Lowy Institute

David Lipton, recently reappointed first deputy managing director at the IMF (effectively number two to Christine Lagarde) was at the Peterson Institute recently to give some insights into being 'fireman in chief' for US international economic policy for the past three decades, ready to act 'every time the IMF needed to be second-guessed'.

His career alternated between the US Treasury and the IMF. He was indeed a key figure during the Asian crisis of 1997-98, sitting in an adjacent room while the IMF negotiated its program with South Korea and acting as chief enforcer for the misguided monetary policies in Indonesia in early 1998. 

Thus his reflections on the success of these policies, nearly 20 years later, are of interest:

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When Thailand, Korea and Indonesia fell into crisis less than three years later, we learned that even countries with successful policies and access to foreign finance can develop vulnerabilities.

We also learned that global financial markets could focus on those vulnerabilities, move as a herd, and generate a reversal of capital flows – not only for one country, but for many other countries seen as similar. We were forced to re-examine our efforts to promote capital market openness and integration. Many countries came to fear the political and economic costs of financial sudden stops, recession, and banking sector stress. Emerging market countries also worried about market access and began to act more defensively – building up international reserves through intervention.

How this assessment has changed since 1997! When Thailand and Indonesia came under speculative attack in 1997, the key economic problems were seen in terms of domestic policy mistakes: fixed exchange rates, large current account deficits and weak financial sectors. But above all, the diagnosis for Indonesia was 'KKN' (corruption, collusion and nepotism), factors which hadn't stopped Indonesia from growing at 7% annually for three decades.

The remedy was to float exchange rates, ignoring the inevitability that free floating in these circumstances would lead to huge overshooting (as occurred, spectacularly, in Indonesia). Budgets were tightened sharply, which ensured that the downturn became a crippling collapse in economic activity. Troubled banks were closed without provision to prevent contagion, which brought down the entire banking system. Interest rates were raised drastically in the misguided belief that capital outflow would reverse and the exchange rate rout would be halted. All it did was bankrupt borrowers. A shopping list of structural conditionality was imposed (desirable for the long run, but in the middle of a crisis this was like insisting that a bleeding road accident victim take a pledge to give up smoking).

With the Indonesian rescue program in chaos, it was easy to add an uncooperative President Suharto to the list of problems that had to be dealt with. The final straw was the program requirement to raise petroleum prices sharply, always a super-sensitive political issue. The resultant riots in May 1998 brought about Suharto's resignation (one senior American had told me earlier in January that 'the quicker this fucking regime goes, the better').

Now the story can be re-written in a way that makes more sense. In the years leading up to the crisis, capital markets were opened up to foreign inflows too quickly and for no good reason (Stan Fischer, who led the IMF's Asian rescue operations in 1997-98, now asks 'what useful purpose is served by short-term international capital flows?'). The excessive inflows pushed up exchange rates (leaving them vulnerable to speculative attack). The inflows overextended bank balance sheets and created a speculative boom in assets. Domestic borrowers took out loans in foreign currency, which bankrupted them when the exchange rate collapsed. The crisis response was seriously flawed. Unlike in Mexico in 1994, there was not enough external funding assistance to stabilise the capital outflow. Direct intervention to limit capital outflows and 'bail-in' foreign creditors was specifically ruled out by the IMF, even though it was later successfully applied in South Korea and had been a central element of Poland's 1989 reforms.

How could the rescue operation have been so misguided? Perhaps one clue is David Lipton's own description of his prior experience:

Working with Jeff Sachs, we did what graduate students do: we built a mathematical model, fancy for its time (with two countries, fully maximizing, infinite horizon, rational expectations, etc.). 

After this, he worked with the IMF on the Latin American crises of the 1980s, and with Jeff Sachs on Poland (usually regarded as a successful, if painful, transition from a command economy to one based on markets). He observed Mexico during its 1994 crisis, where excessive capital inflows were the core problem. Thus there is no excuse for missing their key role in Asia three years later. But none of this fitted the textbook model of capital flows, where:

Everyone gains: the poor country experiences a boom and living standards converge upward. Even the rich country gets richer as investors reap returns to capital higher than any available at home.

The operational lesson he learned from the IMF, Jeff Sachs, and Poland was to see economic reform as a matter of revolutionary change ('shock therapy'); to swiftly impose market-based systems and slash the role of state ownership. The failure, as usual, was with Douglass North's 'institutions'; the absence of deeply embedded norms of behaviour which are necessary for markets to work well. Like many IMF staff, he was well-equipped in book learning, but the practical application was distorted by preconceptions about how well markets (particularly financial markets) would work in these environments. The neoliberal agenda guided policy. 

Belatedly, lessons were learned, but only through experiencing crisis at home a decade after the Asian Crisis. The lessons of 1997-98 were seen as applicable only to developing economies. The response to the 2008 crisis could hardly have been more different: interest rates were lowered dramatically; fiscal policy was eased (at least initially); and financial institutions were shored up with massive government funding. 

Larry Summers gives David Lipton credit for shifting the IMF to a more accommodating attitude to fiscal consolidation during the recovery from the 2008 crisis. The IMF has also shifted rhetoric on capital flow management, even if it's hard to see evidence of an operational shift. There is a long way to go. Most relevant to crises such as Greece, adequate sovereign debt restructure seems as distant as ever.

The enduring legacy of the 1997-98 Asian crisis is that Asian policy-makers are adamant they will never again ask for IMF assistance, preferring inefficient self-insurance in the form of current account surpluses and large foreign exchange reserves to the risk of finding themselves once again subject to IMF policy strictures.

Photo: Getty Images/Milos Bicanski


Last Friday Sam Roggeveen called on Interpreter readers to nominate their pick for the best national anthem. This is the first response.

Judging national anthems without context is akin to asking whether the madeleines baked by Proust's Aunt Leonie were the best sponge-cakes ever. It's not just about the music, and certainly not about the words. A lot of what moves us to emotion is context: what are the circumstances in which we experience the anthem, or remember past renditions?

Who can forget the scene in Casablanca when Victor Laszlo orders the band to play La Marseillaise, Ric nods, and the café patrons rise up to drown out the German carousing?

For me, The Star Spangled Banner wins, because of circumstance. The context was Saigon in 1970. The PX cinema was filled with US service personnel — enlisted and conscripts. Half the audience stood up for the anthem and half of those who remained seated heckled the first group with loud calls of 'lifer, lifer'. For some standing, and for many more who remained seated, this was an emotion-filled moment, with US soldiers torn between observation of a deeply-held ritual and unhappiness about where their country had taken them.


Like all big bureaucracies, the IMF shifts its operational doctrines slowly, rewriting its own history as it does so in order to avoid admitting past errors. We are currently witnessing another episode of this glacial move in relation to two issues: budget austerity and foreign capital flows.

EIMF Chief Economist Maurice Obstfeld and World Economic Studies Division Chief Oya Celasun, 12 April 2016 (Flickr/IMF)

The current debate was triggered by some Young(ish) Turks in the Fund's research department asking whether economic 'neoliberalism' had been oversold. For the authors, 'neoliberalism' is typified by two elements:

The first is increased competition—achieved through deregulation and the opening up of domestic markets, including financial markets, to foreign competition. The second is a smaller role for the state, achieved through privatization and limits on the ability of governments to run fiscal deficits and accumulate debt.

Neoliberalism is a big canvas, and they actually wanted to discuss just two elements: capital flows and budget austerity (aka 'fiscal consolidation'). 

What did the maverick Young Turks have to say about capital flows?:

The mounting evidence on the high cost-to-benefit ratio of capital account openness, particularly with respect to short-term flows, led the IMF's former First Deputy Managing Director, Stanley Fischer, now the vice chair of the U.S. Federal Reserve Board, to exclaim recently: 'What useful purpose is served by short-term international capital flows?' Among policymakers today, there is increased acceptance of controls to limit short-term debt flows that are viewed as likely to lead to—or compound—a financial crisis.

On budget austerity, the Fund has always been a strong proponent of fiscal rectitude. The common quip is that 'IMF' stands for 'It's Mostly Fiscal'. While the 2008 financial crisis was not caused by budget profligacy, deficits did expand in response to falling GDP and the need to shore up the financial sector. The resulting impact on government debt became a major policy issue during the recovery phase. The Fund was part of the chorus of international economic institutions (including the OECD and the Bank of International Settlements) that urged a quick return to budget balance after the brief G20-endorsed fiscal expansions of 2009. By 2012, however, some Fund staff (notably then-Chief Economist Olivier Blanchard) saw that the attempt to get budget deficits back to balance quickly was constraining the recovery: the fiscal multiplier was much larger than had been thought.

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Thus the Fund's advocacy of universal fiscal austerity was modified, although the moment for the Fund to have a useful voice in this debate had passed. Policy in the main crisis countries — the US, UK and Europe — was determined by the domestic debate. 

