Lowy Institute

Sometimes a picture is worth a thousand words.

With the G20 focused on increasing economic growth, it's worth remembering where the global action is. The above graph from the IMF Multilateral Policy Issues Report, published in July, shows that the emerging economies have been doing the heavy lifting, at least as measured in purchasing power parity terms. There is a reminder here, as well, of how they carried global growth during the 2008-09 downturn following the financial crisis.

The October IMF World Economic Outlook is forecasting that the emerging economies will grow as fast in 2015 as they did in 2012 and 2013, so the red bars will be a bit bigger (their rapid growth makes them bulk larger in the global growth calculation). And our region ('emerging and developing Asia') is forecast to continue its steady 6 .5% growth.

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Economic forecasting is the butt of jokes, but someone has to do it. You can't make sensible macro policy without some view of how the economy will travel. It's the IMF's thankless job to be the high-profile forecaster for the globe. The Fund's latest World Economic Outlook acknowledges its recent forecasting errors, and offers an explanation.

It's one thing to get the forecast wrong. It's another to be consistently wrong in the same direction. Figure 3.1 from the the 2014 World Economic Outlook shows the story of the past four years.

The Fund says (see Box 1.5 here) that the main problems with its forecasts were 'serial disappointments in emerging markets'. In particular, it identified the BRICs (Brazil, Russia, India, China) as the main issue (where the Fund missed the change in the underlying trend, particularly in China), plus the difficult-to-forecast shocks of the 2010 European periphery crisis and the Japanese tsunami in 2011.

But here's what the forecast record looks like if we compare the first forecast the Fund made (in April of the previous year) with the actual outcome.

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The revisions for the advanced economies are as substantial as the revisions for the emerging economies. What is more relevant for the policy debate, however, is that global growth was sluggish because of weakness in the advanced economies. The emerging economies were growing three times as fast. 

Suppose the path of the advanced economies had been foreseen more accurately in 2010. Would the G20-instigated fiscal stimulus have been maintained, instead of being replaced with the firm fiscal austerity reflected in Figure 1.6 (below)? If Europe had foreseen a decline of 0.7% in 2012 followed by a further decline of 0.4% in 2013 rather than the forecast of growth of 1.8% in 2012 and 0.9% in 2013, would policy have remained so passive?  Was it so hard to foresee that Europe was headed for stagnation, that Japan was still stuck in the lost decades or that fiscal restraint was keeping the US recovery on an uncharacteristically slow path?

Figure 1.6, World Economic Outlook 2014.

The IMF's successive downward revisions, and the gloomy commentary which accompanies them, might give the impression that global growth is weakening. However the Fund records that this year's global growth is the same as in the previous two years, with an increased forecast for next year. This seemingly contradictory story can be reconciled by saying that the global economy has been chugging along at a steady pace but too slowly for comfort, and the Fund's forecasts have gradually caught up with this reality. 

Usually, we can join the mirth that accompanies economists' failed forecasting efforts. This is one example where more accurate forecasting might have improved the policy debate and altered the outcome for the better.

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In its latest World Economic Outlook, the IMF has joined the chorus of international institutions (G20, OECD) calling for more infrastructure spending.

What new elements does the Fund bring to this argument? Global growth has been disappointing. One reason is that governments have cut back on expenditure — including infrastructure — to get their budget deficits under control and their high debt levels down. But the Fund argues that, at least in advanced economies, for every dollar spent on public investment, these economies can expect an increase of 40 cents of GDP in the first year and $1.50 after four years (or double this figure under the right circumstances). Infrastructure spending stimulates demand and increases supply, and thus actually improves the debt/GDP ratio after a few years.

This is a big shift from the Fund's initial views on budget deficits in 2010, when it thought that the fiscal multiplier was less than one (and even its revised view from 2013 that the fiscal multiplier might be positive). Back in 2010, international financial institutions were all fixated on the debt implications of the crises in Europe. How times have changed. The Fund's summary for the 2014 World Economic Outlook is 'The time is right for an infrastructure push'.

This sort of broad case for infrastructure spending needs caveats, which the Fund duly applies.

For one thing, this fiscal multiplier logic doesn't apply in countries are already operating at full capacity. And the IMF acknowledges the usual problems with infrastructure: projects are often large, complex and long-lived, making it hard to evaluate their social return. Even when the social returns are high, it is often difficult to get those who benefit to pay in full. In these circumstances, political forces can take over the project selection process ('pork barreling'). In Australia, the Darwin-Alice Springs railway is an example. Elsewhere, Japan's 'bridges to nowhere' are often cited, although the Fund points out that Japan's budget blow-out during the 'lost decade' was caused by increases in social expenditure, while public investment actually fell.

