Lowy Institute

Sometimes a picture is worth a thousand words.

Australia ( the red line) has outperformed all the main advanced economies (which fall within the blue segments) for increase in GDP and per-capital GDP, is lower than almost all on unemployment (Japan is lowest, New Zealand a bit lower than Australia), and closer to inflation target than just about everyone.


In July, when congratulating Theresa May on her appointment as British Prime Minister, Malcolm Turnbull sounded a trifle eager, offering to start talks on a Free Trade Agreement ‘as soon as possible’? Trade Minister Steven Ciobo has now brought some reality to the time dimension. A deal is many years away.

Greg Earl covered this topic neatly here. Before Britain and Australia can have any substantive discussion, not only does Britain have to leave the European Union, but it first has to work out (and then negotiate) what it wants for the 50% of its trade which currently goes to Europe. Only then will Britain be talking seriously with non-EU countries. Australia, number 21 on the list of Britain’s most important export markets, will be a low priority for a bureaucracy bereft of trade negotiators.

That gives us plenty of time to think of the ways we might benefit from an FTA with Great Britain (or perhaps a smaller United Kingdom). The list is pretty skimpy. Urged on by Japan, Britain will probably end up with a preferential trading relationship with Europe (at least as close as Canada’s FTA with the EU, and perhaps as close as Switzerland’s near-seamless goods-market integration). Britain’s need to keep its closest links to Europe open and preferential will distort any deal it does with other countries. Australia would have the worst of all worlds; obtaining imports from a preferred supplier rather than the cheapest source, while still facing discrimination in Britain’s market from Europeans who are likely to retain competitive advantage.

What positive benefits could Britain offer? Certainly not to accept agricultural exports from Australia: half a century in the Common Agriculture Policy has fostered a hugely-protected domestic agriculture, which can’t be dismantled any time soon.

What about immigration for all of those Australians who still see London as the embodiment of ‘going overseas’? In the unlikely event that Britain restricts this path, it would be in Australia’s interests that our best emigrants looked more boldly to other regions where their subsequent experience would later be more useful to them and Australia – especially in the dynamic economies of Asia.

And there is the lesson we should have learned from the Australia/United States FTA. Once you get into detailed negotiations on an FTA, politicians are eager to claim advantage and plaudits from concluding a deal, thus removing the most important bargaining card from the hands of our negotiators – the ability to refuse to sign on to a dud deal.

Photo coutesy of Flikcr user Visit Britain


Senator Wong urges the Australian government to commit to an international process of dispute resolution to settle the maritime border between Australia and Timor Leste. The conciliation process currently underway in The Hague goes quite some distance in this direction, providing each side with the opportunity to set out its case. You can listen to the streaming of the opening public session here. It’s a reminder of how complex this issue is.

Source: Department of Foreign Affairs and Trade

The 2.5 hour opening session is a fascinating summary of the tragic history of Timor Leste and the series of negotiations and treaties, including Australia’s ham-fisted spying efforts. If you just want an update on the rival border claims (which I looked at in detail here),   start about 50 minutes in for the Timor Leste argument. For the Australian argument, start around 140 minutes in.

The commission can’t determine the outcome of the dispute, but if it judges itself as competent to act in this case, it is likely to offer guidance on how the parties should negotiate a settlement. This guidance will not be binding on the parties,  but will carry considerable weight. Finding an arrangement that both sides find equitable would challenge the Wisdom of Solomon.

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Let's look at some possible outcomes:

  • If the 2006 CEMATS Treaty is valid, this would leave Timor unhappy, as its position is that ‘CEMATS must go’.  Timor has the option of terminating CMATS, but this opens up a can of worms, with uncertainty as to whether earlier treaties apply and how revenue would be divided. The border would still be unsettled.
  • If the commission suggests that the Joint Petroleum Development Area (JPDA) should belong to Timor (which might be the most straight-forward interpretation of a median boundary), this not only excludes most of Greater Sunrise gas field, but probably leaves Timor with significantly less revenue in the long run: it would get 100% of the JPDA revenue instead of 90%, but only 20% of Sunrise instead of 50%.
  •  To put Sunrise in Timor territory, Timor would not only have to own the JPDA, but as well the eastern lateral boundary has to be further eastward than the edge of the JPDA, which would take the boundary into waters currently administered by Indonesia. If Indonesia becomes involved it might raise two matters: Indonesia’s belief that  it was ‘taken to the cleaners’ in the 1972 Treaty, which might lead it to demand a renegotiation, on the same basis as Timor’s claim that it negotiated CMATS under duress. Indonesia could also point out that most of Sunrise is closer to Indonesia than it is to Timor.

What would Solomon do? His solution to the earlier overlapping claims was to offer to cut the disputed baby in two, which brought the disagreement to an equitable conclusion. Maybe the equivalent shock-judgment in this case would be for the commission to recognise that there are three countries – Australia, Timor and Indonesia –with valid interests in the Timor Sea. Neither Australia nor Timor would welcome this (as most of Sunrise might well end up belonging to Indonesia), but if the key element of UNCLOS is equity, Indonesia should be there.


Last week I noted that the IMF has lost any hope of monetary policy alone lifting Japan out of its deflationary torpor, but Japan is not the only country where monetary policy has disappointed.

The US recovery has been uncharacteristically lethargic, despite adventurous monetary policy initiatives. European unemployment is still in double-digits, with Italian GDP 8% lower than in 2007. A panel of experts looked at this issue recently at the Lowy Institute; for their take, listen here.

If the recovery from the 1930s Great Depression is anything to go by, deep recessions are followed by strong recoveries as the economy takes up the slack and gets back to potential output: US GDP grew by 8% in each of the three years to 1937. That certainly didn’t happen after the 2008 Great Recession. The recovery was neither rapid nor is there any prospect of getting back to the old trend line. Read More

The first chart below shows US actual GDP growth and successive forecasts of potential growth, each one more pessimistic than the last.


This chart shows the same thing for Europe.


Monetary policy responded promptly and strongly to the crisis. By the end of 2008, the US policy interest rate was close to zero and others were not far behind (although the European Central Bank (ECB) was tardy). But not much happened. Output growth was consistently below forecasts and inflation remained below target.

The response was to increase the dosage. With the policy rate already effectively at zero, central banks in crisis-affected economies searched for other ways to apply stimulus. Some of this was fairly conventional, at least in the context of a financial crisis. Where financial markets had become dysfunctional because of investor funk, central banks bought assets to restore liquidity in these markets. They also supplied liquidity to banks, including foreign exchange liquidity via swaps with the US Fed. They provided ‘forward guidance’ to assure markets that policy would remain accommodative. The Bank of Japan (BoJ), the ECB and a couple of smaller European central banks set their policy rate at a small negative level.

As well, all four major central banks (the US Fed, the Bank of England, the ECB and the BoJ) began large-scale bond purchases, with the same motivation: with policy rates at zero, they wanted to apply more stimulus. These massive ‘quantitative easing’ (QE) operations were breaking new ground, flooding financial markets with central bank money (‘base money’), buying up 25%-30% of the outstanding stock of government debt. Japan had tried QE operations earlier without much effect, but these massive operations undoubtedly flattened the yield curve. Just how much this stimulated output is debated, but it certainly boosted share prices and depreciated exchange rates, both supportive of domestic growth. Inflation, however, remained stubbornly below target and the recovery remained limp.

Last weekend, the world’s central bankers met for their annual high-powered get-together in Jackson Hole, Wyoming, with these vexed issues on their minds

There wasn’t much resolution of the unsettled issues.

Some believe that monetary policy did as well as could be expected. After all, every economics student knows that monetary policy is not very effective in stimulating an economy; ‘like pushing on a string’, or so they say. The crisis environment didn’t help. The epicentre of the 2008 crisis was the financial sector, which is always slow to recover, dampening financial intermediation. Both banks and over-leveraged borrowers have to restructure their balance sheets, and prudential regulators (having been caught out in 2007) imposed more capital and regulatory requirements on the banks (and hefty fines for banks’ earlier transgressions). As a result, the financial system (though awash with base money) didn’t expand credit.

