Lowy Institute

Following the stunning success of Thomas Piketty's door-stop book Capital in the Twenty-first Century, Robert Gordon has consolidated his recent writings into a 600-page tome: The Rise and Fall of American Growth, that argues America's 150-year run of rapid economic advance is over. If Piketty worried about the rich getting all the benefits of growth, Gordon argues that the growth we have all become accustomed to will largely disappear. No longer will it be true that each American generation will have double the income of their parents.

This dramatic change reflects an economy facing a number of what Gordon likes to call 'headwinds', of which slower technological progress is the most interesting part of Gordon's story. He argues the application of technology provided dramatic improvements in living standards between 1870 and 1970 but now the low-hanging fruit have all been picked.

The sheer heft of Gordon's book does bring to mind the comment, attributed variously to King George III or Henry, Duke of Gloucester, made upon receiving a volume of The History of the Decline and Fall of the Roman Empire: 'Another damned fat book, Mr. Gibbon? Scribble, scribble, scribble, eh Mr. Gibbon?' If 600 pages provide more than you want to know, an 18 minute TED talk gives the essence of Gordon's argument.

The case he makes is a powerful one. It holds the IT revolution has been less important than the five great advances of the pre-1970 century: electricity, the internal combustion engine, chemicals and pharmaceuticals, urban sewerage, and modern communications. He illustrates this by contrasting the WC toilet with the iPhone. If society was forced to choose between these two inventions, which has been more life-changing?

Of course there are counter-arguments: some would make the case the IT revolution is far from over; others might contend medicine is making stunning breakthroughs, with much further potential; and there are plenty who think the artificial intelligence (AI) revolution has a long way to go, for good or evil. Others hope that virtual reality and cars that drive themselves will change our lives. Paul Krugman has a good review of Gordon here

Gordon is not, of course, the first economist to focus on slow growth. Proponents of the dismal science have been worried about the 'stationary state' ever since Malthus. The big difference is that a stationary state in today's America would be more pleasant than Malthus' subsistence-level wage. Nor is Gordon the first to doubt the transformational nature of the IT revolution. In 1987 Robert Solow famously said: 'You can see the computer age everywhere but in the productivity statistics'. Paul Krugman published The Age of Diminished Expectations more than twenty years ago. 

Let's not be too glum. Maybe it is time for those of us in the mature economies to accept that we are already producing enough things and switch focus onto correcting income distribution (one of Gordon's 'headwinds'), making sure everyone gets a good education (another 'headwind') and putting less strain on nature and the climate. But the adaptation to diminished expectations will not be easy, especially at the political level. There are some big implications for foreign relations as well.

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In any case, this discussion is America-centred, (as Gordon's title makes clear). Rather than be downcast by the prospect of slower growth in the mature economies, we should take Gordon's fascinating account of the power of transformational technology as a reminder of the enormous potential which the poor and emerging economies have to lift their living standards through convergence. This would be accomplished by applying well-tested existing technology which is not yet being used in these poorer countries. We can all agree that piped water, flushing toilets and electricity were fundamental to lifting us out of pre-1900 poverty. But much of the world still doesn't have these. Almost half the Indian population has no toilet at home, and maybe not at school either. In Indonesia, only 20% of the population has piped water (and only the brave would drink it without treatment). Only 1% have sewerage. Indonesia's per capita electricity consumption is just over 5% of America's.

Much of the rest of the world faces a different (and more rewarding) challenge; how to put in place technological advances which have been ubiquitous in industrial countries for a couple of generations. There is a huge literature on why this technological potential has not yet been harnessed. The pessimists on this debate (the nay-sayers of the 'middle-income trap' being the current vogue) ought to read Gordon's book and then tell us what stands in the way of this technology being applied widely over the next decade or two.


So Japan has joined the select group of central banks that have lowered their policy interest rate into negative territory (-0.1%). The European Central Bank pioneered negative rates (-0.2%) in 2014, followed by Sweden (-1.1%) Denmark and Switzerland (both -0.75%).

Leon Berkelmans explored the case for negative rates here. I'd argue Europe and Japan have taken this step because no one can offer anything better to lift their economies out of their post-2008 torpor. For the individual countries, mildly negative rates may do no great harm, but nor are they the policy breakthrough that restore the power of monetary policy. As a cure for global weakness, they are just as likely to be harmful as beneficial. 

Why don't these initiatives signal the demise of the long-standing constraint of the 'zero lower bound' that supposedly stops interest rates from going negative? In practice, the tiny negatives which have been implemented so far aren't much different from the near-zero policy rates that are common among the advanced economies: they don't represent a breakthrough in policy, except perhaps psychologically.

In Japan's case, the move confirms to the Japanese public that the Bank of Japan (BoJ) is still trying hard to get inflation up (the target is still 2% but, like a mirage, this keeps receding into the future). At the same time, however, the new measure is also an uncomfortable reminder that previous experiments with unconventional policies haven't worked so far. It was BoJ governor Haruhiko Kuroda who invoked the Peter Pan logic of the power of confidently held expectations: Peter told Wendy that she would be able to fly, if only she believed she could. There is a corollary here with inflation which is, after all, largely driven by inflation expectations; if everyone believes inflation will run at 2%, price-setters will start increasing their prices and it will come true. But it's hard to make people believe inflation is taking off when past policy initiatives haven't gotten off the ground.

What would happen if these tentative sorties into negative territory were pushed far enough to offer borrowers the opportunity of funding that was not just free, but where their debt diminished perceptibly over time — say a negative rate of 5-10%? That would certainly seem to be an incentive to borrow and invest.

But first a technical problem would need to be solved.

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Borrowers need to be funded by lenders but who would lend if the negative return erodes their capital over time? The relevant academic analysis focuses on the role of currency holdings. Won't investors, faced with the prospect of getting negative returns on their bank deposits, respond by storing their savings under the bed in the form of currency? For some readers, the vision of Scrooge McDuck diving into the cash in Money Bin #23A may come to mind. How to make currency accumulation an unattractive option? With this challenge in mind, many ingenious schemes have been dreamt up to make sure that currency, too, loses its value over time. While these might solve the technical problem, they miss the underlying issue. Investors, faced with the choice of lending at a negative rate or investing in the many real or financial assets (such as equities) that offer some prospect of a return on their investment, will choose the latter.

Buying existing assets doesn't add to GDP; it just bids up asset prices. But does it alter the savings/investment imbalance that many think is at the heart of chronic weak growth? The impact on savings could go either way: negative interest rates might reduce the incentive to save, but if savers are targeting asset accumulation for retirement, they will have to save more rather than less. Would the higher asset prices (say, houses) raise the incentive to build new houses? It might in the short term, but if the underlying problem is low prospective returns on investment, this problem needs to be addressed directly rather than circumvented by setting off another asset price bubble. Japan's asset-bubble collapse in 1990, that ushered in the 'lost decades', is the cautionary reminder.

Of course investors could buy foreign currency or foreign assets offering a positive return. This action will depreciate the exchange rate and that will help exports and discourage imports, thus boosting the local economy. Does this sound like the answer? It has worked for the euro (which is down 20% since negative rates were introduced). Already the yen has lost a couple of per cent. Exchange-rate considerations were the main motivation for Denmark, Sweden and Switzerland: their negative rates discourage capital inflow and restrain unwanted appreciation against the euro. Alas, this is the classic 'beggar-thy-neighbour' policy: boosting your own economy at the expense of your trading partners.

One of the characteristics of the various versions of 'unconventional monetary policy' (quantitative easing, as well as negative rates) is that they have a substantial exchange rate impact; always a case of 'beggar-thy-neighbour'. Even with conventional monetary policy, the exchange rate is one channel through which policy works. It may be that the exchange rate is, in fact, the main transmission channel of unconventional monetary policy, without doing much to stimulate the domestic economy via other transmission channels. The G7 countries — the main users of unconventional monetary policy — have tried hard to downplay this aspect, in the face of accusations of 'currency wars'. No clear consensus came out of this debate, which was overtaken by issues of volatile capital flows. But heated complaints would surely arise again if negative rates were to be used in a substantive way.