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The IMF doesn't push public-private partnerships as a means of funding. The Fund has adopted the powerful argument that well-chosen infrastructure projects add assets to a government's balance sheet. The resulting debt from infrastructure spending should therefore not be seen as a burden on future generations, as it would if the budget deficit were to be driven by social expenditure. This issue is of particular interest in the context of the budget debate in Australia. Figure 3.3.1 from the World Economic Outlook shows how strong the Australian Government balance sheet is, either taken alone or in comparison with other countries. 

The case for infrastructure spending is a strong one (such spending is perhaps even a 'free-lunch'), and the Fund shows that the quality of infrastructure in both America and Germany has deteriorated substantially since 2008. In emerging economies, the case is made compelling by noting just how far they lag behind the advanced economies in provision of electricity, telephones and roads (see Graph 3.3 here).

The infrastructure bottleneck is often in project appraisal and legal issues such as land acquisition, rather than financing (although funding is always included on the list of issues to be resolved). Also high on the list of problems for emerging economies is the low efficiency in terms of the use of infrastructure. 

There is no denying the importance of the Fund's main message that there are many infrastructure projects which are not only viable (especially at today's low global interest rates), but which would also spur lagging global growth. This seems likely to be a widely held view at Brisbane's G20 meeting. Improving global growth while at the same time fixing the infrastructure shortage is a compelling idea. But, as usual, 'between the idea and the reality...falls the shadow'. The G20 needs to turn the generalities into operational prescriptions, like having the World Bank restore its detailed project appraisal capacity and for the credit-rating agencies to improve their capability to sort the beneficial projects from the lemons.

 

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With other international institutions reiterating their forecasts of declining growth in the emerging economies, the latest Asian Development Bank Outlook Update has a more positive view, at least those in our region. Not only are they sustaining a 6%-plus growth rate, but trade integration continues apace.

Australia has not found much of a role for itself in this supply-chain revolution so far, but our strong services sector gives us potential opportunities.

Among the many reasons for Asia's superior economic performance has been the success of supply-chains (what the ADB calls global value chains), which divide the production process so that each stage is carried out in a country which has comparative advantage in that particular process. From 1995 to 2008, the share of Asia's value-chain trade in worldwide manufacturing exports almost doubled from 8.6% to 16.2%. The message from the IMF on emerging economies has been gloomy for the past few years, but those in Asia have sailed ahead at a pace around three times that of the advanced economies, and the ADB sees this continuing. 

What made this possible was close integration and freedom of regional trade.

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Following the implementation of the ASEAN Free Trade Area, over 70% of intra-ASEAN trade incurs no tariff, and less than 5% of that trade is subject to tariffs above 10%. Non-tariff trade facilitation – making it easier to ship things across borders – is the objective of the Asian Economic Community and the Regional Comprehensive Economic Partnership initiatives. The national single window (a one-stop shop to speed customs clearance within ASEAN) has gone live in Indonesia, Malaysia, the Philippines, Singapore, and Thailand, with full roll-out planned for all significant ports and airports by 2015.

Where does Australia fit into all this? Have we been left behind with these fast-expanding opportunities, just at the time when we need to find a substitute for commodities to drive our growth? What have we got to offer?

Japan played a key role in promoting supply-chains when it shifted its manufacturing to lower-income countries. Taiwan provided managerial support for the initial stage of China's manufacturing growth, with Foxconn as the prime example. South Korea's sophisticated electronics industry provided inputs for other countries' manufacturers. All of these countries had inherent advantages in finding a role in the supply-chains. Australia, as a net capital importer and commodity exporter with modest manufacturing capacity and few global manufacturing brands, has found it hard to find a role in the manufacturing boom in Asia.

Many of our best opportunities will be found in services. Our engineers are seen all over Asia, in mining and infrastructure. Australian accountants, lawyers and financiers are there too. But the supply-chains should provide new opportunities, especially as Asian manufacturing goes up-market and needs sophisticated design and better distribution know-how to gain greater access to Western markets. 

Photo courtesy of Asian Development Outlook 2014 Update

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With the passing of the presidential baton from Susilo Bambang Yudhoyono to Joko Widodo just a month away, Indonesia is at a political crossroad, with the first clear break from the politicians who were part of the Soeharto years. Monday's Indonesia mini-update at the Lowy Institute, a half-day version of the Australian National University's annual analysis of Indonesian politics, economics and social developments, revealed an economy also at a transition point.

The easy years of the commodity boom are over. Growth was a respectable 5-6% throughout SBY's decade, and the macro-economics were well managed. But growth has now slipped below 5% and the global economic environment is unhelpful.

