When even the former Chinese Premier describes the growth model as 'unsteady, unbalanced, uncoordinated and unsustainable', it's easy to agree that things need to change. Indisputably, there is always a challenge in transition. 

But China has often confounded its critics, avoiding foretold disasters and diverging from unsustainable paths. As already noted, the export-driven growth model has been replaced. The current-account surplus has been reduced from over 10% of GDP to 2.5%. The real exchange rate (adjusted for inflation to give a measure of international competitiveness) has appreciated by around 25% in the past five years. Comparing real wages would show an even larger adjustment of competitiveness. Despite sclerotic banks and a shambolic shadow banking sector, China has so far avoided a financial implosion.

Boosting consumption can't be done overnight (and so far the transformation has hardly registered in the macro figures, even though real wages and disposable income are both rising faster than GDP). But arranging for the population to increase its consumption seems a less daunting task than those faced by Europe (where the talk is 'austerity, from here to eternity'), the US (where taxes have to rise and social security and health-care spending have to fall), or Japan (where official debt is well over 200% of GDP and rising).

It's worth noting that this transition has been done before, famously by Japan, but more recently by Singapore, which adjusted from a similarly investment-dominated growth model. Moreover, China doesn't have to stop investing. With annual GDP growth at around 7%, China would need investment close to 30% of GDP just to keep the capital/output ratio stable, and on top of this has to narrow the huge shortfall in its capital-per-worker compared with advanced countries.

Any realistic forecaster would accept that there are many potential mis-steps ahead for China. China will have to do something about pollution, and this will be costly without adding to output. No doubt a good proportion of past investment projects wouldn't pass a rigorous cost-benefit test. But then again, neither would the Sydney Harbour Bridge, with its grossly-excessive capacity when it was built in 1930.

The missing element from the low growth narrative is that unemployment would rise, provoking a stimulatory policy response. China would extend the transition and put up with low-return investment (recall that when unemployment was the issue, Keynes was prepared to put people to work digging holes and filling them in) rather than have unemployment rise sharply. To be convincing, the low-growth scenario needs to explain why this policy response will not be effective.

Somehow most countries muddle through with sub-optimal policies, bumpy transitions and more corruption and incompetence than is optimal. Doom merchants and drama queens can be wrong again and again, and then claim clairvoyance if their bottom-line forecast eventually comes to pass, for whatever reason.

Growth-sustaining reform is underway. The frustration for policy-makers everywhere is that they have to be right all the time to silence their critics. The Chinese may feel that the bar is being set higher for them than for others in a very imperfect world.

Indonesia illustrates the issues. Its energy subsidy, calculated as the difference between the domestic price and the international market price, is now nearly 4% of GDP and accounts for over 20% of budget expenditure, about the same as what's spent on education. Petrol costs less than 50c a litre at present and even if the much-delayed increase goes ahead, this will rise to just over 60c.

Many oil producers rationalise high subsidy levels by arguing that low petrol prices distribute the nation's own wealth. However even this misguided argument doesn't fit the reality: Indonesia was a petroleum exporter until 2004 but declining domestic production (now not much more than half of peak production) and the spectacular rise in motor vehicles has changed that, and Indonesia now imports more than 20% of its petroleum needs, with this figure growing quickly. Subsidised petroleum is also used to generate electricity, with consumption growing fast as the middle class turns to air conditioning.

No matter how compelling the economic case, raising petrol prices is politically traumatic. There is some history here. One element of IMF conditionality during the 1997-8 crisis was the removal of fuel subsidies. The rise in petrol price helped trigger the huge demonstrations which led to President Soeharto's resignation in May 1998. Since then, every attempt to raise petrol prices brings the students onto the streets again.

It can be argued that President Susilo Bambang Yudhoyono is unduly cautious, because the petrol price was raised in 2005 and 2008 without toppling his government. He is towards the end of his last presidential term, and perhaps has less reason to worry about his personal popularity. But there is substantial parliamentary opposition. The economic case has never won the day.

Indonesia is far from alone in subsidising fuel. At least on 2010 figures, Malaysia, Thailand, Vietnam, Brunei, Pakistan and Bangladesh all have larger subsidies relative to GDP. Moreover, this is not the whole story of just how underpriced petroleum is. The price should really be set high enough to allow for the negative externalities of petroleum consumption (principally the environmental damage).

What can't be disputed is that energy subsidies are a key part of an intractable longer-term global issue. Looking ahead, petroleum seems the scarcest of the energy sources. Thus it is sensible to shift demand to other sources. But if progress is made in reducing petroleum subsidies, more electricity will be produced from coal.

And overshadowing this narrative is the uncomfortable reality that the debate has not yet seriously addressed how the globe will cope with the energy demands of the countries which are now just at the start of the upward demand trajectory. If America's per capita electricity represents where the emerging countries are headed, China has a five-fold increase ahead of it and Indonesia a twenty-fold rise.

Photo by Flickr user JerryAdiguna.

The most wide-ranging but nebulous anxiety relates to the 'middle-income trap', the observation that many countries have moved out of abject poverty into modest living standards, but few have made the extra step, breaking through to high living standards in the way Japan did in the decades after World War II and Singapore, Hong Kong, Taiwan and Korea have done more recently. Chapter 3 of the IMF's recent Asia report finds support for this view, identifying the Asian middle-income countries as being more vulnerable to episodes of sustained slowing.

But if the middle-income trap relies on some intrinsic dynamic of the growth process which causes growth to run out of puff at the income levels reached by Indonesia, Malaysia and Thailand, then the Asian evidence is weak or non-existent.

The Fund's analysis is based on two types of slowing. First, the countries caught up in the 1997 Asian crisis took a decade to recover from this searing experience. Then there is the more recent experience of India and China, both shifting from a period of unsustainably high growth to slower but still rapid growth.

None of these episodes seems either intrinsic to the growth process or similar to the chronic failed promise found more typically in Latin America (for example, Mexico and Brazil). Having identified Indonesia, Malaysia and Thailand as candidates for 'middle-income trap' status, the Fund's growth forecasts for these countries (found in the same document) are uniformly around 5%, safely above any trap.

If the discussion of the middle-income trap is intended as a salutary reminder to the region's policy-makers that economic growth requires vigorous and continuing reform, then the importance of the message cannot be denied. The essence of the development process is the progressive replacement of inefficient practices by more productive ones.

These transitions are not easy or inevitable: labour has to be shifted to new jobs and techniques; vested interests have to be circumvented; government maladministration has to be reformed.

But the middle-income trap is an unconvincing threat in the Asian context. Anyone observing the myriad opportunities to correct inefficiencies, smooth the production process through better infrastructure and reap the obvious potential for transformational productive change will see the glass as half full rather than half empty.

The refutation of the middle-income trap hypothesis is apparent in countries like Indonesia which, despite the painfully obvious deficiencies of policy, governance, productive techniques and infrastructure, are growing at a steady 6% a year. The same document gives the game way when it records (Graph 1.25) that the return on assets in Indonesia is over twice the rate in any of the advanced countries. The issue is not whether Indonesia is falling into a middle-income trap, but rather why it doesn't take the available opportunity to grow at 8% rather than 6%.

Of course, reaching such higher potential would require the solution to stubborn problems, mainly political rather than economic. Even the current growth rate is not assured, since it is always subject to the risk of financial crisis or serious policy errors. But to base the case for better policy-making on the threat of the middle-income trap risks being ignored through irrelevance.

In a normal recovery, fiscal policy would be working in tandem with monetary policy. But the aftermath of the 2008 crisis has limited the fiscal room for manoeuvre. After the big boost of 2009, fiscal policy changed tack to focus on deficit reduction as countries attempted to get their debt back on a sustainable trajectory.

Each time the budget deficit is squeezed down another notch, there is a contractionary impact on growth. The graph above from the IMF shows the big hit of fiscal contraction in the European periphery (the green bars) in 2012, with an encore planned for this year. Non-euro advanced economies (blue bar) will have more fiscal contraction this year than last (mainly reflecting the sequester-augmented US fiscal impulse, worth nearly 2% of GDP), with further substantial contraction next year.

With the tensions surrounding the Fund's GDP growth prediction, a realistic forecaster would have to contemplate the possibility, even likelihood, that 'something's got to give.' Austerity is fraying at the edges, with Italy seemingly the latest case. Despite the reduction in deficits — and the painful squeeze involved, shown in the graph — they are still large (over 5% of GDP in the US, 10% in Japan and nearly 7% in Spain) and thus official debt is still rising.

The Fund seems prepared to cut some slack for the UK to ease austerity but there is not much sign of a general departure from the soft monetary/tough fiscal combination.

In advanced economies, the right macroeconomic approach continues to be gradual but sustained fiscal adjustment, built on measures that limit damage to activity, and accommodative monetary policy aimed at supporting internal demand...

The main risks relate to fiscal policies in the United States and, especially, Japan, which are not sustainable. It is therefore disconcerting that the prospects for comprehensive fiscal reform have dimmed in the United States and that policymakers in Japan have renewed fiscal stimulus before adopting a strong medium-term consolidation plan and growth strategy.

Are more radical ideas being explored elsewhere in the Fund? 'Rethinking Macroeconomic Policy', an IMF-hosted conference held in mid-April 2013, posed two key questions for fiscal policy: what is the critical debt level in a world of flighty financial markets and what is the optimal speed of debt reduction? The high-powered seminar didn't, however, offer much in the way of specific answers. 

A measure of our ignorance (or the complexity of the issue) is provided by this comparison of the UK and Spain, which have much the same official debt ratio. But Spain's bond interest rate is three times that of the UK and its fragility is far greater. This comparison gives the (British) author the opportunity to repeat the oft-heard English view that the euro was a great mistake. Another (also British) commentator offers a solution: Spain should leave the euro.

Meanwhile, back in the real world, the Fund provides some comfortingly ambiguous words in its G20 Note: 'fiscal tightening must continue at a pace that the recovery can handle'. Indeed.