On top of this, fiscal policy was tightened in the aftermath of the 2008 crisis. After just one burst of fiscal stimulus in 2009, budgets were reined in because of debt fears (some would call it debt-phobia). America, for example, reduced its budget deficit by an amount equal to 5% of GDP. Assuming a budget multiplier of one, this fiscal consolidation took 5% off growth, spread out over a four year period. Austerity in Europe was probably harsher, and Europe also had to cope with the 2010 collapse of the peripheral economies, starting with Greece.

What lessons should monetary policy-makers take from this experience? There is nothing approaching consensus here, but here’s my take.

The mistakes of the 2000s were many: overly-low interest rates, irresponsible lending to NINJAs, ineffective prudential supervision, over-leveraged banks relying on flighty funding, and credit rating agencies prepared to hand out AAA ratings on demand. All this came home to roost in 2007-08. 

The balance-sheet repair needed when the bubble burst was profound. To impose budget austerity after just one small shot of fiscal stimulus in 2009 was a very serious policy error. Strong recoveries (not just 1935-37, but the US recovery after the Volcker shock of 1979) require fiscal stimulus to boost demand. Without this, low interest rates have limited stimulatory effect; new investment needs the clear prospect of stronger demand, as well as cheaper funding. The ‘pushing on a string’ analogy is unhelpful: accommodative monetary policy is a prerequisite for recovery. But it doesn’t get effective traction without fiscal support as well. The unconventional monetary policy measures (QE, negative interest rates, and forward policy guidance) are measures of desperation, with modest impact.

When policy interest rates were lowered to zero, central banks (Ben Bernanke in particular) should have said that the monetary instrument was working strongly, but was ‘pedal to the metal’. To be effective in the face of strong headwinds, this monetary stimulus needed to work in tandem with fiscal policy to give the recovery a strong kick-start. Instead, ‘Helicopter Ben’ assured everyone that things were under control: he had more instruments in his policy kit. He let those in charge of fiscal policy off the hook, to make their usual lame excuses for inaction: debt phobia; Ricardian Equivalence; and ‘confidence fairy’ effects. 

In due course the balance sheet repair will be finished. Some businesses will start looking for expansion opportunities. The low interest rates will encourage them to start borrowing again. This is already happening in America. But the new growth trajectory will be far below what seemed feasible in 2007, with economies suffering permanent damage from the long period of labour underutilisation. 

The extensive use of unconventional policies has undermined the beautiful simplicity of inflation targeting. The core tenet of central banking (that governments cannot command the central bank to fund budget expenditure) has been eroded by QE and would be entirely undone by ‘helicopter money’. Unsurprisingly, the Jackson Hole symposium pondered more radical changes to monetary policy to try to restore its effectiveness; economists are never short of sure-fire panaceas. The Economist joined the clamour, with a confused editorial advocating nominal income targeting as the new ‘silver bullet’. 

Few central bankers will acknowledge the asymmetric nature of their power. They are able to stop an inflationary burst, albeit painfully (the 1979 ‘Volcker deflation’ in America, or the 1990 ‘recession we had to have’ in Australia). With competence and some luck, central banks may be able to maintain inflation close to target in good times. But when the economy falls into a deep hole, monetary policy shouldn’t be expected to carry out the rescue alone.

Photo: Getty Images/Archive


Desperate times call for desperate measures. The International Monetary Fund seems to have lost hope that monetary and fiscal policy can shift the Japanese economy out of its deflationary torpor. The IMF, usually the embodiment of conservative mainstream economics, has published this working paper and these consultation documents that suggest Japan should embark on a comprehensive incomes policy so that wages will rise strongly. 

Incomes policies are normally imposed in order to restrain wages, not to boost them. What’s going on?

Prime Minister Abe’s 2012 ‘three arrows’ program projected a speedy return to growth, 2% inflation and a balanced budget by 2020. The initial reaction to ‘Abenomics’ was favourable: the stock-market rose 60% and the exchange rate fell by more than 20%. This eased financial conditions, boosted corporate profits, and lifted actual and expected inflation into positive territory.

But this improvement was not sustained. The exchange rate has appreciated. The IMF expects the Japanese economy to grow by 0.5% this year, 0.3% next year and slower still thereafter. Core inflation is expected to decline and headline inflation, running at 0.2% this year, will rise to 0.6% next year – well short of the 2% target.

The economic conjuncture in Japan is special, perhaps unique. In the past 25 years (1990-2015) real GDP has grown at an annual average of 1%, which might sound slow, but demographics mean that Japan’s working population has been declining. Japan’s GDP growth per worker over these 25 years (the so-called ‘lost decades’) is about the same as America’s. And current unemployment is quite low: 3%. So maybe Japan is doing just about as well as should be expected for a super-mature economy with declining population. Read More


There are two abnormalities. The first is the chronic low inflation (the GDP deflator has fallen by 0.3% annually over the past 25 years). The result is that, even when the policy interest rate is set at zero (or a small negative, as at present), it does not provide a strong incentive to borrow. The second is that persistent budget deficits have built up a staggering level of government debt: the ratio of gross debt to GDP is 250%, well over twice that of other G7 countries. Japan is still adding to the debt by running a sizeable budget deficit (5% of GDP) so there isn’t room for much fiscal stimulus. In fact, Japan needs to get the deficit down just as quickly as possible.

Thus the two standard macro-instruments – monetary and fiscal policy – are both constrained. In response, the IMF proposes what might seem an outlandish approach: pressure businesses to give larger wage increases so that they will have to raise their prices, thus boosting inflation. The IMF says that ‘slow wage-price dynamics amount to a missing link in the transmission of rising corporate earnings to inflation (actual and expected)’.

If Japan did succeed in getting inflation up to Bank of Japan’s target of 2%, this would mean that the policy interest rate, already slightly negative in nominal terms, would be substantially negative in real terms, which might encourage more borrowing for investment. Then again, it might not: if demand in the economy is stagnant, even the most attractive borrowing opportunities won’t induce investment. Many argue that the near-zero rates prevailing in recent decades just discouraged necessary restructuring, keeping ‘zombie’ firms going rather than encouraging new investment.

The IMF suggests  income policy might help in other ways. A lift real wages might boost consumption spending. If it does succeed in raising inflation, this would make the debt burden seem smaller: higher nominal GDP lowers the debt/GDP ratio.

But all this is surrounded by pitfalls. Higher inflation might force up the interest rate on government debt, which would greatly increase the deficit. Other suggestions (examined in detail by the IMF) seem equally fraught. Paul Krugman has long argued that the Japanese authorities should undertake ‘irresponsible fiscal and monetary policy’, threatening to embark on such expansionary policies that inflation will rise. Lars Svennson (influential academic and former Swedish central bank board member) offers the Japanese a ‘foolproof’ method of getting inflation up: depreciate the yen enough to get inflation up via higher import prices. Adair Turner (former head of the UK Financial Services Authority) wants the Japanese to embark on substantial fiscal expansion, financed by central bank money creation.

All this is borderline-nuttiness. Rather than provoking inflation, the Krugman proposal is more likely to set off bond-yield rise, which would blow out the budget deficit. Svennson’s devaluation idea would require a huge forced devaluation, which would be hard to achieve operationally and would be totally unacceptable to Japan’s trading partners, who would suffer a counterpart appreciation. Adair Turner’s ‘helicopter money’ proposal doesn’t offer any advantages (in terms of debt/GDP ratio or interest cost of funding) over issuing more bonds to fund the fiscal expenditure. 

Meanwhile, the Japanese authorities seem ready to maintain current policies: strong quantitative easing; a mildly negative policy interest rate in the (so far unfulfilled) hope that this will cause a depreciation of the yen; postponing a fix of the budget deficit, as even modest attempts to raise the value-added tax cause consumers to go into a spending funk; and raise the minimum wage by a regular 3% annually. One tiny structural shift: more women are entering the workforce. The truly radical policy would be to ease immigration restrictions, but change here is likely to remain glacial.

The Japanese are travelling a narrow road with big risks on both sides and no safe haven in sight. The one clear lesson is that it’s much harder to run an economy with aging population and shrinking workforce. 