SBY's second presidential term achieved much less than the optimists had hoped. Petroleum subsidies (affecting not only fuel but also electricity) still count for over a fifth of budget expenditures. These, together with the large financial transfers to regional governments, leave the national budget with no room to manoeuvre. There has been painfully slow progress in addressing the backlog of needed infrastructure projects. Sharp increases in labour costs in the formal sector are making Indonesia's large-scale manufacturing uncompetitive. Corruption remains endemic. Income maldistribution has worsened appreciably.

The president-elect brings corruption-free credentials and a successful administrative record, albeit at the sub-national level. The incoming vice-president is experienced and energetic. But the election campaign gave extra momentum to nationalist economic sentiments which are never far below the surface in a country where memories of foreign colonial exploitation still linger. Measures to force greater domestic processing of ore exports are gradually being sorted out at a practical level, but some damage lingers to Indonesia's reputation as a welcoming host of foreign investment.

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A better assessment of the prospects will be possible when Jokowi picks his ministerial team. So far he has skillfully side-stepped pressure from the nationalist PDI-P, the political party he is associated with, to appoint party cronies with their baggage of dirigist economics. But Jokowi's own philosophy has not yet been clearly articulated.

All this is playing out in a global economy full of gloom, especially regarding the prospects of emerging economies. Indonesia did successfully handle the 'taper tantrum' in the middle of last year, when global markets over-reacted to the prospect of America unwinding its quantitative easing. Indonesia came through substantially better than other members of the 'Fragile Five' (India, Brazil, South Africa and Turkey) identified by financial markets to be at greatest risk. But markets remain nervous and Indonesian government bond yields remain well above those of countries like the Philippines, whose bonds were previously ranked alongside Indonesia's.

If the going does get tougher, Indonesia is poorly placed to handle a more serious crisis, either at the global level or domestically. As a still heartfelt legacy of the 1997-8 crisis, Indonesian policy-makers would be reluctant to seek help from the IMF. The operational effectiveness of the Chiang Mai Multilateral Initiative is extremely doubtful. Domestically, the Financial Sector Safety Net bill was rejected by parliament in 2008 and has little prospect of early revival, leaving policy-makers with few options in the event of financial-sector problems. 

An experienced commentator at the mini-update likened the current situation to the early 1980s, when a commodity boom was ending and Indonesia required strong structural reform to set the economy on a less resource-dependent development path. At that time, policy-makers rose to the challenge, introducing growth-enhancing reform measures. 

Jokowi operates in a far more difficult political environment compared with the 1980s. Will Indonesia, without the easy boost of spectacular commodity prices, squib the necessary structural changes and slip into the much discussed middle-income trap? Or will it reprise the restructuring of the 1980s, which could put it back on the 7% growth rates which characterised the Soeharto years? This is Jokowi's economic challenge.

Photo courtesy of Flickr user Ignatius Win Tanuwidjaja.

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Given that emerging economies continue to grow two or three times faster than advanced economies, the persistent gloom about their prospects is puzzling. The latest example comes from The Economist, which argues that convergence, the process by which poorer countries catch up to rich countries over time, was a temporary phenomenon that has largely run its course. The past 15 years have 'deceived people into thinking that broad convergence is the natural way of things.' 

How did they come to this view? The first decade of this century saw a rapid but unsustainable pace of convergence. China led the way with double-digit growth, and even the traditional laggards (such as India and Brazil) did well. Double-digit growth is not unprecedented (pre-1980 Japan, and a number of Asian economies, have come close) but it was never sustainable in the longer term

But just because convergence has slowed from this rapid pace doesn't mean it has ended. China's 7% growth rate doubles total income every decade. And it is sustainable. After all, even countries once seen as 'basket cases', such as Indonesia, recorded average growth of 7% for the three decades of the Soeharto era.

The other sleight of hand is to focus on the catch-up period associated with the 2008 financial crisis. The emerging economies continued to grow while the advanced economies had falling GDP, which has been followed by feeble recoveries. The fact that this was a 'once-off' conjuncture which is now behind us doesn't signal the end of convergence.

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On top of this, the World Bank data used by The Economist does indeed make this look like a halcyon decade: 'output per person in the emerging world doubled between 2000 and 2009; the average annual rate of growth over that decade was 7.6%'. It was  good decade, but not that good. IMF figures suggest that emerging economy growth in this period was around 2 percentage points slower than The Economist's.

The Economist's rose-tinted version of the past is contrasted with a gloomy outlook. It says that the IMF 'put the difference between the growth in emerging markets other than China and growth in the developed world at just 0.39 percentage points this year'. With this differential, full convergence would take 'more than 300 years'.