The self-righting properties have been feeble. Confidence is frail, even in those countries which have implemented impressively tough budget restructuring (notably the UK). And now the 90% tipping-point has been demolished.

In any case, none of these one-dimensional austerity rationales was useful guidance for the actual problem at hand: given the slow recovery and the looming debt burden, what was the optimal budget profile over time to steer between these two conflicting constraints? The sensible compromise was to support the weak economy by not unwinding the stimulus quickly while at the same time making firm and credible medium-term plans to get the debt on a downward trajectory. To implement this common-sense approach required detailed judgment, not doctrine-driven imperatives.

It was a different error which was probably more important in encouraging the switch to austerity in 2010. The 2009 stimulus was so successful that advanced-economy growth during 2010 was twice the pace predicted by the IMF. In 2010 it looked like a sustained recovery was underway and serious efforts to rein in debt could and should begin. This was not just the IMF's misjudgment; the OECD and the BIS also saw the recovery as strong and the need for budget restructure as pressing. Meeting in Toronto in 2010, the G20 countries undertook to 'at least halve deficits by 2013 and stabilize or reduce government debt-to-GDP ratios by 2016.' 

But if the forecasts had understated growth in 2010, the next two years were well below forecast, leaving the weak recovery with an austerity setting designed for a stronger environment.

Policy-makers were, at the same time, let down by a more insidious error: an over-reliance on econometric models. At the time, the IMF's model showed that fiscal austerity didn't have a strong contractionary impact. The Fund now accepts that the fiscal multipliers significantly understated the contractionary effect of austerity.

While the Fund has been admirably frank in discussing this revision in fiscal multipliers, it has been slower to incorporate this into policy advice. If the multipliers are bigger, the austerity should be softened if you want to be on the initial forecast path. This altered perception is slowly filtering into the policy commentary. The Fund seems ready to argue with the UK about its degree of austerity. Perhaps the argument needs to be widened to include the US, where growth forecasts are less than half the usual pace coming out of a recession, while the budget is imposing a contractionary impact this year equal to 1-1.5% of GDP.

The IMF is not alone in re-positioning. Larry Summers now thinks the 2009 Obama stimulus was too small, shifting his alliterative advocacy from 'timely, targeted and temporary' to 'speedy, substantial and sustained'. Australian Treasurer Swan agrees, urging less austerity for Europe.

It can be argued that the economists' views, whether right or wrong, were not central to the austerity debate, which took place at a political level. In the US, in particular, it was a doctrinal debate about the proper size and role of government. Economics (eg. the R&R analysis) was just a handmaiden of politics.

But this lets economists off too lightly. Keynes made the point long ago: 'the ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood.' Good economists know that nothing is certain and everything depends on everything else. They know the weakness of their analytical tools and resist the temptation to enshrine ambiguities with the false precision of models or with the blinkered certainty of doctrine. Economists have to resist the demands of politicians who want simple arguments ('one-handed economists') powerful enough to confound their opponents and sway the public. Economists need to respond quickly to unfolding events and stand ready to take the defence attributed to Keynes: 'When the facts change, I change my mind. What do you do, sir?' 

R&R's mistake was to draw strong conclusions from muddled data and sloppy technique. They were too ready to accept a result that fitted their preconceptions. If we argue that it didn't matter, then we downgrade the role of academic analysis in policy-making. This leaves the field open to Keynes' 'madmen in authority.'

Just as the Chinese had their concerns that the proposed merger between the iron-ore operations of Rio and BHP had the potential to disrupt markets, powerful intermediary traders like Glencore have the same capacity to shift prices in ways that sometimes benefit the supplier, sometimes the buyer, but always the trader. Well-functioning markets require not only competition between the participants, but good information about supply and demand.  It's the sort of global issue that G20 might take on.

This article in the Financial Times gives a more general (and amazing) analysis of the big trading firms.

Photo by Flickr user Tobias Mandt. 

There are some issues while this 'monetary policy plus' is in force. Low interest rates cut the income of pension funds (and pensioners). While low interest rates help banks and companies repair their balance sheets, this may at the same time take pressure off firms to restructure. Cheap borrowing might facilitate projects which will no longer be viable when interest rates rise. Low exchange rates have been a source of discontent for countries on the other side of the rate, who have seen their currencies lose competitiveness. In short, there are some concerns, though nothing demanding immediate reversal of QE.

Looking ahead, does unwinding QE present concerns? While there is no mechanical reason why QE itself should boost inflation in economies which still have significant spare capacity, if the demand for credit picks up, central banks will have to rein in this demand by raising interest rates. This is never popular ('taking away the punch bowl just when the party gets going'). Thus Risk Number One is that these central banks will be slow to raise interest rate when the time comes. This is a serious issue, but not imminent.

Do they need to reverse all the QE to keep a tight monetary rein? No, as they can keep the excess reserves firmly locked in the banks' balance sheets by offering a sufficiently attractive interest rate on these deposits.

The more serious concerns centre on how the economy would react to a higher interest rate, having gone so long (five years and still counting) with historically very low interest rates. It's not just the short-term policy-determined interest rates that would go up. Long-term interest rates are extraordinarily low in many countries. In theory the market has already built this into its plans and prices. But based on the US experience of 1994, even inevitable interest rate rises come as a discombobulating surprise to financial markets. We used to believe that financial markets were forward-thinking and risk-aware, but 2008 disabused us of this view.

Where would the damage occur? When longer-term interest rates rise, bond-holders make a capital loss. A 1% rise would cut the value of the US Fed's bond portfolio by 8%. For the Bank of Japan the losses are smaller now, because the long-term bond-buying has not started, but this vulnerability is about to rise sharply. As well, Japan's commercial banks have one-quarter of their balance sheets invested in government bonds.

Moreover, budgets will take a big hit. Japanese government debt is 240% of GDP, so a 1% rise in interest rates will, in time, add 2.4% of GDP to budget expenditures. So if the BoJ succeeds in raising inflation to 2% and long-term bonds respond, Japan has another set of problems on its hands.

The QE experience has been an amazingly bold policy initiative, justified only by the intractable nature of this crisis, where conventional monetary policy has been pushed to the limit and fiscal policy has been sidelined because of debt concerns. But the longer the abnormal price signals of low interest rates persist, and the more balance sheets are distorted by QE, the more disruptive the unwinding of 'monetary policy plus' will eventually be.

It is building confidence and buying time for other policies to work, but in most cases this time is being frittered away without addressing the basic problems: unsustainable debts in the European periphery which need to be written off rather than rescheduled, fiscal deadlock in the US and unaddressed structural problem in Japan.

The usual argument is that this gives rise to 'moral hazard': if all bank funds are guaranteed, then bank management will be less prudent in their lending, equity backing, and liquid provisioning. Thus the deeper logic is that small depositors ('widows and orphans') are protected for social reasons while larger depositors are left unprotected so they can provide some discipline on banks.

Policy-makers always live in the hope that things won't get to this stage. If vulnerabilities can be identified before the bank is insolvent, then the central bank can keep the bank afloat while the liquidity problems are sorted out.

If the bank is insolvent, authorities have to decide if the bank can be closed without setting off a run. Can the public be convinced that this bank's problems are idiosyncratic? If so, the larger depositors can be given a haircut to help fund the bailout. If not, the authorities have a systemic crisis on their hands, and the only way to stem it may be to change tack and offer a guarantee to all depositors. If the crisis is going to last for more than a few weeks, the bond-holders may have to be guaranteed as well (otherwise they will run as soon as their bonds mature).

Thus it is not amazing that, until Cyprus got into trouble, all European bank depositors (big and small) and bank bond-holders have been bailed out, starting in Ireland.

Of course there is a downside. The more this happens, the greater the moral hazard legacy left behind: henceforth the discipline on bank management is reduced. This is hardly an ideal outcome and much head-scratching has gone on to find a better solution. More bank capital, faster identification of vulnerabilities, and contingent capital (bonds which become equity in a crisis, to help fund the bankruptcy) have all been explored.

On top of the moral hazard issue, 'crisis fatigue' has set in. Taxpayers are getting restless. It's one thing to bail out the widows and orphans; it's another to help fat cats in tax havens. The Germans feel this most strongly.

These unresolved issues came to a head with Cyprus. The required bail-out was not huge, but the European Union was not ready to foot the whole bill, so the residual had to be met from somewhere. Cyprus, anxious to retain its status as a favoured tax haven for Russians, was reluctant to make the bigger depositors bear all this residual cost.

But to attempt a solution which gave a haircut to the small depositors seems to be the height of folly. It's true that this 'solution' only lasted a few days, but by being prepared to contemplate the unthinkable, the damage has been done. Imposing capital controls in Cyprus adds to depositors' skittishness.

The fragile ambiguity that holds flighty depositors in place now has an added element of concern. The Humpty Dumpty of faith in banks is going to be hard to put back together, not just in Cyprus but in the peripheral countries where the big risks lie. The European crisis is not over yet. Greece, Spain, Portugal and perhaps Italy and Ireland will require more debt relief at some stage. Bank depositors will wonder whether they might be part of the solution.

Photo by Flickr user smokeghost.

Perhaps the reform process was over-sold. Even impeccable macro policies can be weighed down by small scale, an absence of agglomeration benefits, distance to markets, a wide dispersion of skills in the workforce and natural disasters.

There is, however, another narrative. Despite its admirable reform efforts, New Zealand has a modest saving performance. This may be the key to the main macro-economic complaint: the strong NZ dollar, around 15-20% higher now than in the decades following the 1985 float. A combination of low savings, a readiness to invest in housing and some strong exports (milk, timber) push up the floating exchange rate. This stronger exchange rate means that other exporters (most vocally, manufacturing) are squeezed, perhaps out of existence.

