Lowy Institute

A month ago, international trade was in the headlines. President Obama had just obtained Trade Promotion Authority for the Trans-Pacific Partnership (TPP), and in Australia, the China-Australia Free Trade Agreement (ChAFTA) was signed. But then all went quiet.

Trade Minister Andrew Robb.

The ministerial meeting in Hawaii that was supposed to finalise the details of TPP didn't reach full agreement. ChAFTA's passage through the Australian parliament is not without opposition. Both these initiatives, however, are still very much alive.

The TPP negotiations are being held behind closed doors, but there seem to be three problems:

  • Canada doesn't want to open up its milk market, while New Zealand (the world's biggest exporter of processed milk) sees this as an important issue.
  • In automobiles, the US wants better access to the Japanese market. Interaction between TPP and NAFTA rules are also complicating this trade.
  • The US pharmaceutical industry wants to keep its biologics testing results secret for 12 years, but Australia thinks five years would be enough.

There may be other issues as well (Australian sugar producers are still hoping to open up the US market), but these are the main stumbling blocks. None of them look insurmountable.  It's hard to see further protection for pharmaceuticals as a deal-breaker for Australia even though our trade minister has given assurances that the TPP will not undermine Australia's pharmaceutical benefits arrangements, a key component of social welfare.

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Nor will the deal be lost because of US-Japanese auto trade. Some observers would regard US manufacturers' hopes of shipping lots of cars to Japan as a conceit and a delusion. But even if there is substance in this trade-opening initiative, it's too small to stand in the way.

It seems just as unlikely that dairy trade will torpedo the agreement, although it might mean that Canada joins late (or New Zealand, as one of the initiators of the TPP, goes away very disappointed). It's just not substantive enough to stop the broad-reaching TPP from going forward.

Given Obama's high-profile commitment to the TPP and the need to put substance into the US rebalance to the Asia-Pacific, he is not going to lose this one without a very serious fight.

The wild card in all this is the US Congress. With the various delays, Congressional consideration is unlikely to take place until next year, while the presidential election is in full swing. There will be the usual Congressional histrionics in defence of local interests, and the vote could be lost, almost by accident. This is the main threat to the TPP. 

The pity of the current debate is that it largely misses the substance of the TPP. Most of this horse-trading has been old-fashioned guerrilla resistance to the longer-term inevitability of integrated global markets. The essence of the TPP is not in trade-opening measures (although they are present, of course), but rather in its effort to lay down a set of broad rules to cover general aspects of international trade, with intellectual property (IP) rights the most prominent. 

IP (and the other behind-the-border issues) are not the win-win issues which usually characterise reductions in global trade barriers. Instead, the rules around IP arbitrate the division of the benefits of innovation between owners and users – a zero-sum game. This should be settled not by an arm-wrestle between trade negotiators, but by a technical consideration of which rules offer the greatest incentives to ongoing innovation. Giving past inventors a monopoly may not be the best way to foster future innovation.

Australia's stand on pharmaceutical data secrecy is on the side of the angels. It's inefficient to keep testing data secret, because it ends up either lost to the wider community or duplicated by other researchers. But it's inconceivable that we would take our principled stance to the stage where we walked away from the negotiations. There is too much else at stake to want to infuriate the US over this issue.

If the TPP goes ahead, the outcome on these rule-setting issues (not just IP but also investor-state dispute settlement) will be a measure of how successful our negotiators have been. 

In the longer term, history may judge the most important issue to be the exclusion of China from the negotiations. Does this tactic allow a superior set of global trading rules to be put in place, with China coming to adopt these later, to everyone's benefit? Or will this turn out to be a missed opportunity to make China a responsible stakeholder in global economic infrastructure, helping to convince it that cooperation within such a framework is better than confrontation?

We don't know if Australia's negotiators ever explored this issue. But we now have the example of the Asian Infrastructure Investment Bank, which suggests that where China is blocked from full participation (as it has been in the IMF and World Bank), it seeks alternative arrangements where its role, for good or bad, will be exercised more individually.

Photo courtesy of Flickr user TPP Media Australia.

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An underlying theme of a recent Lowy Analysis paper (Trade Protectionism in Indonesia: Bad Times and Bad Policy) is that current Indonesian economic policy-making is refuting 'Sadli's Law': good times give rise to lazy populist economic policies while crisis times produce good policies.

Mohamad Sadli, a key member of the 'Berkeley Mafia' of economic technocrats who guided economic policy through much of the Soeharto era, certainly had enough economic ups-and-downs on which to base this insight. But in this Lowy Analysis, Arianto Patunru and Sjamsu Rahardja argue that politics has undermined Sadli's Law: bad times are producing bad policies. Will last week's cabinet reshuffle change this melancholy assessment?

On the surface, Susilo Bambang Yudhoyono's decade as president (2004-2014) seem to have provided some confirmation of the 'easy' phase of the Law: good times encouraged lackadaisical policy-making, with serious reform stuck in the 'too hard' tray. Indonesia's export commodity prices were strong and China's spectacular growth provided a ready market. The good times saw little progress  and even some slippage, through creeping interventionism and industry protection. More fundamental reforms (eg. in finance, the legal system, the bureaucracy and state-owned enterprises) were sidelined by immediate distractions. Indonesia's infrastructure shortfall went from poor to parlous.

But the policy environment has changed post-Soeharto, with democracy encouraging populist policies and self-interested parliamentarians limiting what a president can achieve. Was SBY's rather disappointing economic performance an example of Sadli's Law, or instead a reflection of this more difficult policy environment?

The real test of the Law comes when times are tough. Now, with the benign international environment of high commodity prices gone, where is the reforming policy response, emboldened by the urgency of the moment? Can the current economic ministers reprise the crisis-resolving reforms of the 1970s and 1980s?

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The differences with today's economic policy-making are profound. Then, the technocrats were a close-knit team with a clear leader who imposed a consistency of approach. For most of the Soeharto era, Widjojo Nitisastro was an influential advocate in cabinet for sensible economics. The technocrats operated in an environment (both in public opinion and among rival policy camps) deeply suspicious of so-called 'free-market liberalism' (a legacy of the colonial period), and yet by a combination of Javanese guile and force of argument, they were able to keep the economy open to foreign competition and foreign direct investment.

The technocrats demonstrated that if the big-picture macro-economics could be kept in reasonable order – with balanced budgets, small external deficits, restrained monetary policy and a competitive exchange rate – then the economy would operate quite well, even if many of the micro issues were far from ideal and much potential was left untapped. Crony capitalism, for all its unattractive and harmful effects, was still consistent with three decades of 7% annual growth.

Perhaps the greatest difference was that Soeharto trusted the technocrats and turned to them whenever the going was tough. Jokowi, the former businessman, seems to have confidence that running an economy is just like running a scaled-up business. There are many examples in the wider world where successful businesspeople believe that their skills are readily transferable to the economy as a whole. But skills in running a business are not readily transferrable to the overall economy. A key macro-economic insight distinguishes the business mindset from that of the economist : 'in the macro-economy, everything is connected to everything else'.