On both capital flows and austerity, the Fund has shifted its position in recent years, and has debated these issues extensively. The shift, however, may be more in the rhetoric than in the Fund's actual operations. The IMF's Chief Economist Maurice Obstfelt quickly entered the current debate to downplay any notion that the Fund is shifting much – this is 'evolution not revolution': 

Countries need credible medium-term fiscal frameworks that leave markets confident the public debt can be repaid without very high inflation. Countries with such frameworks will typically have room to soften economic slumps through fiscal means, including automatic stabilizers. Unfortunately, some countries let public debt rise to such high levels that they risk losing market access, and have no choice but to tighten their belts even when their economies are doing badly...Of course, there are limits to the pain economies can or should sustain, so in especially difficult cases we recommend debt re-profiling or debt reduction, which require creditors to bear part of the cost of adjustment.

So it looks like the Fund hasn't moved much at all on fiscal advice: build up fiscal space with budget surpluses so that the budget can soften a downturn by allowing the automatic stabilisers to operate when budget revenue falls and unemployment benefits rise. Even the hard-core proponents of fiscal rectitude would find nothing to disagree with here. But this says nothing about whether the US, the UK and Europe (which clearly were not threatened with loss of market access) were right to impose austerity in the recovery phase from the 2008 crisis.

The shift on capital flows may also be more rhetorical than operational. In 2012 the Fund recognised the role for capital flow management in certain limited cases. It's not clear, however, what this means in practice. The Fund still has its technical assistance teams actively promoting international integration of financial markets which encourage greater short-term flows – the very flows now being questioned.

Obstfelt was quick to point out that budget austerity and capital flows are just two elements in the much broader context of economic neoliberalism and that the Fund's re-examination of these two issues 'has not fundamentally changed the core of our approach, which is based on open and competitive markets, robust macro policy frameworks, financial stability, and strong institutions.'

It was probably unhelpful that the Young Turks put these two issues into the broader context of neoliberalism. It triggered a vitriolic response from the Financial Times editorial writers ('childish rhetoric...in seeking to be trendy, instead the IMF looks as out-of-date as a middle-aged man wearing a baseball cap backwards'). 

In fact, the broad parameters of the neoliberal debate were settled long ago: centrally planned economies all fail (the Soviet Union, China before 1980 and Cuba), and market-based economies succeed if they can find the right institutions and rules. The transition from one to the other is painful (as it was in Russia and Poland) and often gives away too much to individual private interests. 

The sensible debate is at the operational level, in the detail. The devil, of course, is also in the detail.

China is a successful economy with a lot of government interference and ownership. South Korea has been stunningly successful with very dirigist policies, especially initially. Sensible economic policies don't come out of doctrinal debates, but out of measures which recognise the existing conditions (institutions, administrative competence, physical infrastructure and so on), and the limited capacity to change these over time.


None of the US presidential candidates is keen on the Trans-Pacific Partnership. Does this mean that the treaty — signed but unratified — is finished and all that debate, negotiation and angst will have been vain?

President Obama doesn’t see it that way. He’s still plugging away in the hope of presenting enabling legislation to Congress before it breaks in mid-July for the party conventions. It is at least technically possible that Congress could approve it before the presidential election, or even in the ‘lame-duck’ post-election period before the new president takes over. But this is a big ask.

Hillary Clinton has not only come out against the agreement in its current form, but has ruled out any action in the lame duck period if she is elected.  Donald Trump wouldn’t be supporting it. Thus the best chance — if a slim one — is that President Obama sees it as so important for his own legacy that he puts in the huge effort required to see this through in his term.

Unlikely though this seems, there are TPP advocates,  including powerful sectoral interests that would benefit from the agreement signed last February. They understand that if the TPP doesn’t get through this year, it will be on the back-burner for years to come. If it doesn’t go ahead, where does that leave Obama’s ‘pivot’ to Asia? For her part Clinton, if elected, might be content to have had the TPP resolved before she takes over responsibility. 

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Some of the necessary prior actions have been taken. The US International Trade Commission has examined the agreement and concluded that it will benefit the USA, even if the impact on GDP is tiny

Many members of Congress have a fixation with ‘currency manipulation’ and are still calling for counter-measures to be included in the TPP. But the compromise reached earlier was for the US Treasury to address this issue unilaterally, which it has done by spelling out more precisely what it would regard as ‘currency manipulation’.

The Treasury’s criteria illustrates the muddle that arises when bureaucrats attempt to placate public ignorance. Of the three criteria developed for identifying ‘manipulation’, only one makes any economic sense. Perhaps substantial official intervention in foreign-exchange markets might constitute ‘manipulation’ (although the Swiss authorities would regard their attempt to constrain their growth-sapping appreciation as being worth a try, even if it was ultimately unsuccessful).  But the second criterion — concern about large current account imbalances — is harder to justify. And the third — concern about bilateral imbalances (i.e the trade position between the US and its individual trading partners) — is not just nonsensical, but actually harmful. If all countries responded to large bilateral imbalances by imposing trade restrictions, global trade would shrink dramatically. A key advantage of free international trade is that a country can obtain imports from one trading partner and pay for them by exporting to another partner. The bilateral balance between individual trading partners is irrelevant.

Fortunately it is unlikely that all three criteria would be infringed simultaneously, and even if they were, the penalties imposed could be trivial. But this sop to Congressional misunderstandings illustrates the illogical compromises that arise in international rule-making.

What about the alternative set of inferior trade rules which President Obama fears China will put in place if the TPP doesn’t go ahead?

As we speak, China is negotiating a trade deal that would carve up some of the fastest-growing markets in the world at our expense, putting American jobs, businesses and goods at risk.

What he has in mind is the Regional Comprehensive Economic Partnership (RCEP), which is actually an ASEAN initiative, not a rival China ploy. The RCEP envisages a set of rules or reforms which are aimed principally at practical impediments to trade, rather than establishing high-level principles as the TPP aims to do. It won’t address some US concerns (the role of state-owned enterprises, intellectual property rights or industry/state dispute resolution), but some would argue that the TPP over-reaches on these issues. Sensibly enough, Australia regards the two trade deals as conceptually compatible and supports both.  In any case it seems most unlikely that RCEP will be completed on schedule by the end of the year (ASEAN schedules tend to slip, and the negotiating schedule seems open-ended).

Perhaps more seriously, the case for TPP (and the characterisation of RCEP as China’s rules) is increasingly looking like a ‘contain–China’ play. In the Washington Post article, President Obama said:

America should write the rules. America should call the shots. Other countries should play by the rules that America and our partners set, and not the other way around. 

A more nuanced approach might offer China both carrot and stick: cooperation in developing mutually beneficial global trading rules while at the same time pushing-back against China’s South China Sea territorial claims.

Photo courtesy of Flickr user Jens Schnott Knudsen

Election Interpreter 2016

In the United States, international trade is a hot-button political issue. Australia, on the other hand, is likely to get through the long election campaign with hardly a mention of tariffs and industry protection. Why the difference?

Donald Trump’s policy positions may be a kaleidoscope of contradictions, but his message on foreign trade is pretty consistent: exports are good but imports are bad. Hillary Clinton, always a bit ambivalent but at least initially a tentative supporter of the Trans-Pacific Partnership (which she described as the ‘gold-standard in trade agreements’), has now changed her mind and ‘currently opposes it in its current form’.  The US Congress takes a keen interest in ensuring that trade deals favour American interests.

This insularity mirrors a wider public perception that opening up the economy to international trade has been harmful, especially to manufacturing employment. Concern about the ‘giant sucking sound’ of NAFTA taking away American jobs may not have won Ross Perot the presidency in 1992, but this jaundiced view of international trade has remained. It is widely seen as the main cause of the stagnant real incomes of America’s blue-collar workers. Indeed, this discontent might be the single biggest driver of the astonishing rise of The Donald.

Meanwhile in Australia, the Trans-Pacific Partnership (and globalisation more generally) haven’t yet figured in the election campaign. Of course the current Coalition government supports TPP and all it stands for — after all, it negotiated and signed the draft. The Labor Party might have some specific concerns.  It is (justifiably) suspicious of the dispute settlement processes (ISDS), and wants to be assured that the intellectual property provisions don’t undermine Australia’s pharmaceutical benefits program. And of course it is the defender of Australian workers. Thus it was concerned that the China-Australia Free Trade Agreement (ChAFTA) didn’t open up opportunities for temporary import of Chinese workers to undercut Australian labour.

But having rehearsed these concerns and had them allayed, Labor will not stand in the way of ratification the TPP, not just because of its economic content, but because of its place in the wider context of Australia’s position in the world and more specifically Australian-US relations. If an American administration is strongly pushing the TPP, we will sign up without a whimper of disagreement. Similar political realities would prevent Labor from undermining ChAFTA’s ratification.

The Greens and independents, with no prospect of having to actually run the country, can afford to tap more populist concerns about damage to specific local industries and jobs,  but even they have focused on the detail (such as the ISDS) rather than promoted an anti-globalisation agenda.