Housing provides the other element of this story. After a couple of decades of net emigration, since the late 1980s there has been substantial net immigration and population growth of around 2% per year. These new arrivals need houses, putting upward pressure on demand and inflation, necessitating consistently higher interest rates. 

Averaged out over the past two decades, New Zealand's interest rate has been 3.5% higher than US rates. This attracts volatile carry-trade flows to fund the current account deficit, making it hard for the country to do well because it borrows a lot overseas and pays high interest rates. Then it uses the borrowed money to build more and better houses, which is not unimportant, but not the best way to boost productivity and move up the OECD pecking order.

With both the interest rate and the exchange rate high, investment in the export sector is discouraged. While most countries have increased the share of exports in GDP over the post-World War II period, this ratio has hardly changed for New Zealand.

Where to break into this low-performance circle? If New Zealand saved more, the current account deficit would be smaller and interest rates and the exchange rate lower, thus giving better incentives to exporters. Surprisingly absent in the reform agenda is compulsory saving or strong tax incentives for saving. KiwiSaver is an example of a small savings incentive, but is not enough to make much difference.

The high unemployment rate suggests something else seems to be wrong. New Zealand is the country that transformed Chinese gooseberries into kiwi fruit, persuaded the world that grassy sauvignon blanc was palatable wine, taught the world how to sail in the America's Cup, invented economic modeling with the hydraulic Phillips Curve machine, bred the best race horses and film actors, conquered Mount Everest, turned the Lord of the Rings from a fable into an industry, and may have invented the pavlova. The country seems to have lost its zing.

New Zealanders are a long way from throwing in the towel and accepting the offer we made them, more than a hundred years ago, to join in the Australian federation. But consistent sub-par performance encourages good people to shift overseas. There are half a million New Zealanders living in Australia.

More seamless integration across the Tasman is one sensible response. The Closer Economic Relations trade agreement is still being tweaked to reduce the barriers (the day when we can eat New Zealand apples may not be too far off). But sovereignty is a prickly thing. We haven't even been able to unify banking supervision, even though the New Zealand banking system is Australian owned.

Photo by Flickr user wowser.

Greek banks are de facto insolvent, but are being held up by the EU rescue package and support from the European Central Bank. As with Ireland, not only are depositors safe (at least so far), but so too are bond-holders. Again, the generosity of the EU was in part a reflection of the huge losses French and German banks would take if Greek banks failed.

Cyprus represents a further variation on the break-down of old understandings. This time, at least in the initial format of the rescue, depositors (even small depositors) will take a haircut. There weren't enough bond-holders to absorb the size of the losses, but why not give the large depositors (who are rarely guaranteed in full, anywhere) a more substantial haircut, paying the small depositors in full? Again, international considerations seem to have been in play: many of these larger depositors are Russian. Big losses to depositors would put an end to Cyprus' role as a favoured tax-haven for rich Russians.

In each case, the knock-on effects of the need to keep the banks afloat has shifted the problem over to the government. The problem has been kicked down the road through EU/IMF rescue packages, but it is inevitable that there is more pain for creditors ahead.

In a normal domestic bankruptcy there would be some kind of stand-still which limits the creditors' ability to take legal action while an equitable arrangement is sorted out in the meantime. The Greek rescue allowed those whose bonds were maturing to get out at full value even though Greece's insolvency was apparent at the time. An equitable arrangement for remaining creditors still has to be worked out. If private creditors take a further haircut, why not the official creditors? If the ECB takes a haircut, why not the IMF? This is a slippery slope. At some stage, Greece and perhaps others among this group will have to be given an orderly restructuring that restores debt sustainability. But there is no internationally agreed process of sovereign debt restructure.

It's not as if sovereign defaults are rare, with Iceland and Argentina just a couple of recent examples. After the Asian crisis, Anne Krueger, then Deputy Managing Director at the IMF, made a valiant but ultimately futile effort to put in place agreed procedures covering just a few aspects of sovereign debt restructuring. 

The US gave no support, showing its usual disdain for multilateral rule-making. Many creditors thought they would do better with ad hoc arrangements, especially if the ad hocery forced bigger contributions from governments. Even among the potential defaulters there was no agreement on how generous the arrangements should be or on seemingly sensible matters such as collective action clauses. Resolution has been achieved in the past through the Paris Club, or through ad hoc efforts such as the Brady bonds for Latin America in the 1980s, or the negotiated rescheduling achieved by Uruguay in 2003.

This ad hocery, however, saps confidence which in turn undermines growth. We see the outcome in the case of Europe: successive market panics, with self-serving drama-queen creditors ready to warn of widespread contagion, thus putting more pressure on governments to offer more generous taxpayer support. With the Cyprus depositors' haircut, banking runs will now become more common. Recent US court cases relating the 2001 Argentinian rescheduling have undermined existing ground-rules. In short, there is a disconnect between the growth of global capital integration and the rules needed to make it work well.

Photo by Flickr user danielmoyle.

Some commentators gave a positive spin to austerity, though it's not clear that those academics making the case for expansionary austerity (aka the 'confidence fairy') had much influence on the debate. The UK was the only country that had the required precondition (a big depreciation in the exchange rate) and even here exports failed to respond.

Much more important was the doctrinal belief that budget discipline was in itself a good thing, regardless of the phase of the cycle. Germany articulated this view with moral fervour, having extra authority as the only European country growing normally. In the US, this view was held far more widely than just within the Tea Party, but this tiny faction was effective not only in promoting the 'starve the beast' small-government narrative, but in making it politically impossible to repeat the 2009 stimulus. The succession of budgetary/debt confrontations have distracted the US from examining whether continuing austerity (which will take around 1.5% off growth over the next year or so) is appropriate.

In addition, too much faith was placed in the notion that monetary policy alone would do the job. Following the 2008 crisis, central banks swiftly lowered interest rates, which was doubtless very supportive of the economy, but once interest rates are close to zero, there is not much more that can be done.

Nevertheless, quantitative easing (QE) was added to the monetary policy arsenal. Nearly a decade ago, Japan demonstrated that QE has little or no impact beyond the psychological support it provides. The post-2008 rounds of QE may have helped stock markets and lowered exchange rates, but it is a feeble instrument. Now some are suggesting that an extreme version of QE should be used as a way of getting around the fiscal policy impasse. This is desperate last-resort policy advice. It would be better to say that monetary policy had done all it can sensibly do.

Austerity has made debt ratios worse rather than better. Growth forecasts are lacklustre for as far ahead as projections go. The politics in the peripheral European countries is barely holding together. Yet no-one is ready to change fiscal tack.

To advocate abandoning austerity would be too much of a back-down. The UK Government would have to admit that its policy had been 'courageous', in Sir Humphrey's terminology. The IMF has accepted that the fiscal multipliers used in earlier forecasts understate the contractionary impact of austerity, yet maintains its customary 'one the one hand...on the other' ambivalence. The latest G20 meeting did little to soften the targets set down at Toronto in 2010 to 'at least halve deficits by 2013 and stabilize or reduce government debt-to-GDP ratios by 2016.'

It would be easy to blame this on dysfunctional politics: bitter acrimony between Democrats and Republicans in the US, an overly-doctrinal approach in the UK (perhaps falsely comforted by Lady Thatcher's 'There Is No Alternative' legacy), and sharp differences of national philosophy in Europe.

But this lets economists off too lightly. Some asserted that the economy has strong self-equilibrating properties. Others wanted to blame balance sheet problems for the slow growth without also emphasising that fiscal expansion might still be appropriate. Some argued that the answer lay in structural issues, not the deficit. Others delved into the history of totally different economies to prove that debt levels were unsustainable just about everywhere, even though historically low bond yields have been signaling that the market was ready to fund bigger budget deficits.

If economists had offered a clear consensus prescription for restoring economic health, it would have been harder for the politicians (some with their own nutty economic ideas) to have dithered so much. Is it too late to ease the austerity?

Photo by Flickr user gabaus.

As foreign fund managers started taking a harder look at Indonesian government debt or Korean bonds, they saw that these were safer than the debt of some advanced countries which, in the mindless optimism of the pre-2008 era, had been given high rankings by the credit rating agencies. Fund managers were also attracted by the 'search for yield'; easy monetary policy in advanced countries took interest rates close to zero, making emerging-economy yields look attractive.

There has been a perceptible shift in mind-set. Until 2008, advice on financial development followed the broad prescription of the Washington Consensus. Countries should rely on market outcomes, reducing restrictions and regulations. New entrants (especially foreigners) should be warmly welcomed as they enhance competition. The longer-term objective was to develop a full-service financial sector offering a wide range of financial products such as derivatives and forward markets. Capital market development would foster securitisation and financial engineering, effectively tapping into the flows of global capital.

In practice, the market-sensitive, short-term, volatile component of the inflow was of little use to emerging countries. They could not fund longer-term projects with this flighty money.

With the experience of the 1997-8 Asian crisis reinforced by the 'sudden-stop' capital reversals in 2008, the shrinking role of the banking flows should be seen as a plus rather than a minus. Countries will do better to create an attractive environment for FDI (emerging countries account for 38% of global GDP yet host only 7% of the global stock of FDI) and foster a deep government bond market with a stable yield curve which nurtures the corporate bond market. The over-arching aim is to link up the sources of longer-term overseas funding (for example, pension funds or sovereign wealth funds) with priority projects such as infrastructure. The objective is to attract 'patient' capital: investors who will stay put.

Private-public partnerships, which have been the centre of attention in multilateral development banks, will still find a place in this new environment, but they have often turned out to be overly complex in their legal requirements and disappointing in their ability to allocate risk sensibly. Old-fashioned instruments such as bonds (perhaps directed specifically at infrastructure funding) could be the new vogue.