Rather than being guided by this macro view, current policies are essentially reacting in isolation to the latest problem as it emerges. The first response is to attempt to influence demand and supply in individual industries through subsidies and protection. Import quotas are tightened to protect domestic producers, then expanded again when supply shortages push up prices for consumers. Protection for one industry makes life harder for other industries and stifles dynamism.

The Jokowi presidency is less than a year old. Former finance minister Chatib Basri has suggested that all governments come to power with new ideas, and in time end up with the same old tried-and-true views. This is a version of 'mugged by reality', but there are many paths to bad policy, and new players can waste too much time exploring them. Some of Jokowi's Big Ideas, such as infrastructure and maritime development, make good sense if they can be well implemented. But Indonesia currently lacks the supporting bureaucracy and trustworthy legal system to deliver on this strategy.

What of the new economic ministers? It's true that the new economic coordinating minister, Darmin Nasution, has a wider policy-making background than his predecessor, having held senior roles in financial supervision, tax administration, and as governor of the central bank. But in the latter role, his interventionist policies in the foreign exchange market give him a much-criticised reputation for micro-management. The appointment of a former economic coordinating minister Rizal Ramli to coordinate maritime affairs should enliven cabinet meetings with verbal fireworks. His well-established reputation as a scatter-gun critic has already offended other cabinet members, who resent his interference in their territory (even if he may well be right).

Meanwhile, the economy is slowing but is still growing close to 5% (twice as fast as Australia). Maybe Indonesia will just muddle though, falling well short of its potential (and Jokowi's target of 7% growth). As usual, both the optimists and the pessimists will be disappointed that their predictions have not come to pass. One thing is clear: Sadli's Law is no longer operating.

Photo by Flickr user Ignatius Win Tanuwidjaja.

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Given the tragic history of East Timor, it is understandable that Senator Nick Xenophon should argue for an early and generous settlement of the Timor Gap border issues with East Timor. We are rich and they are poor. Current agreements do not draw the division between Australia and Timor equidistant between the two countries, as might seem equitable.

But, as I argued in an earlier post, it's not so simple.

First, this poor country has already accumulated a fund of almost $US17 billion from oil revenues from the existing petroleum agreements between our two countries. They can't effectively spend this money as fast as it is coming in. They receive 90% of the revenues from the Joint Petroleum Development Area (JPDA). If development of Greater Sunrise were to go ahead (with prospective returns often estimated at $40 billion), Timor would receive half the revenue under the existing agreement.

Is Timor entitled to more? If it is about geography, then you have to go to the charts. Drawing the southern edge of the border (running roughly east-west) so that it is equidistant between the two countries would not put Sunrise in Timor's territory, as 80% of Sunrise lies to the east to the JPDA. To get Sunrise into Timor territory, you would have to shift the eastern edge of the JPDA.

This edge of the JPDA is usually described as a 'simplified equidistant line between East Timor and Indonesia', and so there would seem to be no reason for shifting it. In the fraught history, however, there have been claims that it should be redrawn. The most extreme of these came from the Lowe opinion, provided in 2002 by lawyers retained by one of the firms which had been given exploration rights for this area by the Portuguese before they abandoned Timor in 1975. This legal opinion was an ambit opening bid, never taken seriously.

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The map which accompanies Senator Xenophon's article (shown above) also shifts this eastern border. It may be based on this 2006 article, which seems to be a biased source with arbitrary specification of boundaries – judge the article for yourself!

More recently, an American lawyer (sympathetic to the Timor position) has produced some beautiful Google Earth maps analysing possible borders, one of which puts 70% of Sunrise in Timor territory. But it depends on just where you start your eastern border. The critical point where this hypothetical border meets the Sunrise field is actually closer to Indonesia than to Timor, while the existing JPDA edge is about equidistant, as you would expect it to be.

Here is the dilemma: this border depends on East Timorese and Indonesian territory, not Australian. If you want to draw this border with a view to getting Sunrise into Timor's territory, you will surely open up the issue of Indonesia's border. It is certainly true that Sunrise is closer to Timor than it is to Australia, but it is closer to Indonesia than it is to Timor. Indonesia could well claim that the 1972 border was drawn under duress, at a time when Australia was strong and Indonesia was weak, and that it should be redrawn to reflect current UNCLOS norms. If that were to happen, it seems unlikely Indonesia would be ready to give 50% of Sunrise revenue to Timor.

Then there is the vexed issue of the continental shelf. A glance at any chart showing sea-depth (such as the DFAT map immediately above) reveals why the 1972 borders were drawn where they were: Australia has a well-defined continental shelf delimited in this region by a deep trench (the 'Timor Trough').

The continental shelf is still the basis of many international maritime borders, but where countries are less than 400 nautical miles apart, UNCLOS arbitrators have had such trouble with arguments about just where a continental shelf ends that they have taken the easy way out, routinely ignoring the continental shelf and settling on an equidistant border. This is presumably why Australia is reluctant to put this issue to international arbitration. And of course we are not the only country that sees UNCLOS arbitration as unsatisfactory. The US, for example, has not even ratified the agreement.

The continental shelf is not a trivial issue for Australia. This map (reproduced below) shows our sea-borders are largely based on the geography of our well-defined continental shelf, with special provisions for various off-shore 'rises' such as in the Antarctic. This approach has been blessed by the relevant UNCLOS Commission on the Limits of the Continental Shelf. Note, however, the yellow section relating to the JPDA. Drawing the border equidistant with Timor would be giving away an area which we have long regarded as part of our continental shelf.

What would be the result of accepting Senator Xenophon's argument? Replacing the southern edge of the JPDA with an equidistant border would make little difference to Timor's petroleum revenue, as they already get 90% of JPDA revenue. But it would give away a chunk of our continental shelf and might set precedents. Shifting the eastern boundary of the JPDA with the objective of giving Timor all of the potential Sunrise revenue (rather than the 50% in the existing agreement) would open up the border negotiations with Indonesia, with a good chance that Sunrise would end up in Indonesian territory, and Timor would get nothing.

Thus, Australia's core negotiating position seems sensible and easily defensible: we are ready to give Timor the greater part of the petroleum revenues from the disputed area (which would give Timor very substantial revenue for decades to come), but we are not ready to give away the continental shelf or open up the 1972 border agreement with Indonesia.

Unfortunately these negotiations have been seriously tainted by the ham-fisted actions of our intelligence operators, to our enormous disadvantage and shame. As former Foreign Minister Downer said: 'you didn't have to spy on the East Timorese to find out what their position was'. Senator Xenophon might usefully turn his prodigious energies to providing some proper oversight of the Inspector Clouseaus in our intelligence service. 

Ed. note: This article was originally published without the last section (beginning 'The continental shelf is not a trivial issue for Australia...'). We apologise for the error.