Photo: Flickr/Soumei Baba


It’s less than four years since then-Prime Minister Julia Gillard launched ‘Australia in the Asian Century’ at the Lowy Institute. It has sunk, with hardly a trace.

There was much inspirational language about the great opportunity the Asian Century gave Australia to undergo 'a transformation as profound as any that have defined Australia throughout our history'. There was, however, a shortage of specifics on how to achieve this transformation. As I said back then: ‘If anyone didn't already know that we have the good fortune to be next to the most economically vibrant region in the world, this document sets out the full measure of our luck.’ But, beyond some nice-sounding ideas about fostering Asian-language learning, there wasn’t much in the way of an agenda on how to reap the potential, and virtually no funding to help any initiatives get started.

Now ANU’s East Asian Bureau of Economic Research and the China Center for International Economic Exchanges in Beijing have produced ‘Partnership for change: Australia-China Joint Economic Report’. This impressive 300-pages volume, produced with substantial support from both governments, provides some specifics on the keystone of our Asian opportunity: the Australia/China relationship.

Its aim is to define a framework for policymakers and for stakeholders in business, media, research institutions and the community; a framework that enables Australia and China to harness the opportunities that are arising from the profound transformations in their economies.

There is, inevitably, a fair amount of the same lauding of the Asia-proximity opportunity that filled the Asian Century report, but this report has the advantage of focusing on just one relationship, so it goes beyond the feel-good platitudes. It tells the amazing story of what has happened so far (much of it in the last couple of decades).

Two graphs from the report summarise the overwhelmingly dominant element in this narrative. The first says that China’s spectacular growth propelled it into a central role in global resources markets. The second says that that they bought a big chunk of these resources from us.

In short, much of the past success (certainly the success in exporting minerals) springs directly from the synergies of the two countries’ differing comparative advantage. There is something of an inevitability in the story of iron ore and coal: we had the huge resource deposits; they were on track to produce over half of world steel. But here is the important message: even this ‘had to happen’ narrative needed the catalyst of government encouragement in the 1980s and commercial risk-taking by the resource companies. Success is always clearer and more inevitable in hindsight.

Australia rode the minerals boom, which made China our top export destination. But China seems to have reached ‘peak steel’ and coal won’t be the favoured energy source of the future. These resource exports won’t disappear or even decline. But where will the growth come from? To continue to reap the benefits of this bountiful opportunity, we have to find the comparative-advantage synergies in the next phase of China’s transformation from investment-driven growth to consumption-based.

The usual answers are to be found in the report: services and high-end food. Much of the current success in education, tourism and food fads such as baby-formula seem, like resources, to be more about the luck of nature, combined with the mechanical fact that even if we get only a small share of the Chinese market, it will bulk large for us. The key policy question is whether Australia will continue to be dragged along in the slip-stream of China’s spectacular growth.

The answer this report offers is that Australia would still do pretty well even if we just lie back and enjoy the ride. But, says the report, we will do much better if we try harder and play our cards well.

So far the role of policy has been in the background, but important. Iron ore actually required far-sighted initiatives. In the 1960s there was still a ban on iron ore exports, reserving Australia’s deposits for the local industry. Not long after formal diplomatic recognition, a special relationship developed, including at the very top level. In the background, policy was developed to facilitate the initiatives.

On foreign investment, the regulatory environment had to find a delicate balance between encouraging Chinese investment and avoiding a xenophobic backlash in Australia. This policy-development went beyond resources. Behind the influx of Chinese university students was an earlier transformation of our universities to make them capable of providing these services. The influx would be different if visa policy (and the possibility of permanent residence) had not been part of the policy adjustment.

In short, even the seemingly inevitable linkages that have taken the Australia/China relationship to where it is now are not just the product of natural evolution, but required commercial entrepreneurship and government policy.

The special relationships of the 1980s couldn’t continue once China became a major player on the global stage. How will the government’s facilitation role and encouragement of entrepreneurship play their necessary role in the future? The report has a number of suggestions for strengthening the linkages between the two countries, with emphasis on person-to-person relationships at all levels.

The centre-piece would be a Basic Treaty of Cooperation:

This treaty would lock in the practice and principles for cooperation, and: commit to regular high-level government dialogues; set out the principles for managing the relationship that are enunciated in this Report; institutionalise official bilateral exchanges and technical cooperation programs between economic and foreign affairs ministries, including branches of the military; include policy approaches between federal–state governments in Australia and central–provincial governments in China; provide for the comprehensive setting of strategic bilateral objectives in a forward agenda; enfold the agreements, mechanisms and reforms of the ChAFTA arrangement; and entrench cooperation on improving educational, cultural and people-to-people exchange.

This is the high-level long-term plan. The report also spells out the detailed possibilities. A report like this will, by its nature, ‘travel hopefully’. Not all of the ideas explored will prove feasible. It may be too optimistic in seeing Australia as a close partner for China as China seeks to achieve its proper place in international forums, both regional (APEC, ASEAN Plus) and multilateral (G20, IMF): Can Australia join with China to be ‘a powerful force for the strengthening and developing of these institutions’?

The Ausgrid decision provides a reminder of the difficulties in getting the investment relationship right. Here’s the report’s caution:

This will not be achieved if the broader community does not grasp the benefits of foreign investment in both Australia and China. In Australia, this means accepting equal treatment for Chinese investment and reconsidering attitudes towards state-owned investors from all countries. In China, it means building respect for rule of law to make investments secure and predictable for all domestic and international parties .

Elsewhere, the necessary comparative advantage simply may not exist. Australian banks, for example, have shown no aptitude for meaningful overseas operations. The report provides a case study of AMP’s drawn-out efforts to get a toe-hold in the Chinese insurance and funds-management markets, which would have to be described as, at best, a modest success. We have to accept that many Australian businesses have insufficient skills and scale to operate successfully in China, separated by unfamiliar language and custom.

That said, the powerful lesson is that there are opportunities, and these will often require more homework, more institutional infrastructure and more relationships than currently exist. Reaping the advantages of proximity isn’t just about synergies from comparative advantage. It doesn’t just happen.

This report, sensibly, refers to wider security issues only as context with just a box on regional security and a few paragraphs in the text of a chapter about risks. There is no shortage of pundits on the security challenges. We still await the (bold) author who revisits the idea that close economic integration makes open conflict unlikely, even unthinkable.

Image courtesy of Flickr user AK Rockefeller


Indonesian President Joko Widodo has reshuffled his cabinet for a second time. 'Tempo' magazine described the appointment of Sri Mulyani Indrawati to her former position as finance minister as 'the return of the prodigal daughter'. The comparison is not entirely accurate: Sri Mulyani hadn't done anything wrong when she left in 2010 (more below) and she hasn't sought forgiveness on her return. But her return is being treated as a big event, worthy of slaughtering the fatted calf, so that part of the parable does ring true.

From 2005 until 2010, Sri Mulyani was a successful finance minister under former President Susilo Bambang Yudhoyono. She has a reputation for being smart, honest, a straight-shooter, and decisive: she got things done. Some would add that she is 'strongly opinionated'. She made good progress in the viper-pit of raising tax revenue. She resigned in 2010 to take up what is essentially the number two position at the World Bank and her reputation was enhanced by her subsequent time in Washington.

Thus it is understandable that hopes have been raised. But it also says something about economic performance under President Widodo, that the arrival of a new minister is seen as having the potential to make so much difference.

Indonesia has been growing at a respectable rate (around 5% annually) considering the global slowdown, but Jokowi was aiming for 7% and the shortfall makes a big difference in a country like Indonesia. The lost opportunities are on public display. Bickering ministers lost the chance to get the big Masela LNG project going while global markets were favourable. The vital expansion of electricity infrastructure is falling behind schedule. Infrastructure investment (a Jokowi priority) is still dragging, with big projects such as the Jakarta-Bandung high-speed train running into implementation difficulties. Questions are being asked about the tender-process for a big petroleum refinery in Tuban, East Java. A controversial tax amnesty is mired in administrative confusion. 

