message: that opportunity – particularly opportunity for education and health – are hugely important to a well-functioning and equitable society. We can take heart from the upbeat opening line of The Great Escape: 'Life is better now than at almost any time in history.'


Ben Bernanke was a member of the US Federal Reserve Board in the tumultuous period from 2002 until 2014 and Chairman from 2006 to 2014. His version of this period is told in The Courage to Act, his 600-page meeting-by-meeting account. This degree of detail would overload a reader who just wanted to know what the lessons were, and where we are now. This is Bernanke writing for history, and he spells out the detail of how, on each of the many decisions, he got it pretty much right.

He joined the Federal Board with the right background for the times ahead: he is an expert on the 1930s Great Depression. This gave him a head-start over most central bankers, whose mindsets were formed (and perhaps scarred) by the 'stagflation' of the 1970s. While their focus was on inflation, Bernanke had the deflationary experience of the 1930s on his mind.

Does his dovish bias explain what many would see as the Federal Reserve's initial mistake – keeping interest rates too low in 2001-2006, encouraging the housing bubble that initiated the crisis? Not really. While 'Maestro' Alan Greenspan chaired the Fed, his views dominated. He had faith that the market would sort things out. In any case the Federal Reserve could not identify bubbles beforehand and could clean up after the bubble burst. Bernanke did not differ.

Bernanke's chairmanship covers two connected but separable phases. First, the unravelling of financial stability as the knock-on effects of the bursting of the housing bubble spread. Then the aftermath, as the US (and most mature economies) struggled to recover.

The excitement starts in 2007, when the collapse of the housing bubble sets off a slow-motion chain reaction. The beginning was hardly noticed: Bear Stearns bailed-out two of its subsidiary funds in 2007, which put it on the path to failure in May the year after. One by one the pins tottered and some fell, culminating in the bankruptcy of Lehman Brothers in September 2008 and the rescue of AIG the following week. 

Beginning in 2007, the Fed and the Treasury were busy putting their fingers in the many leaking dykes. The Fed added liquidity (base money) to the financial sector, guaranteed the money-market funds, allowed investment banks such as Goldman Sachs to change their status so that they were protected by government guarantees, facilitated mergers of failing banks and saved Citibank with guarantees and capital injection. Critical to financial stability overseas, the Fed made US$600 billion of loans to foreign central banks to allow them to on-lend to dollar-short foreign commercial banks.

Ingenuity prevailed, with many late-night and weekend sessions cobbling together solutions.

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The result was a mish-mash of ad hocery, with consistency taking second place to force majeure. The Fed lends to some insolvent banks while others are taken over; Lehmans goes under but AIG is saved. If you want the minute-by-minute version of these dramtic events, read this book. You will sense the lack of preparedness and the unnoticed vulnerabilities that had evolved over the previous decade as profit-hungry financial firms pushed the risk frontier outwards. You will also hear Bernanke condemn the dysfunctional nature of the US political system.

The financial system had become inextricably interconnected and complex. The bursting of the housing bubble – not in itself catastrophic – triggered contagion, reaching to the whole globe. Each of these interconnections was fragile because everyone had borrowed up to the hilt. It was all held together by confidence that the sun would go on shining. When confidence was lost, depositors and lenders wanted their money back; risk perceptions swung from mindless optimism to deep pessimism overnight. The credit rating agencies, always assessing risk by looking in the rear-vision mirror, belatedly downgraded tottering institutions, ensuring they would topple.

Meanwhile, the US supervisory system was so compartmentalised that coordination was lacking. The huge risks on AIG's balance sheet were supervised by an obscure and understaffed regulator. Much of the shadow banking system was under the oversight of the corporate regulator. Deposit insurance was not in the hands of the Fed but a different agency with different priorities. 

Whenever the problem interfaced with the political system, ideology (in particular, free market non-interventionism) dominated. Congress was uncooperative, hobbling and delaying necessary action. The public was stunned and angry that the richly rewarded 'masters of the universe' in the financial sector turned out to be inadequate for the task. 

The second phase of the Bernanke period began in 2009, when the financial sector had regained some composure. The crisis had left a legacy of over-leveraged home borrowers and chastened banks, pushing the economy into recession followed by a feeble recovery. 