The current bipartisan support for free trade reflects the consensual resolution of a century–old debate. Free–trade versus protection was one of the fundamental issues in the Australian Federation (the Lowy Institute’s usual home is in the building of the now-defunct New South Wales Club, established to support free trade). Until 1973 widespread industry protection (‘protection all round’) was the norm.  This was a key element in the ‘Australian settlement’, Paul Kelly’s interpretation of the first 70 years of Federation.

By the late 1960s, however, both main political parties had come to recognise that Australia, as a medium-sized country, would be hugely disadvantaged if it cut itself off from the global economy through protection.

Perhaps surprising at first sight, the key episodes of tariff-reduction actually took place under Labor Party governments, with its close ties to the union movement. Tariffs were reduced across–the–board by 25% in 1973. Further reductions in 1988 and 1991 (in the middle of a deep recession) took tariffs down to negligible levels, with the important exceptions of footwear, textiles and clothing, and passenger motor vehicles.

While the actual reductions took place under Labor, the conservative Coalition had laid the groundwork in the late 1960, and there was always pressure from the powerful National Party, representing rural and resource export sectors with self-interest in promoting international openness. Radical policy change is always easier if the government of the day is pushing at an open door, with the parliamentary opposition already agreeing with the policies.

One Labor Party insider attributes his party’s free-trade conversion to the power of ideas, overriding the vested interests which had dominated the debate. The Labor Party in this reform era was dominated by big-thinking internationalist politicians who envisaged a global role for Australia and saw that this was incompatible with inward-focused industry protection. Australia’s role in forming APEC (the high point being the tariff reduction pledges at Bogor in 1994), was not compatible with protectionist policies at home. Others were influenced by the example of Sweden, a small economy whose wealth relied on trading with the world.

The detail of history is always more nuanced. Energetic bureaucrats and policy-oriented academics also played an important role. Whatever the true interpretation of this extraordinary reform era, by 1999 Simon Crean, Labor Party stalwart, declared the protectionist debate was ‘confined to the dustbin of history’ for Australia and there it has remained.

Meanwhile, America’s position and pressures are different. Read More

The huge and diverse economy has no need to compensate for small scale by being integrated into the global economy. Its tradition is more self-reliant and inward looking (remember the famous New Yorker cover ‘View of the world from 9th Avenue’?)

Vested interests are more dominant in the US, and more effectively linked into the political process. The squeeze on blue–collar and lower middle class workers is more keenly felt because of the lacklustre recovery from the 2008 crisis. Australia, on the other hand, has experienced nearly a quarter–century without recession.

There can be nit-picking criticism and slippage in execution of pure free trade in the guise of ‘industry policy’.   But the fundamental point remains: this debate is over and Australia is committed to globalisation.

Photo courtesy of Flickr user russellstreet


Last week's budget contained two taxation measures affecting foreign investment in Australia: one lowering tax while the other aims to increase it. The first lowers the rate of company tax, which will fall from 30% to 25% by 2026. The second aims to tax more effectively those large multinational companies, such as Google, which have so far paid derisory amounts of tax considering their Australian revenues.

The reduction in company tax has been promoted as a measure to attract more foreign investment. The argument is that Australia's 30% rate looks high compared with many international jurisdictions, particular low-tax countries such as Singapore and Ireland. The Treasurer himself said; 'Australia has the seventh highest company tax rate of the 34 OECD countries and it is much higher than our neighbours in the Asian region.' This debate, however, has missed some key issues.

First, is the effective company tax rate high? Australia has a system of imputation, which means that Australian shareholders effectively receive a credit for the tax paid by an Australian company in which they have shares, thus reducing their own income tax. The laudable outcome avoids taxing both the company and the shareholder on the same income. With imputation, lowering the company tax rate makes no difference to the return for Australian shareholders: the company tax was already effectively zero. 

Foreign shareholders don't get the benefit of imputation. Is it fair to require them to pay tax in Australia, and if so, how much? The logic for taxing foreign companies operating here is unassailable. They benefit from a well-functioning economy where their intellectual property is protected, the legal system is second-to-none, the regulatory framework is sound and the business environment conducive to enterprise. This secure environment of good governance costs money to maintain and the foreigners should pay for the benefit, in the same way that domestic shareholders pay income tax to fund these services.

We want foreign investment, but there is no reason to discriminate in favour of foreigners by allowing them a better tax deal than domestic shareholders have. Domestic shareholders typically pay more than 30% tax on their income, so why give the foreigners a discount? Let's not argue about where the 'value add' of the production has occurred: these companies make more profit because they have the benefit of operating in Australia.

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Fairness between foreign and domestic investors didn't figure in the discussion of company tax. The debate was settled by esoteric Treasury modelling showing that lower company tax would raise GDP. In econometric modeling there is a counterpart to Newton's third law: for every model there is another model with an opposite result. This model demonstrated that GDP might rise if company tax were to be cut, but foreigners' dividends would increase, so Australians would lose out.

In any case, the unspoken purpose of the company tax cut may have been quite different – business groups have been lobbying for lower company tax so that wealthy Australians can benefit from the substantial difference between tax on companies and that on individuals by incorporation, with their income accruing to the corporation.

As far as the foreigners are concerned, many foreign companies don't pay much tax here anyway, so a lower company rate wouldn't make much difference. Hence the interest in the so called 'Google tax' – the second change in taxing arrangements. The previous budget had already contained measures to make it harder for foreign companies to shift profit to lower-tax jurisdictions. The main change in last week's budget was to boost tax compliance staffing to enforce the latest version of the measures, which includes copying Britain's 'diverted profits' legislation.

The underlying problem is that the long-standing tax rules, ossified in difficult-to-change international treaties, have not adapted to a globalised world; companies can readily shift profits to a subsidiary in a low-income jurisdiction. These actions aren't confined to foreign companies: the locals do it too. The arguments against the budget's course of action were set out here. The OECD has been working hard to put in place a consistent response to these vexed issues and if individual countries address the problems with their own laws, the global outcome will be an incoherent mess.

The counter-argument for doing something is more compelling. Despite the earnest endeavours of the OECD and the G20, it seems unlikely that any consensus will be reached which leaves the beneficiaries of the current system (basically, the mature investor-states of the G7 countries) with a smaller share of company taxes than they have at the moment.

It can be argued that the improvements in international tax that have occurred over recent years have not been a result of consensus reached in international negotiations at the OECD or G20, but from fortuitous leaks of information about existing practices (the Panama Papers are just the latest instance). These practices have been so blatantly contrary to any notion of fairness that transparency is enough to bring about voluntary changes in behaviour, at least among companies concerned about their reputation, without any revision to principles or regulations. Company directors who have had to defend in public their current egregious practices may be shamed into changing their ways. Putting more pressure on the global compliance norms through uncoordinated action by individual countries may not be the best-practice way to develop global 'rules of law' but may at least put reformist pressure on a system which has allowed these rorts to flourish.

Photo courtesy of Flickr user Denise.


Budgets are always pretty boring. Any controversial issues have been leaked (and spun) beforehand. Last night's was no exception. But it does provide an opportunity for a stock-take on longer-term debates about how the economy is travelling.

In a world which has been 'too slow for too long', the Australian performance has been pretty good, especially considering the collapse of commodity prices since 2011 (the graph below shows just how big this terms-of-trade shock has been). On the usual aggregate GDP measure, Australia has grown 22% over the eight years since 2007, just before the crisis. This compares with 10% for the USA, 7% for the UK and 12% for Canada, a rather similar economy. This looks even better against the dismal performance of Europe, where France is up just 3%, Germany up 7% and Italy down (yes, down!) 8%. Among the mature economies, New Zealand is closest, with 16% expansion. (all data from IMF WEO April 2016 database).

If we look at per capita GDP, Australia is less of a stand-out, with an increase of 7% over these eight years. On this measure the out-performance narrows: even Japan is up a couple of percent. But Australia still has twice the growth of the US.

RBA Chartpack

It's too early for a definitive assessment of how the transition from the resources boom is going, but so far the cautious optimists like John Edwards are ahead. There is now a wider acceptance that the impact of the resources boom was exaggerated. Half the increase in resource investment was spent on imports rather than in the domestic economy; the calculation of the terms-of-trade impact on income left a lot of room for different interpretation; and so much of the resources sector is foreign-owned that the big swings (both up and down) are felt more by foreign investors than by locals. Coal miner Peabody is now in Chapter 11 insolvency and Xstrata-owner Glencore is restructuring its balance sheet, but these are wholly foreign-owned.

None of the predicted disasters has come to pass. The banks were said to be vulnerable because of their dependence on foreign funding but this was given a real-life ultimate stress-test in 2008 and they came through untroubled. Anyone predicting a repeat of the freezing of the New York money markets hasn't noticed what prudential supervisors have been doing since then. Another popular alarmist prediction was a house-price bust (with the knock-on effect this might have on the banks' mortgage-heavy balance sheets). Again, so far so good: asset-prices seem to be levelling out and even if they drop back, the biggest exposures are with well-placed borrowers. Unless there is a big rise in unemployment, all this seem a case of scare-mongering — or commentators without enough real issues to talk about.

