Lowy Institute

Forecasting is a mug's game, but we can't resist. Economists usually take a stab at the central growth forecast and then add a shopping-list of things that might go wrong. If you enumerate enough risks, there are built-in excuses when the central forecast doesn't happen.

Inscrutable China provides a popular down-side risk for global growth forecasters. Some prophets have been predicting a crisis for years. Andy Xie is still awaiting China's collapseMichael Pettis' bet with The Economist that China would average only 3% growth this decade looks more outlandish with each passing year: on current growth rates, China will double its income this decade.  How wrong do you have to be before you lose your expert status?

Now George Soros, the man who broke the Bank of England in 1992, has joined the chorus, saying that ‘the major uncertainty facing the world today is not the euro but the future direction of China’.

There are two interwoven threads in this story. One is China's growing financial fragility and debt burden, especially the borrowings of local authorities.  These local governments did most of the heavy lifting in the 2008 fiscal stimulus, with an infrastructure building spree that left them with hefty debt. The second element is the need to rebalance the economy, pulling back on investment (currently half of GDP) and expanding consumption (currently only 36% of GDP, whereas in most countries it would be nearly twice that).

There is no dispute that both these issues need correction. The latest National Audit Office figures show local government debt equal to a third of GDP and rising; adding central government debt takes the debt total to 56% of GDP. Nor is there any doubt that consumption has to become the main driver of growth.

These changes seem eminently achievable. The Chinese authorities have already introduced new regulations to rein in local government borrowing. Moreover, there is time to make the changes.

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China's government debt is not much more than half of the OECD average, and within the OECD there are half a dozen countries teetering on the brink of crisis, with twice China’s debt and fragile governments lacking Beijing's capacity to bring about change.

In winding debt down, it also helps if your interest rate is low (China's rate is half the European peripheral countries’ borrowing rate) and you are growing quickly (China is growing three times as fast as Europe). And Chinese local governments can argue that at least their debt was used to create some socially useful assets, not just to fund unsustainable social expenditures.

At the institutional and macro level, China is well placed. Its debt is denominated in local currency, it has an external surplus, capital flows are tightly controlled, the banks are largely state-owned and fast growth smooths reform and restructuring. When it comes to predicting financial disaster, some commentators just don't understand where the financial risks reside, confusing minor operational issues with portents of disaster.

Financial markets pressed the panic button in June and again in December when interest rates in the short-term inter-bank market spiked sharply. This isn't a sign of impending financial crisis; it's just the central bank signaling, in a clumsy way, that credit is growing too fast. In each case the bank quickly eased off when the signal was disruptive.

What of the need to restructure, away from investment and towards more consumption? If you told European politicians that their main challenge was to rein in an overly dynamic investment sector and persuade the public to consume more, they would wonder where the problem was. Consumption is already growing a bit faster than GDP.  Boosting this further requires the politically delicate task of shifting income from the state-owned enterprises and redistributing this to the workers. Tricky, but a lot easier than Europe’s task of drastically cutting social expenditures and raising taxes.

China has already shown a great capacity for readjustment. Four years ago, the list of issues China had to correct was headed by the current account surplus (running at 10% of GDP) and a growth strategy which relied heavily on export promotion. Since then, China's growth has not relied at all on export growth (the value of imports has risen faster than the value of exports) and the current account surplus is down to 2% of GDP.

China still has unfinished business. No doubt the bad debts in the financial system are far greater than officially recorded and official debt is bigger. Doubtless some of the huge investment surge will turn out to be unproductive. Beijing may not have close control over the debt activities of local governments. Its 'augmented budget deficit' is around 10% of GDP, which is unsustainable.    

Even with good policies, China's sustainable growth rate is now 7% rather than 10%. But if we note Europe's problems, where growth is feeble, unemployment is over 12%, excessive budget deficits are chronic, the peripheral countries can't recover without substantial debt rescheduling, and above all politics is dysfunctional, Soros' spotlight on China rather than Europe seems a bold call.

Image courtesy of Wikimedia Commons.