The shift of interest rates as the crisis unfolded was dramatic, with the policy rate taken almost to zero. Bernanke was ready to do more. In his 2002 speeches, he had recalled Milton Friedman's idea of 'helicopter money': the authorities could give the public extra money to spend, financed by the central bank. In fact Bernanke did not implement 'helicopter drops'. Instead, quantitative easing (QE) was deployed, which the Japanese had tried earlier in the decade to little effect. The Fed flooded the banking system with reserve money to encourage banks to lend and to push down the longer end of the yield curve.

A Friedmanite helicopter drop would have provided a powerful fiscal stimulus (similar to the Australian 'cash splash' in 2009). QE, however, is a much weaker instrument. Instead of directly providing the public with additional spending power, its aim is to lower the longer-term bond rate in the hope that this will encourage spending. It also provides a psychological message which weakens the exchange rate and pushes up equity prices, both helpful for a frail economy.

Whatever the effectiveness of QE, it is a poor substitute for adequate fiscal stimulus. This was made worse by Congress' threats to impose a debt limit on government spending. Bernanke was left to face a problem which monetary policy alone was not powerful enough to solve.

A reader might come away with the feeling that these serious deficiencies have been resolved. That would be too sanguine. Perhaps the new laws, higher capital requirements and rescue techniques pioneered in this period could do the job when needed. Macro-prudential measures are the new panacea, as yet untested. Much is made of the Fed's greater transparency, without much acknowledgment of its inability, so far, to give a clear message to financial markets, whose instinct was always to panic first and think later.

Bernanke and his colleagues can take credit for preventing an even more serious financial melt-down and recession, but the narrative of the crisis and its lackluster recovery needs a more critical vantage-point, more ready to contemplate the possibility that mistakes were made. More important still, the structure of the financial sector needs a more fundamental re-think, without pressures from Wall Street to get back to business as usual.


I'm only too ready to leave it up to strategic experts such as Rear Admiral Peter Briggs to sort out how many submarines we need. I'll stick to the economics. We shouldn't let the number be determined by a perceived need to provide work-continuity for ASC in South Australia. And we should acknowledge that this is a decision about 'guns or butter': spending more on submarines by building them at home means less of something else.

The Senate inquiry on the future of naval shipbuilding in Australia is a 'must read' for anyone interested in the decision-making process. It's an example of Australia's own version of Eisenhower's 'military-industrial complex' in operation. Even though this was the Senate Economics Reference Committee, the list of contributors is almost exclusively construction-industry representatives, regional lobbyist, trade-unionists and former services personnel. The taxpayers were under-represented. 

Reading the testimony, you might get the impression that the Collins saga had been a brilliant success and that building a new fleet of submarines in Australia would be no dearer than building overseas, an assertion consistently refuted by actual domestic ship-building experience (See ASPI's 'Four ships for the price of six').

Members of the Committee would have been courageous (in the 'Yes Minister' sense) to have been critical or sceptical, as all political parties covet those South Australian votes. Even so, the report was not, as Admiral Briggs stated, unanimous. There was in fact a substantial dissenting report issued by the Government members of the Committee, which (inter alia) specifically addressed the issues I raised in my initial post on this issue.

In response to the recommendation that Admiral Briggs quotes, the dissenting report says:

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Response to recommendation 3. The draft report calls for an Australian build at all costs. This could give rise to national security outcomes being compromised by a prioritisation of industry policy over defence policy and it could force the taxpayer to underwrite an economically uncompetitive project. While we want to see the Future Submarine contract awarded to Australian shipbuilders, it must also be the result of a competitive tender process and it must be awarded on merit. This will ensure that Navy receives a fit for purpose product of the highest standard while Australian tax payers receive the best possible value for money.

. . .Recommendation 3 effectively relegates national security policy to second place behind industry policy.

I couldn't have said it any better.

The substantive difference between Peter Briggs and me relates to the impact of spending on submarines on the economy. It is standard practice for consultants-for-hire to make their lobbying case on the basis that spending on the target industry will boost the economy, not just by the amount of the actual expenditure, but by a multiple of this because of successive rounds of spending. This is akin to the familiar textbook multiplier process. You can go one step further (as the 'eloquent' testimony of Professor Goran Roos does) and double-count the contribution of sub-contractors. If you want to get a good reception where 'jobs and growth' are the paramount political concern, this is the way to go.