President Widodo needs someone like Sri Mulyani to drive his reform agenda, and has been trying to lure her back since he became president. She may be able to fulfill his high hopes. Much will depend on the working relationships the new finance minister forges with both Widodo and Darmin Nasution, the economic coordinating minister. Getting along with the parliament is also important in the new democratic Indonesia.

Some commentators in Jakarta question Sri Mulyani's ability to work miracles or even adapt well to the compromise-laden world of Indonesian politics. They recall the series of battles that led to her departure in 2010. She certainly made bitter enemies in parliament at that time, notably with then-kingpin Aburizal Bakrie, who led the powerful Golkar opposition. Her clashes with Bakrie were many. She pressured him to pay compensation for the 2006 Lapindo mud-slide, held up his attempt to take a large shareholding in Newmont's Nusa Tenggara copper/gold mine, was unhelpful when Bakrie's coal companies needed support during the 2008 global crisis, and pursued him over numerous tax issues.

The more lingering stain from that period was Sri Mulyani's decision to rescue Bank Century in 2008.

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This was a well-executed official take-over of a failing mid-sized bank, whose collapse would most likely have set off a depositor-run on a dozen or so banks that seemed to be in similar straitened circumstances during the global crisis. The bank rescue meant Indonesia avoided its own version of the Lehman crisis. As a result, Indonesia sailed through the global crisis with only a small dent in GDP growth; one of the few countries to do so.

But when powerful Indonesian politicians are out to get you, they can cause painful mischief. Sri Mulyani and others associated with the Century rescue were put through the parliamentary wringer, with the KPK (Corruption Eradication Committee) joining the action. All this got too much. Lacking the president's support in her tussle with Bakrie, she left to take up the plumb position in Washington.

Bakrie's wealth and power are now much-diminished and parliamentary allegiances have shifted. Sri Mulyani may find President Widodo, a civilian former-businessman, to be a more compatible boss than SBY, an ex-general who would have been used to subordinates following orders and must have found her forthright style disconcerting.

Fixing Indonesia's tax system is still a herculean task, and it is on her success here that she will be judged. She is off to a quick start, arranging a $13 billion downward revision to earlier unachievable tax revenue targets. But the substance – actually getting the revenue – is still in the future.

After the starring role played by technical economists in Indonesia's economic success during the Soeharto years, the successors to the 'Berkeley mafia' have seen their influence weakened in the post-1998 democracy-era. Sri Mulyani's return substantially enhances the macro-economic capacity of the cabinet. It should mean that the cabinet makes fewer macro-economic mistakes – and avoiding macro-mistakes is enough in itself to produce good growth outcomes. Structural issues are important too, but most of these are outside her domain.

How should we assess the 'power of one' to bring about reform? Raghuram Rajan demonstrated in his relatively short tenure as India's central bank governor that one person can make a big difference; jolting the overall decision-making climate in the right direction. But he ran into the same sort of entrenched parliamentary opposition that brought Sri Mulyani's earlier tenure as finance minister to an end.

The bible doesn't tell us what happened to the prodigal son after he returned home. Let's hope there is much more to come in the narrative of Sri Mulyani's return.

Photo courtesy of Fickr user World Bank


'IMF admits disastrous love affair with the euro led to immolation of Greece'.

So runs a press headline about the IMF Independent Evaluation Office (IEO)'s new report on the 2010 Greek crisis. It was already widely accepted that the IMF's handling of the crisis was badly flawed, so the IEO's report was more about providing careful detail, rather than startling revelation. Even so, it leaves tantalising gaps in the story and unresolved issues for future policy.

You could fill a library with the commentary on what went wrong (the IEO report gives a selection of references). The IMF itself has already issued a kind of mea culpa. Perhaps the best outsider's account is Paul Blustein's, because it goes beyond the technicalities and forecasts to cover the politics and draw out the conflicts, contradictions and unresolved issues within the IMF's operations. The IMF's Chief Economist Olivier Blanchard offered some rebuttal of these criticisms, but the judgment remains: the IMF should have done much better (a view clearly shared by the IEO report authors).

The report identifies weaknesses in pre-crisis surveillance: the IMF didn't see the crisis coming. Nor did anyone else, but this is the IMF's job (and it is well-placed, through its annual inspection visits). It failed to pick up the dramatic misstatement of Greece's budget deficit. When the new government came to power in October 2009, the deficit was revised from less than 4% of GDP to 12% (later turning out to be over 15%).

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More fundamentally, it shared the common misunderstanding that currency unions like the Eurozone could not have balance of payments problems (any more than one of the states of the United States of America could have a balance of payments problem). This missed the possibility that those who had funded Greece's external deficit (which was running at 15% of GDP) would suddenly start worrying about default: their debt was denominated in euros, but it was issued by Greece and so should not have been treated by financial markets as being more-or-less equivalent to German debt. 

The IMF staff treated the Eurozone as being special, so that even when serious problems were identified in Greece in October 2009, the IMF was not involved in the initial discussion within the European Union to sort it out. Five months later, the IMF was precipitated into becoming a major participant in the April 2010 rescue, contributing 'exceptionally large' funds amounting to nearly 15% of Greece's GDP and a record-breaking 3200 % of quota

It is the circumstances of this participation which raise the most serious questions. The IMF faced a familiar problem. Should Greece's creditors (who had made foolish investment decisions) be paid out by providing new rescue funds? If a country is experiencing a temporary liquidity problem, perhaps resulting from a market scare, it may make sense to do so. When market calm returns, the IMF loan is repaid and so too are the other creditors. But if the country has borrowed more than it can repay, providing new support funds just lets the existing creditors get their money back, unloading the problem onto the future. Greece was clearly a case of unsustainable debt.

The IMF's well-rehearsed approach to unsustainable debt was to require a rescheduling of existing debt (a 'haircut' that reduces the nominal value of the debt, a reduction of interest, or delayed payment). This has to be severe enough to make the new debt repayment profile credible to financial markets, so that they will go on lending to the country. These procedures were built into the IMF's operating rules in order to make it harder for political pressure to be brought to bear in the heat of a crisis.

But by the time the IMF become involved in the unfolding crisis, the European authorities had already decided that there would not be a 'bail-in' of creditors. Some were concerned that a 'bail-in' for Greek debt would cause contagion in other tottering countries in Europe's periphery (especially Spain and Italy). Others knew that much of the Greek debt was owed to European banks (especially in France and Germany) and a bail-in would tip some shaky foreign banks into insolvency.

The IMF management and staff, for its part, were only too ready to be involved despite the late invitation to the party. Dominique Strauss-Kahn, the Managing Director at the time, had presidential aspirations back in France and was thus eager to cooperate with his European colleagues. The staff liked the idea of having some serious operational work to do.

Exactly what happened to get the IMF to participate in the rescue under these unpropitious circumstances is still tantalisingly foggy. The IEO explicitly complains that it was not given all the relevant documents on what was a clear breakdown of proper governance. Operational confidentiality at the time was clearly justifiable, but six years later, what is being hidden? 

The outcome of this still-murky process is that the IMF management broke its own rules on debt sustainability, slipping this key change through its executive board in such a low-key manner that it was hardly noticed.

The rest, as they say, is history. Greece's debt was, indeed, unsustainable and a rescheduling took place in 2012, by which time many of the private creditors had been repaid in full. The debt burden was shifted to the European taxpayers and the debt profile is still unsustainable (awaiting a further restructuring). The main burden so far has fallen on the Greek people, with GDP falling by 25 % (the IMF program forecast a fall of just 10%) and unemployment rising to 25%. Once more, the private sector financiers have come out of a crisis better than they deserve.

What was a better approach? The IEO report offers a range of options which were not pursued (including the possibility that the IMF should have declined to participate unless its debt rescheduling requirements were met) and argues that, at least, these should have been explored as a matter of good governance. 

These issues are never clear-cut, especially in the heat of a crisis. The IMF argued in favour of bailing-in private creditors in the case of Ireland (Ireland and Portugal were also covered in the IEO report), but participated in the rescue even though Europe once again vetoed a bail-in. And that rescue worked out well. Some argue that the IMF participation in 2010 bought time for Europe to get its act together (by 2012, the European Central Bank would address the danger of contagion with the promise the 'do whatever it takes'). 