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Gareth Evans is usually credited with initiating the idea that the Indonesia-Australia relationship needed 'ballast' to keep it upright against the storms it inevitably encounters:

For many years now we have possessed what could be called common strategic interests. These interests are important, but they have not been enough to give ballast to the overly intense political relationship.

This powerful image has reappeared many times since 1988. But just what is the 'ballast', and how do we create enough of it to counterbalance the 'overly intense political relationship'?

There isn't just one answer or one approach. But one example, the ANU Indonesia Project, celebrated its 50th anniversary in Canberra last week. This well-attended celebration included the launch of Colin Brown's history of the project, Australia's Indonesia Project: 50 Years of Engagement.

Those thinking that the present strained juncture is the lowest point in the relationship might contemplate the unpropitious climate in 1965 when the Project was established. Laid out in Australia's Indonesia Project, the proposal that the economist Heinz Arndt put to the ANU vice chancellor stated:

There is an almost complete lack of the macro-economic data one normally takes for granted...The present government is unlikely to evince interest in, or facilitate, economic research or policy advice based on research. If political relations between Australia and Indonesia should further deteriorate, fieldwork, already difficult to organise on the outer islands, may become impracticable even in Java

Nor did the Project have support from academic colleagues, as outlined by Arndt: 'Everyone, almost everyone I consulted advised against the effort'. At the time, Indonesia's economy had collapsed. The currency was valueless, exports had shrunken, hyperinflation was rampant and the country was in default of its enormous foreign debt. Indonesia was about to experience the traumatic and drawn-out transition from Sukarno to Soeharto.

Nevertheless, Arndt went ahead.

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50 years later, the convivial anniversary was attended by three former Indonesian ministers (one of them also former vice-president), all alumni from ANU. The Project's academic journal – the Bulletin of Indonesian Economic Studies – has been published continuously three times a year. It's the best (perhaps the only) comprehensive record of the progress of the Indonesian economy from the basket-case days of the 1960s to a well-performing emerging economy with GDP within sight of overtaking Australia.

Perhaps the greatest insight of the Project's founders was their conviction that this should not be solely an Australian-oriented effort. It needed substantive Indonesian participation. The famous 'Berkeley Mafia' economists were all involved, many of them making regular trips to Canberra for project events. A strenuous effort was made to have Indonesians write in the Bulletin (Arndt's intrusive editorial hand bringing them up to scratch in the early days when drafts needed his ministrations).

Today the project is headed by an Indonesian. There are two annual lecture series in Indonesia (the Sadli lecture and the Hadi Soesastro lecture, both given in honour of Indonesians closely associated with the Project). The PhD students studying in the Project are almost exclusively Indonesian. Yet the centre of gravity remains ANU in Canberra.

The other great quality the Project brought was its emphasis on people. Arndt aimed to create 'not an institution, but a network'. The key task was getting people together to focus on the issues of Indonesian economic development. The reach was wide, with many visits to universities outside Jakarta. The central role of the annual Indonesia Update was not to write academic papers just to add to authors' CVs but to attract a crowd ready to learn more about Indonesia. A mini-version of the Update takes place every year at the Lowy Institute, bringing it to a different audience.

Much of Colin Brown's history records the struggle to fund the Project, especially as increasing demands for higher governance and accountability replaced the informal world in which the project had been born. The book usefully records the begging letters to Australia's aid agency pleading for funding – a reminder that this project could have ended several times during its life, never to be revived.

There has been plenty of Indonesian recognition of the Project's value as a source of research. One top Indonesian economist said 'It is ironic that the best institution...on the Indonesian economy is not in Indonesia but is to be found in Australia.' 

But evaluating its worth as 'ballast' in the relationship has proven harder and its value has often gone unrecognised. One of the regular reviewers noted that the Project's budget (less than A$1 million a year) 'represents significantly less than 1/10th of one percent of AusAID's country program in Indonesia. Effectively, the Project operates on a slender shoestring, while providing plenty of leverage for AusAID's money'.

Even in the tough current budget climate, the ANU Indonesia Project seems to have continuing support. But it's only one example of what is needed. The problem is not just funding. Colin Brown's book gives some indications of the critical need for energetic, resourceful, entrepreneurial people like Arndt and his successors. As usual, the luck of time and circumstance is also vital.

Another powerful image that has been invoked about Australia-Indonesia relations suggests we need to create spiderweb-like ties between our two countries. When the inevitable crises recur, these ties would flex, some would snap, but the relationship would be stabilised by those that held. Whether it is ballast or spiderweb ties, we need more.

Photo by Flickr user DFAT.

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Lowy Institute Paper

Debating Condemned to Crisis?

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Maybe it's just the title – Condemned to Crisis? – that gives Ken Ward's book such a downbeat despairing tone, as if the accident of geography has locked us in an unhappy marriage with Indonesia and there is not much we can do about it.

Of course we should be realistic: we won't ever have the sort of familial ties that we have with New Zealand. The intrinsic sensitivities will be more substantial than the petty sibling rivalries we have with our Kiwi brothers. But we don't have to accept serial crises as the norm.

In examining the history, we should separate the problems which were unavoidable from those which were 'unforced errors' or 'own goals'. We can avoid the latter by trying harder.

Ken spends a significant amount of time on the Bali Two. This was an intrinsic conflict-point that was never going to work out well. It was hard for Australia to run an 'in principle' argument against the death penalty, given our stance on the Bali Bombers a few years earlier. But it was an 'unforced error' to link this to the Aceh aid. Even if you knew nothing about how Indonesia might react, the fact that this argument had been put forward by Alan Jones should have been a caution.

The wider lesson here is that our politicians understandably ask themselves what the Australian public are likely to think: our politicians have less concern for the Indonesian public, who don't vote here. With a few notable exceptions, our politicians understand that there is a degree of xenophobia just below the surface in Australia (as everywhere) and the unwritten rule is that this should not be exploited just to win votes.

Is it too much to expect Australian politicians to go a little further, showing international sensitivity?

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Live cattle exports produced another 'unforced error'. The ABC video was horrifying. Why didn't the live cattle industry see this coming? Once the images had been aired, the proper answer was immediate consultations with the Indonesian authorities while putting exports on temporary hold, pending arrangements to ensure that the cattle would be treated humanely, if necessary in abattoirs funded by our exporters.

Eavesdropping on the President's wife demonstrated an abysmal lack of judgment on the part of our intelligence service. Our damage-control added insult to injury. Instead of quickly saying that we wouldn't do this sort of thing again, we used SBY's desire to deal with it quickly as an excuse for changing nothing

The problem in Australian intelligence seems more systemic. It needs a more active watchdog than it has at present, and a thorough analysis of just how much of this 'intelligence' is just juicy gossip and ephemera. Let's shift resources into conventional diplomacy.

Operation Sovereign Borders also needs tougher oversight. If we are concerned about our sovereign borders, why would Indonesians (with a more fraught history) be less sensitive? A simple GPS plotter, as carried by any recreational boat that ventures onto the open sea, shows where the border is and where your boat is. You can check the coordinates yourself. It wasn't just the Indonesian public that were sceptical that a 'modern Western navy had made repeated accidental incursions'.