But the latest IMF forecasts show advanced economies growing at 1.8% while emerging economies are growing at 4.6%. True, this figure includes China's growth, but even so it is inconsistent with The Economist's numbers. This difference in growth rates shown in current IMF estimates (with the emerging economies growing around 2-3 percentage points faster) might be seen as closer to the overall convergence prospects than The Economist's 'indistinguishable from never' assessment. 

But in any case, the convergence story was never about aggregates, combining the diverse experience of all emerging economies taken together. The convergence story is the counter to the view that poor countries are inexorably stuck in poverty because of geography, lack of savings, or unreformable institutions. This pessimistic generalisation is refuted by the cases of Singapore, Taiwan and South Korea. Then, rebutting the argument that these were special cases, less dynamic economies like Thailand and Indonesia showed that the income gap could be narrowed, even in the face of inefficient and corrupt institutions. The point of the convergence story is that, with competent policies, poor countries can grow quickly by adopting proven technology and techniques.

It was never part of the convergence story that all poor countries would make the journey, or that it would be quick. Even China's three decades of outstanding growth have not made it rich, yet. And in any case, the objective of matching the moving target of rich-country living standards is not an essential part of the narrative. Even to get half way, to the stage where most people have been lifted out of poverty, would be a result to be cheered, not disparaged by glum mutterings about the 'middle-income trap'.

There is a message here with relevance for Australia. Convergence is happening, and it's happening in our region. Despite all the gloom from global commentators, the IMF data shows that 'emerging and developing Asia' has recorded a steady 6.5% growth rate, both in recent years and in the forecast. This is in a world full of talk of 'secular stagnation' in the advanced economies, with Europe still mired in debt and gloom, America's recovery yet to gain momentum and Latin America falling back into its traditional languor. Our part of the globe is doing just fine, thanks to convergence.

Graph courtesy of The Economist

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Mike Callaghan is spot-on in arguing that Australia's foreign investment policy needs a wider reassessment than simply looking at limits on state-owned enterprises (SOEs). Let's try to take this a bit further.

This fixation with SOEs is a peculiarly American priority seen also in the Trans-Pacific Partnership conditionality and the debate on sovereign wealth funds, and reflects a touching faith in the magic of the free market. Private sector players, pursuing their own interests, are assumed to also pursue the national interest, while SOEs may not.

Of course the market is a powerful operational framework for a successful economy, but successful economies have often found an important place for government-owned enterprises as well. At the same time, there is ample evidence that private companies without appropriate regulation will not always pursue the national interest. This is not an issue to be determined on doctrinal grounds: we need to examine the behaviour of both private companies and SOEs.

Here's an example. As a major commodity producer with an 80% foreign-owned mining sector, Australia's national interest is to ensure that our minerals exporters get the best price in global markets and that we squeeze as much out of the miners as is sensible in the form of royalties and taxes. Our concerns should be to prevent transfer pricing, tax shifting, monopolistic price-setting or collusion between the demand and supply sides of the market. With these issues satisfied, there is no good economic reason to discriminate between domestic and foreign companies, or between private companies and SOEs. Our concern should be that the market is working well. For this, the national authorities need to have enough information about the operational market structure to ensure that our national interests are met.

We've just seen an example which illustrates how far we are from where we should be. Last year Glencore (a commodity producer and trader with sales of $250 billion) took over Xstrata, our largest coal miner (and itself already foreign owned). The transaction was so large (the fifth-largest in the global history of gigantic resource take-overs) and important for world commodity trade that it needed to pass the scrutiny of competition authorities in South Africa and China. The Europeans required Glencore to unwind its relationship with a zinc company and the Chinese required divestiture of its Peruvian copper assets (giving China the opportunity to acquire these assets).

Australia didn't require anything.

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It's hard to find any record that the Foreign Investment Review Board gave this matter substantive scrutiny, while the Australian Competition and Consumer Commission saw no problems within its remit. This is despite Glencore's reputation as an aggressive tax minimiser, its reputation for underhand dealings, its lack of transparency reflecting its Swiss domicile and its dominant position in segments of global commodity trade. Glencore itself says the transaction will allow it to 'capture value at every stage of the supply chain from sourcing raw materials deep underground to delivering products to an international customer base'. 

What to do? For a start, why not require foreign investors (whether Swiss-based Glencore or Chinese SOEs) to provide the same degree of detailed public transparency required of Australian-domicile companies? This would give Australian authorities a starting point in assessing whether we are getting the best deal out of foreign investment.

Of course there are bigger issues as well. Why do the BCA and the OECD start with a strong presumption that the flow of FDI should be maximised, when there are alternative sources of funding for the current account deficit (debt or portfolio flows) which might be cheaper or more suitable?

