Lowy Institute

'Fight corruption!' A Corruption Eradication Commission event in Bandung in 2009. (Flickr/Ikhlasul Amal.)

Indonesia's reputation for corruption in not in doubt: it comes 114th out of 177 in Transparency International's ranking. For more than a decade, the Corruption Eradication Commission (KPK) has been putting high-level officials away for long jail terms. But any judicial body which boasts of having a 100% conviction rate is likely to have made some mistakes.

Having recently succeeded in putting the head of the Constitutional Court in prison for life and given lesser sentences to ministers close to President Susilo Bambang Yudhoyono, the KPK has returned to one of its long-term targets: the central bank. Since 1998, most of the senior members of Bank Indonesia have spent some time in jail or have survived long periods with this threat hanging over them. The causes have been various, but an ongoing issue has been the 2008 rescue of a failing bank, Bank Century. 

In the context of the global financial crisis, it was feared at that time that the collapse of even a smallish bank would set off a chain reaction of runs on banks. With Bank Century saved by the injection of lender-of-last-resort funds, Indonesia sailed through the 2008 crisis with GDP growth maintained at over 6%. Many would regard the support for Bank Century as an insurance premium well worth paying, especially recalling the damage of the 1997-98 financial crisis. 

But in any case the issue here is whether public servants should face criminal charges (and long jail sentences) when their policy decisions are harshly judged after the event.

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One member of the Bank Indonesia board (which made the decision to rescue Bank Century) has just been given a ten-year jail sentence. While his case is complicated by other factors, the KPK has indicated that it will now turn to the other members of the Bank Indonesia board*, including current Vice President Boediono (who was Bank Indonesia Governor in 2008) and one of president-elect Jokowi's suggested names for finance minister

The KPK has gone so far beyond its proper role here that 35 leading citizens — lawyers, former ministers, politicians — wrote an 'amicus curiae' ('friends of the court') letter to the KPK. Respected senior legal figure Todong Mulya Lubis said that 'If public policy is criminalised, many public officials will be afraid to take decisions'.

Indeed. It is already clear that Bank Indonesia will not attempt another lender-of-last-resort operation, should it be needed. Indonesia goes into a volatile period in global markets, with its own financial sector in a fragile state, without the most basic of crisis-management instruments. The new president begins his term with a commitment to combat corruption, but with the KPK already so politicised that an urgent task will be to discipline the KPK itself.

* Disclosure: some of these people are personal friends.

Photo by Flickr user Ikhlasul Amal.

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One of the messages of John Edwards' Beyond the Boom is that Australia sailed through the 2008 crisis unscathed. As a result, Australia's GDP in 2013 was 16% higher than in 2007, while many of the G7 countries had barely regained their pre-crisis GDP level: the strongest rebound, in Canada, was only 8% above its 2007 GDP. These are feeble recoveries. The damage of the 2008 crisis is, however, even more serious and lasting than these figures suggest.

Economic recoveries usually involve a strong 'catch-up' component, when income grows much faster than its underlying trend rate. Workers and enterprises, unemployed during the downturn, are brought back into full production. Business cycles are often described as 'V' shaped. The implication is that that economies get back to their pre-downturn trend line.

There is growing evidence that this catch-up has not occurred during the present global recovery. The recovery is not a 'V'; it is a reversed 'J', never getting back to the old trend line.

One compelling study of the issue is provided by Johns Hopkins economist Larry Ball. Ball took the potential growth rate estimates made by the IMF and OECD in 2007 showing how each of the OECD economies could grow if running at full productive capacity. He then compared these 2007 potential growth trends with the similar potential growth trends shown in the latest OECD and IMF forecasts. The latest estimate is well below the 2007 estimate. He attributes the difference to the damaging effect of the 2008 global financial crisis. Here's how he summarises his results:

I find that the loss in potential output from the Great Recession varies greatly across countries, but is large in most cases. Based on current forecasts for 2015, the loss ranges from almost nothing in Switzerland and Australia to over 30% of potential output in Greece, Hungary, and Ireland. The average loss for the 23 countries, weighted by the sizes of their economies, is 8.4%.

This graph of the US (above), from the Congressional Budget Office (CBO), illustrates the point. The sharp downward break in actual GDP growth (the solid line) in 2008 has not been reversed. Eye-balling this as far forward as the actual data take us, it doesn't look like the US is getting back to its old trend line (the darker blue dash line) any time soon, or ever. The lighter blue dashed line shows the best current guess of where the potential growth trend lies.

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Nor are most of the other 22 OECD countries Ball examined doing any better. The current potential growth paths (as calculated by the IMF and the OECD) have fallen about as much as the actual fall in GDP during the recession. These countries are now on a permanently lower growth trajectory. Countries which suffered the biggest recessions (notably, the eurozone peripheral countries like Greece and Spain, but also eastern Europe) have lost the most in terms of potential growth.

Less marked examples of this phenomenon have occurred in the past, where a recession discourages investment and leaves a permanently smaller capital stock. Technological progress and innovation are less dynamic in downturns. Most notably, workers who lose their jobs adapt to worklessness and remain jobless either because they stop looking for work or take early retirement. Sometimes their sojourn in unemployment has diminished their skills. Those in education stay there longer, with little accumulation of work-relevant skills.

Iin the jargon, it's known as 'hysteresis', and as a result output never gets back to the original potential growth path. In the US, the participation rate — the proportion of working-age population either working or looking for work — has fallen from nearly 66% in 2007 to less than 63% now. 

The powerful lesson here is: 'don't have a recession and, if you have one, recover quickly'. If you want to see what lasting damage a serious recession does to potential output, look at Larry Ball's graphs for Ireland, Spain or Greece.

But the CBO graph shows that something else is happening: the new potential output trend is not only lower, it is also flatter than before. This takes us to a broader debate about 'secular stagnation'. For example, the US used to have a potential annual growth rate of around 3%. The CBO now thinks it is just over 2% and some estimates are lower still. Demographics are reducing the relative size of the workforce. Various other factors are adding to the fall in participation in the workforce. Productivity seems to be slower in many countries.

There are plenty of esoteric arguments among the cognoscenti about all of this, and plenty of room for differences of opinion. A sensible concept of GDP is hard enough to measure and predict, and productivity is harder still. Many of the huge benefits we receive from technology (not just new products, but quality improvements in old ones) come to us at little or no extra cost, and probably don't get fully measured in the national accounts. Perhaps some of those who have dropped out of the work force are enjoying their new-found leisure, which is not counted at all in GDP.

There is, however, no doubt that the 2008 crisis was hugely damaging, and the inability of most of the OECD countries to achieve a normal rapid recovery has left a deep and permanent scar on living standards. In Australia we missed this bullet, through a combination of competent policy and good luck. The Hanrahans, with their relentless gloom, should be reminded of this.

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Low global interest rates since the 2008 global financial crisis seem to provide an ideal opportunity for boosting infrastructure investment. Bond rates have been historically low, so many governments can borrow at less than the rate of inflation.