Thus looking back, there was nothing inevitable about these mistakes. We could have done better. But what about the future?

The first step is sensitivity training all round. Next time a government does a deal to rotate US troops through Darwin, let's chat with Jakarta before we announce it.

This sensitivity-training might involve getting to know Indonesia better. Our media editors are more interested in titillating stories about Schappelle Corby than in helping Australians understand their near neighbor. When the chief editor of the national newspaper suggests that Indonesia is 'probably the most corrupt country on earth', you can see how big the challenge is.

Upgrading understanding is hard work, but we should identify the places where our interests impinge or even coincide, and turn these into opportunities. The Australian Federal Police built a deep relationship with its Indonesian counterpart, but it took substantial resources. Specialised assets such as the ANU Indonesia Project on economics (celebrating its 50th anniversary this week) has been run on a shoe-string budget, without the resources to build more widely on its peerless Indonesian contacts, or take its accumulated knowledge to a global audience.

The obvious potential friction-point is Papua (not much discussed by Ken). There will be well-meaning Australians who are shocked by what happens there, and will want to do something – most likely protest at least. NGOs will likely want to go. For their part, Indonesians have a lot of historical colonial baggage there. Whenever we say we want Papua to remain part of Indonesia, they think 'that's what you said about Timor'. What's our plan for handling this inevitable conflict-point?

The supposed wise heads in Canberra tell us that these little tiffs in the relationship are normal and quickly forgotten. This is wrong. The relationship is like a marriage, with accumulated never-forgotten slights. We did better in the past, retaining working diplomatic relationships during Konfrontasi while simultaneously fighting Indonesia in Borneo. This diplomatic dexterity made it possible to quickly build close relations after 1966. We need to try harder, and the starting point is to recognise that this is worth doing.

Photo courtesy of Flickr user U.S. Department of State.

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Further to my post on Hermann Abs' role in sorting out the debt of both Germany and Indonesia, there is a small historical footnote on the Indonesian debt negotiations which demonstrates that there was once a much more positive relationship between Jakarta and Canberra.

Some of the Sukarno-debt creditors opposed Australia's participation in the 1966 debt meeting, as we had no debt with Indonesia outstanding (our small aid program had been in the form of grants). These creditors thought Australia would be ready – perhaps too ready — to argue for debt forgiveness. The case had to be made that, as a provider of aid to Indonesia, we didn't want to see our money used simply to pay back creditors. This argument was accepted and, as predicted, our delegation spoke strongly for a generous debt outcome. This was duly noted with gratitude by the Indonesian delegation.

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Just about everyone agrees that the Greek problem has been kicked down the road again, and probably not even very far. 

The fantasy nature of the 'agreekment' is clear. Let's put to one side, for instance, a structural reform program which demands that Sunday be mandated as a work-day. This might remind some readers of a more joyful time in Greece, as portrayed in the 1960s film Never on Sunday: a gorgeous, fun-loving Greek prostitute, played by Melina Mercouri (who later became Greece's Minister for Culture), wants Sundays to herself. 

Let's just keep our minds on the debt.

German bankers Karl Klasen, Hermann Abs and Franz Heinrich Ulrich, 1967. (Wikipedia Commons.)

Coinciding with the latest agreement, the IMF announced that the debt is 'highly unsustainable' under the most optimistic forecasts. Even if demonstrated good behaviour earns the Greeks another round of debt tweaking, this sort of piecemeal rescheduling won't do the job. It leaves a persistent unpayable overhang that will act like a wet blanket on investment and growth. 

Many commentators (including rock-star economist Thomas Piketty) have made pointed references to Germany's debt history – not just to the lessons of Versailles but also the London Debt Agreement of 1953, which left Germany with a light debt burden (and, incidentally, no 'conditionality' to tell them how to revive their economy). The London Agreement recognised that the issue was not a moral one, but about capacity. Thus repayment was linked to Germany's trade surplus, giving everyone an interest in Germany's economic success.

There is a less well known, but even more relevant, historical link here. The German delegation at London was led by Hermann Abs, one of Germany's most illustrious bankers. Thirteen years later, it was Abs who was given the task of sorting out Indonesia's unpayable debt legacy resulting from President Sukarno's profligate expenditure.

Most of the money had been spent on Russian military hardware, but there were also substantial debts to Western countries and Japan.

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By 1966, Soeharto's 'New Order' was beginning to come to terms with the economic collapse. Inflation that year was around 1000%, the currency valueless, exports had collapsed and the foreign debts were in default. Abs was appointed mediator and persuaded the creditors that they would have to give generous debt rescheduling (not, it is worth noting, haircuts that diminished the nominal debt figure). The debt relief came in the form of rescheduling over 30 years interest-free and with the option of delaying the first eight years of repayments. 

It is worth noting that this result was not achieved in the first meeting. It took three time-consuming annual meetings before this long-term solution was reached, allowing Indonesian policymakers to devote their full attention to the economy. They did this with extraordinary success, aided by the supportive guidance of the IMF and the World Bank ('conditionality' hadn't yet been invented).

The Indonesians were also inventive in offering private sector creditors some value. They offered to swap debt for new investment expenditure and explored the possibility of debt-for-equity swaps. Foreign companies which had been nationalised under Sukarno were given back to the original owners.

This highlights the big difference between Indonesia in 1966 and Greece in 2015. In Indonesia, there was full agreement and 'buy-in' on what should be done, and the key objective was to get the economy functioning normally. There was also a realistic view of how much 'structural' reform could occur. The answer was 'not much'. Three decades later, when Indonesia got into trouble again during the Asian financial crisis, the IMF identified many still-unfixed structural faults: cronyism, inefficient state-owned enterprises, an ill-supervised banking system and of course the famous clove monopoly. But in 1966, it was enough to get the economy moving forward again at a brisk pace (7% per year for the next three decades).

Greece will need something like the solution Indonesia developed after 1966, although the poisonous negotiating climate makes it impossible for the moment. There are some similarities with Indonesia:

  • The money Greece borrowed has been largely wasted and so has not created any capacity to repay.  So it makes no sense to develop detailed time-profiles of debt-to-GDP ratios, as the debt will not be repaid. It makes even less sense to calculate the required budget surplus on the basis that this surplus is needed to repay the debt, when everyone knows it won't be repaid. Instead, the budget should be set to foster medium-term sustainable GDP growth.
  • The country involved has a small economy but is important in geopolitical terms, with Western creditors unwilling to see it drift under the influence of Russia.

What is missing in this case is assurance that the Greeks will do the necessary reforms. In the Indonesian case, there was full 'buy-in', although it was still a brave gamble; there was no guarantee that an army general and a few inexperienced academic economists could fix the mess.