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Let's start with the global economic outlook. A common view is that advanced economies are at last on the mend and will take over the running from the emerging economies, which have provided much of world growth since 2008.

The US and the UK seem likely to do better this year, because both are shifting out of their strong budget contractions. Similar optimism surrounds Japan, although the promised structural changes (the 'third arrow' of Abenomics) are yet to materialise.

The European periphery can't recover without much more substantial debt forgiveness. This will hold back the rest of Europe, still wallowing under unresolved official and bank debt.

The growth profile of the emerging economies has been widely misread: they slowed to a sustainable pace in 2011 and since then have maintained steady expansion. Even at this slower pace they are growing twice as fast as the advanced economies. The emerging and developing economies are now slightly larger than the advanced economies (measured in purchasing-power terms), so will still be the dominant component of future global growth.

Thus the emerging economies are not passing the growth baton onto the advanced countries, and we'll still rely on emerging countries to keep the world growing. They are, of course, a mixed lot. India and Brazil have fallen back to their traditional disappointing growth rates. But the much touted slowing of China didn't eventuate: in 2011 China established a 'new normal' of around 7% growth and is comfortably maintaining this. At this pace it will still double its income this decade.Read More

Most advanced economies still need fiscal adjustment. Budgets remain in deficit and official debt exceeds conventional rules of thumb. There is, however, a chicken and egg problem here. The debt and deficits are largely a product of under-utilised capacity. UK GDP, for example, is 5% below the 2007 peak and 12% below the pre-crisis trend. If GDP could be restored to full capacity, the budget problem would largely disappear. But budget stimulus would exacerbate the short term fiscal and debt position.

What is needed is a clearer differentiation between countries which need rescheduling (the European periphery), countries which have no choice but to undergo the hard slog of budget surpluses, those which can grow their way out of debt, and those which should be borrowing to fund growth-enhancing infrastructure.

Financial analysts will spend much of 2014 staring at their computer screens, trying to divine the profile of the Fed QE taper and then, further away, policy interest-rate rises and eventual unwinding of QE

This unwinding is not technically difficult, but financial markets have demonstrated a capacity to panic when they get confused, which happens often. Last May there was the 'taper tantrum', while in December the actual taper announcement was treated as positive news because it meant that the Fed thought things were going OK.

While talk of 'currency wars' has muted, mainstream economists now (belatedly) accept that volatile capital flows are a problem for emerging economies. Emerging economies will just have to put up with the spillover of extreme monetary policy settings in advanced economies, but they will at least be able to take countermeasures without getting lectured by the international community. Capital flow management and intervention in foreign exchange markets are now accepted as legitimate policy actions in response to excessive inflows.

Some commentators still manage to get into a lather over international imbalances, but the issue has faded away. The main target, China, has now reduced its external surplus to 2% of GDP and its exchange rate has appreciated by 15%. Not much left to complain about.

On the trade front, the WTO showed a fragile pulse of life in Bali last month, but the main action for the moment is with the Trans-Pacific Partnership, where there is growing recognition that comprehensive agreements orchestrated by America may not be in everyone's interests. This could go either way. If the US Congress judges the outcome to be insufficiently biased in America's favour, all the effort could be wasted.

There is also increasing interest in an international approach to taxing multinational service providers (Google, Facebook, etc) which can shift profits advantageously. This is a big task, but there is now an acceptance that action is needed.

Financial sector reform has produced voluminous new regulation and the task now is to implement it. Some aspects of global finance will be safer, with tighter capital and liquidity requirements and some restrictions on what banks can do. But the main responsibility still rests with domestic authorities. Where these are diligent and competent, finance will be safe. Where this is not so, banks (and the shadow banking sector) are still an accident waiting to happen, although the memory of 2008 is fresh enough to provide protection, for the moment.

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The Weekend Australian carried a ‘well-sourced’ article defending our listening in on Kristiani Herawati, Indonesian President Susilo Bambang Yudhoyono's wife. Quoting the usual ‘well-connected insider who asked not to be named’, it argues that she was a legitimate target because she was an important adviser to the president, perhaps his most important adviser.