There is spare productive capacity in most advanced economies, but weighed down by a heavy legacy of debt, few advanced economies have been in a position to support their slack economies by expanding the stock of infrastructure. Emerging economies, less hobbled by debt, have seized the opportunity, but have their own constraints. This graph tells the story.The constraint for advanced economies has been an overload of government debt. Despite the strenuous efforts to get budget deficits down, deficits persist and thus debt continues to rise. Former US Treasury Secretary Larry Summers, worried about secular stagnation, sees infrastructure spending as a key response and cites a list of US infrastructure inadequacies. So far, debt concerns have overridden his argument.

The emerging economies, on the other hand, had quite low debt, and have used the opportunity to expand infrastructure spending, albeit from a low base. China, as usual, is a special case. Much of its expansion was in the form of a huge financial stimulus in 2009, to offset the global crisis. Other emerging economies didn't match China's expansion but have also boosted infrastructure funding.

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Most of this has been in the form of syndicated bank loans. Bank loans have the advantage of flexibility that suits the construction phase, but bonds are often a more appropriate form of longer-term infrastructure funding once the project is operational.  

Global financial markets, however, still have limited capacity to accommodate emerging economy bonds. Pricing anomalies are common. It's a puzzle why Indonesia has to pay 8% to borrow while Greece, with its dismal repayment record and patently unsustainable debt level, was able to issue 10-year bonds at 5%. More needs to be done, both by the national authorities and by financial markets (especially rating agencies), to develop these bond markets. The G20 may have something to say about this in November.

Of course there is a danger that low interest rates will encourage projects which aren't viable when funding costs return to normal. The Bank for International Settlements (the source of the graph above) is warning of the urgent need to shift interest rates back towards normal, with this sort of cheap-funding distortion in mind. No doubt there are white elephants among these projects. China is routinely mentioned in this context, but it seems pretty likely that Brazil has spent too much on football stadiums.

That said, the cost of the inevitable mistakes has to be weighed against the debilitating effect of inadequate infrastructure. Budget strictures are crimping maintenance in advanced economies, and most of the emerging economies (with the possible exception of China) have a long way to go before they have adequate infrastructure.

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Economic convergence — the potential for poorer countries to catch up with the richer countries — may be the most important economic narrative of the post-World War II era. More than a billion people have shifted out of extreme poverty, largely by adopting technology and techniques already practised in the advanced economies. Convergence is not, however, an automatic process, like water finding its level. Not all poor countries will experience convergence, and even those that do will not necessarily catch up all the way. A new OECD report sets out this story in detail.

Some previously poor countries have made it all the way to equaling (or even exceeding) per-capita incomes in wealthier OECD countries. Singapore and Hong Kong have clearly done so, and South Korea and Taiwan have gone most of the way. But some of the great success stories among the emerging economies still have a long way to go; despite three decades of stunning growth, China is still well behind. 

The OECD report asks this question: if these countries continued to grow as they have over the past decade or so, which ones would reach the average per-capita income level of the OECD countries by 2050? The graph above gives the answer: those countries below the 45-degree line are closing in on the OECD countries fast enough to overhaul them by 2050; those above the 45 degree line (the majority) aren't growing fast enough to do this.

Of course this is just one aspect of the story.

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For a start, these countries may not go on growing at the same rate in the future. China can't sustainably return to its 10% rate, while others might do better than they have so far. In any case, what's the big deal about equaling the OECD? Quite a few countries are not far from the 45-degree line and will get a good distance towards closing the gap. They might well regard that as 'near enough'.

Yet there is a huge difference between catching up to where OECD countries already are and pushing out the frontiers to where no country has gone before. 

How fast the rich countries grow from now on will depend on the pace of technological advancement, innovation and a whole raft of other unknowns. Some economists argue that the rate of future growth for advanced countries will be substantially slower than before.

For emerging economies, however, the prospects are clearer, and perhaps easier. The technology that can take them to higher income already exists. They just have to copy it. It's a matter of learning the techniques, applying them, educating the labour force and, above all, putting in place the necessary infrastructure and institutions. No easy task, but what has been done before can be done again. This graph shows how much potential there is for increasing productivity by closing some of the gap with the US.

The OECD is concerned that productivity increases derived from shifting people out of low-productivity industries (agriculture, for example) to higher-productivity industries (manufacturing) will soon be used up. It will be necessary to learn how to do things better within each industry. This is harder. But anyone who has sat in a Jakarta traffic jam or battled with the city's slow internet (only 15% of Indonesians have internet) knows the potential for dramatic improvement in the way business is done. Moreover, those who have experienced the world-class standards of a Jakarta five-star hotel know that it can be done.

Perhaps the most original message the report delivers is how much room there still is for the emerging economies to become more globally integrated (which is good for everyone's productivity). By 2060 non-OECD countries will account for three-quarters of world trade.

The promise of convergence was not that every poor country would become rich. Rather, the message was that it was possible to close the gap dramatically. That seems obvious enough now, but that was not the conventional wisdom in the post-World War II decades. Gunnar Myrdal's Asian Drama: an Enquiry into the Poverty of Nations was representative, and deeply pessimistic. The OECD report carries traces of this old-fashioned gloom (look at the title of that first graph above). But it also acknowledges that the path to higher living standards is open for the taking.

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Lowy Institute Paper

Debating Beyond the Boom

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'We'll all be rooned,' said Hanrahan, 'before the year is out.'  

Pessimism is a key part of the great Australian tradition, reflecting a history of booms and busts. It has infected the debate on the mining boom of the past decade. But how does it make sense to treat a once-in-a-century windfall of astonishing export prices as if we would have been better off without it? John Edwards' Beyond the Boom provides a much-needed antidote to this pessimism.

It's one thing for business leaders and journalists to put forward attention-grabbing gloom. But the hand-wringing has been shared by high-profile economists with rigorous analysis to back their views. John Edwards addresses this group with a detailed deconstruction of what the minerals boom has brought.

The starting point is an increase in our terms of trade, which is unprecedented in size and longevity. This triggered a four-fold increase in mining investment. Remarkably, these extraordinary changes did not unbalance the macro-economy. The economy grew at around its usual pace, inflation remained low and stable, wages have been restrained, and the current account actually improved.

To make sense of this successful balancing act, Edwards takes us through each of the components of the national accounts: income, expenditure and production. Mining investment increased, taking an extra 5% of GDP. This didn't push production beyond the limits of capacity because about half of this extra expenditure was channeled into additional imports. For the rest, there was some reallocation from other possible uses, particularly through restraint of consumption. The income component of the national accounts shows the background to this restraint. In the decade before the mining boom, households had gone on a spending spree, encouraged by booming housing prices. During the mining boom, they repented and saved, making room for some resources to shift into mining investment. 

Why were households so thrifty when the terms of trade delivered an enormous windfall to the economy?