This debate is, in any case, a distraction from the main problem. The weak recovery from the 2008 crisis may be attributed to the debt obsessions which prevented sustained fiscal stimulus that would have given the recovery some momentum. The time for conventional fiscal stimulus has passed. Monetary policy is already doing all that can be expected of it to assist the recovery. So what should policy do?

One option is to do nothing, in the hope that the normal self-equilibrating forces of the economy will in time shift growth closer to potential. But the BoJ move illustrates the pressure on policy-makers to 'do something'. What are the active options? Countries could use the opportunity of low interest rates to undertake infrastructure. Or they could undertake structural reform to raise the expected return on private investment. Neither of these are easy options. For infrastructure, the Japanese public would ask how many more 'bridges-to-nowhere' are needed. In emerging economies, where the need for more infrastructure is undoubted, implementation is often the bottleneck. As for structural reform, advocates of this should be required to solve the politicians' lament: 'we know what to do: we just don't know how to get re-elected after we've done it.'

Image courtesy of Flickr user Japan Kuru


Michael Pettis is irritated that I have criticised his pessimism on China's growth prospects and accuses me of revising my forecasts without acknowledging any change. But the two linked posts he offers in evidence seem to be standing up pretty well.

The first, posted in early 2012, forecast 7-8% growth for that year. Growth came in at 7.8%. The second post talked of a sustainable growth rate of 7%. That, too, still looks fine to me. As for Pettis' own forecasts, his bet with The Economist that average annual growth for this decade would 'barely break 3%' is looking more outlandish with each passing year. 

Let's not, however, have an arm-wrestle about the detailed growth forecasts, when we are unlikely to agree on even the growth figures that should be used. What I am keen to pick up on are some of the serious analytical issues Pettis raises. I'm never too confident about paraphrasing his arguments, but one important issue he seems to focus on is the relationship between growth and credit/debt. Let me give my version of this issue, and see how far apart we are.

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It is hard to establish a consistent relationship between growth and credit even in mature economies, let alone economies which are experiencing rapid transition, including financial deregulation and financial deepening. When the financial sector is deregulated, it will grow substantially faster than GDP. After all, that's what deregulation is about: going from an economy where most investment is self-funded, to an economy where investors can borrow and build up balance sheets with assets on one side and debt on the other. When credit grows much faster than GDP, ipso facto, debt/GDP rises.

During the deregulatory transition there is a good chance that borrowers and lenders will make mistakes. They are inexperienced in this new financial world, as are the institutions that often intermediate their borrowings and the policy-makers who oversee this world. Thus one truism is that financial deregulation is usually accompanied by disruption or even crisis. In Australia, the deregulation and fast credit growth of the 1980s was followed by 'the recession we had to have'. The US had the savings-and-loans crisis in the 1980s. Much of Asia had the 1998 crisis. So we can agree that financial deregulation is a fraught transition, with opportunity for things to go wrong.

How does this apply in China? Has credit grown too fast and as a result is debt now too high? Again, we would agree that the answer to both these questions is 'probably yes'. The specific circumstances in China are worth retelling. When the 2008 global financial crisis arrived, the Chinese authorities administered a massive stimulus, mostly in the form of encouraging credit growth. The rest of us (especially Australia) should be grateful that China did this, because it meant that China not only kept on growing, but accelerated out of the crisis-years with double digit growth. China, almost single-handed, kept the world growing through the global crisis and its aftermath.

But that was then: what about now? This pace of credit growth was clearly unsustainable. It has since slowed sharply, although it is still growing faster than nominal GDP.

Total Social Financing (TSF*) and Private Credit (in %, year on year)

*TSF is the IMF’s favoured broad measure of financing and excludes lending to the government. (Source)

The McKinsey Global Institute’s comprehensive report on global debt (with a full chapter on China) includes a fabulous graph that captures both the level and the recent rate of increase in debt for around 50 countries. It’s too complex to be reproduced here, but take a look at the original on page 3 of this document. In terms of debt/GDP, China is in the middle rank but high for its stage of development — somewhat higher than Thailand and about the same as Malaysia. But it is a clear outlier in terms of rapid rise in debt over 2007-2014.

No disagreement so far: in my posts I have consistently noted the need to restructure the financial excesses over time. Where Pettis and I seem to differ (again, it's hard to be sure) is that he sees it as inevitable that the necessary slower credit growth would produce dramatically slower GDP growth (viz, his 3% forecast). If slow growth is countered by policy stimulus to encourage credit growth, Pettis argues, this makes the debt accumulation problem worse and just puts off the crisis to a later date.

The relationship between credit and GDP is an unsettled issue in economics. Since 2008, many argue that central banks everywhere gave too little attention to the role of credit in the lead-up to the 2008 crisis. But attempts to put a universal number on 'too much debt' backfired badly. We know that shifting purchasing power to people who were previously liquidity-constrained (i.e. they wanted to spend more than they had available) increases their spending, but we don't know whether this spending adds to GDP or bids up asset prices. We don't know what is the effect on those who funded this lending: did they cut back their own expenditure, or did their lending come out of their saving? If the borrowers bought existing assets, what did the sellers of those assets do with the proceeds? As usual, 'it all depends ...'

What evidence is there for China? We know that China grew at double digits in the pre-2008 period without a rapid growth of debt/GDP. Thus the two aren't inexorably linked. Investment must have been largely self-funded, especially by the hugely profitable state-owned enterprises. The big growth in credit was a once-off free-for-all credit binge which ended five years ago, although the hangover is ongoing. Credit is now increasing only modestly faster than GDP, and yet growth continues at close to the official target of 7% (which is also my suggested sustainable pace).

Could growth go lower during the tricky ongoing transition? Of course: year-by-year GDP growth will cycle around the sustainable rate. The exact path will depend, inter alia, on the skill of the policy-makers and on corporate profitability (which determines how much investment is self-funded).

Could there be a sudden sharp crisis? It's possible, but by no means inevitable. In any case, there is a supplementary question here: if it happens, would this pull the ongoing sustainable rate of growth down to 3%, or would there be a 'V'-shaped recovery putting China back on the 7% trajectory? Would China be like Japan after the 1990 asset-bubble burst, or like South Korea after the 1998 crisis and Australia after the 1990 recession?

On this, I count myself among the optimists. The greatest economic narrative of the past half-century has been the GDP convergence of previously poor countries (Japan, South Korea, Taiwan, Hong Kong, and Singapore have completed the journey, but there are a good many others still on their way). China has already demonstrated that it is possible to scale up this model to fit the globe's most populous country. The narrative is unfinished, with many catch-up opportunities remaining and many slip-ups likely. Achieving this potential convergence requires skilled policy-making, but isn't this what China has shown for three decades?

Photo by Zhang Peng/LightRocket via Getty Images


To judge from the financial media reports or market commentary, global growth prospects are bad and deteriorating fast. But the IMF's just-updated growth figures — actual and forecast — are more sanguine, if less sensational. For each of the past four years, the IMF's purchasing power parity figures show global percentage growth starting with a '3', as do the forecasts for this year and next.

Curiously, the Fund's accompanying commentary echoes some of the market's gloom. Perhaps this is because the commentary focuses on the forecasts, not the actual historical performance. Successive updates have revised earlier forecasts downwards, reflecting the Fund's persistent bias towards optimism in GDP forecasting. Rose-tinted forecasts might seem, at the time they are made, helpful for business confidence. But when reality arrives, yet another confidence-sapping downward revision is required. Yet, despite all of these forecast downgrades, global growth can best be characterised as 'steady'. Within this global aggregate, advanced countries are still lacklustre, with recent years a bit stronger but still too slow to take up the slack created by the 2008 financial crisis. The emerging and developing economies, having done the heavy lifting for growth both during and after the crisis (accounting for almost 80% of global growth in 2010-2015), are slipping a little, but they are still growing at well over twice the pace of the advanced economies.

GDP Growth % Q4 on Q4Source: IMF

That said, the current global share-market slump, the plunging oil price and the pessimism surrounding the Chinese economy might suggest that prospects are much worse. Let's look at each in turn.