Let's leave the last word on debt repayment to Hermann Abs, quoted towards the end of his long career in banking:

I remember speaking some years ago on the same platform to the Association of Young Bankers. "When I was a young banker," Abs said, "we were taught to ask two questions of any borrower: what is the loan for, and how will it be repaid? Today we know the answers without asking: the purpose of the loan is to repay an earlier debt, and it will be repaid by another loan."

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Now that Congress has provided President Obama with Trade Promotion Authority as we enter the last phase of the TPP negotiations, the treaty seems likely to go ahead. What is left for Australian authorities to think about?

While the TPP draft will come before the Australian parliament for consideration, by that stage there will not be much to ponder. The negotiations will have finished, and the decision will be 'take it or leave it'. We might ask ourselves, just as a thought experiment, whether the world might be better off without the TPP, or with a different TPP, but such options will not be on the table.

Whatever doubts we might have about aspects of the treaty, we should and will sign up. The TPP will create a 'club' of countries which give each other favoured treatment. To be left outside the club would be disadvantageous. 

This is a familiar position, given the ubiquity of these preferential trade agreements, whether bilateral (eg. the China-Australia Free Trade Agreement) or plurilateral (like the TPP). For example, once New Zealand milk producers had been given privileged access to China via their FTA, the sensible action for other milk suppliers was to try to do a preferential trade deal which would restore equal access. Is it any wonder that once the WTO's multilateral focus was eroded by these trade-distorting preferential agreements, the result was that we got more of them, each trying to get ahead of the competition and/or restore a competitive position?

Thus by the same logic, if the coming negotiations successfully settle the details, we should sign up to the TPP. In the meantime, there is still room for greater transparency which will at least tell the Australian public what is happening:

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For instance, DFAT might make public whatever side-deals and 'carve-outs' were done between the US and Japan in order to get Tokyo to sign on. Were our own producers (especially beef exporters) squeezed out in the process?

We should also be given a clear understanding of the intellectual property (IP) rules that might have changed, perhaps to our disadvantage. IP is complex. It's in Australia's interests to encourage global innovation, and for this, the innovators have to be rewarded. But by how much and in what way? The outcome makes a big difference to countries like Australia, which uses far more IP than it produces.

Take pharmaceuticals. We want the benefits of the latest technology and should be ready to pay for it. But it makes no economic sense to allow drug-testing results done by one firm to remain secret for years so that rival firms have to go to the expense and trouble of doing the same testing (unnecessary costs which are ultimately passed on to consumers). Let's hear if these kinds of inefficient rules are being protected by the TPP.

Will the TPP foster a continuation of the sort of manipulation seen in pharmaceuticals in the past, where minor product variations are given fresh protection as the existing patent nears its expiry, thus 'ever-greening' the flow of royalties from a single innovation?

The moment is not far away when it will no longer be tenable (if it ever was) to argue that negotiations are inconsistent with transparency. We will sign up, so why not set it all out? The pluses and the minuses, the failed negotiation ploys as well as the successful ones, the trade-offs that had to be made. It won't change the outcome for the TPP, but might put Australia in a better position for trade negotiations yet to come.

Photo courtesy of Flickr user TPP Media Australia.

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A Greeek solidarity rally in Madrid yesterday. (Flickr/Adolfo Lujan.)

The Greek people have delivered a resounding ‘no’ in the referendum, but the tragedy is still unfolding. It will take some time for the implications to evolve, but it’s hard to see how the vote helps achieve a resolution. The Greek people want to stay in the euro but don’t want austerity. The European negotiators and the IMF have neither the inclination nor the wiggle-room to agree. With the Greek banks closed, time is pressing. Leaving the euro would be hugely disruptive. Staying in the euro means a continuation of the failed policy of austerity. Thus Greece is in for a hard time. But how important is this for the rest of us?

Disruption in Greece doesn't help Europe's lacklustre recovery, but it's not big enough to do substantial harm – Greece is less than 2% of Europe's GDP. Moreover, most of the damage has already been done, notably in 2010 when the unfolding Greek crisis diverted budget policies in the advanced economies from expansion to austerity, thus derailing the post-2008 recovery.

The peripheral countries (Spain, Italy, Ireland and Portugal) that seemed so vulnerable to contagion when the crisis began in 2010 may have their financial markets tested, and the drama queens of financial markets will do their best to turn this into another opportunity for profit-making market volatility. But there is not enough substance here to keep such disruption going for long. The European Central Bank has the ability and means to handle any financial fall-out.

Some see this as the beginning of the end for the euro experiment. With Greece staring at departure, will others follow and the euro disintegrate into national currencies? This outcome would be some kind of wish-fulfillment for the euro-sceptics who dominate the UK press. But for all its challenges (past and future), the core countries of the euro have built up massive synergies and benefited enormously, both economically and politically. The degree of integration now accomplished will not be abandoned lightly. Greece was always an outlier, a misfit in economic structure and maturity. The parting would be painful, but will not unravel the euro.

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Greek public debt is not insubstantial (the part owed to Europeans is conservatively estimated at 3.3% of the Eurosystem's GDP), but almost all is now owed to governments or international agencies, which can wear the losses without dramatic impact on their economies. The IMF has already asserted (rather boldly) that 'the IMF's shareholders will not suffer losses'. 

What are the economic lessons? Countries can run budget deficits, overly-generous pension schemes, and large external deficits for decades if foreigners provide the funding, but there is no free lunch. Unsustainable policies eventually stop and the longer countries have been off-track, the longer it will take to fix. Living standards can't rise if productivity remains low. Incompetent and sometimes corrupt governance might get by when the economic climate is benign, but can't cope when problems arise.

These are the old lessons. What are the new ones?

There is a melancholy message about the political-economy of decision-making: even when there is a better path for crisis resolution available, politics can sometimes push events down a worse path, which none of the participants wanted. When the current Greek Government was elected early this year, there was an opportunity for a fresh start based on mutually held objectives. There was unanimity among the negotiators that staying in the euro was desirable. There was a common recognition that Greece could not repay its government debt (even after the 2012 restructure), although the creditors were politically constrained from acknowledging this in public. Similarly, there was implicit understanding by all that the austerity package imposed in 2012 needed to be softened.

Skillful negotiators would have found a formula to put the debt to one side, thus opening up the opportunity to shift from the budget austerity required to repay the debt towards a more growth-oriented policy package, emphasising the medium-term nature of the reforms needed.

This would have created an outcome all parties could accept: the debt would not be written off but would be extended, with modest payments in the near-term. This would not only suit Greece, but would have allowed a continuation of the fiction in the creditors' balance sheets that the debt was worth its face value. Greece would have shifted from an austerity strategy to one which addressed structural problems, but at a pace which allowed growth. Greece's feet needed to be held to the fire, but reform takes time when structural problems are so entrenched.

Alas, the negotiators did not have these skills. Just who let down the side will be hotly debated, but it looks like all parties were to blame, with the possible exception of the European Central Bank.