In any case, foreign investment policy goes beyond economics. There are, for instance, no good economic reasons for limiting investment in real estate or agriculture, but many countries (including Australia) do so. When it comes to political issues, the overwhelmingly important one for Australia is that we are small and many of the investing countries are big. If Chinese companies (private or SOE) chose to make Australia an important part of their commodity security priorities, they will want to own a large proportion of our resources and agriculture. Politically, we will find this uncomfortable, perhaps even unacceptable.

Photo by Flickr user Kim Farnyk.

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Sam Roggeveen is certainly right to praise the achievement of an Australia-Indonesia Code of Conduct.

There is, however, an additional point to be made. The ambiguity of the text, which Sam says is mutually beneficial, exposes the nature of the negotiations: Australia gave away nothing, and Indonesia had to back down from its initial position.

President Susilo Bambang Yodhoyono wanted to sort this out before his term ends in October, so he was under some time constraint, while the Australian negotiators have demonstrated by their 'sit on your hands and wait for the storm to blow over' attitude that they see no urgent need to fix the relationships with our close neighbour.

This outcome has two drawbacks. First, it confirms the commonly held Indonesian view that Australia is characteristically sombong ('arrogant'). More seriously, it shows that intelligence policy-making is still in the hands of the people who got us into trouble in the first place. It was a serious lack of judgment that had us listening to the telephone conversations of SBY's wife (and members of the Cabinet who were not sensible targets for this sort of operation, such as the Minister of Finance). This lack of judgment is, unfortunately, all too common. It was demonstrated again by the attempts to bug the Timor border discussions, to the benefit of Australian commercial interests.

This agreement would have been more beneficial still if it had demonstrated that the Canberra intelligence community has learned something from its mistakes.

Photo courtesy of DFAT.

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'The Federal Reserve enters its second century as the closest the world has to a global central bank.' So says Ted Truman, who speaks with some authority as he played a key advisory role for many years with the Fed (the US central bank) and the US Treasury.  However, Truman's detailed account of the Fed's international role over the past three decades demonstrates how limited (and sometimes arbitrary) that role has been.

The central issue here is whether the US Fed can act for the global interest where American interests aren't involved or might conflict.

Truman identifies fourteen occasions where the Fed has acted in response to global events, and a clear pattern emerges: where US foreign policy interests are at stake, the Fed will act to assist with global problems. Thus Mexico's crises (in the 1980s and again in 1994) spurred a vigorous and helpful response. The 1998 crises in Thailand and Indonesia hardly rate a mention in Truman's account, while the concurrent crisis in South Korea (where 35,000 US troops were stationed) resulted in a path-breaking (and principles-breaking) intervention in which the US orchestrated controls on capital outflows from Korea. Foreign banks, pressured by their own national central banks, refrained from withdrawing funds which they had lent to Korean banks. An Australian bank (ANZ) was a significant participant in this stand-still, which fortunately turned out well, with Korea able to resume repayments within a short time.

The US Fed's swap operations are akin to global central bank operations, effectively making short-term US dollar loans to foreign central banks, which can on-lend these to their domestic banks to help them through a foreign currency liquidity crisis. This is analogous to traditional liquidity operations, where central banks make domestic currency loans to banks in need of liquidity.

These Fed swap arrangements have been a powerful and valuable stabilising element during global financial crises since 1965 or even earlier. Until recently, however, they have been available only to a small group of advanced economies (including Australia), plus Mexico.

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In 2008 the swaps were a crucial part of the crisis response, especially for Europe. The Reserve Bank of Australia was able to use this facility to on-lend US dollars to Australian banks in need of foreign currency liquidity when the New York money market dried up. 

The usefulness of this facility was demonstrated even more powerfully in 2008 when South Korea experienced a foreign currency crisis. Its own substantial foreign exchange reserves were not sufficient to stabilise confidence. The crisis ended as soon as the Fed's swap facility was announced, arriving like the US cavalry over the horizon to save the embattled Koreans.

As the Korea experience demonstrates, the swap facility is a more powerful instrument than a country's own reserve holdings. This is a current policy issue, as many emerging economies (especially in Asia) are building up huge foreign exchange reserves in readiness for renewed episodes of capital flow volatility. Such reserve holdings have to be funded, so are expensive and often disrupt monetary policy. Wouldn't it be helpful if the Fed really did act as a global central bank, offering this swap facility to everyone?

Unsurprisingly, the Fed offers swaps only to its trusted friends. In 2008, for example, it refused Indonesia's approach for access to the swap facility. It is not, and is unlikely to become, a global facility that would make the US Fed analogous to a global central bank.