It is only in rare circumstances, however, that this makes any economic sense. The multiplier logic relies on squeezing more than a pint out of a pint pot. The implicit assumption here is that there is unused capacity in the economy – capital, managerial talent and unemployed workers – all ready and waiting to respond to this extra demand to build submarines, adding to GDP in the process. Not only are these resources assumed to be unemployed now, the assumption is that they would have remained so over the life of the project.

Of course Australia has unemployment – currently 6.2% of the workforce. But this is close to the lowest level of unemployment Australia has had for the past quarter-century. It would be nice to get back to the lower level we had at the height of the resources investment boom, but this kind of fine tuning is not feasible.

The proper way to analyse how the submarines might affect GDP is to think in terms of opportunity cost: if these resources – capital, managerial talent and labour – were not building submarines, they would be doing something else which society also values. The productivity challenge is not to attempt to conjure productive capacity out of thin air, but to shift the economy's given resource endowment into uses which have a higher social value.

Government industry policy (subsidies, 'picking winners' and so on) may play a part in that process. Economists are not all free-market ideologues. Some of us accept that governments can sometimes use their considerable expenditure to steer resources into areas which will catalyse higher-value output and have longer-term benefits even when the expenditure ends. But economists also look back on the history of infant industries which never grew up, and on politically driven white elephants. Who wants another Darwin-Alice Springs railway? 

Where does domestic submarine construction fit in such a framework?

Will this foster a viable industry which suits our comparative advantage? Will it form the nucleus of a cluster of highly productive firms with a self-sustaining future when the submarine work is finished? Will it link into international supply chains, thus compensating for our lack of manufacturing scale? Will it be disciplined by international competition, or link us more firmly into the rising demands of East Asia?

The Collins-class experience suggests that constructing bespoke submarines is a dead end, a mendicant industry whose survival depends on government subsidies.

Does it make any difference that domestic construction avoids importing? In a globalised world with flexible exchange rates, this 'exports good, imports bad' argument, common though it is, has to be dismissed. The flexible exchange rate looks after the need to keep imports and exports in equilibrium with the available funding from capital flows.

The dissenting report of the Senate inquiry was a brave attempt to put some limits on the size of the hand-out, through giving the rival bidders some flexibility on the domestic content of construction. The competitive evaluation process seems the last opportunity to impose some economics on this politics-driven project.

Photo courtesy of Australian Defence Image Library.


The economic debate in Australia is dominated by the impact of the unwinding of the commodities 'super-cycle'. Australia is having to adjust to substantially worse terms-of-trade (the price of what we export compared with the price of our imports), the slowing of the spectacular resources investment boom and reduced fiscal revenues from resources.

Australia is not, however, the only country which has to undergo this adjustment. In fact, our fiscal dependence on resources is quite low by global standards. It's hard to see on this crowded graph, but Australia is eighth from the right, with less than 5% of budget revenue coming from resources during 2000-2011, according to these IMF figures.

This analysis was delivered at a conference in Jakarta, where Indonesia is fumbling to sort out the mess of its mining legislation. The focus was on our neighbours, with regional data presented in this more legible graph:

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The extreme cases here (Brunei and East Timor) have such huge oil revenue that the current lower prices won't affect budgetary expenditure much in the near future. Timor is accumulating substantial oil revenue in its sovereign wealth fund, rather than spending it all in the budget. But for the other five, the fall in revenue will be painful and immediate.

Indonesia, for example, improved its budget position by cutting petroleum subsidies last year. But lower commodity prices are offsetting much of this improvement. Indonesia also has some self-inflicted challenges. Current Indonesian legislation requires mineral exporters to process ore domestically, which is discouraging investment. The objective sounds reasonable enough: to shift from a simple focus on resource revenues towards a new objective of boosting the wider economy. But this is an illusion. The better way to think about this issue is to see the processing requirement as an imposition, like a tax: if Indonesia didn't impose this obligation, it would be able to collect more mining revenue. This lost revenue is being directed into what are probably low-return investments in ore processing, rather than being available for higher priority budget expenditures, such as infrastructure.

For Australia, there are other elements in this painful adjustment: adaptation to the ending of the investment boom and the lower terms-of-trade. The lower resource revenue requires a policy response, and the IMF argues that a resources-rent tax should be a key element of tax strategy. This is not only a matter of equity: a tax which varies with the commodity cycle would greatly assist macro-economic management.