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Share markets are sometimes given credit for being forward indicators of economic cycles but, as Paul Samuelson famously observed, 'stock-markets have called nine of the last five recessions'. Financial market innovation may have made stock-markets even more prone to volatility: financial institutions and portfolio investors use similar risk models so they respond to new information in the same way and behave like lemmings, while high-frequency algorithmic trading has detached the process of equity-price discovery away from any notion of fundamental values. The fundamental metrics are more positive: global corporate profits have been historically high, while price/earnings ratios are around historic norms.

While petroleum price falls have, in the past, been positive for world growth, Paul Krugman argues that this time might be different. A fall in oil price usually lowers inflation, creating room for easier monetary policy, but monetary policy in most advanced economies is already as low as it can sensibly go. Usually the rich oil producers, which lose when the price falls, don't cut their expenditure much, but this time they are fiscally constrained and will trim spending. Then there is the shale-oil investment story. Shale-oil production has added 5% to global supply in the past five years. Conventional oil producers invest serious money in exploration and drilling, and then the oil flows at low marginal cost. Shale oil producers get results more quickly, but have to keep drilling to maintain production, making running costs higher. They will react more quickly than conventional producers to lower prices. Thus we now see a halving in what has been one of the strongest components of US investment.

All that said, lower oil prices have to be good news for energy importers like China, India, Japan and Europe. While they will hurt Brazil, Venezuela and Russia (all with sharp GDP falls forecast by the IMF), on balance it's hard to see this as cataclysmic news for global growth.

Will petroleum price go lower and trigger some greater disruption? The daily price is dominated by the exigencies of the quotidian demand/supply balance, so it could go lower over the short term. The Saudis have made it clear that they are not going to give up any market share to accommodate the arrival of Iran's now-unembargoed oil. Some US shale companies will go on producing at a loss, just to delay bankruptcy in the hope of change.

Over time, however, the underlying economics will assert itself. The key analytical insight is still a supply-cost curve like the one shown in the second graph here. Updated, this would show that improved technology has reduced the supply-price of shale-oil, but sharply falling investment suggests that production can't be maintained in the medium term at current prices. Sooner or later, the price has to approximate the costs of the most expensive producer, so the equilibrium price won't be determined by Saudi low-cost oil, but by more expensive shale or offshore production. Thus, whatever the pain being administered by the current low price, chances are this will ease and petroleum will cease to be an excuse for market panic.

If you accept the arguments in my posts on China last week, then you would also accept the IMF's forecast that China will continue to meet the official growth target of 'around 7%'. The IMF's precise figure is 6.8% for this year, slowing to 6% by next year. You can be sceptical about the GDP figures, but the rising ratio of job vacancies suggests that the GDP figures, even if fiddled at the margin, reflect an underlying reality that China is still growing at two or three times the pace of the advanced economies, adding as much to global GDP (in dollar terms) as it did when it was growing at double-digit rates but from a lower base.

In due course, the IMF may have to make its customary downward adjustment to its forecast figures, but this would still leave the global economy jogging along, too slow for comfort, but fast enough to refute the current pervasive pessimism. So here is the bad news for all those who have to write exciting stories about global growth: it all looks boringly normal.

Image courtesy of Flickr user Hammonton Photography


In the first of this two part series, Stephen Grenville examined two of the three main concerns about China's economy, the financial sector and the rate of GDP growth. Part two focuses on the third aspect that has observers worried; the exchange rate and capital outflows.

Judged in fundamental equilibrium terms, both the IMF and think-tanks judge the current exchange rate for China's currency to be about right, but the political and market context complicates this simple assessment.

For the past decade or more the renminbi has been the subject of a continual barrage of US commentary complaining about unfair competitive advantage through an undervalued exchange rate. Perhaps reflecting this, the real (inflation-adjusted) value has risen 50% since 2005. The extent of the appreciation is such that many observers have become concerned the currency has overshot and is now over-valued. Even if this is the case, only a modest overshoot is implied: after all, China’s exports are going well considering the weak world market and the current account is still in substantial surplus.

The complicating factor is the deregulation transition. As capital controls have softened, Chinese investors have, understandably, bought more foreign assets in order to diversify their portfolios. In the second half of last year, capital outflow was running at an annualised rate around 10% of GDP. While this transitional portfolio rebalancing is taking place, the exchange rate is under additional pressure.

The combination of some concerns about an over-valued rate plus the capital outflows has the potential for dynamic instability: the capital outflow puts downward pressure on the exchange rate; in response investors (and speculators) increase their capital outflow.

The tiny ‘official’ devaluation last August should be seen as a market-based move in the right direction, as was the tentative move away from a dollar-based rate towards a currency-basket model. Measured against a basket of currencies (a better metric than simply against the appreciating US dollar), the renminbi has hardly changed over the past year.

Nevertheless the current exchange-rate policy is in an irreconcilable bind.

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The small ongoing daily downward adjustments, while in the right direction, just give a one-way bet to speculators. China’s still-huge foreign exchange reserves are being leached away to slow the depreciation. Whatever the precise equilibrium value of the currency, the market has decided that it should be lower. The universal experience is that the authorities can’t successfully defend an exchange rate if the market has firmly decided that it is wrongly valued (the Swiss have provided a recent reminder), even if the market later turns out to have been wrong.

It’s hard for China to make a once-off depreciation which would be substantial enough to satisfy the market that the new rate is ‘right’. The usual US exchange-rate vigilantes (not to mention Congress) are ready to cry ‘manipulation’ and declare their own currency war. It would also be a face-losing step backwards on the deregulation path, especially coming just after the renminbi has been included in the IMF’s SDR currency basket. But if the problem is as intractable as financial markets imply, this is the best way out. China should make a once-off depreciation of 10-15%, adopting a fixed rate against a currency basket. This could be backed up by temporarily tightening capital outflow controls. This modest move shouldn’t discombobulate either the foreign critics or the domestic borrowers with dollar-denominated exposure. Deregulation is so tricky that the occasional step backwards is both forgivable and sensible. Deregulation can be resumed when financial markets have regained their composure.

China could respond to the inevitable critics by reminding them that it was foreign pressure (in the form of the 1985 Plaza Accord) that caused the drastic appreciation of the Japanese yen in the following years, which hollowed out Japanese manufacturing. This led in turn to the abnormally low interest rates that fuelled the Japanese asset-price bubble that finally burst in 1990. China’s circumstances are, of course, different, but the Japanese experience demonstrates that foreign pressures in volatile exchange markets can leave a legacy of distortions which hobble economic growth for decades afterwards.


In the first of this two part series on China's economy, Stephen Grenville examines the financial sector and the rate of GDP growth. Part two will focus on the exchange rate.

China is forecast to contribute over a quarter of global growth over the next five years (calculated in purchasing power parity terms), so what happens to the Chinese economy is hugely important for the rest of us. But how can we make sense of the dodgy data and over-excited commentary?

Newspaper headlines and the market commentary would be a poor guide. The Financial Times recently ran an article headed ‘The 29 minutes that shook the world’. No, this wasn’t the Cuban missile crisis, a huge natural disaster or a political coup. It was a fall in the Shanghai stock-market sufficiently large to trigger an automatic halt to trading, but which still left the index higher than it had been just a year before.

Financial market commentators aren’t much calmer than the press. Market volatility is their bread-and-butter, so they aren’t going to miss any opportunity to get some self-publicity by shouting that the sky is falling in.

That said, there clearly are issues of real concern and the Chinese economy is inscrutable, with deficient data. Is it possible to go deeper than the attention-grabbing beat-ups, to discover some analytical ‘fundamentals’ which might anchor the anxieties?

The main current economic concerns are three-fold: the financial sector; the rate of GDP growth; and the exchange rate. In each case, there are underlying issues that reflect the extraordinary transition China is going through.  Such transitions are never smooth or riskless. And they are by their nature unpredictable as there is no relevant precedent.