To put this forward as if it justifies the action just demonstrates that the Canberra intelligence community has lost its judgement. How offensive would SBY and his wife find this action? Let’s ask ourselves how John Howard would have felt if someone (say the Americans) had bugged Janette’s phone, with the same justification, and this had leaked.

Did no one in Canberra think this was overstepping the line? It’s time for a serious examination of our intelligence services.

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There is a widespread view that monetary policy has been fundamentally changed by the 2008 financial crisis. The IMF’s Chief Economist Olivier Blanchard says that ‘Monetary policy will never be the same’.

Policy certainly explored new areas in response to unusual circumstances, but when the dust settles, how different will it be? For some, the economy has fundamentally changed, and monetary policy has to adapt to the new world. For others, monetary policy itself has shown its deficiencies and needs to be made effective.

Answering the first group is straight-forward. Some economists have become so pessimistic about the intrinsic dynamism of mature economies that they foresee secular stagnation, with this pessimism sometimes extending to emerging economies as well.  They argue that monetary policy should become accustomed to providing constant stimulus in the form of negative real (ie. inflation-adjusted) interest rates, to encourage investment and discourage saving.

While ageing demographics will produce low growth, it isn’t sensible to undertake investments which have such a low value to society that they can’t support a positive real interest rate. Any economy in this state has deeper problems. It may well be sensible for monetary policy to temporarily administer negative real interest rates during a recession, but this can’t be a sensible long-run policy setting.

What did the 2008 crisis reveal about the effectiveness of monetary policy?

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First, should monetary policy be blamed for the crisis itself? It certainly played a role, but it was a policy mistake rather than an intrinsic deficiency — American monetary policy remained accommodative for too long after the bursting of the internet bubble in 2001. But this was a minor issue compared with the comprehensive failure of prudential supervision in America and Europe. Banks leveraged hugely, lent to borrowers who could not repay, and indulged in a welter of derivative-based transactions which made their balance sheets so complex that their own management lost track of what was happening.

Second, should inflation targeting (the near-universal approach to monetary policy) be blamed? Inflation was well contained in the two decades before the 2008 crisis, and the argument goes that this made central banks complacent, lulled by the belief that if inflation was low, all was well. But this ignores the division of labour between monetary policy and prudential supervision. Even where both these functions were in the remit of the central bank, it was supervision which failed.

But surely monetary policy should have stopped the irrational exuberance in asset prices (houses and equities)? Asset bubbles had, in fact, long been part of the monetary policy debate. Some central banks were adamant that they couldn’t identify asset bubbles beforehand (a view most closely associated with former Fed Chairman Alan Greenspan), while others were prepared to ‘lean against the wind’ with marginally tighter policy settings. But all agreed that an interest rate high enough to constrain an asset bubble would be grossly excessive for the rest of the economy.

What about the innovation of ‘unconventional policies’, notably America’s quantitative easing (QE)?

Back in the 1930s Keynes had explored the possibility that even when the policy interest rate was reduced to zero, this might not be low enough to stimulate a weak economy (the ‘liquidity trap’). In responding to the 2008 crisis, the US, UK, Europe and Japan explored what more could be done through ‘unconventional policies’. It’s not clear how much effect America’s quantitative easing had: this graph shows little relationship between QE episodes and lower bond rates, supposedly the main channel of transmission. There is no doubt that QE has had important effects on financial market psychology, but the outcome was unpredictable and ephemeral. Central banks will be happy to end QE and hope not to have to use it again.

‘Unconventional policies’ were, in fact, measures of desperation. After the near-universal fiscal stimulus of 2009, fiscal policy shifted sharply in the direction of contraction. With the recovery still feeble, it was left to monetary policy to do what it could to boost growth. Monetary policy helped but wasn’t powerful enough to offset recessionary ‘animal spirits’, fiscal contraction and the dead-weight burden of  over-leveraged balance sheets. It was a mistake to give the impression that it could do the job.