The resources-rent tax proposed by Kevin Rudd was so complex and confusing that the mining industry pulled off the greatest public-relations coup of all times (combined with political ineptitude of a high order), with super-rich miners winning the debate. The proposed tax was reduced by Julia Gillard and even this tiny vestige was abolished by the Abbott Government. That's not the only reason why Australians now find themselves with an inadequate tax take, but abolishing a tax, no matter how rhetorically attractive, has to be made up by other taxes sooner or later.

There is talk that all elements of taxation will be on the table under Australia's new leadership. Is this one included? Low commodity prices provide the best environment to introduce a super-profits resource-rent tax, because profits are not super in this phase of the cycle, and resistance may not be so fierce. Once in place, the tax is ready to help manage the next upswing, whenever it comes.


The pace of decision-making on Australian submarines is quickening, with the core of the current debate driven exclusively by South Australian politics. But the insistent voices of regional and industry lobbyist need to be balanced by reminders of the price the rest of Australia will pay for make-work projects creating permanent mendicant industries.

The proponents should be obliged to make the economic case, not just threaten to pull the political plug. In a world where the nation is trying to become more productive and internationally competitive, economics should enter this key decision in a more substantial way. For example, ASPI's most recent examination of the project is feather-light on economics.

Where economic arguments are put forward, they are often fallacious: see this demolition of the South Australian lobbyists' advocacy. 

As a small nation in an uncertain world, our best chance is to be highly efficient and productive in what we do, and this means avoiding frittering away our resources on white-elephant projects. We need to correct the false economics in the current arguments over the future of the project and introduce the concept of opportunity cost.

There is a widespread sentimental view about the importance of manufacturing: because manufacturing provided many well-paid jobs in the past, the argument goes that we need to get back to 'making things'. But manufacturing provided well-paid jobs thanks to huge subsidies, mainly in the form of tariff protection, which raised prices for consumers and lowered national living standards. After many decades of tariffs and direct subsidies for automobile production (with South Australia a large beneficiary), we are finally wrenching ourselves free. Consumers now have the benefit of cheaper cars, and the burden on the budget is being lifted.

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Manufacturing is now 6.5% of GDP, less than half of what it was four decades ago. The economy has adjusted successfully to the reality that Australia does not have the scale or cost-base to be a major integrated manufacturer. Manufacturing will find its place as part of a global supply chain, in specialised niches, and in offset projects working with foreigner producers. The Government should be ready to help fund the adjustment process, but we don't want to adjust from one unviable manufacturing model to another.

Part of this sentimental attachment to manufacturing has been a nebulous security argument: in the event of war, we need to be self-sufficient. But self-sufficiency in modern defence technology for a small country like Australia is a pipe-dream. Even if the submarines are built here, large key components are going to have to come from overseas. In the event of hostilities, we'll inevitably be dependent on overseas suppliers to keep our submarines operational (same for our military aircraft). 

Those who put forward the canard of defence self-sufficiency should recall the World War II experience of sending home-made Boomerangs up against Japanese Zeros. This did not turn out well. We need state-of-the-art subs, not compromises to boost domestic content.

The current proposals involve reconstituting the domestic submarine industry, which cost us so dearly and produced an imperfect product with the Collins class. It is more than a decade since the last of these was built, so the specialised skills brought together have dispersed. There is no hope that anyone else will buy our bespoke subs, leaving the construction component as a dead-end industry.

Australia is a federation, and the need to support South Australia (and others) is part of the federation deal. But the question is: how much? Federation shouldn't be a license for political blackmail.

Tony Abbott offered South Australia a substantial medium-term economic future building surface ships, and the prospect of doing the ongoing maintenance of the new submarine fleet. Now, with the South Australian defence lobby feeling the wind in its sails, the stakes (and the subsidies) are rising. One of their arguments rejects the idea of partial (hybrid) construction on technical grounds: modern sub-building has to be done in one place. This argument is put forward in the confident belief that this place has to be Australia. A variant is Senator Nick Xenophon's specification that 70% of the total value of the submarines should be Australian-made. Is there no technical limit to the make-work arguments?