Moody's has put the government on notice that it must do more to get the budget into surplus. It's a puzzle why anyone would take any notice of the credit-rating agencies after their pre-crisis performance in handing out AAA securitization ratings on demand. Certainly the markets didn't take any notice of past down-grading of Japan and the US. But Australian politicians have made a rod for their own backs here, by using the threat of downgrading as an impetus for budget stringency.

In the global context, this pressure for a quick return to budget surplus has been the driver of austerity in the crisis-affected countries. This macro-economic mistake is perhaps the main explanation for 'too slow for too long'. The crisis expanded deficits, more because of the economic downturn rather than the need to support failing banks. Winding these deficits back greatly weakened the recovery: even with a conservative estimate of the fiscal multiplier, each percent reduction in the deficit-to-GDP ratio takes a percent off the growth rate. Look at this graph to see the contraction applied by austerity in 2011-13 and weep.

Source: IMF WEO April 2015 Figure 1.7

Australia had the same debate, with successive governments vying with their opposition in promising faster return to surplus. This was, in fact, unnecessary here. With no recession or bank failures to cause a huge deficit blow-out, moderate government debt levels and time-bound fiscal stimulus, there was no pressing need to return quickly to surplus. Fortunately, the austerity needed to achieve a surplus was never applied. The promised surplus has progressively receded into the future. We were saved by prevarication.

Long-planned resources projects (including LNG) have kept the level of investment from dropping precipitately, and housing investment has helped fill the gap. Total investment has fallen from 28% of GDP in 2007 to 26% in 2015, still strong by international comparison. Unemployment is fairly low, thanks to wages restraint. The slowing has been softened by exchange rates and interest rates. The real (inflation-adjusted) exchange rate is more than 20% lower than its peak in 2012 (the largest fall among mature economies). Interest rates are low in historic terms, but the RBA has not had to resort to the desperation-driven near-zero (and even negative) rates prevailing overseas. Ross Garnaut's advocacy for still-lower rates to get the exchange rate down further seems misplaced in an inflation-targeting regime which has served Australia well.

Of course further structural transition is still needed. While productivity is notoriously hard (maybe impossible) to measure, there is not much doubt that Australia is mimicking the global weakness. At some stage, the budget has to be brought back to surplus.

The valid criticism of past policies is not that they have been seriously wrong, but that the political process has not only failed to take desirable options: it has also blocked them off in the future. The government ignored the main lesson of the successful reforms of the 1980s: when your political opposition advocates good policy, you should seize it as your own. In the current context, trimming back the excesses of negative gearing is an example. Labor's total hash of a resources super-tax in 2010 has put that option off the agenda for as long as memory lasts. Combined with a sovereign wealth fund, this would have been a powerful automatic counter-cyclical instrument for Australian's chronic problem of commodity cycles. The current government botched sensible climate-change policies just as decisively. A carbon-tax was labeled as a 'big new tax' and scuttled forever, ignoring the opportunity it provided to lower other taxes which distort, rather than offset a distortion, as a carbon tax would have done.

Economic reform requires patient gathering of support through rational argument and sensible compromise, not the now-standard point-scoring negative politics. Parties pander to their constituencies. The modest cut in company tax this budget responds to vested interests, ignoring the fact that Australia's imputation policy fully offsets company tax for domestic shareholders. Foreign multinationals are the target of a potentially budget-fixing 'Google' tax, with the actual collection being a problem conveniently in the future. South Australia's political blackmail on ship-building succeeds brilliantly, as industry policy disappears down a dead-end.

Economists, for their part, should be ready to offer compromise second-best solutions, rather than incomprehensible optimality (as was Treasury's proposed resources super-tax).

The key issues for the economy's future are not to be found in last night's door-stop of budget documents. Far-sighted initiatives (such as an infrastructure fund, financed outside the budget) were left for another day. Tinkering has prevailed over structural reform. The strategy which will in due course return the budget to surplus remains uncertain.

On the resources debate, John Edwards' measured assessment of the not-too-disastrous impact of the resources boom is proving correct, but Ross Garnaut's somber message of lost opportunities resounds. With all the advantages of resource endowment and proximity to the globe's fastest-growing region, we should do better than just muddling through. The overall assessment is: 'Lazy: could try harder'.

Photo by Stefan Postles/Getty Images


So we’ve decided to build twelve submarines in Adelaide, a decision which:

  • contradicts the only idea that economists unanimously endorse — free trade;
  • ignores opportunity cost i.e what else might be done with $50 billion of labour, capital and managerial talent;
  • had no apparent operational budget constraints, with the number of vessels determined by the need to create continuous construction and;
  • makes little sense in terms of industry policy; there is no hope of developing an industry exporting bespoke ships.

Perhaps the comprehensive failure of economics to achieve any traction in this debate could be understood (and forgiven) by simply observing that the decision was the inevitable result of Senate politics. But that would let the guardians of rational economists — particularly the Departments of Treasury and Finance — off too lightly. The all-too-common failure of economics in policy debates is its penchant for analytical purity. Economists promote economically uncompromising solutions. But there is no point in pushing pure-economics arguments that can’t fly politically. In the face of irrefutably-rational economic arguments, the politicians reply: ‘We all know what we should do: we just don’t know how to get re-elected after we have done it.’ 

Last week I reviewed Concrete Economics by Stephen Cohen and Brad De Long, who address this political economy dimension.  They see the essence of good economic policy as requiring governments to play a major role in determining the structure of the economy and setting broad direction, so they can’t be accused of being laissez-faire, free market ideologues. The authors also support the sort of dirigist economics pursued by East Asian economies, so they have no objection to industry policy as such. They approve of protecting domestic industry while subsidising exports (by whatever means, including an artificially competitive exchange rate), in order to obtain the scale economies needed to compete on global markets. Above all, they accept the need to step outside the narrow world of economic analysis in order to develop a political consensus. This consensus will involve compromise; placating and neutralising vested interests while accepting second-best outcomes, provided that the core economic component makes some sense.

While mainstream economics is often a poor fit with political realities, there is plenty of alternative economic analysis relevant for political economy synthesis. Read More

Three decades ago Paul Krugman analysed the benefits of alternatives to free trade, and got a Nobel Prize for his efforts.  Industry policy designed to promote specialisation could achieve economies of scale in sectors with increasing returns (the bigger the scale of production, the lower the per-unit cost). Comparative advantage, the lynch-pin of the simple free-trade case, can be over-ridden if comparative advantage can be changed over time through dynamic restructuring. This can justify protecting the domestic market from foreign competition and subsidising exports. But of course the industry has to be chosen on economic rather than political criteria: there has to be some prospect that the output can be sold globally.

Even if the political imperative is to manufacture submarines (rather than some more promising product) in Adelaide, economic advocacy might at least have headed off the prime minister’s open-ended commitment to make everything possible in Australia. This autarchy is a nineteenth century notion of production. The modern supply chain draws its components from whichever country can produce them efficiently. The supermarkets are full of goods ‘made in Australia from imported ingredients’. In the same way, during the great mining boom of 2004-2008, half the investment expenditure was on imports because components could be made cheaper and better in South Korea or Singapore and towed into place. In other areas of defence production such as aircraft, ‘offset agreements’ allow purchasing countries to participate efficiently in complex supply-chain manufacture.

But what about jobs? Don’t we need to make everything here (especially in Adelaide) to keep people employed? Overall, the economy is currently operating with a level of unemployment that matches the best periods in recent history. Within this aggregate, major transitions are underway, particularly to adjust to the end of the mining boom. This involves painful disruption, of the same kind which allowed the successful transformation of the Australian economy from its early agricultural base and then, over the past four decades, to restructure out of manufacturing in response to the inexorable rise of international competition. Adelaide was given the opportunity to be the exception to the inevitable decline of manufacturing: the eventual demise of the long-cosseted automobile industry and the dismal narrative of the Collins submarines are the result. While many across Australia go through painful transition, politics dictates that Adelaide should be protected. But if submarines have to be made in Adelaide, they should at least draw on the efficiency of the global supply chain.

Australia is likely to pay a heavy price for this failure to develop a political-economy solution, certainly in terms of cost of the submarines and, based on past experience with the Collins construction, in terms of the fitness-for-purpose of the finished product. As a small country with a limited defence budget in a world which may become more threatening, we can’t afford to leave sensible economics out of the decision.

This post has focused on the failure of economics to contribute effectively to a synthesis of politics and economics. But the main blame should go to the politicians of the two major parties, who have watched this state-based blackmail evolve over recent years. There is universal agreement that blackmailers’ demands should never be met, for fear of encouraging even larger demands. With the election pending, however, the major parties arrived at a formula for total surrender to the blackmail: both parties have been competing to make sure the other didn’t offer South Australia a more favourable deal. A bipartisan solution, in contrast, could have countered the blackmail. Both parties could have offered the same deal: build the submarines in Adelaide, but with a requirement to call international tenders for components.  This approach would have recognised the special requirements of South Australia within the Federation, while creating the competitive manufacturing environment that State needs if it is to succeed.