Despite falling flows since 2007 and ongoing deleveraging, it seems unlikely that globalisation of capital is under threat in the way discussed in this McKinsey report. The big financial contraction reflected the excesses of the previous period. The need for longer-term funding is too pressing and the differential profit opportunities (dynamic emerging countries versus stagnating advanced countries) are too great. Of course the flows will not all be 'downhill' to the emerging economies. China's capital outflows are now substantial and 'south-south' flows are becoming more important. Closer integration of global financial markets seems irreversible.

Core elements of the Washington Consensus are still relevant: financial sectors in most emerging countries are still shallow and over-regulation stifles financial deepening. But more policy effort should go into fostering a simple but robust institutional structure, with legal certainty and high transparency. The G20, G30 and McKinsey reports reflect this shift in mood but there is a still a long way to go before this stronger institutional environment is in place.

Photo by FLickr user CaptSpaulding.

First, note this news item reporting that the Glencore/Xstrata merger is being delayed because it has not been approved by China. China has some concerns that the dominant position of the merged companies in commodities presents pricing and supply concerns. Given the bulk of the merged company, its history and its non-transparent governance centred in an obscure Swiss canton, these concerns seem to have some basis.

The concerns were not limited to China; the merger also needed to be ticked by the EU and the South Africans. But in Australia, where a large proportion of Glencore/Xstrata's physical assets are located, we don't seem to have had much official interest, despite the fact that we have as much at stake as the Chinese in fair pricing (we are suppliers; they are customers), and more interest than anyone in ensuring that Glencore/Xstrata pays its proper share of tax and royalties.

Foreigners buying up Australian companies have to pass through the Foreign Investment Review Board process, but look how widely the net was spread when Chinese company CNOOC took over Canadian oil-producer Nexen. Not only did the Canadian authorities have to approve this deal (which they did, with conditions, the main one being that this would be the last of this type of take-over approved), but because the company has some petroleum leases in the US, these leases had to be in a form approved by the Americans before the deal could go ahead.

Perhaps the most contentious issues arise where the 'freedoms' embodied in international treaties come into conflict with domestic laws. A case in point is the legal efforts by Philip Morris to use the disputes-settlements provisions of an old free-trade agreement to oppose Australia's new cigarette packaging requirements. These requirements were not without controversy here in Australia, but after a public debate, they have been put into law and have a high level of public support. How can the general provisions of a trade treaty over-ride this?

While this is being fought out in the courts, the same general issue is under debate with regard to the negotiations for the Trans Pacific Partnership agreement. Australia has said it will not be party to the disputes-settlements clauses of the TPP draft that give foreigners the sort of leverage which Philip Morris is attempting to use. A US Under-Secretary of State affirmed last week that this clause is non-negotiable. 

Let's hope the Australian negotiators get the political backing they need to protect Australia's sovereignty (and that they ensure that foreign investors have no special exemptions or advantages over domestic investors).

One of the central characteristics of the TPP is that it goes well beyond simple trade issues. Whereas there is overwhelming support among economists for the idea of free trade, this blanket endorsement does not carry over to other aspects of the TPP. Issues such as intellectual property rights require specific measures to ensure an equitable sharing of the benefits between producers and users of IP. Issues such as labour markets and foreign investment rules are legitimate areas of difference between countries.

The general presumption in favour of free trade should not be invoked to create a halo effect over other issues where there is room for legitimate differences of national interest.

Photo by Flickr user Lightmash.

The selection process for the new BoJ governor (announced any day now; Haruhiko Kuroda is the front-runner) ensures that he will be a fully committed expansionist, whereas outgoing Governor Masaaki Shirakawa has dragged his heels on QE and has been defeatist on boosting inflation. Textbook logic is on Shirakawa's side, but the depreciation in the yen since Abe's victory shows that the exchange rate can be shifted simply by the expectation of different policies.

Provided the magic doesn't wear off, the new regime may be able to keep the exchange rate around its current level, or even manage to depreciate it more without being accused of 'manipulation' by its G20 partners. This would, by itself, be a useful stimulus. In the aftermath of the 2008 crisis, the yen appreciated by well over 20%, making Japanese exporters less competitive. With this painful appreciation now reversed simply by the anticipation of Abenomics, the mere arrival of the new regime at BoJ might, just possibly, be enough to inspire confidence and stir business out of its lethargy.

Prime Minister Abe has promised a fiscal stimulus of 2% of GDP, though there is some double counting so the effect will be a bit smaller.

Fiscal stimulus has a more dependable expansionary impact than QE, but not everyone is enthusiastic. No one is arguing that this modest expenditure is the straw that will break the back of Japanese government debt, but it is a move in the wrong direction. Japanese debt is often quoted as being 230% of GDP, but this is a gross figure and there are large official bond holdings (by the social security fund and the BoJ), so netting these out gives a less dramatic 120% of GDP. While this is still high, the real concern is that it is projected to rise, with the IMF arguing that at some stage Japan has to wind back its underlying budget deficit by around 10% of GDP.  

Japan is a lightly taxed country by international standards. The GST is 5% compared with an international norm of nearly 20% (although it is scheduled to rise over the next two years to 10%). Thus this fiscal consolidation is not unachievable. But Japan does not have a lot of room (or time) to continue fiscal expansion. The Government currently pays less than 1% on its debt, but if debt concerns or higher inflation pushed this up to, say, 3%, the budget would be in serious trouble (and bond holders would make a big capital loss).

That leaves the hardest area: structural reform and deregulation which would instill new dynamism into sclerotic sectors. No one doubts the potential for reform, but no politician knows how to do it while simultaneously getting re-elected. One way to package the necessary disruption might be for Japan to sign up to the Trans-Pacific Partnership, which requires participant countries to meet 'platinum standards' of openness for a wide range of behind-the-border regulations. Japan's thickets of protectionism (especially in agriculture) would, however, be difficult to penetrate.

Perhaps we shouldn't be too surprised, or too critical, about the current conjuncture if we recall just how much Japan has had to adapt in the past 25 years. It used to be the fastest-growing OECD economy, with an exchange rate that made exporting easy (300 yen to the dollar, compared with 90 now) and asset prices that promoted national pride and confidence. Remember when the grounds of the Imperial Palace were valued the same as the whole of California?

But that was then and this is now. It's hard to create a spirit of dynamism in an economy with few growth prospects, a shrinking labour force and a huge government debt. Demography has caught up with Japan, limiting flexibility and weighing down the social security system.

Tweaking monetary policy and another shot of fiscal stimulus aren't going to change much. Structural reform, the third element of Abenomics, is hard work. The alternative is more of the genteel stagnation of the past two decades. Even in the lost decades, per capita income crept up and unemployment remained low. Maybe that's not too bad, after all.

Photo by Flickr user Mullenkedheim.

The Brazilians fired off the first salvos in this skirmish more than two years ago when they were subject to huge capital inflows and strong upward pressure on their currency. Since then, their exchange rate has fallen sharply, slower domestic demand has allowed their own high interest rates to be eased, and capital inflows have diminished.

As for the Japanese, the yen certainly appreciated painfully (by more than 20%) in the wake of the 2008 crisis, and the sharp fall since it became clear that Abe would be elected just restores normality (in as far as normality can be judged with Japan's volatile exchange rate).

The US dollar has certainly weakened during the post-2008 period, but the change has not been dramatic. The main beneficiary of a weaker exchange rate has been the UK. Within the euro area, there are different views: the French are complaining, but the Germans, whose competitiveness has improved since 2008 and who continue to run a big external surplus, will muffle the French complaints.

What about the other countries on the receiving end of the 'war'? China tacitly accepted, long ago, that its exchange rate had to appreciate and has concentrated on ensuring that this is a controlled process. The yuan has appreciated around 5% over the past year or so, and perhaps twice that in inflation-adjusted terms. The current account surplus is below 3% of GDP (ie. not abnormal) and foreign exchange reserves have leveled out. Most of the competitiveness adjustment is taking place in the form of rapid increases in domestic wages, which will at the same time address the consumption/investment imbalance.

Other Asian emerging countries have not so far been seriously affected, with exchange rates not under strong appreciation pressures. South Korea will feel the effect of the yen's weakness, but this offsets their own substantial depreciation in 2008, so they can't complain too much.

Among the advanced countries, the Swiss have had to resort to a fixed exchange rate to stem the loss of competitiveness, leaving them busy explaining this unusual action. Australia is accepting the abnormally high exchange rate, with the resources boom softening the pain, at least for the moment and for most of us.

This fortuitous conjuncture allowed recent meetings of G7 and G20 to issue bland communiques designed to down-play this issue. Avoiding acrimony is, of course, important. But this discussion was a distraction from the higher task of exploring the possibility of 'win-win' coordinated policy.

There is a growing recognition that the commitments made at the 2010 Toronto G20 to wind back budget deficits and official debt have been inappropriate for the feeble recoveries that have occurred: budget consolidation should be on a slower schedule. Easing the austerity would, at the same time, soften the 'currency war' fall-out of tighter monetary policy. Those emerging countries which have capacity to widen their external balances and welcome capital inflow could benefit from historically low borrowing rates to expand their infrastructure investment. China, freed from the chore of defending its exchange rate policies, might be ready to join in by allowing more consumer imports.

This exploration of international policy coordination might be the basis of a better discussion than the phoney 'currency war' debate, with its narrow focus on justifying domestic policy settings.

Photo by Flickr user iota_fr.

The shadow banking sector was central to the problems of 2008. It generated many of the mortgage-backed securities which funded the housing boom and gave loans to people who couldn't afford them. It created the layered collateral chains of short-term funding and the complex derivatives which obscured the underlying realities. It traded without recognition of counterparty risk, thus distorting financial prices. Moreover, it existed largely outside the supervisory framework, relying on the fiction that it was a 'buyer beware' market, where market discipline prevailed, losses could be absorbed and firms could become insolvent with no more consequences than a routine bankruptcy.