But it's hard to argue that all this ad-hocery leaves sovereign debt rescheduling in a good place. The IMF has now formalised its new view that it can lend, even when debt is judged to be unsustainable. Thus it will be under political pressure to step in to fund repayment to foreign creditors who should be held responsible for their own risky lending decisions. Combining this with the creditor-friendly outcome of the Argentinian sovereign debt resolution leaves the process in a mess. The IEO findings on IMF governance failings are just as concerning. Bureaucracies are always ready to widen their mandate ('mission creep') and the executive board, dominated by a few large shareholder countries, is no defense against political pressure. Recent big loans to Ukraine and Iraq, neither of which seems like a good economic risk, demonstrate the political input into IMF lending decisions.

Photo: Getty Images/Milos Bicanski


Many political pundits see widening income disparities as the key factor in the Brexit vote and associate these with a single cause — globalisation. There is no doubting that income distribution within individual countries has become more unequal in recent decades, but is globalisation the main culprit?

Thomas Piketty’s heavy-weight tome Capital in the Twenty-first Century had astonishing success because it rode the zeitgeist: everyone could see that those at the top of the pile were minting it — and flaunting it.  Piketty just gave chapter and verse to confirm this. But Piketty didn’t lay the blame on globalisation: his main cause was the patrimonial society, and if anything, globalisation should expose the fat cats to more competition.

The latest offering in the ongoing income-disparity debate is from the always-thoughtful McKinsey Global Institute: ‘Poorer than their parents? A new perspective on income inequality’. Whereas Piketty focused on the very top of the income pyramid, McKinsey looks at what has happened to the whole spectrum, income-group by income-group. In the six advanced countries studied in detail, two-thirds of income-groups had no increase in income during the decade 2005-2014. This is not quite the same as saying that individuals had no increase, because some people shifted between income-groups. But the message is clear: stagnant incomes were not confined to the poorest segment of society: middle-income groups also did badly.

The punch line is that this is the new normal. Gone are the days when just about everyone would be better off than their parents, with the promise of similar advances for their children. In the previous decade, almost all groups became better off.

The social implications are obvious. Social cohesion is much easier if people feel that things are getting better and, whatever life’s struggles, their children will be better off. This promise is now in question. This, surely, is a big part of the explanation for the Brexit discontent: anti-immigration was just the human manifestation. But what role did globalisation play?

This stagnation in low/middle incomes is, in itself, not a new story, but McKinsey disaggregates the generality to explain what happened, perhaps identifying the part played by globalisation.

First thing to note: there are big differences between countries. This is crucial: the dismal general picture may not be so inevitable if some countries have done much better than others. Almost everyone in Italy was in the ‘no better off’ group, while in Sweden only around 20% were in this category.

So why did some countries do better than others?

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The first clue is in the 2008 global financial crisis and its aftermath. All the countries studied had a recession and a slow recovery, but some handled this better than others. Italian GDP is now 8% lower than before the crisis. No surprise, then, that almost no-one in Italy is better off. Sweden instituted active policies to keep employment from falling after the crisis and avoided fiscal austerity and its GDP rose 15% over the decade, so there was a bigger GDP pie to go around.

Thus the first requirement in avoiding the bleak future foreseen by McKinsey is to dodge a recession and, if you have one, implement active policies to speed the recovery. Nothing very new here, but this provides half the explanation without mention of the current bête noir of ‘globalisation’.

Feeble GDP recovery, however, was not the only factor. Keeping with the comparison of Italy and Sweden, both had serious adverse demographic changes (fewer people of working age). Again, it’s hard to blame globalisation for this. But it’s also harder to correct through macro-policy, so the gloomy prognosis stands for countries with substantial population ageing and no political support for immigration. Sweden’s preparedness to accept refugee immigration will help it here.

In just about all countries the distributional problems were made more serious by structural changes which began much earlier. Wage-earners share of GDP has fallen by around 10 percentage points over the past 25 years. In the US, the fall in the wage share is about the same as the OECD average, but has been much sharper since around 2000.  In addition, prime-age men dropped out of the labour force.

Globalisation must explain some of this. China has become ‘manufacturer to the world’, displacing conventional manufacturing in advanced economies, and the well-paid, secure jobs it involved. McKinsey notes that between 1980 and 2010, competition for low- and medium-skill jobs became global, with 85 million workers in emerging economies joining the labour force in export-related activities. Global competition undercut labour’s bargaining position and diminished the opportunity for industry ‘rent seeking’ in protected industries, which had often benefited unionised labour. Union membership fell just about everywhere.

But globalisation was not the only factor in the diminished wage share. The International Labour Office cites ‘financialisation’ as being at least as important — ‘sharp-pencil’ managerial pressures for greater productivity which weakened labour’s bargaining position. Globalisation might have put extra pressure on management for efficiency gains, but much of this pressure originated elsewhere, particularly from stronger shareholder pressure and economy-wide deregulation.

Earlier analysis had explained the falling wage share largely in terms of technological progress (smarter ways of doing things, with more sophisticated tools: robots replaced humans). The ILO gives this lower importance although the anecdotal evidence is compelling. Germany has retained a big manufacturing sector, but employment in manufacturing has fallen nearly as much as elsewhere. In any case, labour-shedding technological advance would have occurred even without globalisation.

The nature of production changed, with more low-income services, typically creating low-paid part-time jobs. So too investment changed, with Google and Facebook requiring little in the way of big factories with blue-clad workers bent over their machines. Whatever ill effect these seismic changes had on the demand for unskilled labour, it’s hard to blame globalisation.

In short, globalisation was not by any means the only factor, although it played an important role. The standard response is that more must be done to help those left behind. The McKinsey report fills in some important detail here. It may not be too surprising to learn that  tax/transfer policies helped overall income distribution in Sweden during this slow-growth period (so that almost no-one was worse off), but such policies did just as much in the US (e.g. through extension of unemployment benefit eligibility). Before taxes and transfers, 80% of the income-groups had no increase in income, but after tax and transfers, this fell to 20%. Thus redistributive measures have been important in softening the greater income disparity, even in free-market America.

So what are the lessons?

First, don’t have a financial crisis. The optimistic interpretation of this period is that the crisis was the result of clearly identifiable mistakes (inadequate prudential supervision of finance which allowed an asset bubble to form in fragile and overextended financial sectors in the main advanced economies). Competent policy would avoid repeating these mistakes.

Second, use active counter-cyclical polices when necessary. The crisis-affected economies had a pathetically weak recovery, exacerbated in 2010 in Europe by the secondary crisis in the peripheral countries, whose debt problems reflected policy failure.

Third, GDP growth is needed if aspirations are to be met. Abandoning the huge benefits that globalisation has brought would be throwing out the baby with the bathwater. It’s hardly surprising that everyone understands that post-Brexit, the UK will still be a great outward-looking trading nation, because there is no sensible alternative. No-one is suggesting putting the Yorkshire journeymen back behind their hand-looms. But if the Trans Pacific Partnership is any indication, globalisation is under pressure in America.

There are lessons, too, about the best ways to soften the impact of globalisation (and technology). Tax/transfers are clearly part of the story, but there are limits to how far this can be pushed without distorting incentives. Mendicants don’t generally enjoy their status.  Better to find employment for those left behind, even subsidising this through negative income-tax. Industry policy may be making a comeback (see speeches by the new UK PM),   but governments have a bad record at picking winners, and the incentives need to be general rather than project-specific (the dead-end nature of our submarine project provides an example of what to avoid). Education is the key to offering life-enhancing progress up the ladder.

When there is enough perspective to evaluate Brexit objectively, it will be judged to have been a failure of politics to play its core role in reconciling different views — a triumph of emotion over rationality. And the nefarious side of globalisation will be seen as a minor blemish. Good policy can still deliver the social glue of equitable outcomes.

Photo courtesy of Flickr user Philipp Lücke

4 of 12 This post is part of a debate on South China Sea ruling

Tuesday's South China Sea adjudication demonstrates that the UNCLOS framework is totally unsuited to sorting out the complex conflicting claims in the South China Sea in a way that the relevant parties will accept. By effectively announcing the Philippines as winner and China as loser, the tribunal's finding is now the basis for empty point-scoring. There is zero chance that China will accept an outcome arrived at in this way. 