If the economics was lamentable, the politics has been abysmal.

Photo courtesy of Australian Defence Image Library


The last decade hasn’t been kind to economists’ egos. Almost no-one saw the 2008 crisis coming. The subsequent recovery has been ‘too slow for too long’. And, at a deeper level, there is widespread discontent with the way the middle class has been left behind while a tiny fraction is enjoying a repeat of the ‘gilded age’.

Thus economics seems to be in need of root-and-branch rethinking. The tried-and-true macro-economic policies that should have ensured a rapid recovery after 2008 are inadequate, with monetary policy resorting to distortionary settings of interest rates and exploring policies (‘helicopter money’) that speak more of desperation than rational analysis. Fiscal policy has been left on the sidelines by a combination of fixation with debt and far-fetched academic theories designed to support doctrine rather than recovery. 

This reappraisal has been underway for some time. On macro-policy, the International Monetary Fund has shifted a long way from its initial support for austerity, although it hasn’t much to offer other than the general mantra of ‘structural reform’. This falls on deaf political ears (‘We all know what to do: we just don’t know how to get re-elected after we have done it’).

Meanwhile there is the rise of structural explanations, each with its recommendations for change. Thomas Piketty’s analysis of the return to Downton Abbey has been overwhelmingly supported, but his solution of higher taxes has not. Larry Summers sees partial salvation in more infrastructure spending, but at the same time worries that entrepreneurial dynamism is dead. Robert Gordon’s view is similarly dismal: the dynamics of the 1870-1970 century were driven by life-altering innovation, which has petered out.

Stephen Cohen and Brad De Long add to this structural-focused analysis with Concrete Economics. They draw their lessons largely from the history of the US, described as ‘the place where economic policy has been, without a doubt, the most successful over the last couple of centuries’.

This book tries to remind us, in simple concrete terms, of how the American economy, again and again, was reshaped and reinvigorated by a loveless interplay of government making broad economic policy and entrepreneurs seeking business opportunities.

In recounting the history of America’s economic success, they show that in each phase of development the government played a central role in giving broad direction, leaving it to private-sector entrepreneurs to innovate and experiment within the environment of incentives and constraints set down by the government. Each new phase had broad public support, with trade-offs, compromises, subsidies and division of the benefits determined by the political process.

Some of the early history will be of more interest to Americans than to others, but the post-WWII period from Eisenhower to Kennedy had such international influence that the narrative is broadly familiar to all. The progressive elements that Cohen and De Long advocate were all present. Administrations were prepared to take a major role in the economy. Defence expenditure, running at 10% of GDP (twice the current level), was a major instrument in guiding private industry into areas that were seen as the most promising. Government-funded infrastructure (such as the national highways in the 1950s) opened up scale opportunities by reducing transport costs. Suburban housing proliferated, epitomising the ‘good life’ and providing strong demand for home-improvement. Education expanded rapidly, and with it high-level university research.

There was very little doctrine driving these decisions. Pragmatism and experimentation prevailed rather than dogma. The whole spectrum of policy tools was used: infrastructure development, tariff protection, direct picking and promoting of winners, exchange rate devaluation, and selective protectionism through import quotas and ‘voluntary’ export restraints by trading partners. The aim was not simply to direct resources according to comparative advantage, but rather to change America’s comparative advantage. This environment produced a flood of high-technology productivity-enhancing inventions.

The authors see the last redesign of the American economy, beginning in the 1980s, as quite different; and inferior. America allowed its manufacturing to be eroded by competition from East Asia, believing that the way ahead lay in a post-industrial world — the higher-value industries of the future. The government had no concrete practical plans for this new era: just a doctrinal faith that deregulation and free markets would deliver the right answer.

The pervasive doctrine of ‘the magic of the market’ was sometimes beneficial (deregulation of airlines), but more often encouraged resources to flow into areas of doubtful benefit for productivity and living standards. Read More

The prime example is the financial sector, which doubled its share of GDP and put the best-and-brightest into innumerable variations of re-packaging finance and trading, with no more benefit to society than a casino. The additional resources in finance didn't improve price discovery and investment allocation. And it all unraveled in the 2008 crisis.

Finance is not the only example. America’s litigious society means its best brains arm-wrestle each other. A market-based health system accounts for 17% of US GDP (compared with 11-12% in most advanced economies), weighed down by top-heavy, paper-shuffling administration. The pre-2008 real estate boom was a bonanza for those who organised the transactions, the real estate agents and lawyers.

Certainly, there are winners: there is no denying the success of Silicon Valley and Hollywood. But these industries are too small and too specialised to provide jobs for the blue-collar and clerical middle class, displaced by imports and technology.

Where do the strongly-dirigist policies of the East Asian successes (Japan, Taiwan, South Korea, Singapore and now China) fit into this narrative? Cohen and De Long seem to see these as having many of the desirable attributes the authors advocate, although a key ingredient of these countries' success — a ready global market for exports — is not an option for all. But aren’t these successes counterbalanced by the failures of similarly-dirigist policies in Latin America, starting with Argentina, once counted among the richest countries in the world? It’s hard to identify generalities which explain the diversity of the successes and failures.

Of course it is easy to find fault in this latest effort to pick apart what has gone wrong with economic policy-making. But each successive contributor to the debate — whether Piketty, Gordon, Summers or Cohen and DeLong — identifies three common themes. The pernicious influence of doctrine (and specifically the free-market ideologues); the insidious undermining of political consensus through income mal-distribution and the rise of politically-powerful vested interests; and the misallocation of our best talent into finance, with so little apparent benefit to society.

Photo courtesy of Flickr user Chris Devers


‘Too slow for too long’. This is the title of the just-released IMF World Economic Outlook. Global growth has been stuck in a rut, running between 3% and 3.5% for the past four years, and the forecast numbers are not much stronger. Policy-makers have become inured to this persistently feeble performance, with policy unresponsive to the pleas from the Fund (and a growing chorus of others) for policy action.

With its Plan A message (growth-enhancing policies) falling on deaf ears, the Fund has been exploring the adequacy of the existing Plan B — the global financial safety net, aimed at preventing a domestic crisis from becoming global. The Fund points to the greater complexity and interconnectedness of global finance now, compared with 2008. The Fund sees an important role for itself in this Plan B, but the starting point in thinking about this issue is to ask: ‘what role did the IMF play during the 2008 crisis — not just the worst recession since 1930, but also the most globally interconnected?’

Foreseeing impending problems is the best way to avert them, however we shouldn't judge the Fund too harshly for its failure to see the 2008 crisis coming. Hardly anyone else did either, although the Bank for International Settlements staff did better, muffled and censored though they were by the Bank's major shareholders, particularly the US. The Fund’s monitoring, through the resource-intensive annual Article IV reports on every member country and the Financial Sector Action Plans, gave no operational forewarning of the problems to come.

Once the 2008 crisis began to unfold, the core issues reflected domestic failings, with ineffectual national prudential supervision at the epicentre. The main failings were in countries which had the capacity to handle their own problems (the US, the European Union, Switzerland and the UK), with national central banks and treasuries shoring up failing financial institutions.

Certainly, there was global contagion that affected ‘innocent bystanders’, such as South Korea and Indonesia. But the IMF was more or less irrelevant in the first phase (2008-2010), with tiny Iceland, among the affected countries, the only one to call on Fund assistance.

The key cross-border action was the US Fed’s provision of swap arrangements (i.e loans between central banks) to a range of countries in need of dollar-denominated liquidity. The 2009 G20 meeting in London provided the only example of international policy coordination, when it orchestrated what most countries were going to do anyway; provide fiscal stimulus.

The second stage of the GFC began in 2010, affecting the European periphery, where Greece, Spain, Portugal and Ireland all ran into trouble. Among these, the only one involving an IMF program was Greece, and a strong case can be made that the IMF should have left this to the Europeans to sort out. The IMF was involved because the then-managing director Dominique Strauss-Kahn saw political advantage for himself and the institution, and the Germans were glad to have someone else to share the rescue costs and the unenviable task of trying to put some discipline into Greek finances.

The Fund approved 27 assistance programs in the crisis period, but only Greece and Iceland had any close connection with the global crisis. There were large programs with Ukraine, Hungary and Romania, but economic contagion was not the main issue (although political contagion might have been a central motivation).

So much for the past. Will there be a greater role for the IMF next time?

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It’s true that the current Plan B is not in great shape, although the Fund itself is much better prepared. Countries’ first line of defence is their own foreign exchange reserves, which are a costly and inefficient form of insurance: as was demonstrated in 2008, a modest fall in reserve levels is taken by financial markets as a signal to panic. The various regional arrangements (such as the Chiang Mai Initiative Multilateral) have yet to be used and there is no formal coordination mechanism between them and the Fund. Many of the regional swap deals would not be much use in time of trouble.