Let’s start with the financial sector. The stock market ‘has only three speeds --boom, bust or comatose’. There is no point in spending too much time on traditional ‘fundamental’ measures such as price/earnings (P/E) ratios. Leaving aside the doubtful accounting data, the range of P/E ratios is so wide that overall judgment is impossible. The Shanghai composite P/E ratio is currently around 15, about the same as comparable global markets, but the median ratio (with half the companies lower than this number and half higher) is around 65 because there are many smaller companies with stratospheric P/E ratios. In any case the stock-market has only a tenuous relationship with the Chinese real economy, and only 6% of Chinese having any direct holdings.  All that can sensibly be said is that after the market rose 150% in the year to mid-2015, it was very likely to fall back subsequently, which it did

Some have drawn the conclusion that the bureaucratic mishandling of the stock-market (and also the foreign exchange market — more on that in part two of this series) has a wider meaning, demonstrating general incompetence. But these moves have been pretty much what you would expect from a system still deeply imbued with command-and-control ethos. You can fault the individual moves, but you can’t draw a wider conclusion of bureaucratic incompetence. In any case the mis-steps are trivial.

On the other hand, the issues in the broader financial sector are anything but trivial.

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Judging by the near-universal experience elsewhere, the path of financial deregulation is intrinsically crisis-prone. The financial sector expands into unexplored territory with embryonic institutions and inexperienced people.

Simply saying that debt has grown a lot tells us nothing useful about the risks involved: growth of debt is the core metric of financial deepening, so a substantial increase at this stage of China’s development is not just normal, but desirable.  But borrowers and lenders can make mistakes. Has credit grown too far or too fast? China is towards the high end of debt ratios in comparable countries, and the post-2008 growth has been very fast (boosted in particular by the massive 2009 stimulus, for which the rest of the world should be grateful, not least Australia). Anecdotal evidence suggests that substantial cleaning up will be needed, but China has done this before and has the direct administrative controls to do this better than most countries.

The break-neck pace of credit growth needed to slow and consolidate and that is happening now. In the process, funding for new productive assets and new housing will be constrained, so these sectors will feel a financial pinch. That’s part of the wider adjustment which is a desirable transition but will probably be bumpy. If it gets too bumpy, the authorities have room to give further monetary stimulus. Moreover, it is worth remembering that China’s pre-2008 double-digit growth was not driven by fast credit expansion, so the link between debt and growth is not close

What about slower GDP? Again this has been over-dramatised. The point of inflection from double-digit growth took place six years ago and since then China's sustainable rate of growth has been around 7%. This is still the official target, and is close to recent experience (today's figure for 2015 was 6.9%) and to the market's consensus forecast (6.5%). There is a widespread view that the official figures are puffed up by officials anxious to achieve the target, but most observers see this as relatively minor.

Rather than debate the interstices of GDP compilation  which is complicated by the transition to a more consumption-based economy, Chinese officials would be focused on ensuring that unemployment doesn’t become a political problem.

It’s hard for outsiders to judge the truth behind the unbelievable stability of the official unemployment figures,  but each of the reasons why the official figures undoubtedly understate the ‘true’ rate are also good reasons why a modest rise in ‘true’ unemployment might be less politically damaging in China than in most countries.

Can the safety-valve of return-to-the- countryside (which was important during the GDP growth inflection-point in 2009) still work to buffer the impact of slower GDP growth? It seems certain that Zhongnanhai officials are monitoring this issue in a degree of detail far beyond the official statistics. If necessary they would provide more monetary stimulus. Everyone wants to make the necessary transition to a more market-based economy as quickly as possible, but sensible policy-makers will take a step back to regain balance if the pace of transition threatens stability.

Image courtesy of Flickr user Asian Development Bank


When do we need global rules? And who should write them? This is a central issue for the G20 process.

Bank protest November 2009. Photo courtesy Flikr user peoplesworld

In recent years, the UN, specialist technical agencies, and even the private sector have all played in this space. Now the Trans-Pacific Partnership (combined with the nascent Transatlantic Trade and Investment Partnership) represents another approach towards near-universal rules. Even so, the G20 remains the home of global rule making for the finance sector. After the 2008 financial crisis, it set about re-writing a good chunk of the regulation that had proved so inadequate. So how is this high profile attempt working out? It's fair to say the outcome on capital requirements, for example, is mixed while the whole exercise raises questions about appropriate priorities.

The process has been coordinated by the Financial Stability Board, a G20 offshoot working closely with the Bank for International Settlements, that established earlier global financial-sector rules. Those pre-2008 rules were clearly deficient. Banks and other financial institutions didn’t have enough capital to ride out the crisis. Voters were incensed that taxpayers’ funds had to be used to bail out the financial fat-cats.

Against this background, it is not surprising the key reform aim has been to increase capital requirements and thwart the widespread gaming of the old Basel Rules through which some banks (especially in Europe) operated with levels of capital that, we now know, were perilously skinny.

But there are clearly intrinsic constraints on effective global rule-making. In the immediate aftermath of the 2008 crisis, public anger generated strong political will for root-and-branch reform. But it takes time to sort out the technical details and Wall Street (and London’s ‘City’) have been quite successful in steering the rule-making to avoid damaging either their franchise or their bottom line. Delay is the deadliest form of denial,  and, as public anger faded, the proposed rules have softened.  One example of this is the voluminous Dodd-Frank Act,  legislated in 2010 and since watered down in implementation regulation.

Meanwhile, the deep-seated risks inherent in the financial sector have gone largely unaddressed.

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As 2008 demonstrated, the most damaging risks are not external events, such as a housing bubble, but the endogenous responses of market participants. A modest problem escalates when investors simultaneously attempt to strengthen their balance sheets. Risk management is uniform across the entire financial sector, so all market players respond the same way when a risk event arises and, with too many sellers and too few buyers, markets collapse. Prudential rules force banks to recapitalise at precisely the time when financial markets are unwilling to provide capital. Addressing these structural issues would require fundamental restructure of the financial sector. No one has the stomach for that.

The continuing focus on risk-weighted capital requirements means the system is still vulnerable.  One of the key weaknesses exposed in 2008 was that, when the crisis came, bond holders were treated differently than anticipated. In theory, bond investors' funds were available to support failing banks but, when the crunch came, bond holders were repaid, just as if they were guaranteed depositors. Forcing bondholders to write off some of their debt, or 'bailing them in' as the jargon goes, would have been politically painful and might have started a contagious run on other financial institutions. It was easier to pay out the bond-holders, even though this shifted the burden of bank failure to the taxpayers. When Ireland’s largest banks failed in 2009 the bond-holders (mainly European banks) were left unscathed.

Despite the apparent lesson here, the higher capital requirements specified by new rules are achieved by designating exactly this sort of bailing-in process for some bond-holders. Why will it work any better in the future?

The resource-intensive complexity of the new rules also raises a more fundamental issue: do we really need uniform global rules in the financial sector? The rule makers have designed key parameters around the very largest banks (so-called Global Systemically Important Banks or G-SIBs),  of which there are no more than a few dozen world-wide. Banks that are not G-SIBs require less capital, but the complexity of the approach is the same. Prudential regulators in all countries (including those with limited bureaucratic resources) will, as a matter of national pride, set their goal to implement the new rules, even though they may be designed for different circumstances than their own.

It would have been better to have explicitly stated that the 'global' rules should apply only to those banks that provide a threat to the global economy. Other regulators, (including most G20 countries) should have had had a much clearer brief to set their own, simpler versions, more appropriate to their circumstances. After all, competent domestic supervision will do far more to avoid crises than global rules.

So can we conclude this huge effort was a search for a solution to a problem that doesn’t need this high degree of global coordination? More importantly, are there higher-priority areas which do, in fact, require globally uniform rules?

Consider, for example, another G20 agenda item: company tax; or, in the jargon, base erosion and profit shifting. This is a live issue for Australia, given the vocal lobby for lowering company tax. Some of those advocating are, of course,  motivated by the simple personal desire to pay less tax. But even disinterested observers who want to promote an effective tax system understand that capital is the most mobile of resources; profits will move to whatever country has the lowest tax rate.

Does this mobility endorse as inevitable the present position where many foreign multilateral companies pay little or no tax in Australia?  At the risk of sounding naïve, there should be an alternative, where companies make a fair contribution to the costs of administering the economy in which profits are earned.  But this can’t happen without global rules, rules that would have to navigate the different perspectives of large, foreign-investing countries and a capital importer like Australia.