We will learn more about the mistakes of the European Commission and Greece as each participant attempts to shift the blame over coming months. But one thing is clear already: the International Monetary Fund played its cards badly and has lost both prestige and credibility. The Fund should not have become involved in the first place. This was a matter for the Eurosystem to sort out, just as federated states such as the US or Australia would resolve state debt without calling in the Fund.

Dominique Strauss-Kahn, the Fund Managing Director at the time the crisis began, wanted to restore the waning influence of the Fund and perhaps burnish his own political ambitions in Europe. Instead, the outcome has been to demonstrate the Fund's weaknesses:

  • Its Euro-centric governance structure over-rode its own rules and precedents to achieve a support program which at the time suited Europe.
  • It was unable to orchestrate a timely bail-in of excessive private-sector debt in 2010 (thus allowing the private-sector creditors to get off too lightly), or arrange a subsequent realistic restructuring of sovereign debt.
  • Its forecast of Greek GDP in the face of budget austerity was, as usual with these support programs, hopelessly optimistic.
  • It forgot the lessons of the disastrous Indonesian 1997-98 support program. The Fund's detailed involvement in the politically sensitive Greek pension reform seems to be on a par with its insistence on Indonesian petrol-price increases during the fraught political circumstances of 1998. The prerequisite for competitiveness reforms is reminiscent of the Fund's requirement to dismantle the Indonesian clove monopoly two decades earlier.

So much for the economics. Much less has been said about the strategic politics of what is unfolding. Greece's small size keeps the global economic consequences manageable but the same can't be said within the strategic context, where small problems can have large ramifications: 'For want of a nail, the battle was lost'.

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When we get enough perspective to write a balanced history of the 2008 global financial crisis and the subsequent feeble recovery, fiscal policy mistakes will surely feature largely in the narrative. In the form of a new IMF paper, we are beginning to see that history taking shape, and with it a clearer idea of what fiscal policy should have done.

After a bold start with the G20-coordinated fiscal stimulus of 2009, the Greek crisis at the end of that year (and the knock-on crises in Ireland, Spain, Italy and Portugal) shifted the focus onto excessive public debt. Instead of making a distinction between these grossly over-indebted countries and others in which the debt was easily sustainable, there was a universal shift to budget tightening in the advanced economies, urged on by all the international economic agencies – the IMF, the OECD and the Bank of International Settlements. The result of this fiscal austerity has been a pathetically weak recovery which has left per capita GDP in quite a few advanced countries not much higher than it was before the crisis, seven years ago.

Some of the IMF's most heterodox thinkers have now begun to make this distinction, which was missing in the rush to austerity in 2010. The full paper is here, but a more accessible version is here

To make sense of the complexity involved in fiscal policy, the authors separate the debt analysis from the heated debate about Keynesian stimulus versus fiscal austerity (whether budget deficits boost the economy through the usual Keynesian stimulatory effects, or alternatively whether a round of fiscal austerity would work better by boosting private sector confidence). Instead, they focus just on the debt.

Should countries that find themselves, post-crisis, with a substantial increase in debt make it a matter of priority to get this debt down?

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If a country pays down its debt, it has to do so by raising revenue or lowering spending, which will slow growth. On the other hand, once the debt is down, underlying growth will be faster because the cost of servicing debt will be a smaller burden on the economy. What's the trade-off here? The IMF authors argue that these two effects are equal, so there is no compelling reason to think that getting the debt down is a policy priority. As they say, 'When and only if countries have ample fiscal space, there is no need to obsess about paying down the debt. Living with the debt is likely to be the better policy.'

They offer the graph below, which identifies the countries with 'fiscal space'.  It's worth noting that in an international comparison, Australia's public debt level is modest and its fiscal space large. You might wonder why the political-economy narrative here is centred on getting the budget into surplus.

Not that this Fund paper is in itself a sufficient basis for policy. To start with, its analytical simplifications need to be taken into account. And there are many other aspects of fiscal policy that need to be considered.

Why not, for example, use the opportunity of low interest rates and spare productive capacity to issue more debt to fund socially profitable infrastructure? Such debt liabilities would then be balanced by the infrastructure assets. If the latter are well chosen, the government's net debt position is stronger, not weaker.

The fiscal rethink at the Fund is also exploring how to make automatic fiscal stabilisers work better so that governments don't simply spend the extra revenue that accrues to them in the cyclical upswing (or, more typically, offer vote-winning tax cuts), but instead put it aside to cover the fall in revenue and extra social expenditure that accompany the downturn of the cycle. The ABC's just-screened The Killing Season touched on the lamentable story of how we fumbled the opportunity to put in place the key element of strong automatic stabilisation in the form of a counter-cyclical super-tax on our minerals industry.

The influence of the Fund's analysis is strengthened because this rethink comes from such a fiscally conservative institution (it's often said that IMF really stands for 'it's mainly fiscal'). Better late than never.

Photo courtesy of Flickr user International Monetary Fund.

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Trade agreements were in the news last week. Australia signed the China-Australia Free Trade Agreement (Chafta), while the Trans-Pacific Partnership (TPP) struggled to achieve the required support in the US Congress. Both agreements include measures for investor-state dispute settlement (ISDS). What's at issue here?

In the Chafta, negotiated last year but only just signed, the ISDS provisions remain to be finalised by committee. Just what is entailed remains under wraps. Even in the case of the TPP (which is likely to get Congressional support, despite the current hiccups), the details are still not public.

It's easy to see why ISDS is a source of controversy. While the original intention of such clauses might have been to give foreign investors some protection when investing in countries with dodgy legal systems, ISDS provisions have been misused in attempts to give foreigners special treatment in opposing well supported domestic legislation. For example, Philip Morris is using an ISDS clause to attack Australia's Tobacco Plain Packaging Act.

In response, the then-Labor government said in 2011 that it wouldn't sign any further agreement that included ISDSs. The current Labor opposition says it doesn't support ISDSs, while the Greens oppose them. The Government has a 'case-by-case' approach. Some of our past agreements (eg. the Australia-US FTA) don't include ISDSs, while others do (The Korea –Australia FTA).

It's also easy to see potential for further misuse of ISDSs. The UN Conference on Trade and Development records around 50 disputes initiated annually in recent years, with a rising share (40%) initiated against developed countries.

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One case has been brought by the Swedish owner of a German nuclear power station affected by Germany's decision (after Fukushima) to phase out nuclear electricity generation. Two cases against Canada also involve environmental issues (regional bans on fracking and wind farms). When Australia eventually comes to grips with climate change, there are likely to be similar environmental disputes. What happens, for example, when Australia legislates to ban the burning of high-polluting brown coal? Will the foreign owners of Victoria's brown-coal generators be ready to accept Australian law as the final arbiter?

A transparent debate would be more helpful here than the generalised assurances given so far. Australia's High Court Chief Justice Robert French points the way, with academic lawyers and economists also expressing their concerns. Canada's G20-oriented Centre for Governance Innovation (CIGI) sees the issue as important enough to commission a research project compiling the current state of play of ISDS cases.