The big change, however, is that the relevant part of Plan A (preventative measures in the financial sector) is in much better shape. For a start, the memories of 2008 are fresh, and awareness is a powerful antidote. The G20’s Financial Stability Board (successor to the BIS’ Financial Stability Forum) has had principal carriage of reinforcing the prudential framework. The national prudential supervisors are far better prepared than in 2008 and the domestic Plan Bs are much more fully developed.

This is important when thinking about the nature of any future financial crisis, and the need for a global ‘Plan B’ to contain the fallout. Europe might yet experience something that looks a bit like the 2010 crisis in the peripheral countries, if Italian banks fail. But this should be for the EU and the European Central Bank to sort out. Let’s hope the IMF has learned the lesson of Greece, and stays on the sidelines.

Elsewhere, the problems are much more likely to be the standard problem the Fund has dealt with since its creation: an individual country which gets into trouble through poor policies or bad luck (usually the former), whose problems are idiosyncratic and not very contagious. Brazil comes to mind, but there are others as well. The Fund’s resources have been substantially augmented since 2008 to handle these situations.

What about the Big One: if China has a financial crisis? This would certainly have repercussions for the rest of the world (including Australia) but it is hard to see much of an expanded role for the Fund. It seems extremely unlikely that China would ask for a Fund program to handle something which it has the resources and ‘fiscal space’ to look after itself. There might be ‘innocent bystanders’ dependent on China trade (Africa is probably more vulnerable than our region), but these are small-scale problems which the Fund’s existing programs seem well placed to handle, with not much likelihood of the sort of global contagion demonstrated in 2008.

It’s good that the Fund is ‘thinking the unthinkable’ and exploring all the things that might go wrong in its sphere. But having done that, there doesn’t seem much of a case for any empire-building in Washington.

Photo courtesy of Flickr user Graeme Maclean


What will our Prime Minister say about Chinese investment in Australia when he visits China later this week? Of course he will give his version of 'open for business': that we welcome foreign investment. After all, we have run a current account deficit almost every year for well over two centuries, funded by foreigners. But it's more complicated than that.

As the Chinese know well, we don't welcome every proposal. The Australian authorities were ready to knock back Chinalco's attempt to buy a larger share of Rio Tinto in 2009. The recent bid for the Kidman cattle properties was rejected because part of the property overlapped the Woomera Weapons Testing Range.

It's not as if we reject only Chinese bids. Singapore's attempt to take over the Australian Securities Exchange was rejected. Shell was not allowed to buy Woodside. Even our closest allies sometimes get knock-backs too: an American firm was denied Graincorp. Some areas are predesignated as off-limits: foreigners might, perhaps, be able to take over one of the big four banks, but not more than one.

That said, we don't treat all foreigners quite equally. If history has resulted in an economy with many state-owner-enterprises (SOEs) — which is the case with China — these SOEs will be treated with greater circumspection than privately-owned foreign firms.

Nor do we treat all Australian industries as equally open. Around 80% of Australian mining is foreign owned, while agriculture (with only a little more than 10% foreign owned) seems especially sensitive. When foreigners buy up housing, we feel ambivalent about higher house prices (depending on whether we are already owners) and see them as crowding out our children's ownership dreams.

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What principles emerge from this history? What nefarious activity would SOEs carry out that foreign investors like tax-avoiding reclusive Zug-based Glencore (sole owner of Xstrata) wouldn't do in its own market-oriented self-interest? The outrageously successful effort to torpedo the resources super-profit tax in 2009-10 was orchestrated and fronted by Aussies. When we have second thoughts about allowing China to have a lease of Darwin's port, what exactly did we think that the Chinese might do that could harm our security? None of this is transparent in the present system.

That said, letting foreigners own essential services has legitimate sensitivities. To disallow Chinese-maintained equipment into vital areas of our telecommunications might make sense, given their reputation for eaves-dropping. And yet, we don't mind Singapore owning one of the key telecoms companies, despite its reputation for official intrusiveness. Would these issues restrict China from owning key services like electricity? We've already sold off quite a bit of this utility to foreigners. Might the Hong Kong owners of the Latrobe Valley power stations be pressured into turning off the lights at some dark moment in the future? Might the Canadians who have a long-term lease on Sydney's desalination plant try to blackmail us into paying more for their water when we have a serious drought?

There seem to be some fanciful elements in some of these security-based arguments. The foreign-owned assets are physically here in Australia, subject to Australian regulation and law. Surely we can protect our own interests in these circumstances? 

The starting point for policy might be to sort out some of the ambivalence:

  • Yes, we want foreign investment, but since the float of the dollar in 1983 removed the external constraint, we should not have to beg or offer special incentives to foreigners to fill the nation's saving/investment gap. Our openness to foreign investment is an opportunity given to foreigners to join with us in taking up the many profitable opportunities which our resource-rich, well-governed, secure country offers – a benefit we are bestowing on the foreigners as much as it is a favour they are doing for us.
  • In exchange, the foreigners should make an explicit undertaking to be good corporate citizens. This means paying a fair amount of tax in Australia, not arranging their affairs to have the profits accrue in tax-avoidance centres like Ireland or Singapore. Australian shareholders make such a contribution through income tax, so it is not only fair. It is also economically efficient (competitively neutral) to expect foreigners to pay the same. Foreigner's profits come, to large degree, from the benefit of being able to exploit Australia's natural endowment and to sell into this well-functioning market with intellectual property protected and legal rights enforceable through due process. We don't want companies that are unwilling to contribute to the cost of running this governance infrastructure.
  • Sensitive areas should be either clearly off-limits or subject to negotiated safeguards. In most cases, the owners of vital service sectors can't do us much harm without doing more harm to themselves. Let's try to put a bit of realism into these nebulous security arguments.
  • Perhaps the greatest opportunity for a change in the mindset would be if we stopped thinking of the Foreign Investment Review Board's job in terms of allowing foreign investment unless a problem can be identified (a negative focus). Instead, we should ask the foreigners to set out why their proposal is positively good for us. This might actually change the nature of the proposals. Rather than tweaking them to get around the downside objections, foreigners could make proposals more inclusive and beneficial for Australia. Does the proposal open up markets in the foreign investor's home country? This should be particularly relevant for China, which needs to set up supply-side security in basic commodities – minerals, energy and food. How can they help us break into their huge market? It might be beneficial to have a substantial Australian partner. Don't try to take over our icons or national champions.
  • The trickiest issue is to articulate why we might want to discriminate between different foreigners on the basis of 'community concerns'. This has something to do with not wanting to be dominated by overly-powerful foreigners. The issue for China is that they are huge relative to us, and even modest proposals will easily overwhelm us: the 'elephant in the canoe'. This might be hard to explain to the Chinese, but the Prime Minister might begin the task.

Of course the Prime Minister has a winning rejoinder in the unlikely event that he is backed into a corner on this topic: the Chinese don't allow open investment in their own country, so any restrictions we apply are just reciprocity – tit for tat. But a better long-term answer is to develop some principles.

Photo: Lowy Institute/Peter Morris.


The financial press and market commentators focus on China's stock market gyrations, tottering exchange rate, capital flight and imminent credit collapse as elements in an ongoing narrative of impending financial crisis. Meanwhile, the process of internationalising the renminbi (RMB) continues. If you want a balanced account of this underlying story without the daily drama, you should read Renminbi Rising, authored by William Overholt, Guonan Ma and Cheung Kwok Law for the Fung Institute in Hong Kong.

Three measures of internationalisation are analysed.

First, the RMB is being used more frequently as the invoicing and funding currency for China's international trade. In the 2008 global crisis, China came to recognise that its dependence on foreign banks for trade finance made it vulnerable when these international institutions came under pressure. As well, there are efficiency gains to be had from simpler transactions and reduced currency risk for China's traders (although probably more currency risk for overseas suppliers). Around 20% of China's trade is now denominated in RMB, compared with 50-60% denominated in the home currency for the euro area, and 30-40% for Japan. This process will continue without drama, reaping modest but worthwhile efficiency gains along the way.

Second, the volume of RMB transactions in foreign-currency markets provides a general measure of acceptability of the currency. There is not much to show here: the RMB accounts for a tiny 1% of global FX turnover, well behind the Australian dollar.

Third, how is the RMB faring as a 'reserve currency' (ie. routinely held by foreign central banks in their foreign-currency portfolios)? Over the years, this idea has created angst and envy. French Finance Minister Valéry Giscard d'Estaing opined that America had 'exorbitant privilege' through being able to fund an external imbalance using its own currency. More recently, this privilege seems less clear-cut: other major countries such as Germany and Japan have seen no advantage is attempting to achieve this status.

Renminbi Rising is quite explicit in seeing no advantage — nor any real prospect — of the RMB attaining widespread reserve-currency status. More than 30 central banks now hold the RMB in their reserve portfolios, but the amounts are small; just enough to 'hedge trade and curry favour with China'. Nearly two-thirds of global reserves are currently held in US dollars, and as the authors note 'it would take a major catastrophe for this to change'.