Those, like Australia, in the swap network should be grateful that this powerful facility is available to us, though we might note that Truman reports earlier efforts by the Fed staff to close down the facility.

Truman avoids specifically addressing a vexed current issue. What obligations does the Fed have to consider the impact of its policies on other countries? Financial markets certainly expect a significant global effect from the unwinding of quantitative easing (QE). Raghuram Rajan, the Indian central bank governor, sees the Fed as having important obligations to countries so affected. But beyond ensuring that these QE operations are understood by financial markets, the Fed sees itself as having no wider obligations.

It's hard to see how the Fed could act otherwise. There are, in fact, historical examples where the US has helped its closest friends and paid a price. In 1927 it lowered the discount rate in response to the entreaties of Montagu Norman, governor of the Bank of England, who was struggling to contain the damage from Churchill's disastrous return to the gold standard two years earlier. This lower interest rate encouraged the asset-price boom which ended in 1929 with the Great Crash, ushering in the Great Depression.

If the US Fed cannot be an effective global central bank, what about the IMF? Truman talks of the IMF as if it is a simple extension of US policy. Taken together, perhaps there is some truth in the idea that the US Fed and the IMF can serve as a global central bank. But a precondition for this to be acceptable to the rest of the world is to implement the IMF governance reforms (especially voting shares) which are currently held up, pending US Congressional approval.

Photo by Flickr user jareed.

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The Interpreter hasn't had much to say about European growth for a couple of years, mainly because there hasn't been much of it. European Central Bank President Mario Draghi brought this melancholy story up to date at the central bankers' annual get-together at Jackson Hole, Wyoming, last week, far from the bustle of the financial markets. The bankers have exhausted the usual topics of monetary policy at past meetings; this time their focus was on labour markets.

The graph below shows the starting point of Draghi's narrative. US unemployment rose much more sharply than Europe's in the first phase of the 2008 crisis, but US unemployment came down substantially while European jobless rates continued to rise.

Most of this difference reflects the second wave of the crisis which hit the European peripheral countries (starting with Greece) at the beginning of 2010. But the overall euro-area unemployment rate of nearly 12% is not just a reflection of 25% unemployment in Greece and Spain. With the exception of Germany, none of the core European countries has had any recovery to speak of, with employment lower and unemployment substantially higher than before the crisis. The table below (source) shows the percentage change in GDP, employment and unemployment between the pre-crisis peak and the first quarter of 2014:

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What is to be done? Draghi's answer is 'a bit of everything'. He'll keep monetary policy loose (and presumably do 'whatever it takes' if the euro comes under threat). But he is looking for help from fiscal policy and structural reform. A call for structural reform (ie. productivity improvement) is a standard element of just about any macro-economic prescription, but it carries more weight and urgency given the duration and depth of the European recession. 

Draghi quotes figures showing that European structural unemployment (the part that can't be fixed just by getting economic activity back to full capacity) as having risen from 8.8% in 2008 to 10.3% in 2013 as a result of the crisis and the lacklustre recovery. This would imply that the usual instruments of counter-cyclical macro-policy can't take the unemployment rate down very far. 

He reports that Ireland has done better than Spain in terms of wage flexibility, but Ireland's main method of getting its unemployment rate down has been emigration, not only of disenchanted Irish youth but also the migrants from other parts of Europe who had flocked to Ireland when it was the Celtic Dragon, before the crisis.

Even this dismal litany doesn't complete the list of problems facing Europe. The European banking system is undercapitalised and in no position to support a strong recovery. And the unsustainable debt burdens on the peripheral countries make it most unlikely that a recovery can occur in these countries without a substantial additional debt write-off

Draghi (and others) are giving more attention to the possibility that Europe may be facing secular stagnation of the sort demonstrated by Japan over recent decades. This is not a novel idea, but its revival is gaining wider attention, including in this comprehensive e-book from Vox-EU

Just as a postscript on the Draghi speech, his presentation contrasted to the typical central banker's view, which is interested in the labour market only in as far as it affects inflation. Draghi began his speech by sounding, well, human:

No one in society remains untouched by a situation of high unemployment. For the unemployed themselves, it is often a tragedy which has lasting effects on their lifetime income. For those in work, it raises job insecurity and undermines social cohesion. For governments, it weighs on public finances and harms election prospects. And unemployment is at the heart of the macro dynamics that shape short- and medium-term inflation, meaning it also affects central banks. Indeed, even when there are no risks to price stability, but unemployment is high and social cohesion at threat, pressure on the central bank to respond invariably increases.

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Perhaps the most fundamental change in international trade in recent decades has been the development of multinational 'supply chains'. The production process has been 'unbundled', with different stages of production taking place in different countries. An iPad is assembled in China, but only $10 of the total production costs takes place in China; most of the total cost comes from inputs made in other countries, including the intellectual property and design input from Apple in California.  