Where is the Government's substantive response? What is the case, in the Australian context, for giving foreigners more favoured treatment than domestic players? Negotiating tactics should not be an excuse for lack of transparency here: an open debate is just part of good governance. The Government should make the case why ISDS benefits Australia. ISDS is not something to be bargained away in exchange for some (probably ephemeral) export advantage.

Photo by Flickr user Chris Guy.

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'What's in a name?' Shakespeare's Juliet asks. Quite a lot, as things turned out for her. And so it is for the just-published proceedings of the ANU Indonesian Update, titled The Yudhoyono Presidency: Indonesia's Decade of Stability and Stagnation. A 'mini' version of the Update was held at the Lowy Institute, but this volume contains a much fuller record of the diverse opinions on the SBY years.

The title of the volume has triggered debate among both Indonesian commentators and the 'batik-shirt brigade' of Australian Indonesia watchers, some of whom see the word 'stagnation' as too harsh a judgment on SBY's decade as president.

Taken literally, both words – 'stability' and 'stagnation' – have the same meaning. But one is positive, the other negative. For many political scientists, it was not enough that SBY presided over a decade when democracy was maintained and strengthened (he implemented the policy of democratically elected heads of provinces, cities and districts; the Corruption Eradication Commission [KPK] also became operational during his term). Yudhoyono, says one contributor to the ANU volume, 'merely stabilised Indonesia's fragile democracy without ensuring that democracy became "the only game in town".'

Even at the start of his presidency, local cynics said SBY stood for Saya Belum Yakin ('I'm not sure'), and this proved to be a persistent criticism. He was a hesitator and vacillator.

This volume sets out SBY's own answer to the charge. He saw himself as a moderator 'leading a polity and a society characterized by deep divisions...he believed that his most important role was to moderate these divisions by mediating between the conflicting forces and interests to which they gave rise'. He was also a president with a multi-party parliament, an inherently difficult arrangement. In response, he maintained over-sized government coalitions whose internal differences he fuzzed over rather than resolved. This is what enabled him to maintain stability. It also explains the stagnation.

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Thus he failed to support the KPK at critical junctures, was weak on human rights in failing to protect minority religious groups, and failed to safeguard the budget from the enormous rise in petroleum subsidies during his second term. 'Yudhoyono's constant poring over the polls and thin skin for criticism often had a paralyzing effect on him'. But he achieved the Aceh peace accord and gave Indonesia a higher profile on the international stage, especially at the G20. Above all, he held the ship of state steady after the weak performances of Gus Dur and Megawati, his predecessors. In his own defence, he says: 

Whenever the winner takes all, it's harmful, there will be losers, and losers generally like to hit back and if that gets out of control, then it can be terrible. Ya, I must admit that I love to maintain balance, yes, the balance in life, in our country.

The economists who contributed to the volume, while acknowledging the shortcomings, give SBY a pass mark. He maintained 5% annual growth and lowered poverty rates.

The contrast with the Soeharto era is brought out in a volume coincidentally published at the same time: A Tribute to Ali Wardhana (available soon from Gramedia). Ali Wardhana was Indonesia's finance minister for a record-breaking 15 years (1968-83), followed by a decade as Coordinating Minister for the Economy.

It's hard to overstate the differences of policy-making style and environment between this period and the SBY years – 7% annual growth was maintained for three decades despite persistent shocks, both domestic and foreign. And this period was characterised by decisiveness. Two examples stand out. The first was the 50% currency devaluation in 1978, despite the strong current account. It was a path-breaking response to Indonesia's loss of international competitiveness as a result of the 1970s oil shock (the so-called 'Dutch disease'). The second example was the replacement of the entire (hopelessly corrupt) Indonesian customs service by a Swiss company to carry out the task of customs inspection. Not much of SBY's moderation and balance there.

Whatever the judgment on the words 'stability' and 'stagnation', the early days of the Jokowi regime provide plenty of room for a more generous and forgiving view of SBY. It's early days, but some commentators, both domestic and Australian, have already fallen out of love with President Jokowi. Perhaps both SBY and Jokowi suffer from the problem of overly optimistic initial expectations. 

Indonesia will always be judged as having missed many opportunities to do better. More than 50 years ago Clifford Geertz, a sympathetic observer of Indonesia, said: 'Indonesia at its base is an anthology of missed opportunities, a conservatory of squandered possibilities'. Yet for all this, the country has transformed radically for the better since then, both politically and economically, confounding the critics while disappointing the optimists.

With Australia-Indonesia relations at a nadir, The Yudhoyono Presidency is a must-read for anyone who thinks this relationship matters.

Photo courtesy of Flickr user AK Rockefeller.

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The unexpected policy failures associated with the 2008 global financial crisis have provoked soul-searching among macro-economists. The leading lights among the profession were at the International Monetary Fund's Rethinking Macro Policy conference in April. Olivier Blanchard, the widely admired IMF Chief Economist, encapsulated the state of the debate in his Ten Takeaways: Progress or Confusion? 

There is actually more agreement than might be implied by Blanchard's title – and more recognition of how far the conventional wisdom had to be changed to fit the evolving world.

Nowhere is this more evident than with international capital flows. Blanchard 'see(s) this as one area where the rethinking has been striking, compared to ten years ago'.

Indeed, ten years ago the Fund was urging countries to open up their capital accounts for foreign flows, unconstrained by any interference in the market. The promise was that the impact of volatile foreign flows would be ironed out with flexible exchange rates. The new consensus is that the effects of volatile capital flows are complex (impinging especially on the stability of the domestic financial sector) and can't be counter-balanced simply by exchange rate movements. In any case, exchange rates often overshoot, creating problems of their own.

So much for demolishing the old paradigm. Its policy implication was 'masterly inactivity' (leave it up to the market). Now the challenge is to formulate active policies which would address these newly perceived problems. There is less agreement here.

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Some see the all-purpose answer in macro-prudential policies: adjusting the financial regulation parameters according to the state of the cycle, imposing lending limits and extra capital requirements during the upswing and easing them in the downswing. Some older hands among the central bankers remember that this is what used to be done before the financial deregulation revolution of the 1980s. But extra constraints on the regulated financial sector cause the action to shift to the less regulated shadow banking sector (this process used to be called 'disintermediation'), leaving the economy still vulnerable to surges and retreats of foreign capital flows.

While not a consensus, the majority opinion now accepts the need for foreign exchange intervention (a no-no in the old world) and restrictions to help manage capital flows, but without any firm belief that this is a complete answer to the challenge.

All this may get a field-test before long, when global financial markets, already twitchy about the impending shift of US monetary policy away from its stance of extreme ease, finally have to respond to the reality of tightening.

As Paul Krugman often reminds his readers, anyone who followed the 1997-98 Asian crisis would have recognised the inadequacy of the free-market view of capital flows. It was only when the problems directly impinged on the advanced economies that mainstream economists (and the Fund) saw the need for rethinking. This process has been assisted by mavericks within the IMF such as Jonathan Ostry, and more recently by the high-profile evangelising of Helene Rey.