The RMB's acceptance as part of the IMF's SDR basket occurred after this book went to press. It represents a strong political signal that China has arrived on the global financial stage, but has very little substance. As Charles Kindleberger once noted, SDRs are like Esperanto — a nice idea but of little practical importance.

Analysed in this mechanical way, the globalisation of the RMB might be judged to be of marginal importance for China and the world. This would, however, be too narrow a perspective. It has importance both for the development of China's own financial sector and for the world monetary order.

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Perhaps the greatest advantage comes from the pressure that globalisation puts on Chinese financial institutions to increase their efficiency so that they can cope with the openness. Part of this pressure is on the policy makers, supporting those who want a deeper and more sophisticated financial sector with a wider range of instruments. The factors which facilitate internationalisation also facilitate financial deepening. A deeper bond market and well-developed hedging market are needed for internationlisation, but are also needed for the much more beneficial process of domestic financial development.

An analogy with Australia might illustrate the point. There was never any prospect of the Australian dollar becoming a globalised currency in terms of $A-invoicing, large-scale $A-trading, or becoming a reserve currency. But the process of integration with global financial markets was hugely beneficial in raising productivity.

What are the implications for the global monetary order? Globalisation of the RMB is an element in the process of China becoming a responsible global stakeholder. In general, China has been a well-behaved participant. Avoiding depreciation during the Asian crisis was helpful for world stability. True, China's overly competitive exchange rate gave it an unfair advantage in its push into export markets early this century, but the inflation-adjusted value of the RMB has appreciated 30% since 2010 and is now generally accepted to be fairly valued (or even, perhaps, overvalued). 

China's entry into the global monetary order is a two-sided process and China might well feel that it has received a rather icy welcome. The US Congress has opposed IMF governance changes which would give China a greater voice: the US worked hard to undermine the Asian Infrastructure Investment Bank initiative; China has been excluded from the TPP; and the US has been very ready to accuse China of currency 'manipulation' while at the same time finding no fault elsewhere.

So far China has done nothing to suggest that its ideas on global monetary order would be very different from the existing system. China has, after all, done well out of the current arrangements, unrepresentative though the governance may be. China's initiatives have been generally compatible and helpful. For example, central bank swap facilities have proven to be the most effective form of response to foreign-exchange crises, and the Chinese central bank has now put in place more swap arrangements than the US Fed; some 28 active swaps, compared with the Fed's five standing liquidity facilities. Thus, as China finds its new and more important place in the international monetary order through the globalisation of the RMB, 'schism is hardly inevitable'.

Overholt, head of the Fung Institute and respected veteran of Asian finance, puts these issues frankly in an interview publicising this book:

To retain monetary leadership, and to sustain a unified global monetary system, the next US administration must quickly improve the capital and governance of the Bretton Woods institutions and join the AIIB. To be taken seriously by the rest of the world, the US needs to get its politicians to eschew the dishonest rhetoric about currency manipulation and its effect on the US economy. Over two decades the RMB has appreciated more than 60% in real effective terms, more than any other emerging market currency. Rapidly rising Chinese wages have magnified the effects of that appreciation. For four years the RMB has been well within the range the IMF uses to judge a fairly valued currency — trade surplus of 4% or less — and recently it has been clearly overvalued. The Chinese authorities have spent a sixth of China's reserves in less than half a year to keep the RMB overvalued. In 2015 the IMF formally announced that the currency was not undervalued. But US politicians continue to denounce China for predatory undervaluation. Such nonsense eventually leads our allies to walk away, as most did on the AIIB decision.

Photo by Zhang Peng/LightRocket via Getty Images


Can China continue its stunning transformation from economic backwardness to become a modern economy? The Reserve Bank of Australia gathered leading experts from around the world to debate the issue in Sydney last week.

When economists gather together, there is never a definitive resolution. Everyone, however, agrees on one thing: China needs an economic transformation. The double-digit growth of China's pre-2008 period was unsustainable, and the future pace of growth (officially put at around 6.5-7%) requires less investment and more consumption. Can the current share of investment (close to half of GDP) be cut back while still maintaining the overall growth target?

When China began its growth spurt in the 1980s, there had to be a substantial 'rotation' of GDP in favour of investment. This is the familiar textbook 'accelerator' process: to produce an extra dollar of output, you need to invest around three dollars to increase the capital stock. If you want to grow at 10%, you have to put 30% of GDP into investment just to keep capital/output the same. Higher living standards require capital deepening as well, so you need to invest even more.

But this accelerator process doesn't last. Investment can't rise faster than GDP forever. Growth slows and the pressing need to expand the capital stock quickly passes.

China's current sequence is, in fact, a common pattern in the countries which have already achieved rapid convergence. Japan, Taiwan, South Korea, Hong Kong, and Singapore all exhibited this extraordinary capacity-enhancing rise in investment, largely funded from a spectacular rise in domestic savings. China's investment/saving performance has been outside this prior experience, but not by much.

What happens next?

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Not all of these precedent countries had a seamless transition from the take off growth-spurt back to longer-term sustainable pace of growth. But Singapore, South Korea, Hong Kong and Taiwan pulled it off successfully. This should give some confidence that China can scale up this same sequence.

So far so good. The apex of China's growth trajectory was the pre-2008 decade. Double-digit growth was made possible on the supply side, by a rapid expansion of investment, and on the demand side, initially by exporting, as reflected in a current account surplus of 10% of GDP in 2007. 

The 2008 Global Financial Crisis brought this phase to an end. With global demand weak, the current account surplus fell dramatically — to less than 3% of GDP. The shortfall in demand was filled by a huge policy stimulus (close to 10% of GDP), not in the conventional form of fiscal expansion, but through the easing of direct credit controls. This meant that China not only avoided the global slump (and thanks to that, Australia did also), but actually restored double-digit growth in 2010 and 2011 while the rest of the world was mired in the Great Recession.

But this too was unsustainable. With credit constraints eased in 2009, China's overall debt position went from being financially conservative to being an over-leveraged outlier. China can't go on supporting high investment by increasing financial leverage. This is where China is now. The rotation from investment to consumption has begun, but is hardly perceptible in aggregate data.

Will China follow the successful transitional example of South Korea and Singapore rather than the unhappy experiences of Thailand and Japan?

The mechanics of this key challenge were set out in one of the conference papers. The paper explores a rotation of 1% of GDP per year (investment share of GDP down 1%, consumption up, to offset) which would bring China to a more normal GDP composition by 2030, with investment around 30%.

What's so hard about that? Especially as this probably overstates the required transformation for an economy still on the above-average-growth path of convergence. Well, this would require investment to grow much more slowly than it has in recent years, which might reduce overall growth. If overall growth slows, a recessionary dynamic gets underway, with slower income growth dampening consumption.

The authors of this paper are cautious about the prospects. And these rotation transformations are not the only things that can go wrong. Some worry that the inefficient state owned enterprises, diminished in importance though they now are, are still large enough to weigh down productivity and profits. Others worry that the necessary reforms in the financial sector will be neglected in the interests of keeping investment going. 

That said, the mechanical calculation in this paper does plot out a feasible transformational path. There are shoals, but the transit is navigable. China has other things going for it. Boosting consumption seems a far easier policy challenge that the more common task other countries face: restraining consumption. Transformations are easier in a fast-growing economy like China, than in a stagnant one like Japan, as growth reduces excess capacity over time. While rebalancing expansion currently requires investment growth to slow and sectors such as housing construction to contract sharply, China's capital stock per worker is a small fraction of that in the US and its housing stock will, in time, need to be greatly augmented and upgraded. There is much worthwhile investment to be done in due course.

The Chinese authorities have already pulled off a succession of substantial transformations: the initial rotation in favour of investment that expanded productive capacity; the saving increase that funded this from domestic sources, leaving China free of international debt; the urbanisation that provided the labour for industry; and the reduction of the current account surplus after 2007. And it's not as if the authorities have no policy levers. They can tweak both investment and consumption with their traditional command-and-control levers, supplemented by the newer, market-based instruments.

Put a group of economists in a room together and they will fret about textbook issues such as rebalancing demand. It may be that China's tougher challenges lie elsewhere: pollution, water, climate change, politics and the many surprises that litter the path of economic development.

Photo courtesy of Flickr user Jonathan Kos-Read.


Every country has some form of domestic bankruptcy procedures, whereby debtors who are unable to repay can come to some equitable collective settlement with their creditors. International debt, however, has no such set of resolution procedures. As international capital flows have increased dramatically over the past two decades, this lacuna has become more serious. Former International Monetary Fund chief economist Olivier Blanchard sees substantial progress in new measures developed in the IMF. How much of a breakthrough is this in practice?

The new procedures address a problem that occurs when a country needs emergency support from the IMF. As Blanchard explains it, the country is either illiquid or it is insolvent. If illiquid, the Fund can provide transitional funding to tide the country over until normal times return and foreign creditors (and the IMF) are repaid. Alternatively, an insolvent country requires a debt restructure, with 'haircuts' (debt reductions or deferred repayments) all round for foreign creditors.