In conventional trade statistics, exports are counted in gross terms, so the cost of the assembled iPad (including those elements imported into China) is counted in China's export figures. Over recent years, the misleading implications of the gross trade figures have been more fully recognised. Since 2012, an alternative value-add data set has been available.  

The Reserve Bank of Australia has built on this data to provide new insights into Australia's international trade, particularly on trade-partner shares. The diagram below, from the RBA, illustrates the issue. If Australia exports $100 of iron ore to China, which is then used as the input for products which China exports to the US worth $110, conventional statistics would record this as $100 of Australian exports and $110 of Chinese exports. But China has, in this exaggerated example, only added $10 of value.

Comparison of gross trade and value added trade

Focusing on 'value-add' statistics changes the picture of Australia's export partners.

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In this example, the destination of $100 of iron ore exported by Australia is no longer China, but, in final product form, America. Comparing the two measures of Australia's export destinations, we get the following table: 

These value-added statistics also provide a very different perspective on the importance of the services sector to Australia's exports. In gross terms, services make up only 22% of exports, but services form an important input into other exports (especially manufactures). Recalculating exports according to value-added model takes the services component to over 40% of Australia's exports (a bit bigger than resources). This different perspective fits Australia's comparative advantage: our export future doesn't lie in manufactures, but in commodities and services.

These value-add statistics don't replace the conventional gross statistics, which are available more quickly and don't rely on so many assumptions. Nor are they the last word in the ongoing process of refining statics to reflect a changing world. But they provide a valuable alternative perspective, sometimes with policy implications. At the very least, they are a reminder of the complexity of international trade: our exports will depend not only on what is happening in China, but on what is happening in China's export destinations as well.

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The Director-General of the World Trade Organization is sounding despondent after the latest setback to the December 2013 Bali Agreement. Meanwhile, a survey of exporters has given some endorsement for the alternative path of free trade agreements (FTAs). Is there any hope for furthering the multilateral trade agenda?

Mike Callaghan described the Bali Agreement signed last December as a small win for the WTO — the first multilateral trade agreement since the WTO replaced the GATT as the multilateral trade forum in 1995. The main components of the Bali Agreement were trade facilitation (aimed at cutting red tape and corruption in ports, thus encouraging international trade), an agriculture package that allowed governments to run food security programs without breaching WTO commitments, and a reaffirmation of market access for less-developed countries.

While the agreement reached in Bali required subsequent endorsement, this was seen as a mere formality, as the text was signed by all trade ministers and had been painstakingly tailored to India's special sensitivities on food security. Yet India late last month blocked the deal.

The time limit for final endorsement expired at the end of July, with India insisting on re-opening the agricultural issues. The WTO Director-General, reporting to the WTO ambassadors in Geneva on 31 July, had a tone of desperation. This is not 'just another delay which can simply be ignored or accommodated into a new timetable'. Here is the wider context:

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I want to stress the importance of each of the three pillars of the WTO: disputes, monitoring and negotiations — not to mention our work on technical assistance and aid-for-trade. We saw the importance of our work during the financial crisis when, unlike with previous crises, there was no surge in protectionism. Having the rules in place and adherence closely monitored — with the dispute settlement mechanism there to back them up — helped to keep protectionism in check during a dangerous period for the global economy. The value of those pillars was plain to see — and they performed very well. But, when I took office last September, I was clear that I had real concerns for the future of the negotiating pillar. Bali was a very important moment in reviving and revitalising the negotiating function. But, just seven months later, once again I am very, very concerned.

The central component of the Bali Agreement (making ports more efficient) is hardly controversial. But why is food security policy such a sticking point? In an imperfect-market world, surely India should be able to offer some subsidies to its own farmers? When, however, the farm price-support programs result in what are effectively export subsidies, it becomes a multilateral concern

The WTO Director-General expressed some hope that the European summer holiday period might deliver a breakthrough when the ambassadors next meet in September. But if not, the consequences do indeed seem dire for the future of multilateral trade agreements. When a hard-fought negotiation, finally brought to fruition, can be torpedoed in this way, who will bother to try again?

Meanwhile, the rival model for international trade negotiation, FTAs, received some endorsement from a survey by The Economist Intelligence Unit. Senior executives from 800 exporters in Australia, China, Hong Kong, India, Indonesia, Malaysia, Singapore and Vietnam were quizzed on their experience.  All these countries have extensive FTA coverage. The survey finds that each FTA signed in Asia is used, on average, by only one in four exporters. But where they are used, the result is positive: more than 85% of respondents report that their exports to the markets concerned have increased either significantly or moderately as a result of FTAs. According to the EIU report:

Critics of FTAs have long warned this would happen. FTAs, they say, replace the relative simplicity of multilateral WTO agreements with a "noodle bowl" of overlapping preferences and rules and regulations that, in practice, often prove more trouble than they are worth for companies to use. But the result is nonetheless surprising, given the benefits in terms of increased exports reported by companies that do use the FTAs.