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There is no doubt that the improvement in the terms of trade gave a huge boost to income, but by and large it was not Australians who benefited. The largest part of the increase in income went as profits to the mining companies, which are four-fifths foreign owned. Of course some went to mine workers, but mining is capital intensive and in any case the workers were wage earners, not equity participants in the huge windfall. Federal company tax on mining companies was limited by the favourable depreciation allowances that the miners were receiving on their huge new investment expenditures. Glencore-Xstrata (our largest coal exporter) has gone further, arranging its affairs so it pays no company tax in Australia.  

This skewed distribution of mining income may reconcile John Edwards' narrative with that of leading academic Bob Gregory. Professor Gregory calculates that the terms of trade increase boosted our income by a whopping 14%. He (and many of the rest of us) worried about what would happen when the terms of trade fell (as was inevitable). But if the greater part of the benefits have gone to the foreign miners, we won't miss what we never had. 

In fact, the terms of trade haven't fallen much so far, so the point has not been tested. But we might take a kind of perverse comfort from this paradox: Australians may have avoided the problem of the well-known 'resource curse' by giving a large part of the windfall to foreigners.

How did we avoid a blow-out of the current account deficit, which usually accompanies a boom? Export prices saved us. We didn't produce much more or export substantially more in terms of volume, but with iron ore and coal both fetching seven times their pre-boom price, enough foreign currency was being earned to keep the deficit from growing. Why didn't the huge profits show up as capital outflow? They did show up in the detailed accounts, but were offset in the aggregate figures as the miners funded most of their new investment by ploughing back their profits.

Edwards is clearly right in saying that things have turned out well enough for Australia so far (what other advanced economy has maintained 22 years of sustained growth?). Looking ahead, our prospects are good. We have ended up with a lot more investment (albeit, still predominantly foreign owned), with much more to come in the LNG industry. Additional export volumes are starting to flow (again, with much more to come from LNG). 

When the miners have used up their depreciation allowances, federal company tax will take around 14c in every dollar the miners produce and state royalties about six cents. Australian workers will receive nearly 20c. Australian shareholders own a fifth of the mining investment, and will get the benefits of this. In total, Australia will end up with around half of the long-term export income stream. 

In addition, we're well placed to benefit from China's ongoing expansion, when exports of high-end food and services (tourism, education, technical expertise) will keep exports growing even when iron ore demand slows. If the terms of trade fall back further (which is quite likely), most of the impact will be felt by the mine owners — mainly foreigners. The exchange rate will depreciate, increasing the competitiveness of non-mining sectors.

That said, could we have done better? And did we make any obvious mistakes? With hindsight, the most serious error was the failure to put in place a resource-rent tax that would capture a large share of the mining boom, as we had done earlier with petroleum and gas.

The belated effort to do so, when the boom was well underway, was an abject political failure. The miners, despite having billionaires as their spokespersons, were able to convince the public that if they were asked to pay a resource-rent tax, they would shift their investment to rival resource-rich countries. Rio Tinto's painful experiences dealing with the governments of these countries (with Simandou iron ore in Guinea, Riversdale coal in Mozambique and Oyu Tolgoi copper in Mongolia) were ignored as the CEO warned us that Australia was his largest sovereign risk. The Rudd resource-rent tax was renegotiated by the former BHP chairman, with predictable outcomes for expected tax revenue. The current government is removing even this feeble tax. Mining royalties, a state government domain, fall victim to special relationships and inter-state competition to attract projects.

If government had been able to get hold of more of the mining revenue, this would have opened up opportunities to address the other sore point of the resources boom: its effect in pushing up the exchange rate to levels uncompetitive for traditional industries, particularly manufacturing. The awkward consequence of big cyclical swings on mining prices is correspondingly big swings in the exchange rate. The Australian dollar was worth much less than 50c in 2001 and well over parity ten years later. An effective resource-rent tax could have funded a sovereign wealth fund (as has been done by many other resource-rich countries), to be used to counter cyclical swings in commodities. Perhaps some could have been put aside to soften resource depletion. The result would have been a lower exchange rate and a more balanced economy; perhaps less investment in mining, and more in a variety of other industries. 

In short, we had more than our share of the luck. We didn't blow the opportunity presented. We did well in macro-management of the boom. With better politics we could have done a lot better, but looking around the world, we've done better than most and we're well placed to keep up the good performance. John Edwards has set out this story with clarity and precision, providing the counter-case to the modern-day Hanrahans chanting 'we'll all be rooned'.

Photo by Flickr user josh.

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Sam Roggeveen yesterday showed us how much demand for coal has risen in Asia during this century. Now consider what the future will hold.

A recent joint publication from the International Energy Agency and the Economic Research Institute for ASEAN and East Asia forecasts what is in store for the ASEAN countries  over the next twenty years. The report covers everything from the variation in technical efficiency of burning coal, to fossil fuel subsidies (more than $50 billion a year).

These two graphs show a key message: that there is going to be a lot of coal burnt in our neighbourhood in the next twenty years. The first graph shows how much catching-up the ASEAN countries have ahead of them, starting as they do with per-capita electricity consumption only about one-seventh of OECD countries. As your income gets higher, you consume more electricity. The second graph shows estimates of how this will boost coal consumption much faster than other energy sources, because coal is cheapest.

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The long running Argentine debt-default saga has taken another step forward (or backwards, depending on your viewpoint). The US Supreme Court has ruled definitively against Argentina over 'sovereign immunity'. The ramifications, however, go far beyond Argentina.

Although sovereign debt restructuring falls outside the usual bankruptcy laws, a mix of formal and ad hoc processes have in the past facilitated some sort of resolution when countries are unable to repay. The Supreme Court's confirmation of earlier court decisions has brought informal voluntary resolution to an impasse.

Just as couples getting married do not typically plan for divorce and armies do not regularly practice retreats, financial contracts are made on the assumption that things will turn out well. But the existence of divorce and bankruptcy laws demonstrate that contracts do not always work out as hoped and the law must help to resolve the mess. Sovereign debt contracts, however, have no clear legal resolution methods when the sovereign says it can't pay: sovereign immunity restricts the legal recourse of the creditor.

The US courts have lost patience with sovereign immunity. The plaintiffs, a vulture fund that bought Argentine debt cheaply after the majority of creditors agreed in 2005 to a restructure, can now use the normal methods of debt recovery (such as threatening seizure of Argentine assets anywhere in the world) in order to get a better deal, perhaps even full repayment.

The International Monetary Fund, which has been struggling for more than a decade to find a sensible solution for sovereign debt restructuring, had this to say:

In essence, the US courts have interpreted a 'boiler plate provision' of these contracts (the pari passu clause) as requiring a sovereign debtor to make full payment on a defaulted claim (in this case, held by the secondary market purchaser) if it makes any payments on the restructured bonds. As discussed in the 2013 Board paper, the Argentine decisions, if upheld, would likely give holdout creditors greater leverage and make the debt restructuring process more complicated for two reasons. First, by allowing holdouts to interrupt the flow of payments to creditors who have participated in the restructuring, the decisions would likely discourage creditors from participating in a voluntary restructuring. Second, by offering holdouts a mechanism to extract recovery outside a voluntary debt exchange, the decisions would increase the risk that holdouts will multiply and creditors who are otherwise inclined to agree to a restructuring may be less likely to do so due to inter-creditor equity concerns. 