UNCLOS acknowledges the futility of this sort of process: the over-arching UNCLOS principle is that the parties involved should sort things out by mutual agreement. UNCLOS then blesses whatever they have agreed on, even if it doesn't fit precisely into UNCLOS norms. 

With the South China Sea, a complex multi-party solution will be needed rather than a few general rules-of-thumb and one-sided legal proceedings. The South China Sea disputes can't be resolved by lawyers in a distant court or some surveyor's equidistant lines on charts.

Before the disputing parties dig themselves into positions from which retreat is difficult, a different negotiating pathway needs to be opened up. The first step would be to bring all the parties together in a single negotiation forum. The obvious grouping is ASEAN and China (but not Taiwan, as it just raises too many side issues). ASEAN hasn't had the unity or resolve to do this so far and China has worked to keep its dealings on a bilateral basis. But with Indonesia now feeling pressured by China in the Natuna Sea and China rebuffed in The Hague, there just might be the chance for ASEAN to seize the initiative. If this really is an important issue, the core ASEAN countries can't let the weak peripheral members dictate continuing irrelevance.

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What would be the basis of this 'Outside-UNCLOS' framework? The starting-point is a recognition that 'win-win' is better than a contest with a winner and a loser. Economics can provide this win-win. The key is to seek out opportunities for economic collaboration rather than make futile efforts to draw definitive borders. The first element might be to postpone attempts at border demarcation until later – much later. The second is to identify the many economic opportunities which would arise if the area is not actively contested and to seek opportunities for joint development. These could be in fishing (sorting out the illegal fishing and sharing the area equitably), petroleum joint ventures, and undersea pipes and cables which become feasible and profitable when areas are developed jointly. Seabed and water column could be divided up or shared in innovative ways, which delivers something for each of the contesting participants. Revenue from petroleum exploitation could be divided between the relevant parties by negotiation. China's engineering expertise can find an outlet in these projects. The ADB and AIIB could provide favoured funding, recognising the many beneficial externalities that would result from joint projects. The local marine environment, under great threat, could be a big winner.

Working together, all parties would have some interests at stake which would be lost if they decide to go it alone. Each has to feel that the deal is more beneficial than the traditional confrontation, in which any economic development in the area will be contested physically and diplomatically. 

Does this sound a bit like the state of play in the Timor Sea? At the time when the CMATS Treaty was agreed in 2006, it was seen by both Australia and Timor-Leste as a way of moving forward to reap the economic benefits in the disputed area (in particular, proceeding with Greater Sunrise gas), with a revenue sharing that reflected negotiation rather than geography. Seabed was separated from water column (as it had been earlier with Indonesia), contrary to UNCLOS norms but allowing each country to have an ongoing interest in the disputed area. Maritime boundaries were put on hold for fifty years. 

Since then, Timor has become disenchanted with the Treaty, and strong nationalist feelings have put the benefits offered by CMATS beyond reach. But the historical precedent is there: countries can sit down and hammer out complex agreements well beyond the scope of UNCLOS. The key is to shift the negotiating priority away from delineating borders and towards the economic benefits that lie on the seabed and in the waters, waiting to be shared.

Photo: Getty Images/VCG


Standard & Poor's (one of the 'Big Three' credit rating agencies) has put Australia on negative watch, with a one in three chance that our rating will be downgraded before long. On the face of it, this sounds like a big deal that can only be avoided by budget-tightening actions (which the close election result has made less likely). There would be knock-on effects from a rating downgrade, the banks, for instance, have the same threat hanging over them, as their rating can't be higher than that of the government. 

But hang on a moment! Aren't these the same agencies that handed out AAA ratings to financiers that packaged up a bundle of dubious mortgages into a portfolio with fancy name (Collateralised Debt Obligations, or CDOs)? Wasn't this endorsement provided by the credit rating agencies in exchange for fat payments from the CDO-promoters? The Standard & Poor's character in The Big Short movie blurts out the rationale: 'if we don't give them the rating, they'll go to Moodys.'

Yes, these are exactly the same, although of course (just to confuse the investing public), those AAAs for CDOs weren't exactly the same as AAAs for government debt. For government debt, the credit rating agencies' record is, however, only marginally less misleading. S&P took away Greece's investment-grade rating months after Greece's budget cover-up (and inevitable debt disaster) became public in 2009.

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So why would anyone take any notice of credit rating agencies? Despite the portentous reporting that always accompanies such announcements, in practice financial markets don't take much notice. The US AAA downgrade in 2011 and Japan's downgrade in 2002 were treated by financial markets with total equanimity, with no detectable change in financial prices. Similarly, the S&P announcement last week was greeted with calm composure by financial markets. The news media cited the exchange rate and weaker equity prices when reporting the downgrades, but any impact was indistinguishable from the normal daily fluctuations. Financial markets make their own judgments about risk, without help from the credit rating agencies.

Why do governments routinely take these announcements so seriously, and respond by confirming that they are doing exactly what the credit rating agency recommends? Usually, it is just part of the political parlour game. Treasurers wants to draw attention to how brilliantly they are steering their national economies in a tumultuous world. They can justify unpopular proposals by asserting they are necessary to avoid the threatened downgrades. It would take a brave government to tell these agencies that they were entitled to their opinion, but that the government will not take any notice.

If the clear experience is that rating downgrades have an imperceptible effect on market prices (bonds, shares and the exchange rate), maybe we should just ignore all this brouhaha. But the credit rating agencies have had some malign influences, both overseas and in Australia.

Future historians may well give a harsh judgment on the macro-policy response to the 2008 financial crisis. Policy responded appropriately to the sharp downturn by easing monetary policy and providing fiscal stimulus (endorsed by G20 in London in 2009). But by 2010, a debt-paranoia set in. This was turned into panic by the collapse of the European periphery (led by Greece). Even countries that had no pressing need to get their debt down were pressured by all the international agencies (including credit rating agencies) to rein in their budget deficits, even though this meant strong headwinds for the recovery. Over time, agencies such as the IMF came to see that the contractionary effect of this fiscal consolidation (also known as 'austerity') had been underestimated. The IMF reversed its advice for countries that can fund their deficits easily (as all the big countries can, in a world where governments can borrow long-term almost without cost). 

Of course, the credit rating agencies were not single-handedly responsible for the 2008 crisis or the subsequent policy mistakes; they were just one cause and one voice among many. But they were on the wrong side of the argument then, and they may still be now. This debt fetish has produced nearly a decade of unbalanced macro-policy (monetary policy too loose, fiscal policy too tight). The result is a pathetically limp recovery in Europe, with unemployment still in double-digits today. Some countries realised the error after a few years (USA, Japan and UK) and quietly abandoned austerity. Their growth performance immediately improved.

You might wonder how Australia avoided this same mistake. After all, we've had the international agencies and the credit rating agencies telling us about debt and external deficit vulnerability forever. The secret of our comparative success is the bipartisan policy of promising to prioritise restoring the budget to surplus quickly, yet not actually doing it. The very characteristic that S&P complain about (failure to deliver on budget promises) is the masterstroke that allowed Australia to sail through the crisis without a recession and record a rate of growth twice that of the advanced economies. This higher GDP gives us capacity to shoulder the increased debt S&P frets about.

That said, there is a long-standing malign influence on Australia from the credit rating agencies' debt fixation. For the past few decades, state governments have lived in fear of a downgrade. This is not because it would change borrowing costs much; the impact would be tiny. The fear is the damage to political reputations; such has been the focus on ratings that any state government that seemed indifferent to downgrade would be lucky to survive beyond the next election. 

As a result, state governments have shifted to a form of infrastructure funding which is around twice as expensive as issuing their own bonds, without in any way making their underlying financial position any stronger. Sydney's desalination plant illustrates the issue. This was funded by 'selling' the newly-completed plant to an offshore fund, involving a thirty-year take-or-pay contract which gives the investor the same sort of security and cash-flow that they would have from holding a government bond (although, admittedly, without the liquidity of a government bond), and twice the return. This contract is not counted as government debt although it has the same characteristics: an obligation by the government to make debt-like payments over a long term. The government's financial position is actually weakened because of the higher funding cost.