The call for monetary policy to be restructured to increase its effectiveness misses the reality that monetary policy has always been an important but limited instrument. The impact of short-term interest rate on the economy is not well calibrated or consistent.

We did learn one important lesson from 2008: that the financial sector, left to its own devices, is an accident waiting to happen, just as soon as memory of the last crisis fades. But this is not something monetary policy can fix.

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The latest round of negotiations in Singapore for the Trans-Pacific Partnership (TPP)  wound up last week, still a long way short of agreement. Negotiators will meet again in January.

 Thanks to WikiLeaks and other seepages from the confidential negotiations, the public discussion is starting to come to grips with the wide scope and serious ramifications of the TPP. Intellectual property rights will affect pharmaceutical prices and entrench the discriminatory price regimes which result in Australians paying nearly twice as much as Americans for music and computer games.

Even with these leakages, how well informed is the public debate? It’s easy enough to understand why detailed negotiation is best done behind closed doors, but this is no excuse to avoid giving the public a better understanding of the broad principles being thrashed out.

Here’s just one aspect of the debate which would be helped by more transparency. If this is the platinum-standard agreement which will transform global trade for the better, how can it exclude China, our top trading partner? The usual answer is that China’s state-owned enterprises and command economy aren’t consistent with TPP principles, but if this is the case, how can Vietnam be included? 

Kurt Campbell touched on these issues in his recent Owen Harries lecture. Having said that ‘no country has done more (than America) to support China into WTO and G20’ and that America had ‘proposed many initiatives’ in its ‘sustained effort to work with China’, he noted that ‘China had shown some interest in joining’ but ended with the limp explanation that China was ‘not quite ready’ for the TPP.

Cynics might argue that America first wants to get the rules set in its favour, and then give China the same choice it had with WTO accession: join our club (with our established set of rules) or remain an outsider. Is this the best way of getting China fully engaged in the globalised economy? Australia might usefully take an independent line here.

All this hard pounding at the negotiating table still has to receive the blessing of the US Congress, with its rampant vested interests and demonstrated capacity to thwart sensible economics. Thus this may well end up a futile exercise. 

The sad reality is that the world would be better off if there was, in fact, a more comprehensive set of rules to govern international economic relationships. Having laboured so long to produce so little at Bali, it’s doubtful the WTO can do the job. But it’s also doubtful that an equitable set of rules would be approved by Congress. The TPP, lacking universality and with all its pro-US biases, may be as good as we can get.

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'The world economy is now in a very strange place. We should not forget how strange and disturbing it is.' These are the words of Martin Wolf, the Financial Times' Chief Economic Commentator.

Wolf's 'strange place' has the world economy in a 'contained depression', where only two of the six largest advanced countries have higher GDP than in 2007; where monetary policy has lost the power to stimulate; where fiscal policy has been incapacitated by excessive government debt; and where the financial sector has channeled capital flows in the wrong direction.

In short, the global economy is in a mess and we don't yet have the formula for setting it right.

Wolf's story starts with the 1997-98 Asian financial crisis.

The argument goes that the emerging economies (especially China) concluded that they should take out self-insurance against similar crises by encouraging domestic saving and accumulating foreign exchange reserves. The reserves flowed into US assets, pushing up the US dollar and opening up a current account deficit. This weakened demand for US production, encouraging expansionary policy settings in the US (low interest rates and a fiscal deficit), which led to the sub-prime crisis which triggered the wider financial crisis.

Wolf has been pushing the 'blame China' line for some time. Doubtless these factors were operating, but to give China central place in the policy narrative is misleading.

The US financial disaster was largely the home-grown product of lax prudential supervision, misguided doctrines and vested interests.

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Low interest rates began as a fix for the 2001 'tech wreck'. Budget deficits reflected the doctrinally driven Bush tax cuts. The current account deficit was already more than 5% of GDP by 2004, before China's surplus became significant. Europe and the UK had their own versions of financial excesses and regulatory failure.

In 2006 (the height of the US external deficit), China accounted for little more than a quarter of the US current account deficit, with Germany, Japan and the oil producers accounting for the rest. As we now realise, the intrinsically unsustainable imbalances were in the European peripheral countries, which went unnoticed until the Greece debt debacle of 2010.