We will need a good international process to get a fair outcome.  If G20 can’t effectively address a problem like this, which unambiguously requires a global solution, we should question its relevance.


In all the festive excitement, it was hard to find any mention in the Australian press of the confirmation of the US-ASEAN meeting at Sunnylands in February.  There is commentary here, here, and here

While we should welcome this demonstration of America's higher priority for our region, it's another example of Australia is missing the 'two steps forward, one step back' progress of ASEAN. Erratic though this progress may be, there is likely to be more happening in ASEAN than in our favoured forum, APEC.

We can't elbow our way into the Sunnylands meeting, but perhaps we should acknowledge the 'centrality of ASEAN' for its members and search out new ways of working with ASEAN. 

Photo by Flickr user ASEAN.


If you just read the headlines, you would get the impression that 2016 was going to be a shocking year for the emerging economies. In reporting the World Bank's just-published forecasts, the Financial Times headline was 'Grim year forecast for developing nations', while The Guardian headline was 'World Bank issues "perfect storm" warning for 2016'. 

If you looked at the World Bank's actual forecast, you'd find that growth of 4.8% is predicted for 2016, 0.5% higher than the estimated growth rate for 2015. You might also note that the emerging economies are growing at well over twice the pace of the high-income economies.

It's apparently very hard for a newspaper to publish an article with a headline saying that things are jogging along as usual. This bias does matter, as it adds weight to the gloomy commentary of financial market, always more concerned about the down-side risk than the up-side. And what happens in the emerging economies is now much more important for the rest of us. The IMF's new Chief Economist, Maury Obstfelt, put the importance of emerging economies this way:

During the 1980s, emerging and developing economies accounted for around 36 percent of global GDP (measured in purchasing power parity, or PPP, terms) and some 43 percent of global GDP growth (with PPP weights). For 2010-2015, the numbers were 56 percent and 79 percent, respectively. So a predominantly advanced-economy lens for viewing the world economy has become ever more outmoded.

All this hand-wringing over emerging-economy growth prospects raises another issue. Why not get the IMF, World Bank and UNDP to consolidate their forecast teams, rationalise the numbers and put the spare forecasters onto some productive work?

Photo by Flickr user wackystuff.


Well, we seem to have scraped through the oft-predicted economic crises of 2015.

The financial markets spent the past year worried about the US Fed raising its policy interest rate, which happened in December with imperceptible adverse effect. Some still worry that we just haven't seen the damage yet, while others try to work up a concern about future rate increases. But 'Wolf!' has been called too often to stir widespread concern.

The China worry-warts have convinced just about everyone that China is on the brink of depression, whereas in fact it is growing twice as fast as the advanced economies, and the necessary transition from the unsustainable pre-2008 growth to a viable pace at around the present rate seems on track. Michael Pettis' 2012 wager of 3% annual average growth for this decade becomes longer odds with each passing year. Tyler Cowen, the new drama-queen on China, is still waiting for a financial collapse. At some stage China will have a growth glitch, and these pundits will claim victory, but predictions have to be time-bound to be of any practical use. In the meantime, China plugs along, still adding more (in dollar terms) to world growth than it did in the 2000s, when it was growing faster but from a lower base.

Perhaps the main 2015 lesson is an old one: economic predictions aren't very reliable. It's not just that the predicted risks rarely eventuate: it's the unforeseen risks that do the damage, because we haven't prepared for them.

That said, let's welcome in the new year by trying to find fresh things to worry about. With commodity prices down (especially oil), resource investment worldwide is likely to fall over the next few years. As well, the steam has gone out of property investment. One forecaster predicts the only prospect of strong positive investment growth over the next few years will be in the high-tech sector.

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This prediction doesn't comprise just Silicon Valley, but that's where the most dynamic action is. Things have changed since the 'tech wreck' of 2000, but it is still a sector built on dreams, with only a minute proportion of start-ups likely to join the ranks of FANG (Facebook, Amazon, Netscape and Google). Sure, there are still plenty of ideas around — driverless cars, virtual reality, big data, artificial intelligence and many variations on concepts for errand-running — and there will be things that no-one (not even Steve Jobs' successors) have yet realised we all want.

But disruptive technologies will, to a large degree, replace things already being done. Domino's mastered the art of speedy home delivery three decades ago, and the pizzas won't taste any better if delivered by drone. The existing banks have a huge advantage in developing payments systems which rely on absolute trust, so they are likely to retain their dominance. Driverless cars would replace existing investment opportunities rather than add to them.

The start-up industry itself is still, for a major part, as insubstantial as dreams. The herds of 'unicorns' (Silicon Valley has nearly 100 start-ups which each have a purported value of more the $1 billion) are vying for the limited pasture. They all want to dominate an area (say, food delivery) so that they can reap the network externalities which go with becoming the dominant player. But by definition, they can't all dominate, and there is no place in this kind of world for the multiplicity of viable competing producers which are typical of traditional industries.

The world has changed since the 2000 tech wreck in that there are now some established successes, but the many failures of the earlier collapse are still relevant. Pets.com raised $US110 million to deliver kitty litter and pet food, but went out of business in under a year. Kozmo.com (speedy snack-food delivery), Webvan.com (grocery delivery) and Flooz.com (e-market payments) all raised substantial sums before permanently logging off.

The inventor of the term 'unicorns' has now coined another: 'unicorpses'. Many of these companies are raising funds, not to make physical investment but to cope with 'cash burn' as they try to establish a dominant market position. Even Uber (valued at more than $US 50 billion) is reported to be losing US$470 million a year.

How far should these concerns be translated into adverse effects on the wider economy? There is a fundamental difference between the tech-wreck and the 2008 financial crisis. In 2000-03, NASDAQ shareholders lost hugely, as did venture capitalists who had invested directly in these failing start-ups. But in most cases they lost their own money; they weren't geared up with borrowing. Thus the financial sector was largely unaffected by the collapse. For the main part, people who had suddenly been made rich by the tech boom found themselves back where they started, and life resumed as before. There was a blip in US GDP growth, but it was short-lived.

If this kind of ephemeral investment comes to a halt, it would not presage an economy-wide contagious crisis like 2008. But it would still take away the one element of investment strength in these forecasts. It's time to think about possible policy responses.

It looks like monetary policy has been pushed to the limit (and perhaps beyond). Fiscal expansion is still constrained by a fixation with debt and deficits. But it's not as if there are no valuable investment projects to be done. So perhaps we should be thinking more about the near-universal infrastructure deficiencies and how these can be funded and made profitable. If the market for infrastructure worked as well as the market for smart-phones, people might prefer to have airports with adequate capacity, better metro-rail networks and fewer potholes in the roads rather than the latest software upgrade. If Silicon Valley could invent an app to offer consumers that choice — between better infrastructure and a new set of emoticons to play with — that really would be an advance.


Ever since the 'taper tantrum' in May 2013, global financial markets have been on tenterhooks, anxiously anticipating the first increase in US interest rates in almost a decade. Now it's happened and the sky hasn't fallen in. Perhaps, as one market observer has suggested, we can start obsessing about something else.

In itself, the increase has very little meaning. A quarter of a percentage point on interest rates isn't going to bring the US recovery to a halt. Nor is it enough to assuage opposite concerns, that low interest rates were inviting asset price inflation. Fed Chair Janet Yellen was careful to signal the change in advance, and to convey that it was not the start of a rush back to interest-rate normality, but, rather, was a tiny step in that direction, with future moves 'data-dependent'.  Elsewhere, forward policy guidance remains some version of 'low for long'.

Nonetheless, there are good reasons for moving rates closer to normality as soon as this can be done without upsetting fragile confidence. Investors should be reminded that 'normality' is not near-zero, and it's certainly not sustained negative interest rates. It can't be sensible to encourage investment projects that are viable only when funded at a negative rate.

Monetary policy has changed greatly since the 2008 financial crisis, as policy-makers explored ways of coping with the initial financial crisis and the subsequent feeble recovery. For a start, the crisis distracted central banks from monetary policy, as they grappled with the other element of their mandate; financial stability.