Most financial institutions which were caught up in the blame-game of the post-2008 period have had to make painful changes since then. The credit rating agencies, however, seem to be Teflon-coated. Their opinion is still a central requirement of various official prudential processes; they still adjudicate on the critical distinction between funds which are 'investment grade' and those which are 'junk'.

Assessing the full import of a country's debt position is hugely complex. Australia currently holds an AAA rating because its performance (even with budget deficits and a perpetual substantial external deficit) has been consistently competent. Australian government debt is remarkably low by international standards (much lower than Canada, which is also rated AAA). 

Source: Australian Parliamentary Library

Of course Australia needs to live within its means, making sure that overseas borrowings increase our capacity to service those borrowings and putting in place measures which will strengthen the budget by removing anomalies. We can do this without the constant hectoring from agencies whose egregious misjudgments are still fresh in our memories.

It's time to stop genuflecting at the ratings altar.

Photo: Getty Images/Timur Emek


Sam Roggeveen reminds us that Brexit has spotlighted the political unpopularity of globalisation, immigration and the 'neoliberal' economic agenda. The politics of these issues is fraught, with strongly held opinions for and against each of these ideas. Yet economics is pretty clearly in favour of all three, at least as generalisations about complex issues. Why did the economic arguments gain so little traction in the UK debate? Closer to home, is Australian policy-making vulnerable to a populist political push based on these issues?

Let's try first to clear away the baggage surrounding the idea of 'Neoliberalism'. It has come to be used as a term of rhetorical abuse hurled by those on the left of the political spectrum at those on the right , just as 'socialist' is often used (at least in America) as an accusation rather than a description. The case in favour of market-based economies, as opposed to a centrally planned economy like the former Soviet Union, is no longer seriously debated. The clear-cut victory of the market didn't come out of either doctrinal wrangling or text-book analysis: central planning failed comprehensively wherever it was tried, including the rare cases where it still survives; Cuba and North Korea.

That said, this triumph of the market did not result in libertarian economies with minimalist government and little regulation. The same period of history that demonstrated the failure of central planning also demonstrated the inadequacy of the libertarian model. The 1930s depression showed that markets are not self-equilibrating and need quite a lot of government interference to work tolerably well. In the course of the last century, America (where the rhetoric of free markets is loudest) went from the age of the free-ranging robber barons (astonishingly successful if judged purely in economic terms) to the intrusive institutions and ubiquitous regulations of today.

There was another clear lesson from the post-WWII period: countries with very different degrees of government intervention (as measured, say, by the size of the public sector and the degree of regulation) can succeed equally well. Government-heavy Scandinavia has done as well as countries where the public sector is little more than half as large.

What about globalisation? Just as the empirical evidence is clear that market-based economies perform better than centrally planned economies, the Post-WWII experience shows that economies work better if they are open to interaction with the outside world. Even the big-government/high-taxing Scandinavians have made sure they remain deeply engaged and competitive in the outside world. For such a small country (just 10 million people), Sweden has substantial world brands (Ikea, Ericsson, Volvo, Astra/Zenica, Electrolux, H&M, Skype and Spotify, for example). The most dirigist economic planners (such as the amazingly-successful South Koreans) had international competitiveness as the key policy element driving dynamism and weeding out weak players.

The demonstrated benefits of globalisation just confirm a closely-related idea that economists have long promoted: free trade. This is one of the few ideas that economists agree on (with just a minimum of caveats). Countries should specialise in the things that they are good at, export these and import the things which others are better-suited to making. The benefits go well beyond the cloth-for-wine exchanges that Ricardo explained two centuries ago: exposure to foreign competition enhances dynamism. Productivity growth is always higher in the tradables sector than in the sheltered domestic sector.

Yet the public has never bought this argument. The benefit of being seamlessly connected to a large foreign market was the core of the 'Remain' argument: the Brexit losses predicted by the UK Treasury reflected a big hit to forecast productivity. A majority of voters remained unconvinced.

Perhaps this is because globalisation gets blamed for unemployment and increasing income-inequality. Read More

Competition from low-wage countries (notably China) is seen as hollowing-out manufacturing, with the loss of its well-paid jobs.

Certainly, China's transformation to become 'manufacturer to the world' put pressure on labour markets everywhere, although other factors — labour-saving technology and the decline of trade-union power — were probably more important in squeezing the labour share of GDP. But even if the direct effects on labour-share are small, globalisation doubtless has a down-side: global exposure involves doing things differently, sometimes with new firms replacing old. Success now depends on being sharper, perhaps working harder. The disruption is often painful and not everyone adapts.

In any case free trade certainly doesn't claim to make everyone better off: all it says is that the benefit to the country as a whole is sufficiently large so that the winners could compensate the losers, leaving some better off and no-one worse off. In Britain, however, instead of compensating the losers, the fruits were showered on a small high-profile elite who epitomise this brave new unequal world. Ostentatious income disparity, combined with a lacklustre recovery from the 2008 crisis, left many in the working class unimpressed by what globalisation had done for them.

Their search for scapegoats went further: to the EU's open-border immigration policy. Immigration illustrates the chasm between general economic principles and political reality. The overwhelming majority of economists favour market-based solutions in general, and yet you rarely hear advocacy for cross-border free labour markets. Economists know that this would be a futile argument, overwhelmed by politics. Since the US restrictions on immigration in the 1920s, no country has had free labour markets, open to all comers.

With the hard-working migrants from Eastern Europe already putting pressure on UK labour and the threat of greater numbers if Turks were allowed to join the flow, a gap opened up between those who benefited from EU migration freedoms (the cosmopolitan elite and the mobile young) and those who did not. In the lead-up to Brexit, the UK Treasury cited numerous studies showing that UK's immigration had been good for the economy and was a net-positive for the budget: in addition, it had not harmed the employment prospects of Britons. Some telling evidence: UK unemployment is historically quite low. Yet the public doesn't believe this: they are more swayed by the anecdotal evidence, from friends and the press, that Britons have been pushed into unemployment by the flood of Eastern Europeans. More anecdotal evidence gives credence to the widely-held view that social security benefits attract indigent immigrants who are a drain on the budget and a burden to society.

There was strong tension between the EU's eastward enlargement and the sensitivity of the immigration issue. There is not much an economist can say to mitigate this. It's up to the politicians to gauge what society will tolerate, with its diversity of perceived losers and beneficiaries. David Cameron tried to negotiate some migration amelioration in Brussels, but the fundamental tension remains between those who want a United States of Europe (where there cannot be constraints on internal migration), and Britain's vision of a more limited economics-based integration.

Dani Rodrik argues that there is a 'trilemma' that would constrain such a 'globalisation-lite' option. In his view, globalisation requires supra-national rules, which are incompatible with democratically-based national sovereignty. This draws the choices too starkly: a globalised world will have multiple layers of rules, some perforce global while other rules can reflect the idiosyncrasies of the local environment. It is true, however, that measures to soften the down-side of globalisation can undermine the upside, dampening incentives and leaving inefficient production in place. The answer is to devise tempering strategies which encourage flexibility and adaptation without ossifying existing production practices.

Ed Miliband, former UK Labour Party leader, argues that the political-right can't provide the offsets to inequality which successful globalisation needs: 'The right can't solve the problem of inequality because to do so would be to abandon too much of what they believe, from a belief in the small state to trickle-down economics.' Again, this may overstate the contradiction. 

What lessons are there for Australia? The success of Pauline Hanson's One Nation Party (with its strong anti-immigration baggage) and Nick Xenophon's team of industry protectionists demonstrate that the same issues resonate with some Australian voters. Australia's tough policy towards undocumented arrivals is now bipartisan, which has allowed the high rate of formal immigration to continue without much debate. Nick Xenophon may succeed in keeping South Australian steel production going, even though it has been made uneconomic by China's massive overcapacity. But this is a small distortion in the larger economy which continues to integrate with the outside world.