Other commentators have been more explicit on how unhelpful this court decision is:

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This new regime is based on the idea that dealing with a defaulted sovereign will become so risky and expensive that it is simply not worth it. As a result, the country will become a financial pariah, unable to do basic financial business outside its borders. In sum, the decisions leave the prevailing system for sovereign debt management badly shaken.  

It's understandable that Argentina gets little sympathy, and not just from the financial press (which is reporting all this with a tone of glee). The problem, however, lies in the implications beyond Argentina.

Just as individuals default, countries also reach a stage where they can't repay their debts in full. Simply insisting on the 'sanctity of contract' doesn't get us far in resolving the issues. The debt problem is usually as much the fault of the creditor as the debtor — remember all those Euro-periphery bonds that were bought at yields almost the same as Germany's? Sitting down to reach a practicable resolution makes sense. When the clear majority of the creditors have done exactly that, those who come along afterwards to buy the 'hold-out' debt at a heavily-discounted price and then act as if they should be paid in full shouldn't be surprised if they earn the title of 'vultures'.  

The damage is now done. Sovereign debt resolution can't be left in this unsatisfactory state. Europe provides many examples (Greece being the most prominent) of where the outstanding debt is clearly unsustainable and more restructuring is needed.

This presents a particular problem for the IMF. How can the IMF provide funds to rescue a stricken economy if these funds are then used to repay creditors who shouldn't have lent in the first place? A restructure of private debt ('bailing in the creditors') has to be the prior step. The Fund has struggled manfully (actually it was Anne Krueger who did the heavy lifting) to come up with a sensible solution, only to be frustrated by the Wall St proxies on the Fund's executive board.

Despite the large role played by sovereign debt in the 2008-2010 global financial crisis, this issue was not resolved consistently or satisfactorily. It's just possible that the dead-end of the US court decision may be the catalyst that gives the Fund the opportunity to get a sensible restructuring framework in place.

Photo by Flickr user marsmettnn tallahassee.

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Much of the mountain of commentary and analysis of the 2008 Great Recession has been either critical (Paul Krugman might be typical), or a self-interested defence (Tim Geithner and Larry Summers provide examples). Daniel Drezner's The System Worked is atypical in two respects: he was not a protagonist yet he thinks things turned out pretty well; and he comes at this issue from an international relations/political economy vantage point, rather than as an economist.

Of course all such judgments are relative. Drezner's main comparison is with the 1930s Great Depression. The core of the defence is that we didn't make as many mistakes or end up in such a parlous position. If this is the benchmark, it's easy enough to agree.

The main achievement is that the market-based globalised trading and finance system survived. Even though the initial fall in GDP and in world trade was worse this time round, the trajectory of trade didn't mimic the extended contractionary spiral of the 1930s (depicted in this famous graph). There was a surge in protectionism in 2008, but this was swiftly pin-pointed and largely wound back.

Nor did the GDP fall continue. International macro-policy coordination has been rare in history, but the G20-orchestrated fiscal stimulus in 2008-9 was an undoubted success.

The international cooperative framework not only survived (where the League of Nations didn't) but improved a bit. The G20 Leaders' meetings supplemented the G8 (although not superseding it). If the communiques are constructed of boiler-plate platitudes, the peer pressure of regular meetings is still a great advance on the failed 1933 London Conference. A start was made on fixing the governance deficiencies of the International Monetary Fund by enlarging the quotas of the emerging economies. Membership of the Basel-based finance-oriented arrangements was similarly enlarged.

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The 'international received wisdom' improved a bit. The core of the Washington Consensus (market-oriented globally open policies) survived and was improved by softening its doctrinal insistence on free capital flows. More inward-looking alternatives (the 'Beijing Consensus') didn't get any traction, even in China. Balkanising alternative forums such as BRICS (invented as a Goldman Sachs marketing ploy) are fumbling for substance.

There were complaints about 'currency wars', but exchange rates remained market-determined and volatility was not excessive. The US dollar retained its key role and underlined this with the swift provision of currency-swap facilities between major central banks to assure the flow of international finance. Perhaps in response to international pressure, China allowed its exchange rate to appreciate markedly and its huge current account surplus to shrink.

If the World Trade Organisation has not been able to make much progress, the so-called free-trade agreements compensate for this. If 2008 revealed the inadequacies of the international financial rules, significantly tougher rules (Basel III) were devised in record time (two years).

Drezner is so surprised by this list of successes that he trawls through the political economy and international-relations literature for some explanation. Was it a result of interest groups pushing their own agenda, for the good of all? Are there now more people who directly benefit from open-market globalisation? Have the vested interests which emasculated earlier attempts at global rule-making for banks (Basel I and Basel II) been neutralised in the Basel III rules, which not only toughened capital requirement but will introduce a liquidity requirement?

Was the success a reflection of the continuing hegemonic role of the US in maintaining a globalised system? This ongoing US hegemonic leadership contrasts with the 1930s, when the UK was too weak to provide global leadership, while the US was unwilling to do so. Drezner notes that the rising power of China is not yet able to offer any convincing international global cooperative paradigm as an alternative to US-dollar-based open-market globalisation. China actually helped put the system back on track, with its huge stimulus in 2009, holding up world growth in the middle of a deep global recession.

In short, if you set the bar low enough — just to do better than in the 1930s — then you can have the satisfaction of clearing the hurdle.

Judged against the higher bar of what was possible, the assessment might be harsher. The recovery has been weak in all the advanced economies (UK GDP is only just back to the 2007 level). The global collective fiscal stimulus was stopped too early. Europe mistakenly tightened fiscal and monetary policy in 2011. QE is a measure of monetary policy desperation, with as yet unclear longer-term effects. Policy incompetence in a tiny economy like Greece was allowed to trigger contagion and depression in the European peripheral countries, leaving an unsustainable debt burden unresolved.

The World Trade Organisation seems unable to make any substantive progress. Basel III might be an improvement (when it is eventually implemented, towards the end of the decade) but the international financial sector is still top-heavy with risky transactions of doubtful benefit to society. The incomplete IMF governance reforms are woefully inadequate, still vigorously resisted by Europe and awaiting US Congressional blessing. The economic cooperation framework is fragmented between the G20 and G8, unable to adapt to a world where the like-minded G8 countries no longer dominate.

Drezner's analysis seems to confound policy issues with are intrinsically domestic with those which might, in an ideal world, be handled globally. The similar fiscal and monetary policies of 2009 were not so much a triumph of international policy coordination but rather were the coincidence of countries responding to a similar environment with similar policies. There is scant evidence that policies will be coordinated where interests differ, or when powerful domestic interests bring effective pressure to bear. Climate change, taxation, intellectual property rights and many other issues are still in the 'too hard' basket.

As Drezner notes, there are worse examples of international governance, topically demonstrated by FIFA's 'buffoonery'. But how much comfort should we take from knowing that international economic governance is better than FIFA?