This was just one of Blanchard's ten 'takeaways'. We'll return to the other important shifts in policy thinking at a later date.

Photo by Flickr user IMF.

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The renminbi is still some distance from being an 'international currency', but it is moving fast in that direction, passing some important waypoints over recent months.

It's not exactly clear what being an 'international currency' means, but one aspect is whether the currency is included in the IMF's notional currency, the Special Drawing Rights.

China is pushing strongly on this. Central bank governor Zhou Xiaochuan made the case at the recent IMF meeting. Since then capital controls have been eased further, especially for outgoing capital flows, but Governor Zhou notes the lessons of the 1997-98 Asian crisis – that completely unregulated capital flows, with their surges and 'sudden stops', have caused great disruption. China intends to retain enough controls to avoid these pitfalls.

In practical terms, being included in the SDR basket is no big deal, but there would be considerable prestige involved, symbolising China's arrival at the epicentre of international transactions (the SDR currently includes just four currencies: the US dollar, the euro, the UK pound and the Japanese yen). The US is looking for more reform before the renminbi is included.

The pressure to have the renminbi included will continue when the 'SDR basket' comes up for its regular five-yearly reappraisal at the end of this year. The present focus is on capital account openness, but this is not the only criterion. The currency must also be 'freely available', which for China might mean a much deeper domestic bond market with greater foreign participation, as suggested here

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The IMF has also changed its tune on whether the renminbi is undervalued ('manipulated'), giving China extra international competitiveness. Again, the US is resisting this assessment, with the US Treasury maintaining that the strengthening has not been 'as fast or as much as is needed'. 

This debate, however, has lost its fervour. The Chinese current account surplus is now 2% rather than the 10% recorded in 2007; foreign exchange reserves are no longer growing; and the yuan has appreciated by 30% over the past decade. More recently it has maintained its value against an appreciating US dollar, which means it has lost competitiveness against just about everyone else. 

Even one-time renminbi warrior Ted Truman (a long-serving senior official at the US Treasury and the Federal Reserve) not only accepts that the renminbi is no longer 'manipulated', but also that if the US pushes too dogmatically on this issue (as is being done by his colleague at the Peterson Institute, Fred Bergsten), the US might have to acknowledge that its quantitative easing policies have also had the effect of enhancing US international competitiveness. 

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Thomas Piketty's Capital in the Twenty-first Century put inequality centre-stage in the economic debate. But the topic has been around for a long while. Brookings has recently republished Arthur Okun's 40 year-old Equality and Efficiency: The Big Trade-off, The launch was an opportunity to bring it up to date.

Okun set out the arguments which became the mainstream among economists for the next three decades, up until the global financial crisis of 2008. The key idea was that there was an trade-off between growth and equity. If you imposed high marginal tax rates on entrepreneurs, or set the minimum wage too high, or tried to fix inequality using the 'leaky bucket' of government tax-and-redistribute policies, you would pay a substantial price in terms of lower growth. In poorer countries, some would get rich while others lagged behind, but too much concern about how the national-income pie was sliced up would result in a smaller pie.

The failure of socialism, notably the collapse of the USSR, lent support to these views.

What's changed in four decades? First and foremost, the equal distribution of income in many economies, notably America, has become much worse. 40 years ago the consensus opinion was that income distribution was fairly constant, and rises in living standards had to come from growth rather than redistribution.

That's not how it has turned out.

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In America, the share of income received by the top 1% has gone from 8% in the 1970s to 20% today. It gets worse right at the top of the pyramid: the top 0.01% got 1% of the income while today they get 6%. As one analyst has said:

Okun pondered a trade-off between equality and efficiency just when those at the top of the wealth and income ladder began hauling off all the gains of economic growth.... When Okun was writing, the typical CEO earned about 25 times the typical worker. How could he know that today, they earn nearly 300 times the typical worker?

The wealth distribution has shifted even more than the income distribution:

Okun writes that the richest one percent of American families have about a third of all the wealth, and the bottom half hold about five percent.... [Today] the richest one percent have over 40 percent of the wealth, and the bottom half have only one percent.

This unpalatable reality is not all that's changed since Okun wrote. We have taken a more comprehensive view about what drives growth. There is now greater recognition that if substantial sections of the population are poorly equipped for the modern economy – either through poor education or constraints on social mobility – then the outcome will be low growth. It's all very well to make sure the top entrepreneurs have incentives, but when those lower in the distribution have no clear path for advancement, their incentives are damaged and growth suffers.

Others have been more pointed – and more political – in their criticism of how the rich got to be at the top of the pile. The free-market, regulation-reducing, tax-lowering policies begun in the Thatcher/Reagan period have boosted inequality more than growth. The economic elite have turned rent-seeking into an art form, exploiting the many distortions and monopolies in the economy. They have buttressed their favoured position by manipulating the political process. Their share of national income reflects their power rather than their productivity.

As if on cue, the OECD has produced another fascinating study contributing to the inequality debate: Why Less Inequality Benefits All (try the OECD's online survey to see how well you know the equality position in your own country). This focuses on the growth-constraining effects of leaving the poorest 40% of the population without adequate opportunities to realise their potential. Greater participation in the workforce by women has substantially helped income distribution, but there is a long way to go. Freeing up the labour market through more 'non-standard' jobs (ie. not a full-time permanent job) has created opportunities but also inequalities. 

The power of the OECD report is its international comparisons. When senior officials say we need to lower tax rates to foster growth, the refutation is in the counter-examples overseas.

What to do? We should accept that Okun identified issues which are still relevant today: 

  • Confiscatory rates of tax will dampen entrepreneurship and encourage capital and skills to move to lower-taxed jurisdictions. But the Scandinavian countries have demonstrated that it is possible to have high taxes and good growth. As a result, they lead all the indices of equality set out by the OECD.
  • It is possible to seriously damage an economy with excessive minimum wages, as we did in Australia in the 1970s. But Australia's current minimum wage is around twice America's, and so far this has been consistent with good growth and greater equality. Larry Summers notes that the US minimum wage in real terms is lower now than when Okun wrote his book.
  • While entrepreneurship needs to be fostered, it's hard to argue that the rewards needs to be as big (or as widely spread) as they have become. Salaries for top business people and financiers are more a reflection of relative pecking-order rather than necessary to reward talent. Again, Scandinavia shows the way.
  • The leaky bucket of government redistribution can be addressed intelligently, through focusing on social mobility (especially through education) and encouraging labour-market participation.

As well, there are clearly many opportunities to help both growth and equality at the same time. Better public transport is one example. While Piketty (and also Anthony B Atkinson) sound unworldly in their advocacy of 'tax-and-redistribute' policies, addressing tax evasion should not remain forever in the policy-makers' 'too hard' basket.

So much for the gloomy story of income distribution within countries. In the emerging economies, where income distribution is typically bad, the overall rate of growth has lifted a billion people out of abject poverty, with the process of convergence still leaving room for much more reduction in income inequalities between countries.

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