Here are some considerations:

  • The competitive evaluation process should be rigorously enforced to limit the intrinsic 'open cheque-book' nature of the project. Construction promises should wait until this process takes place.
  • Let's not preempt the competitive evaluation process by specifying the local content in advance. Let's see what the bidders offer, each of them knowing that domestic content has a favourable weight in the assessment.
  • Out of this evaluation process should come a well-based figure of the extra cost the nation will have to pay for home-made subs. This can be weighed against our obligations as a federation.
  • The number of subs to be built shouldn't be set by the need to provide continuous work in South Australia, but by a realistic evaluation of our security needs and capacity.
  • Past performance (in this case the lamentable Collins experience) can't predict the future but, as usual, it's a good place to start. Objective assessment, not industry assertion, is needed to evaluate domestic capability.
  • The Department of Defence should articulate the reality of opportunity cost. If submarines cost more to make here, that should mean less defence spending elsewhere: fewer subs or fewer guns. It shouldn't mean upping the demands on the general budget ('more guns, less butter').
  • Given the political reality that some manufacturing subsidies are inevitable and that adjustment support is desirable, is this the best option? What alternative manufacturing industries might offer a realistic prospect of creating a viable internationally competitive industry? 

The cost of the subs puts the project on a par with the National Broadband Network, which was endlessly debated in public. In contrast, home-made subs might become a fait accompli without ever passing any serious economic scrutiny.

Photo courtesy of Australian Defence Image Library.


Global financial markets are on tenterhooks waiting for the US Federal Reserve to decide when to start raising the Fed funds rate – the short-term interest rate which sets the datum for many other interest rates. The media have reported this in portentous tones, exploring every possible downside risk including a repeat of the 1997-98 Asian financial crisis.

But exactly when the Fed makes its first tiny move in the tightening sequence is not very important, and should have little or no effect on the real economy, in the US or elsewhere.

The current interest rates in almost all mature economies are at extraordinary lows, with the policy rate effectively zero in many countries and even negative in some. Most accept that, with the US recovery underway, interest rates will soon begin returning to more normal levels.

But the exact timing doesn’t matter much. Janet Yellen, the Chair of the US Federal Reserve, has said again and again that the Fed will move when the time is right, and that the sequence will be gradual. Yellen has emphasised that the policy moves will be ‘data dependent’; in other words the Fed will move sooner and with more follow-up increases if the economy is seen to be expanding fast, and more gradually if the expansion is weaker. 

There can't be many investment projects whose viability hangs on the exact timing of this first decision. Nor should the decision have much impact on financial markets. If the Fed goes earlier and the sequence is faster, it means the economy is stronger, thus equity prices face offsetting factors. Current expectations about the sequence of future tightenings have already been built into longer-term yields, and the Fed’s first move won’t add much to what the market already knows about subsequent tightenings.

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What about the hand-wringing over the impact on emerging markets? The last panic about the Fed’s policy prospects was the notorious ‘taper tantrum’ in May 2013. Ben Bernanke, then Chair of the Federal Reserve, told the markets something that was already widespread knowledge: that at some stage quantitative easing (QE) would come to an end. In response to this non-news, exchange rates in a number of emerging economies fell quite sharply. When active QE did come to an end later that year, financial markets hardly noticed. 

Since then, the large capital flows that went to the emerging economies during the QE period (2009-2011) have reversed, and exchange rates in these countries have adjusted downward in response. The Indonesian rupiah, for example, is down about 10% this year and about 25-30% over the past few years. That’s about the same as the fall in the Aussie dollar. In neither country has this caused great trauma. It's part of the usual commodity-price adjustment process.

What market adjustments will be necessary when the Fed makes its move? All those with vulnerable portfolios have already adjusted – hence the capital outflows from emerging economies over the past year. Those with dollar-denominated debt are already dealing with the consequences. Longer-term interest rates have adjusted to the best guess of the future.

It’s true that the tightening phase in the past has sometimes been stressful. Commentators look for guidance from the 12 Fed adjustment cycles since 1955, and in particular the 1994 tightening which came as a surprise to the bond market. But there are no surprises in store this time.

It’s also worth noting that all the early tightenings in this history took place in a very different policy environment, where it was necessary to rein in an economy that was travelling too fast. With the crude policy tools of the time, this often caused a sharp downturn. Policy instruments are now more subtle and exchange rates are flexible. This tightening can be gentle because it's not responding to runaway demand.