Addressing these issues requires more restructuring than has occurred or is in prospect. The key is to ensure that failing institutions can be identified early and 'resolved' quickly (closed, merged or re-capitalised) without systemic impact. It's easier said than done. Just as retreating armies are inevitably chaotic, collapsing financial institutions will always be mired in delay, denial and confusion.

The lessons taken from 2008 add to the ambiguity. The public was unhappy with the bailing out of the big financial institutions, especially as management seemed to avoid the consequences of their mistakes.

This has revived long-standing concerns about moral hazard: helping troubled institutions which took too many risks just encourages them to take too many risks next time. Thus the Dodd-Frank legislation makes provision for bank liquidation but explicitly prohibits taxpayer bail-outs. As this would seem to prohibit the sort of policy actions which saved the system from total collapse in 2008, in practice ways will be found around this prohibition. This sort of 'constructive ambiguity' has always been part of the stock-in-trade of prudential supervisors, but this accidental outcome of conflicting objectives just ensures confusion and delay in the event of a crisis.

Running parallel with national attempts to make the financial sector less fragile are the international rule-writing efforts centred on the Bank for International Settlements (BIS) in Basel. The global nature of the 2008 crisis created momentum to rewrite the inadequate Basel II Rules. This international coordination has made it easier to impose higher capital and liquidity requirements, with the Basel rules discouraging countries from competing with each other to provide the most lenient regulatory framework. Similarly, the G20 has exerted pressure to bring derivatives within a safer central-counterparty framework.

These international measures are, however, painfully slow, not only resisted by countries jealous of sovereignty, but by the finance lobby. For key structural issues, international rule-making has had little to offer. The US (with the Volcker Rule), the UK (with the Vickers 'ring fence') and Europe (with the Liikanes proposal) are each going their own way to separate banks from the shadow banking sector. Even coordinated efforts to sort out a failing institution across international boundaries seem problematic.

Despite the modest achievements of this reform process, there is little danger of a repeat of 2008 any time soon (although Europe still has a long way to go before its banking sector is secure). The misjudgments and foolishness of the pre-crisis decade are still too fresh for these mistakes to be repeated just yet. The shadow banking sector has shrunk. Supervisors are feeling bolder.

The pity, however, is that the crisis was not used more effectively to drive substantial reform ('You never want a serious crisis to go to waste'). The process of financial deregulation which took place over the two decades preceding the crisis created a pro-cyclical hyperactive sector where there was too much credit creation, too much leverage, too much trading, too much financial engineering and too much risk taking. In countries where the financial sector has substantial political power, such as America, these problems are dormant rather than resolved.

Photo by Flickr user Christopher S Penn.

There is not much doubt that the 2009 budget boost was beneficial for the recovery, and that the budget consolidation since then has been a drag on growth. But continuation of the 2009 fiscal stimulus ran into opposition not only from the Tea Party small-government fanatics, but also from those with a well-based concern that persistent deficits were expanding the debt ratio sharply. The unhappy compromise has seen the deficit wound back through budget cuts, with the inevitable knock-on effects for growth: this year, the budget will exercise a contractionary impact of 1-1.5% of GDP, unhelpful for an economy struggling to grow at much over 2%.

With a healthy economy, the medium-term (ten-year) budget horizon would involve some tricky but manageable trade-offs. It would be possible to articulate a realistic recovery strategy involving short-term expansion and medium-term consolidation. Departing Treasury Secretary Tim Geithner has talked of a mix of short-term stimulus through infrastructure spending combined with practicable adjustments to expenditure and revenue. These adjustments would take a modest 0.5% out of the budget deficit over the next ten years, which he says would be enough to stabilise debt.

Others support this view that the revenue and expenditure changes required for debt stabilisation are not too onerous. One caveat is that these scenarios rely on getting the economy back to full potential soon, with the virtuous feedback that follows.

Superimposed on this economic scenario, however, is Washington's poisonous politics. Instead of a clear, binding commitment to such a sustainable trajectory, the US is headed for more budget drama with imminent sequesters and a revisiting of the debt ceiling in May. And the drama queens of financial markets stand ready to panic again.

If all this seems depressingly difficult, further into the future there is a still more intractable budget problem. The next decade will bring a sharp increase in the proportion of the population over 65, and thus eligible for Medicare, the most expensive of the out-of-control health entitlement programs. The health care component of the budget is forecast by the Congressional Budget Office to double over the next 25 years from its current 5% of GDP. Together with the other social programs, the budget cost of entitlements rises from 10% of GDP to 16%. Even if the federal tax take rises from the current meager 15% of GDP to exceed its long-term average of 18%, debt is forecast to reach 200% of GDP.

Health care costs are a nightmare challenge in themselves. Total health care currently accounts for over 17% of GDP, compared with an average of less than 10% in OECD countries and only 12% of GDP in the next-most-expensive country, the Netherlands.

Thus a budget solution requires cheaper ways of providing health care and the paring-back of budget entitlements. But the political context is out of step: Obama has just beaten the Republicans on tax and is in no mood to give any ground on entitlements (which would deeply disappoint his supporters). The 'Obamacare' health care initiative is his pet project, and skimping on this would be excruciating.

Sooner or later the idea of a Grand Bargain (along the lines of the 2010 Simpson-Bowles proposal) will have to be revived. Higher taxes have to be a part (and America is still lightly taxed on international comparisons, with numerous loopholes and no federal GST). 

There are, however, no signs that President Obama is ready to repeat Bill Clinton's commitment to 'focus like a laser beam on the economy'. Without this single-minded commitment to addressing the budget in both the medium term and longer term, the alternative — a succession of mini-crises followed by palliative solutions — will leave America on an anemic recovery path.

Photo by Flickr user bitzcelt.

Central bank independence is important because of the perception that governments will always be in favour of accommodative monetary policy. But this concern has not been relevant in the period since the financial meltdown of 2008. Certainly, central banks have been very ready to put in place accommodative policies, but this was their own reaction to the parlous economic circumstances, not a response to governmental pressure.

Central banks in advanced countries were quick to lower interest rates to near-zero levels. Both the US Fed and the Bank of England have, on their own initiative, expanded their balance sheets hugely with QE operations. The Bank of Japan, for its part, has maintained its long-standing accommodative stance. If the Bank of Japan's efforts seem less active, this reflects its well-based scepticism that more QE or a higher inflation target will make much difference.

Thus nothing in the experience of the past five years would suggest that central banks have bowed to political pressure. Nor is the replacement of the governors in the UK and Japan with more dovish candidates a demonstration that the era of central bank independence has finished. Governments have always had the right to appoint central bank governors of their choice when the incumbent's term expires.

Routinely, the setting of the inflation target has been done either by the government or in concert with it. Shifting to a different target (eg. nominal GDP instead of a simple inflation number) is not a revolutionary idea; it was fully explored as an alternative when inflation targets were first devised. And while many would regard a GDP target as an inferior approach, it would formalise a message that central banks already accept: output is important as well as inflation.

More generally, the independence enjoyed in recent decades has always been conditional, not absolute. Absolute and irrevocable independence would be a serious 'democratic deficit'.

All that said, there is a potential issue here. There was a third key element in the 'end of history' framework: governments should not require central banks to finance budget deficits. Budget discipline requires that deficits should be funded by bond sales to the public.

This seemed straightforward enough until the 2008 financial crisis made QE a routine part of monetary policy. The key principle of budget funding has not been transgressed so far. After all, the QE operations in the UK and the US have been initiated by the central banks themselves. But if a central bank already voluntarily buys government bonds in the market to implement monetary policy objectives, it is only a small further step to asking the central bank to fund bigger budget deficits directly, taking the debt directly onto its balance sheet. 

The proponents of this idea argue that this would allow more expansionary fiscal policy without the drawback of pushing up the interest rate on government debt or risking adverse market reaction to a higher government debt level. Others argue that QE has become so large that it is de facto part of the budget and this reality should be recognised by ending the fiction of independence.

It is premature to announce the death of the successful monetary policy framework of the past two decades. The huge challenge of the 2008 crisis pushed US and UK central banks to the edge of what they can and should do. These extraordinary circumstances justify the risks that the subtle balance between central banks and governments would be undermined.

The time will come for re-building the credibility of this framework. If central banks talk and act as if they are in the pocket of the current government; if the operational objective is set so loosely as to leave inflation expectations unanchored; or if central bank bond purchases are directed at funding the budget deficit rather than influencing market interest rates, then the framework which performed well for two decades will, indeed, have reached the end of its usefulness.

Photo by Flickr user RC_Fotos.

For these big public projects, the PPP model is an irrelevant distraction. PPPs don't work unless there is a strong guaranteed cash flow, which a toll road or an electricity generator may be able to supply, but neither a sewer nor public transport can provide because only a small part of the benefits can be collected in the form of revenues. The current floods are hugely expensive in damage and disruption to production and commerce, not to mention the heartbreak and trauma to submerged households. But if this problem were to be solved with better infrastructure, you couldn't charge the customer for the benefit of flood protection in the same way you can charge a motorist for using a toll road.

Thus a purely revenue-driven PPP solution for Jakarta's flood problems is impossible. The same goes for public transport. Few cities of the world manage to run a profitable mass transit system, and none where the users of the service are so poor that they can't afford a full-cost service.

Let's not ignore the 'magic of the market'. Let's accept that there will be 'suitable cases for treatment' using PPPs. But let's also observe that cities like London are viable because, long before PPPs were invented, governments found the resources to build the Underground (celebrating its 150th birthday) and get the sewage out of the Thames.

In Sydney, the cost-benefit of the Harbour Bridge must have looked hopeless in the 1920s, when the decision was taken. When the ten-lane bridge was completed early in the 1930s, photos show it being used by a handful of T-model cars and a couple of horse-drawn carts. It took four decades to reach capacity.

But we can now be thankful that this wasn't a PPP project, which would have occupied the prime crossing site with just enough capacity for the then-current traffic. This sort of infrastructure has to be built by governments with a broad, long term vision of what constitutes a viable city.