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Economists are pretty hopeless at predicting sharp downturns, leaving them open to the sort of derision handed out by Tim Harford and reported by Sam Roggeveen. Actually, Harford went on to give us economists an excuse. Picking up Keynes' hope that economists would become simple technicians, such as dentists, Harford observes that we don't expect dentists to predict when our teeth will fall out – just to help stop it happening.

In fact, things aren't quite as bad as Harford makes out. If he had quoted his source more fully, he would have had to note that forecasters do see normal business recessions coming, although not far in advance. It's the big downturns associated with financial collapses that they miss altogether.

It's easy enough to see why. These are 'tail events', meaning they are quite rare. Economies routinely operate with many tail risks, but if you predict that the sky is falling every time you see a tail-risk problem, you will soon have neither credibility nor audience.

There is, however, more than meets the eye in the article Tim Harford quotes. The authors, both IMF economists, use 2009 (a deep recession associated with a financial crisis) as a definitive illustration of economists' forecast failings, giving Harford his storyline: 49 out of 77 economies were in recession in 2009, but in a large sample of economic forecasts made in the previous year, not even one recession was predicted. The conclusion is that all economists, whether private sector, official or from international institutions such as the IMF, are equally blameworthy.

Was it a coincidence that this IMF-authored article appeared at around the same time that a report examining the Fund's own forecasting record was published by the IMF Independent Evaluation Office (IEO), a body set up to assess the IMF's performance?

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The IEO made many of the same points about the challenge of forecasting. By and large, it assessed that the Fund forecasting performance was about the same as private-sector forecasters (in fact all forecasters tend to cluster together). But the IEO does make a substantive observation on the Fund's performance: 'they tended to be optimistic in high-profile cases characterized by exceptional access to IMF resources; these cases represented over eighty percent of the dollar amount of IMF resources disbursed.'

It's easy to see how this bias might happen (I have written on this in the past). In cases where the IMF has a substantial assistance program, it's awkward for policy-makers to predict a poor GDP outcome because it would raise the question: 'why don't you do something to make it better?' This is especially fraught when there are political constraints surrounding the assistance package: either it is too small to do the job properly or there has been disagreement about its terms. It would be unhelpful, to say the least, to deliver a dismal forecast at a moment like that. Unlike a weather forecast, an economic forecast can actually change the future.

Examples abound. At the end of 1997, when the Indonesian economy was already being swept into an economic maelstrom, the Fund continued to forecast positive growth. More recently, each of the European rescue operations has been accompanied by forecasts which were absurdly optimistic. How could those rescues, which stretched the limits of the Fund's lending powers, have gone ahead without such rosy outlooks?

Equally, it would have been unhelpful to the Fund's 2010 efforts to get countries to tighten their fiscal policies if the accompanying forecast had showed the recovery to be sluggish (which proved to be the case).

So Tim Harford has written a slick piece asking why economists bother to make forecasts. But the focus on the uniformity of forecast failure avoids the more serious point, made very gently in the IEO Report: it's one thing to be wrong randomly, but it is another to be wrong mostly on one side and in only certain circumstances. The Fund's forecasts are biased at exactly the time when it matters most for policy-makers to have a clear-eyed view. Whatever the answer to this quandary, Harford's article has nothing to offer.

Photo by Flickr user Allan Foster.

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I've just written on the widespread antipathy in Indonesia to foreign investment, and how it is colouring the presidential election campaign. I attributed this hostility to the historical experience of colonialism. Now the Lowy Institute's annual poll reminds us that a similar (if less pronounced) aversion also exists in Australia, without the excuse of centuries of foreign domination:

  • 60% of Australians oppose foreign investment in agriculture, ports and airports.
  • Smaller majorities oppose investment in Qantas (51%) and the National Broadband Network (52%).
  • Australians are divided on foreign investment in the resources sector (49% in favour, 48% against).

Will the foreigners do something harmful that Australian capitalists don't do? Do we gaze on green pastures filled with frolicking lambs and get a warm feeling from knowing they are owned by fellow Australians? Do we think foreign investment makes our economy more vulnerable to changes in foreign sentiment? Should we borrow more overseas rather than selling the farm (and the mine)?

The Lowy Poll doesn't shed much light on the deeper motivations behind the opinions. For better or for worse (probably the former), foreign investment policy is not determined by popular poll. But there are complex issues here, not least about whether the foreigners pay a fair share of the costs of running Australia; and whether a dominant investment position might possibly be translated into dominant influence on politics (in the way that the foreign-dominated mining sector managed to persuade the political system that the miners shouldn't pay a resource-rent tax).

What the Lowy Poll reminds us is that there has not been enough public debate to achieve the sort of support that should accompany these important policy choices.

Photo by Flickr user sofakingevil.

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Both Indonesian presidential candidates have taken a strongly nationalistic stance on foreign investment in their pre-election campaigning. When one of them takes office in October, will they be 'mugged by reality' and soften their stance? If not, how much does it matter?

When Indonesia achieved independence at the end of World War II, four hundred years of colonial domination weighed heavily on politics and public attitudes. Domestic opinion was unanimous that the Dutch had grown rich by exploiting Indonesia's vast natural wealth, leaving independent Indonesia in poverty. The first two decades of independence deepened this view, with foreign companies nationalised.

This changed in 1967, ushering in three decades of 7% annual growth. Foreign investment was not the sole factor in the transformation but was a key element, bringing investment funding, technology and access to foreign markets.

It would be wrong to see foreigners as having had open slather since 1967. Policy needed to accommodate the residual antipathy to foreign business. After 1967, state-owned enterprises still occupied the 'commanding heights' of the economy, and even today there is a 'negative list' of industries where foreigners are excluded.

The democratic era since 1998 has allowed greater opportunity for venting this suspicion of foreign exploitation. It was perhaps inevitable that, with the incumbent president not running (and therefore not defending the status quo), the two candidates would compete to exploit this sentiment. Whoever is elected next month is likely to be more nationalistic than his predecessors. The question is just how damaging this might be to Indonesia's growth prospects.

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The issues are illustrated by the current policy measures to restructure foreign investment in mining. This has always been a sensitive area. Even when foreign investment was first opened up in 1967, it was envisaged that foreign miners would relinquish some ownership to domestic parties (either government or private) over time.

In 2009 this was take a step further, with a law requiring miners to 'add value' to their production. This was to be implemented over time, and many foreign observers assumed the regulations would be softened. In 2012, a tax was also imposed on some ore exports. The crunch came in January this year, with export of nickel ore and bauxite (the ore that becomes aluminium) banned. Other ores (principally, copper) can be exported as ore for the moment, but with an export tax which will rise over time to a level where export will no longer be profitable.

What should we make of all this?

There is some damage to Indonesia's business-friendly reputation: the measures raise the risk perception and therefore the cost of attracting investment. Foreign investment is only around 2% of GDP. This is a small part of overall investment (which is well over 30% of GDP), but foreigners continue to provide the same dynamism and innovation that was instrumental in shaking Indonesia out of its basket-case languor in 1967.