Despite Malcolm Turnbull's lauding of smaller government, freedom and entrepreneurship, both major parties have provided about the same level of government expenditure and much the same safety-net for those left behind by the modern world. Most of us can reconcile with equanimity the Prime Minister's theme-tune that 'there has never been a more exciting time to be an Australian' with the view that we are exposed to a world over which we have little control. After all, Australia has operated successfully in this volatile world environment without a recession for a quarter century and is adapting without drama to the end of the globalisation-induced resources cycle. In this exciting world, who misses John Howard's 'relaxed and comfortable'?

Photo courtesy of Flickr user Loic Lagarde

The Brexit referendum

A vote to leave would represent an immediate and profound shock to our economy. That shock would push our economy into a recession and lead to an increase in unemployment of around 500,000, GDP would be 3.6% smaller, average real wages would be lower, inflation higher, sterling weaker, house prices would be hit and public borrowing would rise compared with a vote to remain.

George Osborne, Chancellor of the Exchequer, May 2016.

The longer-term consequences are predicted to be even more parlous:

If we take as a central assumption that the UK would seek a negotiated bilateral agreement, like Canada has, the costs to Britain are clear. Based on the Treasury's estimates, our GDP would be 6.2% lower, families would be £4,300 worse off and our tax receipts would face an annual £36 billion black hole. This is more than a third of the NHS budget and equivalent to 8p on the basic rate of income tax.

George Osborne, April 2016.

And yet Britain has voted to leave.

As usual in economics, 'it all depends', but there is near unanimity that this will turn out badly for Britain's economy, even in the longer run when the shockwaves have dissipated. See the chart on page 24 of the IMF's assessment. The only positive prediction is from a cock-eyed optimist who sees Britain retaining the substance of its EU relationship, supplementing this with free-trade agreements with fast-growing economies, and a productivity burst resulting from deregulation.

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The main economic issues are:

  • trade
  • investment
  • regulation
  • fiscal costs of membership
  • immigration.

On trade, the starting point is that favoured access to a large nearby market should provide a clear advantage, and about half of Britain's exports currently go to Europe. Many economists are lukewarm about so-called 'free-trade agreements' and common markets as they distort trade and Britain is currently buying some EU goods which could be obtained more cheaply from a non-EU supplier. Let's not, however, make too much of this argument. The EU is a large market and the distortions are probably small (with the notable exception of agriculture — more later). Losing preferential tariff rates doesn't matter much because tariffs are generally low, but it will be painful to lose the seamless connectivity that a common market provides with its uniform regulations and procedures.

It might seem that Britain could negotiate a deal with the EU that retains its current access (as Norway has done). The EU may well be peeved about Britain's departure, but it is still in the EU's interest to maintain a larger trading block. The UK is much less important for Europe than Europe is for the UK (its exports to the UK amount to 3% of the EU GDP, compared to Britain's 13% of GDP from exports to Europe). That said, Europe would be better off with close integration with the UK. 

While economics doesn't stand in the way of this outcome, politics probably does. Norway has to abide by all the EU rules except fishing (an outcome was critically important to its economy), including immigration. Switzerland has negotiated largely-free access to the EU, but contributes to the EU budget, abides by EU rules and is a signatory to the Schengen immigration protocols; all without a vote in Brussels. With these precedents, it seems unlikely that the EU would provide the current degree of access without insisting on many of the existing obligations (including immigration) and fiscal contributions.

The main trade advantage which the UK has at the moment is the ease-of-doing-business which harmonisation of standards and protocols brings. Whatever the deal finally reached, it won't be as good as Britain has at present.

The EU currently has 60 FTAs (and even more under negotiation), with the likelihood that Britain will be excluded from these once it leaves. Where will Britain stand in the Transatlantic Trade and Investment Partnership (TTIP) currently under negotiation? Maybe there is a glimmer of hope here. The US aim is to make this type of high-level agreement the new model for global trade. If Britain could somehow tag along with these arrangements, the result might provide good access to Europe. But the TTIP is a long way off and in any case these broad rules and high level principles are far removed from the detailed harmonisation of the EU common market. 

Potentially just as serious is the impact on foreign investment into Britain. There is not much doubt that Britain has benefited very substantially from being the first choice as an investment destination for non-EU companies looking for easy access to the EU market. Similarly, EU firms find the global orientation of Britain's legal system and language attractive in their dealings with the outside world. This applies particularly to London's financial sector which accounts for 8% of UK GDP. Under the 'passport' system, financial transactions are seamless not just for travel, but for mutual acceptance of prudential regulation. Some of this financial business will shift to Frankfurt, Paris and other European cities. No wonder London voted overwhelmingly to stay!

The popular complaints are about over-regulation, with lots of risible anecdotes about requirements on the dimensions and shape of bananas and cucumbers. But Britain has managed to remain lightly regulated overall, including (most importantly) in the labour market. Derisory anecdotes are legion, but the reality of a globalised economy is that any exporter will have to meet foreign-designated specification (at a minimum, for biosecurity, product safety and rules-of-origin) if it wants to do business overseas. This won't change much. In any case, many of the most efficiency-sapping regulations are home-made (such as urban planning and building regulation). Britain could go its own way on issues such as the environment, but again there are powerful pressures to conform (not least from the domestic public). Thus, EU regulations will probably be replaced by similar domestic rules.

Won't Britain be freed from the undoubted inefficiency of the Common Agricultural Policy (where domestic farm production is sheltered by the highest tariff levels, around 20%)? Much of British agriculture is subsidised (Britain gets back around half of what it puts into funding the CAP) and wouldn't survive without subsidies. It is inevitable that the CAP subsidy will be replaced by a domestic one in the short term, and even in the longer term it will be hard to wean British farmers off their subsidies.

What about the burden of supporting the EU's budget, with all its bureaucracy and costly subsidies for Europe's poorer members? The net cost of EU membership to Britain is around 0.3% of its GDP: not small change, but not all that large either.

Even free-market economists understand there are political sensitivities when it comes to labour markets. Nevertheless, they generally see economic advantage in immigration. The IMF assessment (section 25) quotes a number of studies showing the positive impact of EU immigration on the UK. A growing labour force is usually thought of as a positive for an economy (for the counter example, think of the gloom associated with Japan's declining demographics). That said, the public generally doesn't like outsiders. Looking more closely at the composition, however, only about half of Britain's recent immigrants come from the EU, and these tend to be, in economic terms, the best immigrants; educated, young, mobile, hard-working, motivated, and often bringing special skills. If there is a political imperative to cut immigration, reducing the non-EU migrants could be done without leaving the EU.

From an economic perspective, Britain obtained an attractive deal within the EU. It isn't a member of the euro-zone (it kept its own currency), so it continues to have independence in monetary policy. It is not a member of Schengen, so it keeps control over its borders. It had to accept EU immigration, but this is a plus in economic terms, especially as Britain negotiated the right to restrict social security benefits for the newcomers. Its net membership cost is below average as a share of GDP. It negotiated specific exclusion from the inevitable costs of bailing out troubled EU members like Greece. The sometimes-weirdness of regulatory burden is a source of endless amusement, but is a serious issue only for doctrinaire libertarians; an increasingly globalised economy requires more regulation at a supra-national level. Britain's natural advantages of language and law meant that it could dominate Europe's finance industry and that led to lots of high-paying jobs.

Thus from an economic viewpoint, Brexit is inexplicable. Does it make more sense in a longer timeframe? If the 'Europe' project is moving inexorably towards a huge country called 'Europe', with fully integrated budgetary policy involving large transfers to the poorer members, then the push-back is more understandable. Perhaps Britain's half-hearted integration (notably, its decision to stay outside the euro zone) was a forewarning that it wasn't a suitable candidate for the Europe project, and what happened last Thursday was inevitable at some stage.

Even if this were true as a longer-term trajectory for Britain, why not ride along for the benefits which remain to be gained for continuing membership? The economic case for remaining in the EU is so overwhelming that Brexit has to be counted as yet another case where the economic arguments never gained traction. Of course the economics may not turn out as badly as Chancellor Osborne predicted (he was, after all, a biased source). Financial markets hate uncertainty and always overreact. But what is indisputable is that the down-side risks facing the economies of both Britain and Europe have substantially increased.




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.