Of course the practical problem is that it's rarely possible to know, at the time of a debt crisis, whether the issue is illiquidity or insolvency. More importantly, the political pressure is on the IMF to go ahead and provide assistance, whatever the prospects of repayment. If, however, the Fund provides assistance to a country which turns out to be insolvent, the IMF money has been used to repay creditors who should have been 'bailed-in' to help the resolution process by taking a haircut on their debt.

This scenario played out in Greece in 2010. It was obvious that Greece could not repay its debt, but nevertheless the IMF and the European Union provided funding to allow debt falling due to be repaid in full. By the time the issue of restructuring was addressed in 2012, many of the private creditors had already been repaid in full. Those private creditors still with outstanding debt in 2012 took a haircut but the overall effect was to leave the debt (still unresolved, still unsustainable) in the hands of the EU and the Fund, to be sorted out later.

This is a long-standing problem. It was relevant in 1997 when Australia contributed to the IMF-organised support for Thailand. We didn't want to see Australia's contribution used to repay foreign private creditors who had been so eager to provide Thailand with more borrowing than it could afford to repay. But the Fund doctrine at the time had no place for such niceties. IMF deputy managing director Sugisaki, chairing the donors' meeting, insisted that no attempt should be made to bail-in the foreign creditors (including large debts owed to Japanese banks).

Subsequently, IMF senior manager Anne Krueger laboured mightily to put some sense into sovereign debt resolution, but was rebuffed by the big creditor countries, led by the US.

Is the new Fund policy the breakthrough that Blanchard implies? Time will tell. He says if there is doubt as to solvency, the outstanding debt will be 're-profiled' i.e rescheduled for delayed repayment, but not written down. Perhaps in some cases this might be as successful, such as the Korean debt 'stand-still' in 1997-98, during the Asian crisis, when creditor countries worked together through their central banks to ensure that repayments to foreign creditors were delayed until the Koreans were able to make full repayment — which was achieved within a few months. But this was a once-off, highly interventionary process which would be hard to repeat successfully (and was not attempted in any of the other Asian crises countries).

Meanwhile, another development seems to be taking sovereign debt resolution in an unfortunate direction. The new Argentine government has reached an agreement with the hold-out creditors from its 2001 default. A debt negotiation in 2005 ultimately reached a settlement with over 90% of the creditors to accept 30 cents per dollar of debt. Much of the balance of the debt was picked up cheaply by so-called 'vulture' funds that subsequently sought legal redress through various courts, including seizing the Argentine naval training barque. These bond-holders were hugely assisted by a maverick US court ruling that prevented Argentina from making any payments to those creditors who had already agreed to take the substantial haircut. With the change of Argentina's government, the US court ruling has softened, and a deal with the hold-outs seems likely. But what message does this send to any country attempting a sovereign debt resolution in the future? Those who agreed to the 2005 settlement took a 70% haircut while the 'vultures' will make a profit of upwards of 400% on their investment. Next time a debt rescheduling is needed, why won't all creditors be hold-outs?

The Fund hopes that revised provisions in future bond contracts (inter alia, covering collective action clauses limiting the ability of hold-out creditors to resist an overall settlement) might prevent a repeat of the Argentine mess.

But collective action clauses have been included in earlier contracts, and sharp bankers and smart lawyers may find ways around the new versions. Of course debt should be repaid in full, as a matter of principle. But there comes a time when restructure is the only way forward. Given the new Argentine precedent, the unsettled Ukraine negotiations and Greece's unsustainable debt overhang, to leave these issues in the hands of the exigencies of domestic legal process seems inadequate. It's hard to share Blanchard's view that 'the world is now a safer place'.

Photo courtesy of Flickr user Jim Howard


There are a couple of issues from the The Interpreter discussion of the maritime border with Timor Leste that merit more exploration. First, the relevance of 'rules-based order'; second, the ASIS spying.

Rules-based order

Malcolm Jorgensen makes an eloquent argument for handing over the rule-making on maritime boundaries to UNCLOS, largely on the basis that to do otherwise undermines our arguments elsewhere (in particular, in relation to the South China Sea) for a rules-based order. 

Everyone is in favour of a rules-based order. The operational question, however, is 'who writes the rules?'

In this case the relevant rules are not found in UNCLOS itself, but in dispute-resolution outcomes. In my most-recent post, I hazarded the guess that an arbitrated solution in this case would leave everyone unhappy: the Timorese because they are unlikely to get wider laterals that include the Sunrise gas-field; Australia because it would likely lose some of its continental shelf; and Indonesia (not a direct party, but closely interested) because the new border would be a constant reminder of how they were 'taken to the cleaners' in the 1972 treaty with Australia.

Could patient negotiation find a better solution? By all reports, past negotiations have been acrimonious, justifying the Timorese view that they were bullied. Even so, the 2006 Certain Maritime Arrangements in the Timor Sea treaty (CMATS) demonstrated a degree of flexibility, compromise, and give-and-take that international arbitration could not have achieved, with its search for consistent universal rules.

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Indeed CMATS, at least initially, was favourably received by both parties as a reasonable compromise (Robert King's submission to the 2013 Joint Standing Committee on Foreign Affairs, Defence and Trade, Inquiry into Australia's relationship with Timor-Leste, records this history comprehensively).

Timor got 90% of the revenue from the Joint Petroleum Development Area (JPDA). It opened the way for Sunrise to be developed, with Timor getting 50% of the revenues, even though only 20% of Sunrise falls within the JPDA. Timor's Exclusive Economic Zone (EEZ) would encompass the whole of the JPDA. The vexed issue of a permanent maritime border covering the seabed was put off for 50 years. 

The CMATS logic seemed sound: let's get on with developing the valuable resources, giving Timor a bigger share than it would most likely get from international arbitration. The differences of view on the maritime boundary were put off into the far distant future. Indonesia still felt it had been cheated in 1972, but it could take solace in two aspects. First, the Timor-Australia maritime border was not settled at equidistant, which would have been a constant reminder of Indonesia's own anomalous maritime border with Australia. Second, the 1997 treaty with Australia had confirmed Indonesia's EEZ extended to the median.

Does this arrangement need further adjustment? If Timor needs to settle its maritime boundaries now and comes to a re-opened negotiation believing that widening the laterals and getting direct ownership over Sunrise is a matter of national honour, then it's hard to see how negotiations could succeed (if only because Indonesia has a close interest and isn't present at the table). In time, the parties may be able to reset their expectations. The solution may be at variance with UNCLOS norms (as CMATS is), but would still be consistent with the UNCLOS over-riding principle that the best solution is an agreement between the parties.

Does it seem too much of a stretch to envisage that this kind of flexible give and take process might even have relevance as a model for the South China Sea disputes? Agreement in the Timor Sea would demonstrate that patient negotiation between all the parties can reach an acceptable, flexible and innovative outcome that might involve sharing resources and responsibilities in ways other than those envisaged in UNCLOS.

In the South China Sea there is no chance of finding an overall solution by submitting ad hoc parts of this problem to international arbitration. Is anyone suggesting that calling in the surveyors to draw some equidistant lines between the relevant countries could ever settle this issue? An overall agreement with all interested parties (perhaps beginning with a negotiation between ASEAN and China) might be a big ask, but it would open up possible compromises and innovative solutions specific to the region and the circumstances that are simply not on the table if this goes to international arbitration. For example, can you see anything familiar in this proposal for two Joint Development Areas in the South China Sea? 

So of course we are all in favour of a rules-based order. But sometimes patient efforts at agreement are better than legal process.


Let's turn now to the spying. As I have said before, this was not only scandalously unacceptable behaviour, but incompetent as well. So what should we do now? First, we should admit what we did, apologise and undertake never to do this sort of thing again. If the information collected was of any use, and got us a better outcome in CMATS, we should offer to rectify this unfair betterment. But so far no one has suggested what aspects of the CMATS outcome would have been different if we had refrained from this bumbling stupidity. As the then foreign minister said, 'you didn't have to spy on the East Timorese to know their position'. 

How can we put substance behind a promise not to do this again?

We have to fix the failed governance of ASIS. It's not good enough to hide behind the 'never confirm or deny' smoke-screen, when the only lesson learned is: 'next time don't get caught'. Like other Government institutions (which also have their secrets), ASIS should not only be held accountable for its actions, but the value of its output requires continuous critical appraisal. The current accountability doesn't seem to go much beyond checking administrative issues (was the petty cash properly accounted for?). How many more episodes of incompetence occurred but didn't happen to come to light? In this process, we need to ask why we need this kind of cloak-and-dagger James Bond activity at all? And it's not the intelligence community's sole recent public debacle: listening in on SBY's wife was just mindless.

What is needed is a wide-ranging enquiry into the net benefits of this kind of intelligence-gathering. If we do need ASIS, then it requires a degree of oversight which has clearly been lacking. If such an inquiry produced a substantial shrinking (or even disappearance) of ASIS and reining-in of the Signals Directorate, that would free up resources to boost DFAT's overt intelligence collection.

Photo by Pamela Martin/Getty Images