Then the downturn was so deep and the recovery so anaemic that even lowering interest rates to near-zero was not enough to trigger a recovery. Hence the use of quantitative easing (QE) by US, UK, the European Central Bank and Japan. This has often been called 'printing money'. But it is actually just an expanded version of the usual monetary operations, where central banks buy bonds from the public in exchange for central bank money ('base money').

The legacy of QE is two-fold. First, it has left the balance sheets of central banks with huge bond-holdings and commercial banks with enormous counterpart deposits at the central bank. These will have to be unwound over time, with uncertain impact. In the meantime, QE-expanded balance sheets are at substantial risk from interest-rate mismatch.

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Second, and more fundamentally damaging, QE created the idea that central banks can support economic activity, without limit or cost.

This touching faith in the power of monetary policy was promoted by Ben Bernanke's discussion of 'helicopter money' in 2002, when he was a Fed board member (not yet chairman).  In QE, the central bank exchanges bonds for base money. In contrast, with helicopter money, the public receives a cash gift. There is no doubt that the latter would be much more effective than QE in boosting economic activity, but it should properly be seen as fiscal expenditure, not monetary policy. The 2009 Australian 'cash splash' was a successful example of such expenditure, but it was funded by bond issue, not by the central bank. Helicopter money breaches a key principle of central banks; they do not directly fund budget deficits.

While no country has actually implemented 'helicopter money' so far, the idea has taken hold. Adair Turner, head of the UK Financial Services Authority during the 2008 crisis, is an advocate. British opposition leader Jeremy Corbyn  has called for 'people's QE'. 

Before 2008, most central banks operated with an inflation targeting regime, which gave prominence to price stability, and a subsidiary role to economic activity. This prioritisation made good political sense, as it protected central banks from populist pressures to maintain an overly accommodating monetary stance. With the focus on price stability, central banks had a mandate to 'take away the punch-bowl just as the party gets going'.

Since 2008, the priorities have reversed. Supporting economic activity has become the primary focus. Moreover, monetary policy — rather than fiscal policy — is the favoured instrument for restoring the economy to a satisfactory pace of growth.

Rather than focus on the essentially trivial issue of the timing of the next policy interest rate hike, financial markets could more usefully debate how monetary policy can be returned to a normal footing, where its role in supporting economic activity is secondary and there is no confusion between budget expenditure and monetary policy.

Before the 2008 crisis, inflation targeting was the near-universal best practice framework for monetary policy. It was so explicitly simple, transparent and accountable that it could be implemented by independent central banks, outside the constraints of the parliamentary decision process. This halcyon period for central banks might have been seen at the time as the 'end of history'; the arrival at a stable and optimal framework for monetary policy.  History was upended by the 2008 crisis, and the task of returning to this kind of policy framework should be a current obsession of both financial commentators and policy-makers.

Photo by Chip Somodevilla/Getty Images


There is more to be said about Martin Parkinson's speech on US economic diplomacy, and in particular how Australian attention has been diverted from the challenge of developing our relationship with Asia through region-based arrangements.

Parkinson says that 'what is striking about post-war Asia was the absence until the 1980s of virtually any regional institutions to support economic growth and strategic stability.' This is not really true; both ASEAN and the Asian Development Bank date from the 1960s and, from 1967, the Inter-Governmental Group on Indonesia helped foster that country's post-Sukarno growth path.

What is true is that Western-oriented economic institutions paid little regard to Asia. Toyoo Gyohten, one of the prominent figures in Japan's post-WWII economic global integration, recalled in a 2006 speech that when Japan was admitted to the OECD in 1964, it was the only non-Caucasian nation among the 24 members. Gyohten said:

I still remember vividly the day when I went to a meeting at the Bank for International Settlements as an observer. It was the year the Cultural Revolution was sweeping China...But at the BIS meeting, central bankers from all the European countries were gathered, had cocktails, lunches and dinners and talked endlessly about gold, the dollar and the pound sterling, switching among English, French and German. There was absolutely no interest in the upheavals that were going on at that moment in China. The Vietnam War was at a critical stage but, apparently, the bankers had little interest in such events. I thought uneasily that, for these bankers, the world still seemed to end somewhere around the Dardanelles.

As Parkinson notes, there was some progress in the 1980s and early 1990s. APEC was formed in 1989. In the early 1990s Japan made efforts to link Asian finance ministries, mainly focused on ASEAN but sometime including others, even Australia. In 1991 the Bank of Japan sponsored the formation of EMEAP, bringing together Asian central bankers (including Australia).

In its regional initiatives, Japan was keen to form arrangements that excluded the US. The US, for its part, worked assiduously to avoid such exclusion. Sometimes it could veto the initiative (as it did with the Asian Monetary Fund in 1997) or disband it (as it did, much later, with the Manila Framework Group). If the arrangements looked like going ahead, it could insist on joining or create a similar group. When Japan formed the Four Markets Group in 1992 to foster communication with financial markets in Hong Kong, Singapore and Australia, for example, the US expanded this to become the Six Markets Group, adding itself and China in 1997.

Japan’s motivation was clear enough: it wanted to establish leadership in the region, become the region's channel into the G7 and, perhaps, act as its champion in multilateral forums. The US position was more ambiguous. Its participation in APEC was sparked by a fear of being left out of a Japanese-Australian-Korean initiative, rather than any heartfelt desire to build regional groupings. Perhaps its preference was to foster multilateral arrangements. Whatever the motivation, the manifestation was a lack of enthusiasm for Asian regional arrangements, but a strong desire to participate when they existed.

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One initiative from this time deserves mention because it originated with Australia and was influential in pro-Asian changes to global governance. In 1995 the then RBA Governor Bernie Fraser proposed an Asian version of the BIS. His motivation was to encourage greater Asian participation in the global debate. The BIS response the following year — to admit four Asian countries (and five others) — was a satisfactory outcome: integrating Asia into the global dialogue was the objective, and regional matters could be handled within EMEAP. Further, it was Fraser's talk that spurred Japan to develop its proposal for an Asian Monetary Fund that pre-dated the Asian Crisis.

With these arrangements still in the embryonic stage, global knowledge of Asian economic affairs remained thin until the Asian Crisis. I can recall the then US Fed Chairman Alan Greenspan at a BIS meeting in 1997, assessing the unfolding crisis as a problem of excessive budget deficits (in his ignorance, he was confusing this crisis with the crisis in Latin America in the 1980s; budget deficits were not an issue in Asia in 1997).

Since 1998, Asia (and especially Southeast Asia) had developed a comprehensive web of discussion at all ministerial and bureaucratic levels, mainly built around ASEAN. The most ambitious macro-economic initiative was the Chiang Mai Initiative (it gained the suffix Multilateralization in 2010). So far this has been ineffectual in practice. CMI could have provided helpful support to Korea and Indonesia during tense moments of the 2008 crisis, but was not yet ready to do so. More generally, the ASEAN Economic Community (starting next year) provides the basis of closer integration. 

Sceptics see all this — especially the 'ASEAN way' of non-confrontation and snail-pace progress — as lacking the dynamism needed for effective cooperation. But ASEAN has eliminated almost all its tariffs and smoothed import procedures, as demonstrated by ubiquitous regional supply chains.

Overall, evaluation of ASEAN should not be too harsh. As recently as the mid-1960s, its members were in military conflict (actually the 1980s if you count Cambodia-Vietnam). Europe took 50 years to integrate, with many failed promises, empty communiques and false starts along the way. Asia is also not going to make Europe's mistakes of a single currency and a huge central rule-making bureaucracy (contrast ASEAN's tiny secretariat in Jakarta with the Brussels monolith).

The US is not in the inner circle of these ASEAN-based groupings (and not a member of EMEAP). In part this may reflect the long-standing Japanese idea that if Washington was kept out, it would mean a bigger role for Japan. Or it may reflect the more widely held view that the US would be the 'elephant in the canoe'; it bulks too large, and wants to run things.

If Australia is to find a larger role in Asia, it will have to make its own way, rather than tailgate the US. We should recognise that many Asian countries want some groupings that don't include the US (but could include a less assertive Australia). This attitude doesn't ignore the huge contribution North America makes to Asian security. It just says that Asia needs softer, less assertive forums to sort out its own ideas, which can then be taken to the global forums.