More seriously, these measures seem unnecessarily damaging. It is easy to sympathise with the residual anti-colonial angst and to see today's foreign investors as their legatees (with their Indonesian partners as compradors, in the best Marxian tradition). But the measures will make some production uneconomic. Policy which leaves minerals in the ground doesn't help Indonesia's pressing problems. Nor does it make sense to prioritise high-capital/low-labour investments which have low returns (as these refining processes seem to have), in a country struggling to provide the necessary infrastructure (roads, ports, electricity) for the population at large. And it's not even as if these measures will shift ownership of mines or refineries into Indonesian hands.

In the longer run, the measures are of doubtful economic validity, and in the short run are clearly damaging to Indonesia's finely-balanced current-account position and budget. Moreover, there are much better ways to respond to the historical legacy of colonialism.

To maximise national benefits, Indonesia needs to own the most profitable parts of the process and ensure that the price is as high as the market will bear. For this, it needs a majority stake in the mine itself. Rather than a blanket requirement that all ores be processed domestically, the better policy would be to encourage the ones which lend themselves to domestic refining.

A resource-rent tax would achieve this far better than a blanket requirement for domestic processing. The experience since 2012 has shown there is capacity for existing mines to pay a super-tax. Mining is an industry with huge cyclical price fluctuations, and the tax regime should reflect this volatility, aimed at super-profits. These revenues could be used to buy back ownership, fund new mines or even establish new refining facilities, provided they are economically viable.

If Indonesian economists could devise such a rational plan and persuade the new president to adopt it, it would achieve a dual function. First, it would give Indonesia a growing stake in exploiting its own mineral resources, answering nationalist calls. Second, it would demonstrate that Indonesia's mineral policies are tough but rational.

Photo by Flickr user Randi Ang.

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Jokowi with his vice presidential running mate Jusuf Kalla (REUTERS/Stringer). 

With the Indonesian presidential race now reduced to two candidates, their economic programs are coming into sharper focus. The prospect is not reassuring.

Both Joko Widodo ('Jokowi') and Prabowo Subianto promise to be more dirigiste and inward looking. Jokowi, in particular, talks in terms of returning to Sukarno's concept of 'Trisakti', where the central economic principle is self-sufficiency ('standing on one's own feet'): 

In the economic field Indonesia must free itself from its deep dependence on foreign investment/capital/assistance and technology, and reliance on imports for food and other basic goods. Liberal economic policies which emphasise the market have left Indonesia dependent on foreign investment, while our natural resources have been drained away by multinational companies and their Indonesian compradors...The irony is that, for all its natural wealth, Indonesia still has to import foodstuffs...Food and energy security are two things that can't be bargained about any longer. 

This kind of language (check Das Kapital for 'compradors') has been absent from the mainstream Indonesian economic debate for 50 years, and with good reason. These are the policies that were implemented in the first two decades of independence, with abysmal results. Economic growth failed to keep up with population increase and by 1965 the economy was bankrupt.

In one of those unexpected disjunctures that history sometimes throws up, Soeharto — who might have been expected to favour command-and-control — delegated economic policy-making to a group of academic economists (the 'Berkley Mafia' or, more accurately, the 'technocrats'). Under the strong leadership of Professor Widjojo Nitisastro, they implemented sensible mainstream macro-economic policies (balanced budget, low inflation, small external imbalance) and encouraged a market-oriented environment. In the economic watershed of 1967, the economy was opened up to international commerce, with nationalised foreign companies returned to their former owners and new foreign investment welcomed. 

Thus began three decades of 7% annual growth which transformed the Indonesian economy and demonstrated that even basket cases could prosper, given competent macro-economic policies. Indonesia could have done better still with a less corrupt and more competent administration, but the absence of such things made it all the more important to rely on the market to determine prices and allocation wherever possible.

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These market-based policies, reliant on imported capital and technology to drive exports and facilitate labour-intensive manufacturing, pre-dated the formalisation of the Washington Consensus.They were, in fact, the forerunners which demonstrated its validity. The technocrats were not doctrinal free-market ideologues. State-owned enterprises still dominate the 'commanding heights' and the technocrats were ready to nudge the economy and soften the sharp edges of capitalism. But they had a well founded suspicion of too much state interference.

These market-oriented principles did not go unchallenged. Habibie's aircraft manufacturer and Ibnu Sutowo's Pertamina empire building were diversions from the Washington Consensus precepts. But by and large the technocrats ran policy in the Soeharto era, to Indonesia's huge benefit.

The post-1998 democratic era brought new challenges to good economic policy-making. Business vested interests and self-interested politicians found new opportunities to divert decision-making to their own advantage. Democracy created new imperatives for fundraising. Devolution of responsibilities to the regions diluted policy coherence.

Whenever these departures occurred, the results have been unhappy. When Australia's beef export ban paved the way for monopolistic import quotas, the process was subverted and abused. Foreign mining investors were required to increase local ownership, but finding the domestic capital has been problematic. The ban on exporting unprocessed mineral ores is undermining foreign exchange earnings. Bank ownership rules were tightened, leaving Indonesia with a financial sector lagging behind its regional peers.

Despite these departures, the core planks of globally open and market oriented policies have, until now, remained in place. The economy remains open to foreign investment. Widjojo's technocratic successors still hold most of the key economic portfolios.

Will Jokowi, if elected, turn the clock back and reinstate the failed policies of the 1950s? He comes from a practical business background and has shown himself to be an adept administrator. His vice presidential running mate, Jusuf Kalla, is deeply experienced in both business and politics. The bureaucracy, too, will exert some inertia to prevent policy slipping the wrong way too quickly. 

In the meantime, Jokowi may learn a key lesson of politics: good economics sometimes requires pre-election promises to be broken or at least re-interpreted. Perhaps Australia should offer some bipartisan technical assistance on how it's done.

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Tim Geithner's Stress Test: Reflections on Financial Crises will be read mainly for its take on the 2008 financial crisis, as the author was head of the New York Federal Reserve and then US Treasury Secretary during this dramatic period. But Geithner was also present at the scene of all the financial crises of the past twenty years (starting with Mexico in 1994). He should have something interesting to say about the common threads that run through them. What did he learn from the early ones that helped him handle 2008?

In this aspect, his book is a disappointment. It records the struggle of hard-working and talented bureaucrats (he is fawningly laudatory of nearly all his colleagues) striving to make the problematic world a better place, battling the forces of unstable financial markets and a recalcitrant Congress. But it is a Sisyphean task. If the early crises provided him with any lessons in 2008, Geithner doesn't draw them out. Each crisis is faced anew, with policy combining first principles with ad hocery to weave a path through the thicket of complexity, half blinded by the fog of war.

Others are dissecting Geithner's  narrative of recent events. I'll focus here is on the earlier episodes: Mexico and the Asian crisis. What might we learn?