Commentators also point to the mistakes which policy makers have made in past tightening phases, including two recent examples: Japan in 2000 and, notably, Sweden in 2010-11. But the very fact that Yellen quotes these earlier mistakes is insurance that the Fed won’t repeat them.

In any case, even if the Fed does make a mistake and tightens too early, we won’t know that it was a mistake for some time.

Nor will this first move tell us anything about future moves, or whether the Board of the Federal Reserve is dominated by hawks or doves. Yellen is by inclination on the dovish side, but she has talked about the impending increase so many times that the move, whenever it comes, cannot be interpreted as a victory for the hawks. 

Some are arguing that if the Fed moves while inflation is still so low, this will confirm that there has been a change in policy regime – the abandonment of the implicit 2% inflation target. This, too, seems an overwrought interpretation. The mature economies have experienced an unusual, perhaps unique, period of zero-interest rates. This has distorted saving and investment decisions and leaves economies vulnerable to asset mispricing. A move while inflation is still low will confirm what we already know: that central banks are uncomfortable with near-zero interest rates and anxious to get them up off the floor just as soon as they can safely do so. Getting inflation back to 2% will take longer, but the idea of using inflation as the key guidance for setting the stance of monetary policy hasn’t been abandoned.

To argue that the exact timing of the Fed’s first move is unimportant is not to deny that there are serious unresolved issues in macro-policy. There is no disputing that the normalisation of interest rates over coming years will traverse unknown territory. There are also real concerns about possible secular stagnation. Have the mature economies lost their mojo? The recovery in the mature economies in the seven years since the financial crisis has been pathetically slow, notably in Europe. How can growing income inequality be addressed? Can China maintain the 7% growth we have all come to depend on?

In this uncertain world, why have financial markets fixated on this trivially unimportant decision? One possibility is that much of the business of financial markets – forward contracts, futures, options and so on – is a form of gambling about events which in themselves don’t affect the real economy much. But the outcome of the gamble does have great import for the players themselves. Unfortunately there is collateral damage to innocent bystanders, adversely affected by the gloom and general uncertainty produced by this fixation. Perhaps this is why emerging-economy policy-makers are now urging the Fed to just get on with it and to put an end to the confidence-sapping agonising.

Photo courtesy of Flickr user International Monetary Fund.


In terms of the world's financial markets, China is the centre of attention. Last week I argued that concerns about stock markets and exchange rate devaluations were minor and ephemeral issues. Attention should instead be on the longer-term challenges that China faces in keeping its growth rate close to 7%.

How much does this matter to Australia?

Sometimes a table can tell the story better than a thousand words. The table below shows the share of each G20 country's exports going to China. Australia is at the top. This dependency has increased dramatically since 2007 – well over two-fold.

Exports form G20 member states to mainland China, as a share of the country's total exports, in percent (Peterson Institute)

Actually, Peterson Institute data suggests that there are 10 or so other countries (such as the special cases of Hong Kong and Mongolia, but mainly in Africa) which may be even more dependent on exports to China than Australia. But Australia tops the list of countries with data that is sufficiently reliable to draw a firm conclusion.

The graph below draws on the same data, but groups countries by region. China's imports have grown so quickly that every region has increased the share of its exports. Overall, China's share of global exports has grown from 6% in 2007 to 9% in 2013.

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These statistics are over a year old, and more recent information shows a sharp fall in the value of China's imports. This may be evidence of a significant slowing in China's growth rate. But there are other possibilities. It may instead reflect cheaper global commodity prices (a ton of iron ore or coal now costs a lot fewer US dollars). Or there may be reduced reliance on imported inputs into manufacturing production, as China develops capacity to make these requirements domestically. Or the larger volume of services now in China's output mix may have little or no import content. Whatever the reason, it seems unlikely that the spectacular growth of imports will resume.

Australia has a lot of adaptation ahead if we are to continue to be pulled along on the coattails of China's evolving economic expansion.

There is an often-heard concern that the export-led model that propelled China's growth in the two decades before 2007 cannot be maintained. But that model expired six years ago when China shifted away from using net exports to boost growth. Exports are still important, but have grown more slowly than imports (shown by the negative net exports in the most recent years in this graph).