Governments are often inept at project selection. Pork barreling distorts decisions, and without clear projections of cash flow, cost-benefit estimates can vary enormously, depending on how the externalities are valued. They run the risk of building grandiose white elephants (is the proposed Sunda Straits bridge in this category?).

So government should try hard to winnow out the poor projects. But when a capital city regularly closes down due to flooding, and lack of public transport brings city traffic to a crawl even in the dry weather, there are clearly so many high-social-value projects that the right course is to say 'just do it'.

Photo by Flickr user nSeika.

Then growth ran out of steam in 2011 and 2012, with the advanced countries falling to half the 2010 rate. The GFC legacy quickly boosted official debt-to-GDP ratio, partly through bank rescue costs (Spain and Italy Ireland), but more widely through the fiscal drag of the on-going downturn. High-profile economists analysed a century of disparate experience and confidently pronounced that many economies had now reached a critical universally-relevant debt threshold, beyond which debt would be unsustainable. Others thought that households had to atone for their years of balance-sheet expansion with years of austerity to grind down their excessive borrowing. No promise of a quick fix here.

Meanwhile, the small-government lobby (whose extreme form is the US Tea Party, but parallels are found everywhere) saw the opportunity to promote their 'starve the beast' advocacy, where cutting government spending is always good, whatever the phase of the cycle. Simple extrapolation of expenditures (eg. US entitlements) backed the case. Their economic acolytes argued that strict austerity would promote growth through raising confidence.

Economists have always been known for their disagreements, but now the differences get more public coverage, via blogs and the 24-hour news cycle. There is a premium on strongly-held views. In the name of 'balance', nutters get air-time.

This cacophony of disparate nostrums doesn't help. When economists were asked about the net benefit of the 2009 US fiscal stimulus (a specific example of what is perhaps the central macro-policy issue of the past few years), there was a babble of voices, with less than half saying that the stimulus was beneficial. Moreover, the same survey suggests that even when economists agree (which is not that rare among practical policy-makers), the public is quite likely to have a firmly-held contrary view. Most economists agree that the US stimulus lowered the unemployment rate, but less than half of public respondents agreed.

The key problem is the political process: who could argue that it was a good idea to take the US debt-limit confrontation to the edge of default, and yet that happened in 2011 and may happen again. The succession of decisions 'kicked down the road' reflects a dysfunctional system, 'vehemently adversarial' and 'scornful of compromise'.

What to do? There may be guidance in the precedents where good economics was also good politics. There have been some remarkable successes. The public is unconvinced of the benefits of free trade and yet there has been huge progress in opening up international markets. Deregulation (particularly the enhancement of competition and the reduced role of state monopolies) has changed the business environment in many countries, without wide public support.

What were the key enabling characteristics of these successes? Sometimes international peer pressure helped (GATT/WTO on trade, OECD on deregulation, the IMF on flexible exchange rates). Sometimes the key was institutional reform. The classic case (currently under vigorous discussion) is central bank independence, which distanced monetary policy from the political arena. Some argue that putting fiscal policy into a similarly independent institutional framework is the answer. Perhaps a rule or binding commitment would help. Maastricht didn't ensure European fiscal rectitude, but a Golden Rule (budget balance over the course of the cycle) sometimes nails down waverers and shifts the recalcitrants.

Agreement among economists is not in itself essential for good policies. But good policies rarely come out of lowest-common-denominator compromise or arm-wrestling trade-offs between strongly differing models or ideologies. Institutional fixes (central bank independence) and decision rules (the budget Golden Rule) don't last forever, and have some element of democratic deficit. But they take the decisions beyond the gridlock of doctrinal differences and the excessive power of vested interests.

Meanwhile, economic forecasts will be based at least as much on politics as on economics. 'Political risk has entered our vocabulary. Whether staring over the fiscal cliff, battling the eurozone crisis, trying to profit from a rising China, or taking cover from the Middle East; around the world, politics has come to dominate market outcomes.'

Photo by Flickr user mikemcsharry.

Some (a minority, but with loud voices) argued that fiscal contraction would boost private sector confidence so much that the effect would be expansionary. Others dismissed this counter-intuitive 'confidence fairy' view, but forecasters must have been subliminally influenced, as they now accept that they drastically underestimated just how contractionary the fiscal consolidation would be. Even though the IMF agreed it had got this wrong, the debate continues.

The second mistake identified by Skidelsky was thinking that expansionary monetary policy was still powerful, even when interest rates had reached zero. While interest rates at zero should still help the economy, the greater mistake was to overestimate the power of quantitative easing.

The IMF's formal revision of its fiscal multipliers may reflect another problem: the over-reliance on model-based forecasts. When the shell-shocked Goldman Sachs chief financial officer complained, during the 2008 financial meltdown, that he had just seen 25 standard-deviation changes in asset prices, three days in a row, this was not to be interpreted literally as an event which would happen only once in many multiple life-times of the universe. The proper translation of his comment is 'the risk model was hopelessly wrong'.

This possibility, rather than a simple parameter mistake, might be relevant for the Fund's forecasts as well. The real world is far more complex than the models.

It might also be argued that the uniformly downward revisions were a reflection of globalisation: when a critical mass of countries slows, everyone slows because they are so interconnected. In fact this doesn't seem to have been a strong factor: the emerging countries have done remarkably well, with China sailing along at its 'new normal' pace of 7-8%, despite predictions of near-stagnation.

Another possibility is over-confidence in the self-equilibrating forces that usually help an economy to return to normal growth after it is hit by a shock. But this heuristic is a weak short-term forecasting tool, with these self-equilibrating forces battling the headwinds of politically-constrained policy-making and (related to this) subdued confidence among businesses and households.

There were probably other problems too, more intrinsic to the politics of the forecasting process itself. In Europe, the US and the UK, the heavy official debt build-up has made policy-makers reluctant to add to the debt through fiscal expansion. The UK, in particular, embarked on a 'courageous' debt consolidation budgetary tightening strategy. When policy-makers need to take tough but necessary measures that they know will crimp growth, they feel the need to bolster the case for these policies with a growth forecast which is at the upper end of the credible range. Why give opponents ammunition by producing a dismal forecast? It will just provoke them to argue that if policy is going to produce such an unhappy outcome, then policy ought to be changed.

Why should this last bias apply to the supposedly independent IMF, OECD and BIS? In practice, they find it hard to differ much from official forecasts, especially in the pessimistic direction. They don't want to be accused of 'talking the economy down'.

With the Greek debt can kicked down the road and the US fiscal cliff averted, financial markets have regained some composure. This will be reflected in forecasts for the year ahead. But confidence – the elusive animal spirits which drive the economy – will be weighed down by the political intractability of underlying economic problems (unsustainable debt in Europe and medium-term fiscal problems in the US). Reversion to normal rates of growth still seems some way off in most advanced countries.

Photo by Flickr user Phil_Parker.

Central banks must always have another trick up their sleeves, such as the Fed's announcement of an unemployment target. This leaves them open to a raft of policy suggestions, of varying coherence.

One set of suggestions is designed to embolden central banks to be more accommodative. In Japan, this means the Bank of Japan should adopt a formal mandated inflation target, set this at some positive number such as 2% and do whatever is necessary to achieve it. For others (the UK and US) the related idea is that the central bank should have a nominal income target, encouraging (or mandating) policy to be eased further until growth has revived.

But there's not much use giving central banks a more expansionary target if they have no way of achieving it. Japanese inflation is stuck around zero, whatever the Bank of Japan does. The UK could replace the inflation target with a nominal income target, but monetary policy is already doing all it can to boost growth.

Other, more eccentric, schemes have been put forward: central banks should buy debt in the market and then the government should write this off. It is claimed that this fall in official debt would break the gloom caused by excessive debt. A related idea is that governments should run more expansionary fiscal policies (which may in itself be sensible) but avoid the debt implications by funding the extra budget expenditure by 'printing money'.

Any panacea relying on 'printing money' misunderstands the way monetary policy works. No, printing money would not unleash some Weimar-style hyper-inflation. It's just that it will have little or no impact. The public already has all the currency it wants to hold, so if the central bank tries to add more, the excess money gravitates to the commercial banks which, unwilling to expand their balance sheets further, just deposit it back with the central bank. The net effect is that both sides of the central bank balance sheet expand, but not much else happens (see Graph 1 of Glenn Stevens' speech covering these issues). If government debt were to be written off, it would leave a hole on the asset side of the central bank balance sheet, bankrupting it. This is unlikely to help confidence.

If monetary policy is already doing all it can, what about fiscal policy? Fiscal policy just about everywhere was relaxed in 2009 to boost recovery from the financial crash. But since then policies have been tightened, with fiscal policy in most advanced countries actually subtracting from growth:
 

The idea that tight fiscal policy would help confidence (the 'confidence fairy' argument) has lost favour, but there is still a widespread view that, for countries with heavy official debt, it is necessary to trim back budget deficits vigorously. A slow economy makes this painfully difficult.

Policy is in a serious bind, with no attractive options. There is a sharp policy imbalance between easy monetary policy and firming fiscal policy, causing increasing international unhappiness about 'currency wars' and beggar-thy-neighbour exchange-rate depreciation.

Whoever is to blame, we are where we are. We need to accept that monetary policy is doing all it can, and not waste too much time on harebrained 'print money' schemes. The focus should be on the opportunity for fiscal policy to maintain a stimulatory stance in those countries (such as the UK and the US) where historically low yields in bond markets demonstrate that there is room for more official debt.

Photo by Flickr user OccupyMCR.

Until recently, conventional wisdom judged countries to be free to set their monetary policies without regard for knock-on effects on other countries. But opinion is shifting. The Fund's U-turn on capital flows seems to include this issue as well, putting focus on countries whose macro policy settings cause excessive capital flows to countries with more normal policy settings.