  • When a financial crisis arrives, it's always bigger than previously experienced or anticipated. Mexico had an IMF quota of just US$2.6 billion as a crisis backup, but needed US$40-50 billion to restore confidence. 
  • Cobbling together this sort of support on the fly creates challenges and hostages to future policy-making. In putting together the Mexican rescue package, Congressional approval was bypassed. This so incensed Congress that the US had no funds to draw on when Thailand and Indonesia needed help in 1997. This didn't stop the US from taking the leading role in directing the rescue. For example, the US strongly opposed the formation of an Asian Monetary Fund which might have mobilised much greater funding from Japan, motivated by the self interest of channeling funds to its own ailing banks.
  • Financial markets are powerfully pro-cyclical, with ignorant over-confidence replaced by total funk in the blink of an eye. Contagion spreads quickly and widely. The Mexican 'Tequila Crisis' was felt in Brazil and Argentina. We saw this repeated in Greece and the European periphery in 2010.
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  • The success of the 1994 Mexican rescue was a victory for what Larry Summers called the economic version of the Powell Doctrine: decide who matters to you, and support the ones who matter with overwhelming resources. Mexico had just joined NAFTA, was a US neighbour (with potential for huge additional cross-border migrant flows) and was a test bed of the Washington Consensus market-oriented economic policies.
  • The Asian crisis may have been a demonstration of the economic Powell Doctrine too: Thailand and Indonesia received inadequate rescue packages, but South Korea (with 35,000 US troops on the ground) got an adequate package and additional measures (see next dot-point). But was the absence of the US in the Thai rescue (and the empty promise on the Indonesian pledge) simply an unfortunate consequence of Congressional anger at being bypassed on Mexico, or an application of the Powell doctrine? A clue may be found in the background comment of Ted Truman, US crisis veteran, on Indonesia: 'The quicker this f…ing regime goes, the better.' 
  • When you really want to help, ways can be found. IMF assistance to Korea easily broke all previous records, at 19 times its quota. Korea also required a US-orchestrated concerted standstill of foreign bank creditors, where foreign governments leaned on their home banks (including an Australian bank) to delay calling in the money owed, giving Korea crucial breathing space.
  • Doctrine has to be cast aside: the Korea standstill went against the strong antipathy towards any form of capital controls. Before the crisis, free-market advocates gave stern 'Old Testament' warnings about the dangers of 'moral hazard', the virtues of 'market discipline' and the logic of 'bailing in' creditors to punish foolish lenders. When the crisis arrives, these principles are cast aside with arguments about the 'least-worst solution' (this from Alan Greenspan, free market cheerleader). A rescue inevitably helps some who don't deserve it ('collateral beneficiaries'), often the very people who argued most vehemently against any interference in the market. 
  • 'Bailing in' creditors remains logically attractive but elusive in practice. When the crunch comes, the creditors are a vocal lobby. Their threat of spreading the contagion to other vulnerable situations usually wins the day (as it did so often in 2008). Was it a matter of high principle or Japanese self interest that prevented bail-in being a part of the Thai rescue? 
  • Geithner acknowledges that the fiscal lever was pushed the wrong way (towards more austerity) in the Asian crisis, but glosses over it as a minor issue. At the same time, he regrets that the US didn't 'sustain the initial power of the (fiscal) stimulus' after 2009. 
  • Similarly, no one would now repeat the sharp rise in interest rates and harsh tightening of liquidity that was a central plank of policy in 1997. Now the US can't get interest rates low enough and has to flood the financial system with liquidity through quantitative easing (QE). It is now acknowledged that trying to restore collapsing exchange rates with higher interest rates would be like trying to get the audience to return to a burning theatre by offering discount tickets.
  • We've come to understand that exchange rates, when under pressure, overshoot. We're ready now with intervention to support an overshooting exchange rate. We're even ready to weaken the exchange rate with QE, if that suits. 
  • Imposing economic reforms as part of rescues ('conditionality') is problematic. 'In general, crisis managers have to be careful about tying too many strings to emergency assistance', Geithner says. He says efforts to abolish the clove and cashew monopolies as part of the Indonesian rescue package were excessive. The nearest he comes to criticising one of his close colleagues is to say that David Lipton (now one of the most senior IMF officials) was 'playing General MacArthur, trying to reshape the Indonesian economy'.
  • When the crisis arrives, the safety net has to be drawn more widely. In Indonesia, the initial depositor guarantees covered only the banks which had already been closed. In 2008, just about everyone in the financial sector was covered.
  • Above all, the lesson is that it's cheaper to rescue than to clean up afterwards. Indonesia still bears the scars of the 1998 collapse.

Crisis rescue underwent a revolution during Geithner's time at the centre of the action. Mexico was the initial step towards expanding the scope and scale of the rescue process, which has now been extended to hopelessly insolvent countries (Greece in 2010) and to a country which seems to be in the process of dismemberment, the Ukraine.  How did we get here and where is this going? You won't learn the answers from Stress Test.

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Economists owe a debt of gratitude to Gary Becker, who passed away on 3 May 2014. In the words of his Nobel Prize citation, Becker 'extended the domain of microeconomic analysis to a wide range of human behavior and interaction, including non-market behavior'. Put more informally, he took economics into new places that are more fun, more popular and sometimes more relevant than much of mainstream economics.

Becker moved economics beyond the dry areas of national accounts and the balance of payments, applying its rigorous analytical techniques to both everyday problems such choosing a parking spot and to more important issues like discrimination. In doing this, he widened the range of issues where economists had something to say. 

For him, incentives were the driver of behaviour, and people made rational decisions in order to maximise their own welfare, widely defined. He accepted the analytical intransigence of the real world:

Behavior is driven by a much richer set of values and preferences….individuals maximize welfare as they conceive it, whether they be selfish, altruistic, loyal, spiteful, or masochistic...the past can exert a long shadow on attitudes and values.

He took on issues which seemed to be deeply embedded in social norms rather than economics. His work on crime and punishment illustrates this approach. Triggered by his own experience of taking a chance on being booked for parking illegally, he argued that criminals make a rational calculation about the probability of being caught, the severity of the likely punishment and the benefit from the crime. 

This illustrates both the strengths and weaknesses of his methodology.

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Yes, economics has something to say about decisions to commit a crime. But it's not possible to put all the complex motivation of serious crime (say, murder or rape) into the rational welfare-maximising framework. 

He didn't argue that upbringing and different standards of morality were unimportant — only that economic tools had something to offer on the subject. Economics could inform public policy decisions about whether to spend more money on enforcement or to raise penalties. Economics suggested that fines are often better than jail, as they helped government revenue rather than being a costly drain. But economics has little to say on important behavioural questions (does jail deter murderers and rapists?). 

Becker brought this same approach to a wide range of social issues, inserting economics into family affairs: births, marriages, and divorces could all be analysed in terms of incentives and rational maximisation of individual welfare. He wasn't the first to apply economics to the family. Malthus' pessimistic take on population was based on simple economics: fertility would rise and fall depending on income. Undeterred by the failure of Malthus' predictions, Becker brought the family back into the economic fold. Families were smaller now because the opportunity cost of child raising had risen. Families held together (or not) depending on the economic incentives.