It's understandable that our starting position is often a desire to make APEC the centre of our plurilateral interaction with Asia. We were one of its parents. But we will make no progress in getting closer to the core group of ASEAN unless we accept the centrality of ASEAN. See here for a well argued case for our eventual membership of ASEAN. Why not start by offering $20million-$30 million of untied funding for the ASEAN secretariat?

We have made much progress with lower-profile bilateral relations between our politicians, businesspeople and bureaucrats. Australian police, our Treasury and others should be given credit for establishing close ties with their Indonesian counterparts. Much more could be done. We could, for instance, build relationships with SEACEN, AMRO, ERIA and CMIM. It ought to be part of an Australian economic bureaucrat's optimal career path to spend a few years at one of these institutions. We need to accept the glacial pace of progress on operational issues and recognise this is not the only purpose of these groupings.

When it comes to the multilateral links and the regional groupings, the first step is to establish a degree of independent thinking rather than ask 'what would America do?'

Image courtesy of Flickr user Fushimi Inari-taisha


It's not often that Canberra's senior bureaucrats provide a sustained critique of the functioning of global economic diplomacy. But Martin Parkinson did just that a week ago in the 5th Warren Hogan Memorial Lecture,  using the extra freedom he had while 'between jobs', after he was dismissed in December 2014 as secretary of the Treasury, and before he starts as the new head of the Department of Prime Minister and Cabinet.

Dr Parkinson's speech covers too much ground to be adequately précised here. Instead, let's pick up the central thread.

While the collapse of the Soviet Union left the US the dominant power economically and militarily, that dominance of the last quarter century has come to an end, replaced by continuing US pre-eminence accompanied by the rise of other countries, each individually weaker on each dimension of power, yet able to stymie or challenge, although not displace, the US on different issues at different times.

Washington sometimes found the right response for this new world. It recognised, for example, that the G7's peak role in global governance had to pass on to a more representative group, the G20. But China's rise has proven more problematic, with the US unable to reconcile its security concerns (and loss of overwhelming strategic dominance in Asia), with its desire to see China become a 'responsible stakeholder' in the US-designed global economic framework.

At the heart of the problem is American politics; specifically the power doctrinally-driven ideas in Congress have to thwart good policy-making. Here is Parkinson's example:

The US' often singular focus on global imbalances and exchange rate manipulation is widely seen as a reflection of domestic political imperatives ... a continuing tendency to criticise Chinese exchange rate policies will challenge the abilities of the US and China to cooperate to ensure that minimal global dislocation results from China's impending capital account liberalisation.

He cites three recent examples of mis-steps:

  • The failure of Congress to support IMF quota reform;
  • The US response to the Asian Infrastructure Investment Bank. In Parkinson's words: 'By making the establishment of the AIIB a contest of wills between the US and China — that China won — the US elevated the issue from a useful contribution to the global institutional framework to an issue of global leadership';
  • Going slow on the Trans-Pacific Partnership (TPP), about which Parkinson had this to say: 'putting aside the economic merits of the TPP, failure to have it completed and enacted this year will damage significantly perceptions of the US' ability to deliver on its own initiatives'.

So much for Washington's mistakes. What about Australia's? Parkinson writes:

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Australia's recent history of economic diplomacy is, at best, a mixed bag ... Like the US, Australia hasn't always been as strategic as possible in pursuit of national interests — witness the strident opposition to the Asian Monetary Fund proposal, which damaged our credentials within the region for several years, and the opportunity missed to shape the AIIB with the initial rebuff of China, notwithstanding China's genuine efforts to respond to Australia's concerns.

On the TPP, he notes that 'it seems short-sighted to keep out the world's largest emerging economy from a core trading group, one in which it is the major trading partner of most if not all members'. Did Australia make this case forcefully during the closed negotiations? If not, why not?

Other Australian mis-steps go unmentioned; perhaps because Parkinson wouldn't see them as such.

On the 1997-98 Asian Crisis, Parkinson readily accepts that:

The US, through the IMF, was perceived as both misreading the nature and causes of the crisis and then orchestrating a response which advanced its own political and economic interests.

The response was a watershed in relations between Asia, on the one hand, and the developed countries and the IMF on the other. This is still felt today in Asia's focus on regional institutions and an unwillingness to even contemplate using IMF support facilities.

But he doesn't mention that within Australian policy circles at the time, the Reserve Bank (and perhaps others) had a much clearer idea than his Treasury colleagues as to what was going wrong with the Fund's program. Treasury strenuously opposed the RBA's attempt to influence the Americans and the Fund in what history has shown to be would have been the right direction.

The opportunity cost of this internal bickering is hard to define precisely, but probably considerable. If Australia had determinedly articulated this alternative assessment, the course of the crisis may not have been changed very much. But we would have established our credentials as an insightful and forceful friend of Asia. It might have helped us to be accepted as part of Asia and to shed the 'deputy sheriff' tag. We might now be in the core of ASEAN, rather than on the periphery.

To what degree are Australia's mistakes linked to Washington's? We are one of the closest friends of the US, and a beneficiary of the global order it created. We were more than an innocent bystander: we cheered the US on at every stage. Its failure is our failure too.

What stops Australia from continuing to act as a close ally of the US while at the same time being ready to offer a well-argued case when American policy lacks the cohesion and strategic focus that Parkinson identifies? Our policy makers have some, but not all of the same political pressures: the influence of those members of Parliament with outlandish views is muted by our Westminster system.

Part of the problem may lie in Parkinson's old bailiwick; Treasury. On issues of global economic governance, the Treasury tradition has been to ask 'what would America do?', and then do it faithfully. Issues are evaluated through the prism of the IMF. Of course constantly running interference on Washington's views in global forums would be counterproductive. We do however, need to be intellectually prepared for independent analysis. When our interests differ, we should argue the case.

This might at times be uncomfortable. Insiders recall the shock-and-awe retaliation we received when the initial APEC proposals excluded the US. Parkinson also himself reminds us of 'the anonymous spokesman for the White House whose 'throwing the toys from the crib' response to the UK decision to join the AIIB alienated many'.

But Americans are accustomed to vigorously expressed opinion. We won't often win, but we won't lose anything either. Who knows? It might even provide some helpful direction for the US, a nation for which, as Parkinson writes, 'economic diplomacy has become increasingly more tactical rather than strategic'.

Photo by Brendon Thorne/Getty Images


Now that the terms of the Trans-Pacific Partnership (TPP) have been agreed, the participant countries have to decide whether to ratify the deal. In assessing the benefits, where might we turn for guidance on the economics?

First thoughts might go to David Ricardo, father of one of the few ideas that economists largely agree on: comparative advantage. Countries should produce the things they do best, and trade these for things they do less well. The key insight is that countries should trade internationally, even if they are better at doing everything (they have 'absolute advantage') than their trading partners. 

The policy message is that countries should abandon tariffs and quotas and open up their markets for international trade.

This is, more or less, what Australia has done. Over 90% of Australia's imports have tariffs of 5% or less. We've done this largely unilaterally, believing it to be in our own self-interest. Can't we now just rest on our laurels, while urging other countries to follow our virtuous lead?

Economists might believe this, but they have never persuaded either the public or the politicians. The WTO has struggled in vain for the past decade to make progress at the multilateral level.

So-called Free-Trade Agreements (FTAs) such as the TPP have been the response to this failure. These are preferential agreements, so Ricardo's simple free-trade dictum doesn't apply. There is trade diversion (imports may not come from the cheapest source). Nevertheless the TPP will push some of our partners, over time, towards some reduction in quota restrictions on our agricultural exports. And having 12 TPP members (accounting for one third of world trade) reduces the trade diversion, compared with bilateral FTAs.

Thus, viewed from Ricardo's vantage point, the TPP is not ideal, but it might be the best that can be done in an imperfect world.

The main issues are however, elsewhere, in the high-level 'platinum standard' rules that the TPP imposes on participants. Most of these rules are not closely related to international trade.