Of course exporters (the survey respondents) are not in a position to judge the overall national or multilateral benefit of FTAs. The central criticism of FTAs (which should properly be called 'discriminatory preferential trade arrangements') is that they divert a country from buying its imports from the cheapest foreign supplier. FTAs are unambiguously second-best, compared with multilateral agreements. But the current multilateral model seems in need of drastic modification.

Photo by Flickr user Betsy Dorset.

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Standard and Poors' credit ratings. (Wikipedia.)

Foreign investors learn about the Australian economy from a variety of sources, but the credit rating agencies (CRAs) have a special place, as many investment managers are committed to following the rating agencies' assessments. As well, the CRA ratings are used in prudential supervision. This gives special importance to Standard and Poors' (S&P) latest pronouncements, reaffirming Australia's AAA rating.  

The S&P press release begins by noting 'the country's strong public policy settings, economic resilience, and significant fiscal and monetary policy flexibility' as well as its 'strong ability to absorb large economic and financial shocks, as was demonstrated during the global recession in 2009.'

So far, so good. Then come the caveats: 

Australia's high external imbalances, dependence on commodity exports, and high household debt moderate these strengths...In our opinion, while Australia benefits from many fundamental strengths, its key credit weakness is the economy's high level of external liabilities. The banking system in particular has a high degree of external indebtedness and remains highly reliant on the ongoing backing of foreign investors...Meanwhile, Australia continues to run significant current account deficits... 

Pressing the panic button? Not really. This is just having 'two bob each way', as S&P goes on to say:

In our opinion, however, the risks associated with Australia's high private-sector external debt are manageable because of the strength of the country's financial system, the high degree of foreign currency debt hedging, and an actively traded currency that historically has allowed external imbalances to adjust. Additionally, Australia's highly credible monetary policy framework remains able to help counter the impact of any economic shocks.

So we're OK after all? Not so fast.

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Just in case you’re getting lulled into complacency, S&P concludes with some warnings and a line-in-the-sand threat:

We could lower the ratings if external imbalances were to grow significantly more than we currently expect, either because the terms of trade deteriorates quickly and markedly, or the banking sector's cost of external funding increases sharply. Such an external shock could lead to a protracted deterioration in the fiscal balance and the public debt burden. It could also lead us to reassess Australia's contingent fiscal risks from its financial sector. We could also lower the ratings if significantly weaker than expected budget performance leads to net general government debt rising above 30% of GDP.

What would a country have to do to get a clean bill of health? Australia's banks are no longer obtaining new funding flows from overseas, and their outstanding balances are smaller than in 2008 (see graph below). Sure, the AAA government guarantee helped them to come through the crisis smoothly but the same thing could be provided again, if needed. The financial system was given the ultimate stress test in 2008 and came though well, unlike many countries. As for the warning on external imbalances, since 2008 the current account deficit is significantly smaller, as is the external income deficit

Source: Reserve Bank of Australia.

What about the 'line in the sand' on net government debt? With the current level at just over 20% of GDP, it would indeed be a major slippage if we were to find ourselves over 30%, so for S&P to finish its press release with this hypothetical outlier is drawing a long bow. It's drama-queen stuff, but it has been picked up by the press, always happy to spotlight an impending disaster, no matter how unlikely.  

Let's also put the current level (and even the 30% line in the sand) in perspective. Here are the equivalent IMF figures for the G7 countries:

Source: IMF Global Stability Report, Table 1.1.1.1.

Remarkably, some of the key actors responsible for the 2008 financial debacle have managed to restore their reputations, and no rehabilitation is more remarkable than that of the Teflon-coated credit rating agencies. Leading up to 2008, they handed out AAA ratings to worthless mortgage securitisations (but of course these were a different sort of AAA rating: the debt issuers simply paid for it). Nor were the country ratings much better: S&P's 'investment-grade' endorsements of bankrupt Greece survived well into 2010.  The role of the CRAs was under critical review well before the 2008 crisis but no satisfactory answer has yet been found for their undue influence and they are still accorded a role in the Basel prudential supervision arrangements.   

Could it be that S&P is peeved because it recently lost its reputation-damning court case in Australia? It's little wonder that analysis of the sort produced by S&P for Australia evokes a derisive response. Can't they do better?

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'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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