Like most pioneers and proselytisers, Becker went too far in applying hard-edged market-oriented economics to areas which are deeply embedded in non-economic issues. Immigration, divorce, human capital formation, and crime all have elements that can be analysed in terms of rational decision making, but it is an incomplete and sometimes trivial narrative. 

He worked in the sharp-edged world of the University of Chicago, where the 'magic of the market' is gospel. This viewpoint (some would say bias) coloured some of his work. He argued that an efficient tax might turn out to be inefficient for society, because it encouraged inefficient government expenditure. Whatever its analytical merits, this view is reflected in the opposition of the US Republicans to a VAT (what Australians call a GST), on the grounds that it is too efficient in shifting resources to the government. 

His greatest legacy for economists might have been to shift economics onto the popular stage, opening up all sorts of entertaining topics like the incentives for cheating (not just in sumo wrestling, but in econometric regressions). Others followed. Steven Levitt and Stephen Dubner produced Freakonomics and Superfreakonomics.  The Undercover Economist (Tim Harford) followed suit, using economic principles to address problems such as the high cost of popcorn in cinemas.

Paradoxically, Becker's interests created a link to a branch of economics which emphasises the stunning complexity of human motivation and refutes the relevance of simple-minded rationality-based economics: behavioural economics. One of the leading practitioners, Daniel Khaneman, author of Thinking Fast and Slowwas on the board of Levitt's consulting company alongside Becker. They found common ground in being intrigued by the infinite variety of human behaviour.  One huge difference remained: Becker used the precise tools of mathematical economics to analyse situations which the behaviourists categorised as too complex, too inconsistent, too dependent on context or simply too quirky to be amenable to welfare-maximisation analysis.

Often society was just not ready for the insights he offered. Are we ready to auction off migration rights? Can higher divorce rates among poor people be satisfactorily explained in terms of the larger income losses faced by rich divorcees? Is theft bad just because it takes resources (guns and time) to steal, without adding to output?

It almost goes without saying that Becker trod on toes by trespassing on other disciplines and overstating the power and relevance of his approach. His analysis of family formation (why women bring up the kids while men earn the main income) might have been logically impeccable, but was seen as politically incorrect.

Society often resists rational ideas such as higher prices when demand is strong ('surge pricing' for taxis on Friday night) or market clearing prices for football tickets ('scalping'). Some saw Becker's take on human capital (where education is undertaken to improve income, rather than to elevate the mind) as another justification for salary income inequality on the basis that these differentials are merit-based.

Market failure was never part of the Becker analysis. But there is little doubt that his effort to bring precision to the fuzzy world influenced not only economics but other disciplines, and helped to illuminate the complexity of human behaviour.

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Rock-star economist Thomas Piketty is getting headlines for his book on income distribution,  mainly focused on disparities within advanced economies. This might be the moment to ride the wave of attention and record something of the long-running parallel narrative on emerging economies.

If Piketty’s message is a sobering one of inexorable trends making the rich even richer, there is a good-news story happening at the other end of the income distribution spectrum in emerging economies. In the last couple of decades, a billion people have been lifted from abject poverty to a modest but more adequate standard of living.

This is the convergence story: the astonishingly speedy catch-up of quite a few economies, reducing income disparities between these countries and the advanced economies. It took a century for the now-advanced economies to raise living standards to a respectable level. Many emerging economies are doing it in a few decades.

This astounding success story coexists, however, with a theme which mimics Piketty’s: the rise in living standards has been accompanied by a marked worsening income distribution within these countries, with the position of the uber-rich even more offensive because they are in the midst of those who remain close to destitution and those who have risen only just above abject poverty.

Development economists have for decades grappled with a question Piketty largely ignores: is unequal income distribution necessary for growth, either to provide the required savings or to provide the incentives for dynamic entrepreneurship?

It is obvious to Piketty (and most of his readers) that the wealth disparities seen in advanced economies are not the essential drivers of growth. Patrimonial wealth is not more dynamic than earned wealth. And after all, the three decades after World War II were not only a time of greater equality; they were also a time of strong growth.

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For emerging economies, however, the relationship between growth and income distribution has been much less clear-cut. 

The newly independent post-colonial governments often prioritised economic equality through state ownership, cooperatives and strong social programs. Whatever these approaches did for equality, they failed miserably in growth. Cuba illustrates the point. The response was a shift to more market-oriented arrangements, summarised in the Washington Consensus. The Consensus was often taken over by free-market ideologues with a conscious disregard for income-distribution. Their influence was, however, at the margin. The sensible middle ground has long accepted the importance of pro-poor policies and social programs to soften the sharp edges of the free market, even if this meant some cost in terms of slower growth.

Indonesia provides an example of this more nuanced debate. Three decades of 7% annual growth under Soeharto lifted a huge chunk of the population out of abject poverty (watch The Year of Living Dangerously to see what it was like in 1965). By accident or design, some elements of policy were hugely helpful for income distribution: for example, the emphasis on agricultural productivity, simple health facilities and family planning.

Subsequent governments have raised the level of anti-poverty rhetoric. According to the World Bank’s measure, poverty has halved over the last couple of decades. Sure, there is still a long way to go: more than 10% of the population is still below the poverty line and a further 40% teeters just a few cents above the cut-off.

Still, the emerging economy experience differs from Piketty’s. The rising tide has lifted nearly all boats.  Piketty's story is about the top 'one-percent'; the emerging economy central narrative is about the bottom half of the income distribution.

At the same time, however, at the other end of the income distribution, Piketty’s inequality symptoms are apparent. Through the first three or four decades of Indonesia’s economic progress, the Gini coefficient (one measure of inequality) remained pretty steady. But it has risen sharply over the past five or ten years. Judged by over-the-top conspicuous consumption, the deterioration has been going on much longer.

This has led some development economists to question the earlier view that some degree of income maldistribution is a necessary and acceptable price for strong growth. Perhaps inequality, rather than fostering savings and dynamic entrepreneurship, is just a manifestation of institutional failings which distort decisions and undermine growth. Established wealth seeks safety in traditional investment rather than funding innovation. Efforts are diverted into rent-seeking and influence-buying to preserve position. Because politics is an expensive business, the rich are able to buy influence in ways that are not only self-serving but also bad economics.

Piketty’s 700 pages represent just one more way-point in an unfinished journey. Even if the Piketty message is acknowledged in countries like Indonesia, fixing the problem is even more challenging than in advanced economies. It requires not just more efficient and progressive tax, but institutions which reduce the opportunities for rent-seeking and blatant misuse of position. In Indonesia, the post-1998 democracy has created huge opportunities for outright corruption and influence peddling. At the same time, it created powerful opportunities to combat these, via an open media and anti-corruption institutions. This narrative is currently being played out. It awaits the sort of data-driven analysis which Piketty provided for the advanced economies.

Image courtesy of Flickr user Le Rétroviseur.

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