If that seems to be an advance in policy thinking, then (as usual) there is an offset: the Fund has no suggested policy action for the capital-exporting country. But at least the issue is on the table for discussion.

How might that discussion go? The main argument in defence of these extreme policy settings is that, if the advanced countries succeed in stimulating their economies, global growth will resume at a more normal pace. But of course this same argument could be made in defence of China's policy: what's good for China will spill over into some benefit for the world.

In the end, the argument is about the mix of policy. If a country has tight fiscal policy combined with loose monetary policy, it will get the unfair advantage of a lower exchange rate, just as surely as China benefits from its exchange rate policies.

But it is harder to establish that advanced countries have the wrong policy mix. The IMF explored this issue in its latest World Economic Outlook (WEO), but as usual the discussion was so perfectly balanced that it is hard to draw policy implications. Box 1.1 of the WEO noted that fiscal multipliers might have been understated, giving an unintended boost to fiscal restraint. But this message was immediately followed by Box 1.2, showing that official debt levels in a number of advanced countries were dangerously high, so fiscal restraint should not be relaxed.

In short, the world has got itself into a macro policy bind. The accommodative monetary policies in advanced countries are accumulating serious problems at home and gathering ill will overseas. But it looks like the emerging countries will just have to take their own policy actions, as best they can, if they find themselves with excessive capital inflows.

The boldest of the policy makers might see this as a once-in-a-lifetime opportunity to make use of these low-cost funds to build infrastructure. Not every emerging country will want to seize this opportunity: China needs no foreign funding for its massive infrastructure spending. But the Philippines and Indonesia, both seriously constrained by inadequate infrastructure, can borrow dollars at less than 4% and local currency for only a little more. The World Bank and its regional counterparts can borrow for 2% and could act as intermediaries for countries unable to borrow in their own name.

This might be seen as 'global Keynesianism', where demand deficiency in advanced countries is countered not by make-work programs at home but by expansionary policies in countries which have the fiscal capacity and a multitude of high-social-return projects.

Photo by Flickr user paolo zalameda photography.

Financial markets were threatening to spread debt contagion to Spain and Italy. Germany and France were not ready to accept the big losses this would have inflicted on their banks, which held much of the Greek debt. The ECB, for its part, was not ready to accept any weakening of its balance sheet or offer strong backing to counter the threat of contagion.

By early last month, after two-and-a-half years of kicking the can down the road, Greece's debt/GDP ratio had risen from 120% and was projected to be 190% by 2014, largely because Greek GDP is 20% lower than initially forecast.

The measures agreed last week are designed to show that the situation is still sustainable. Interest rates on the assistance have been lowered to concessional levels, the maturity has been lengthened by 15 years, the ECB will return 'profits' on Greek debt to Greece, and Greece will buy back around half of the residual debt still held by the private sector at a price well below face value.

Even with the benefit of these measures and unrealistically optimistic assumptions about budget performance and growth, Greece's debt to GDP ratio is projected to be 126% in 2020, thus missing the IMF's sustainability line-in-the-sand.

All this puts the IMF in an unenviable position. In normal circumstances, if it assesses that a country has an unsustainable debt level, a debt rescheduling would be required before support is offered. Not only is this sensible economics, but unless this is done, the Fund's money is at risk. What if the Fund had done this in the beginning? We don't know how this would have played out, but one seasoned observer says:

Just imagine what would have happened had the no bailout rule been invoked in May 2010. Greece would have gone to the IMF and defaulted on its smallish public debt of 120% of GDP. By now, the crisis would be over.

The Fund is clearly uncomfortable with last week's outcome, and its agreement is conditional on a successful buy-back of debt. In the course of the negotiation, the IMF Managing Director is reported as saying: 'it's not over until the fat lady sings'.

But the Fund has little choice other than to go along with this deal. Europe clearly wants all this put on hold until after the German elections in September. In the meantime, the interest burden on Greece is bearable, but Greece cannot meet the forecast growth targets because the weight of foreign debt discourages investment and entrepreneurship and causes a state of chronic uncertainty. Even under the best circumstances, another round of debt reduction will be needed before the end of 2013.

The fat lady has not yet sung: the debt buy-back is still to be arranged. Those still holding Greek debt (such as the Greek banks) may not have this valued in their books at market price and will realise substantial losses if they sell. In any case, opera buffs will be worried about the fat lady reference: when Wagner's Brunnhilde stopped singing, the world ended.

In a governance sense, the troika's assistance program sets unfortunate precedents. Unsustainable debt has been rolled forward. Private sector creditors have come off better than they should have, with maturing debt repaid out of official assistance. The IMF's credibility as a forecaster has suffered and its reputation as a stern task-master has weakened. Working as part of the troika has tied the Fund's hands: will it be as ready to work in tandem with other regional arrangements such as the Chiang Mai Initiative?

The treatment of Greece has also reinforced the view that the Fund is Euro-dominated and more helpful to advanced countries. There may even be pressure on the Fund to participate in the inevitable debt-reductions later, even though its money is regarded as 'super-senior'. And the enduring European crisis has been bad for world confidence and growth.

IMF head Christine Lagarde has done what she can to play the unfortunate hand which Strauss-Kahn thrust on her as he left the Fund. She understands that the Fund's rules, based on economic logic, have to be trimmed to take account of political realities. The European mess is, in its essence, a political problem and she has been negotiating with Prime Minister of Luxembourg Jean-Claude Juncker, the man who invented the politicians' favourite aphorism: 'We all know what to do, we just don't know how to get re-elected after we have done it.'

Photo by Flickr user World Economic Forum.

'Behind the border' issues present opportunities for freer international exchange but these are conceptually less clear-cut than tariff reduction.

Whereas the case for reductions in tariffs is universally accepted, many 'behind the border' issues are matters of judgment and balance. Some country-specific quarantine laws are well justified, while others may be de facto trade protection. Different labour and safety laws may, in fact, be part of the legitimate comparative advantage of low-labour-cost countries. Not everyone will agree on uniform environmental protection measures. Intellectual property regulations may not strike the right balance between owners of IP and users. Some will be unhappy with the way investor/state dispute settlement procedures can be mis-used.

The RCEP was an important element of the ASEAN meeting in Phnom Penh this month and the East Asia Summit meeting that followed. It is envisaged that RCEP would cover ASEAN+6 (including Australia); while RCEP does not include America, the US can build its trade relationship via the Expanded Economic Engagement initiative.

The TPP was promoted by President Bush and has been taken up enthusiastically by President Obama, pushing it forward in the APEC context, with around ten countries on both sides of the Pacific already in negotiation and several more in discussion. India has shown no interest so far.

Neither approach has settled on detailed terms yet. Both will cover some 'behind the border' issues. But there is little doubt that the TPP will be a more demanding set of commitments, with fewer opportunities for individual countries to contract out on aspects which don't suit them. This makes the TPP harder for Japan, with its powerful agricultural lobby. It will be impossible for China to sign up to the TPP because the competition clauses are directed at state-owned enterprise business practices. Also, the IP rules may be too slanted to IP owners, rather than users, and investment protocols too favourable to foreign investors rather than the host country.

The RCEP will be more accommodative of individual differences and political constraints. This lessens pressure for wider domestic regulatory reform and lets vested interests off the hook. But it might be a more feasible way forward for some Asian countries. RCEP's geographic concentration is also an advantage in bringing peer pressure to bear.

Australia says it sees no need to choose: like several other countries, it will take part in both negotiation streams. If the TPP moves faster than the RCEP, we might find ourselves party to a high-profile treaty which excludes our main trading partner, China. US Secretary of State Clinton said recently: 'We welcome the interest of any nation willing to meet 21st century standards as embodied in the TPP, including China.' But if this means basic changes to SOE business practices, China might argue that its economic structure seems to have served its purpose well, and that the 2008 financial crisis must leave some concerns about private enterprise.

It is early days for both of these initiatives, with membership of the TPP far from finalised and RCEP following on from years of slow progress on the East Asia Free Trade Area. For our part, it seems sensible to join the RCEP negotiations eagerly, with the objective of getting as 'high quality' an agreement as possible (eg. on agriculture).

At the TPP discussions, our New Zealand brothers are fighting hard on IP issues, and there is a good case for trans-Tasman solidarity on this issue. More radically, we might explore why it is in the interests of the parties to have China de facto excluded on the basis of its economic structure.

Photo by Flickr user Zanthia.

Australian prime ministers have found President Susilo Bambang Yudhoyono to be serious, amiable and cooperative, even on sensitive issues. But he will be gone in 2014 without a successor in the same mould. So too will Australian-educated Vice President Boediono. The current list of contenders would be harder to work with (some with reputations far less bland than SBY’s), requiring more skill and understanding on our part.

Australian business generally finds Indonesia a tricky environment. Even with the travel advisory eased, business practices differ: what are considered to be normal business dealings in Indonesia may transgress newly enforced Australian corruption laws. Singapore, South Korea and Japan find it easier to do business in Jakarta.

Our economies are not particularly complementary (in the way China, Japan and South Korea are for us): Indonesia is, for example, our biggest rival in thermal coal exports. Indonesia has no need to look for resource security by investing in external supply (as China does). Mining, the area of foreign investment in Indonesia where we have most expertise, has consistently proved to be booby-trapped with nationalistic sentiment, overlapping layers of government and fickle bureaucracy.

This, then, is the challenge. Instead of thinking of the relationship in terms of the status quo management of transactional problems such as drug couriers and boat-people, we need to foster such a dense interaction between the two countries that when interests diverge or viewpoints differ, these issues are muffled and contained by a spiderweb of mutually beneficial linkages.

Much of this already occurs, through both governmental and private channels. Where are the additional opportunities? There will be a limit to how often Indonesian ministers wants to engage with our visiting politicians. Such meetings will need substance and real warmth if they are to succeed. Keating's own relationship with Soeharto provides an example. With Australia hosting the G20 in 2014 and SBY a keen participant, there is an opportunity to seek Indonesia's help in welding the diverse G20 membership together, especially across the cultural and historical divide between the G7 countries and the newer members of the international dialogue.