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We can't object to the idea of rules, per se. Ricardo's free trade took place in a fantasy world, where cloth merchants met wine traders and agreed on price, quality, payment terms, delivery date and then everyone kept their side of the bargain. Transaction costs were ignored. In the real world, enforceable rules are needed to ensure markets work well. If there are not enough rules, uncertainty and asymmetric information raise transaction costs. If there are too many rules (or the wrong ones), there is a dead-weight cost to transactions; too much 'red tape'.

Thus we need more than Ricardo's 'free market'. But what rules are needed, who makes them, and in whose interests? 

For academic guidance on this, we might draw on the work of economic historian Douglass North (who died last week, aged 95). One of his best-known studies examined the self-imposed rules that developed between long-distance merchants during the revival of trade in the late middle ages.

North's interest was in generalising from this experience, analysing the evolution of rules of conduct. He called these 'institutions' — 'the humanly devised constraints that shape human interaction' — and likened them to the rules of sporting games.

For North, the rules evolved out of social interaction (often by the participants) rather than being imposed by governments, and in response to perceived needs. Whether a particular set of rules persisted or evolved over time depended on whether they served the objectives of the participants. 

So where does the TPP fit into North's view-of-the world? If Australia had been writing the rules from scratch to foster our international economic interaction, does the TPP represent the set we would have devised?

We're an intellectual property net importer, so have little national interest in strengthening the current IP rules, perpetuating the misconception that innovation is best fostered by awarding monopoly rights to the innovator. The same goes for foreign investment dispute resolution. As a major capital importer, we are entitled to think our own domestic laws should be enough to protect foreign investors. Labour laws, environmental issues, corruption, the role of state-owned enterprises and free capital flows are all issues we might best handle with our domestic laws and practices, which might or might not coincide with TPP requirements. In short, while acknowledging the desirability of rules-based international order, these are not the rules we would have prioritised.

Just as in football, we now have the opportunity to sign up for this TPP code which is a less-than-perfect fit with the way we would like to play. One strong incentive to sign is that this is the 'only game in town', at least at the moment. If we don't join, the TPP partners will be off playing with their own set of rules, including some which divert trade away from us. On top of this, economics isn't the only consideration: the TPP is part of our overall relationship with America.

So we will sign up. This should not, however, be the end of the story. Douglass North's narrative analyses why some 'institutions' are persistent (unchanging) while others evolve. Two paths of evolution are open. 

The first is to expand TPP membership, starting with China and Korea, but going on to include Southeast Asia and India. The biggest advantages come from enlarging the number of participants playing by the same rules.

The second is to align the rules more directly with the practical needs of international trade. The TPP rules are unlikely to evolve much, but there are opportunities outside the TPP for rule-making (and rule simplification). In the longer term, the more operational focus of the ASEAN-based Regional Comprehensive Economic Partnership (RCEP) might offer us more advantages, more analogous to Douglass North's trade-facilitating rules. It is moving slowly but is more focused on our region, where our greatest trade potential lies. 

The ultimate advance would entail moving away from competing codes, towards a 'world game' where everyone plays with the same rules. International trade would benefit from both the TPP's high-level behind-the-border rules and the detailed operational facilitation that is at the heart of the RCEP.


Treasurer Scott Morrison has rejected the proposed sale of the Kidman cattle properties to foreign interests:

Given the size and significance of the total portfolio of Kidman properties along with the national security issues around access to the WPA (Woomera Protected Area), I have determined, after taking advice from FIRB (Foreign Investment Review Board), that it would be contrary to Australia's national interest for a foreign person to acquire S. Kidman and Co. in its current form.

There are some special, perhaps unique, factors in this case. The cattle properties involved are certainly exceptional, not only in sheer geographic mass (100,000 square kilometres, or 1.3% of Australia’s total land area and 2.5% of agricultural land), but in terms of their iconic historical status. In addition, one of the properties overlaps the WPA where sensitive weapons-testing takes place.

There are also some not-so-unique factors involved. Selling agricultural land to foreigners has become an emotional issue, especially for the government’s coalition partner, which represents rural interests. The prospect of selling to a Chinese firm (even privately owned) adds another layer of resistance.

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Nevertheless, in principle Australia actively encourages foreign investment. The public generally accepts net benefits have been positive. Foreign investment funds a good part of our substantial current account deficit, which for more than 200 years has allowed us to invest more than we saved, and to grow faster than otherwise.

It's not as if much foreign investment has been blocked. Outside of agriculture, much of the family silver has already been sold: 80% of our mining resources are foreign owned. In agriculture, it's just 12%, and even there we don’t have an 'in principle' objection to Chinese investment and we have accepted a rapid growth of Chinese ownership in this sector.

If we are concerned about foreigners using transfer pricing to avoiding paying a fair share of taxes, then our concerns should focus on the large-scale chronic tax avoidance practised by many multinationals operating here. The national security argument might be relevant in the Kidman property case because of the special location, but it can’t have widespread application, unless we accept the spurious argument that all Chinese investment is a 'projection of power' and that if Chinese own the electricity grid, they might turn off the lights

Past rejections don’t provide much in the way of precedents to establish clear principles. We knocked back Shell’s attempt to buy Woodside, Singapore’s bid to take over the stock exchange (ASX) and the attempted purchase of grain-handler GrainCorp. The approval process also scuppered Chinalco’s attempt to increase its stake in Rio Tinto.

It’s not as if Australia is the only country that vets foreign investors, nor are we the only country  wary of Chinese investment. The US rejected Chinese investment and the US president ticked off our prime minister for not consulting America before leasing Darwin harbour to a Chinese company. Farmland stirs patriotic fervour everywhere. New Zealand recently rejected Chinese investment in a dairy property. China itself is also very restrictive of foreign investment.

Thus just about all countries show a mix of paranoia and parochialism, perhaps with a touch of racial prejudice, in their attitude to foreign investment. But in the end Australia lets almost all of it happen. When purchases have been blocked, the public intuitively understands and largely agrees (this was the case with Woodside, Chinalco and ASX).

This ambiguity isn’t surprising; politics represents community values, which are ambivalent, even inconsistent. Governments have to dissemble, ducking and weaving to maintain sensible balanced policies, and in this case that means considering current account funding and providing a global element to investment.

It is, however, important for Australia, as a substantial capital importer, to either articulate a clear policy on foreign investment or learn to live with a smaller external deficit. It is also possible to squeeze more benefit out of the foreign investment that is coming in.

The starting point is to look ahead a few decades at what our world will look like. Asia (and particularly China) will be a substantially bigger economy. If we are to succeed, our economy will have to be much more integrated with the region. Resources (iron ore, LNG and coal) will still dominate our exports. China (and other Asian markets) will have established the stable supply relationships needed for food and resource security. Australia could provide a significant component of both.

The central policy issue is this: what is the commercial and regulatory framework that will maximise the benefit to us as a nation?

It will require specific skills, knowledge and guanxi to tap the Chinese market successfully. For agriculture, it will require scale well beyond the traditional Australian family farm (just as it does in resources). A high level of Chinese involvement in the Australian supply-source seems inevitable, even desirable. But how to ensure that the disparity of scale (they are huge and we are relatively tiny) doesn’t mean that the value add (the very considerable difference between the farm-gate price and the retail price) doesn’t all go overseas, and the choice jobs along with it?

This needs more concerted policy thinking than just tweaking the FIRB rules in isolation. For a start, our competition authorities need to recognise that scale is often needed to compete globally. Some of the elements of a more comprehensive process are underway. The Productivity Commission is looking at the agriculture sector. DFAT has examined the trade aspects, and the China-Australia Free Trade Agreement (ChAFTA) has helped to define some of the relevant issues.

But if we don't want to run the risk of becoming 'hewers of wood and drawers of water', we will need to do more.

This might include the development of an Investors’ Code of Conduct to provide a template for a broader FIRB application process, putting specific content into the nebulous 'national interest' criterion. This could cover tax and transfer pricing. There might be a presumption there would be a substantive Australian partner. Where it makes economic sense to carry out value-add processing in Australia, this might be mandatory. There would be opportunity, too, for the foreigners to refute the more fanciful of the security concerns.

We should be able to put out the welcome mat for foreign investors while at the same time demonstrating to domestic sceptics they are not on the way to becoming mere share-croppers in their own country.

Photo courtesy of Flickr user Alex Prolmos