John Howard's initiative to link the federal bureaucracies with their Indonesian counterparts through staff swaps didn't work in all cases, but where it did work it was so successful that its subsequent fading away is lamentable.

There have been other lost opportunities to have senior Australian officials working in key Indonesian departments: some of our most experienced Indonesia hands are flying the American flag, working for USAID. AusAID, seemingly with more money than it knows how to administer, outsources funds to the World Bank and contracts foreign firms to run key programs. The purist will say that aid money must target poverty alleviation, not the relationship between our two countries. But no-one else thinks of their aid program in these one-dimensional terms. The aid money should be consciously used to get more Australians involved in Indonesia.

Economic complementarity is not static and can be fostered, as has been done in tertiary education and professional services. Our media could try harder: why does the boring predictability of China's leadership transition get more attention than the fascinating machinations of Indonesian politics? And the Indonesian press might be encouraged to do its bit too.

Regional security is the area of potential cooperation which has changed most since Keating's 1994 call. Indonesia, long seen as a potential threat, is now a potential ally.

We would be foolish to ignore the deep cultural differences that stand in the way of full understanding, but these can be bridged with awareness and sensitivity. Indonesians don't share all our values. Next time a minister wants to ban live cattle exports, a chorus of voices should suggest a better solution (such as to establish humane slaughter facilities). Jailing young sailors crewing for people smugglers doesn't seem a constructive solution.

Keating has given the rallying call. Let's hear the debate. In particular, let's hear specific suggestion that would put operational substance around this bold idea.

The Standard and Poor's rating of ABN-Amro CPDOs (constant proportion debt obligations) was found by the Australian Federal Court to have deceived and misled investors and that a 'reasonably competent' agency would not have given these instruments a AAA rating. The judgment sets out in 1500 pagers of amazing detail just how S&P went about its business.

These CPDOs were a derivative product based on corporate debt packaged up by ABN-Amro, then sold to various local councils through an intermediary. Within two years of purchase, the 12 local councils involved in this case had lost 90% of their $17 million investment. Local councils are, properly and obviously, conservative investors. They are often unsophisticated in financial matters, relying heavily on advisers to protect the savings of their rate-payers' funds. Thus the AAA rating given by S&P was very important in their investment decisions.

Even with this clear-cut example of the failure of the ratings system, this case will not, in itself, solve the problem. Even if the judgment stands (S&P is appealing), court cases are not enough. Rating agencies don't have large enough balance sheets to take full responsibility for the losses resulting from their negligence. If this decision stands, it will serve to make the CRAs more careful for a while. But memories fade, and their role in the financial sector needs to be redefined.

In tailoring the Golden Straitjacket, the warp of private-sector remedies such as this one has to be held together by the weft of official regulation, however hard this is to put in place in the international context beyond the jurisdiction of any single sovereign. In the face of financial sector lobbying, this official rule-making has been largely ineffectual so far.

Perhaps the Australian judgment will strengthen the arm of the international regulators to take tougher action. They could, for example, require separate agencies to assess government debt, on the one hand, and private companies on the other. Then, at least, it would be blindingly obvious that a AAA rating given to a company that paid for it was not the same as a AAA rating given to a country.

It's not that the rating agencies have done a stellar job in ranking countries: they are always looking in the rear-view mirror, are slow to downgrade failing governments and upgrade better performers only belatedly. Though in comparison with their efforts with the CPDOs, these seem to be honest mistakes.

Photo by Flickr user 3SugarCubes.

For close to three years, the unsustainable government debt load in the southern periphery has kept Europe stagnant, with growth prospects pushed further into the future with every new forecast. The excess government debt has been kicked down the road with various partial support systems but the basic problem has not been addressed through a substantial debt reduction. 

Greece, Spain and Portugal (and perhaps Ireland and Italy as well) can fix their debt in three possible ways: growth, inflation or default. The first is unattainable, the second undesirable and the third inevitable.

In addition, a solution is needed for the international uncompetitiveness of the southern periphery. What limited progress there has been in recent months has been on a different track: the 'more Europe' discussion about centralisation of fiscal policies and bank supervision. Whatever the merit of this remedy as the next step in evolution of the EU, it will take decades to achieve. The debt problems can't wait.

Meanwhile, across the Atlantic, whoever is president on 1 January has to prevent the US economy falling over the 'fiscal cliff': the 5% of GDP contraction that will occur if legislation on income tax, payroll tax and unemployment benefits is not changed. While total inaction would be so disastrous that most commentators see it as inconceivable, avoidance will be ad hoc and incomplete. From this unresolved mess, a solution must be found to the longer-term problem that America does not raise enough taxes to pay for a level of government services which are the minimal norm for an advanced country.

Without overstating the power of international discussion to make the world a better place, these are the circumstances where a well-functioning G20 might play a positive role at the margin. The Europeans, bogged down in moralistic arguments about fiscal rectitude and the sanctity of debt, might be gently reminded that their efforts of the past half century to create a better Europe are at stake. Americans, away from the doctrinal tub-thumping of Washington, have an opportunity to discuss how they might go about funding a level of government services appropriate for the world's most advanced country.

For these discussions, the IMF's World Economic Outlook provides the context. Whereas two years ago economists were in heated disagreement on whether fiscal austerity would promote or harm growth, the Fund has crystalised the commonsense reality that sharp fiscal contraction is bad for near-term growth. Similarly, the Fund has sieved through the historical record to demonstrate that adjusting international competitiveness by austerity rather than by changing the exchange rate is excruciatingly painful. These discussions, relevant to the domestic policy of the growth laggards, might strengthen the hand of sensible domestic policy makers.

Instead, Secretary Geithner is staying in Washington. He is not a politician, so the election is not an excuse. And it's not far for him to go. He has already decided to quit the job after the election, so maybe he just can't be bothered. Or maybe he doesn't want to be on the receiving end of advice on how to fix the fiscal cliff, or field complaints from emerging economies around the table that America's sustained monetary policy accommodation is distorting exchange rates and international capital flows. Or maybe he is having trouble explaining why America, as a champion of fixing the IMF's governance structure to belatedly give emerging countries a fair share of the decision-making votes, has not passed the necessary legislation to implement this policy.

Perhaps the Europeans don't want to have the inadequacies of their current policies put up for public discussion either. The differences of view between Draghi and the Germans are sharp. But if G20 is not the forum for such discussions, what is its purpose?

Photo by Flickr user Garthe Knight.

This is the nature of the White Paper and it's difficult to know what else it could have been or done in the circumstances. It would be amazing if the authors had been able to come up with a radically new viewpoint: we've been thinking about these issues for decades. Nor is there room for dramatic new policy initiatives, in a budget-constrained world.

The risks, problems and trade-offs are equally well known, and it would cast a gloomy shadow over this positive outlook if the document dwelt in detail on all the things that might go wrong, the policy dilemmas and the delicate paths our diplomacy will have to tread.

It would have been unhelpful, for example, to go deeply into the vexed security issues raised by the Hugh White debate. It would be equally unhelpful to agonise too much over the challenge of straddling our relationship with the US (our historical best friend) and China (our biggest trading partner). If in the past we have tended to view Asia through the US prism, this is not the place to sort out whether the future lies with Asia alone or with the Asia Pacific. We know without reminder, for instance, that we have little to offer on issues such as South China Sea disputes. We know we will often be treading on eggshells to keep a balance between Japan and China.

Even confining ourselves to economics, focusing on the positive and downplaying the difficulties has some attraction. The Doha Round trade negotiations can rate a positive mention without the need to say that it is effectively dead. The Trans-Pacific Partnership can be held up as a high quality trade model without mentioning that the bar is set so high that our main trading partner will not be able to join in the foreseeable future.

Of course we can still talk trade with China through the regional arrangements. Regional integration is easy to talk about but hard to implement, partly because China is an elephant in the canoe, hard to accommodate because it is so big, confident, powerful and ready to right perceived historical wrongs. But why fret about these problems when Australia, as a late arrival in these regional arrangements, can be no more than a bit player in resolving these difficulties? Why spend time lamenting that we were slow to join the ASEAN sphere and are not part of the Chiang Mai Initiative, the basis of much regional economic dialogue?

From Australia's internal policy perspective, there are unresolved issues in foreign investment. China understandably looks to Australia to provide an important element of resource security, but if this is given in the form of foreign ownership, the scale of the Chinese resource-security objectives and the uni-dimensional resources focus will run up against domestic sensitivities. With resource policy spread between federal and state levels, there are many opportunities to offend foreigner investors while at the same time selling our birthright for a mess of pottage. But the White Paper is not the place to resolve this.

When it comes to our close neighbor Indonesia, we are still groping to find substantive dialogue issues which are not tension riddled crisis resolution, whether it is boat people or drug convictions. We know that Papua is waiting to destabilise the relationship in one way or another. The live cattle debacle was a reminder that mutual incomprehension still characterises this relationship.

Australian business still finds Indonesia an uncomfortable environment. The inhibiting travel advisory has finally gone, but now business has to worry that the Australian legal system will prosecute them for business practices which are the norm not just in Indonesia, but just about everywhere in Asia. There seems no way to raise the tone and quantity of journalistic reporting.

Long ago, wise heads developed the view that the best we could hope for is that there would be enough ballast in the diplomatic relationship to see us through these tribulations. What more can be offered?

If the White Paper sounds complacent, there is certainly a realistic prospect that Australia will be borne along in the slipstream of this historically unprecedented burst of economic growth that began with Singapore, Taiwan, and Hong Kong in the 1960s and still has far to run in the unfinished growth stories of China, India, Indonesia and our other Asian neighbours. It will be up to others to explore the detail of what might go wrong, and what more could be done to smooth this ride.

Photo by Flickr user go_nils.