Whatever the role of external imbalances in the lead-up to the 2008 crisis, this isn't the main issue now. China's current account surplus has fallen from 10% of GDP to 2%. If any country were to be singled out, it would be Germany, although it's hard to pinpoint what Germany is doing wrong in its policy settings, other than the unalterable reality that euro membership gives Germany an uber-competitive exchange rate.

The main issues are elsewhere: how to unwind America's quantitative easing and restore normality to monetary policy without a damaging external spill-over; how to get budget deficits and debt down over time without stifling the feeble recovery; how to restructure a financial sector which failed so comprehensively over the past decade; and how to bring some order into volatile global capital flows.

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Economic growth has been so slow in the advanced countries since 2010 that there has been a revival of an old idea: secular stagnation. This hypothesis suggests that profitable investment opportunities have become scarce. Even with low rates of interest, economies want to save more than they invest.

Is this what explains the feeble performance of most advanced economies in the aftermath of the 2008 crisis?

No one would dispute the 'stagnation' part. Of all the major European countries, only Germany has a higher level of GDP than before the crisis. Even the UK is well short of its 2007 GDP. American GDP is now above the 2007 level, but only just. Its recovery, normally a vigorous 5% or so per year, has barely registered 2%. All these economies (again except Germany) are operating perhaps 10-15% below capacity. In the euro area, unemployment is over 12%.

Former US Treasury Secretary Larry Summersalways ready to stir debate with a controversial argument, has pondered aloud about the old secular stagnation concern.

Summers' comments might have made an interesting conference dialogue, but taken seriously, would distract policy from its proper course. Rather than invoking a unified theory of what has gone wrong, the better explanation is that these weak economies have experienced a mix of common and idiosyncratic influences.

The 2008 financial crisis was certainly widespread. But the worst-hit economies had accumulated country-specific problems which explain their slow recovery. Where the financial collapse reflected over-borrowing and asset-price bubbles, it takes time to unwind the over-leveraged balance sheets of both households and banks.

Then there were the policy errors. Read More


The 2009 G20-coordinated fiscal stimulus softened the downturn. But in 2010 there was an abrupt policy reassessment, probably triggered by the Greek debt debacle. Some countries (like Greece) had no choice but to repair their budgets, whatever the cost to output. But just about everywhere, sovereign-debt phobia forced fiscal policies to contract sharply. No one should be surprised that this stunted the recovery. 

The US has had two debt-ceiling crunches, a Tea Party revolt and sequestration. And the budget deficit has been speedily wound back from 10% of GDP to 4%, with the resulting fiscal contraction this year subtracting 2% from growth.

The European peripheral countries should have been given a deep debt rescheduling in 2010, clearing the slate for a restructuring revival. Instead the debt remains a wet blanket suffocating recovery. For the rest of Europe, bank balance sheets are still weighed down with doubtful assets. Macro policy settings appropriate for Germany are foisted on the whole euro area.

All these factors, both widespread and idiosyncratic, are enough to explain the lackluster recovery. So this is not structural stagnation (for one thing, structural stagnation is inconsistent with the high profit levels now being experienced in the US). Yet the structural stagnation concern has deep roots.

Paul Krugman has joined the debate, and Robert Gordon worries that innovation is not progressing fast enough to avoid very low growth. Japan's 'lost decades' set a disquieting precedent. Looking back on the US before 2008, there seems to be a chronic need for the stimulus of low interest rates, expansionary fiscal policy, fast credit expansion and asset-price bubbles just to keep the economy operating close to capacity.

But rather than invoke the despair of secular stagnation, there is a swag of structural fixes that would help if politics allowed. The usual suspects range from regulation simplification to competition policies.

There are also historically anomalous structural shifts which have dampened demand. Exhibit one is the shrunken wage share and the related stunning rise in income inequality. Low-paid workers in the US have had no increase in real wages for over three decades. If workers had more income, they might find something to spend it on and the shortage of demand would disappear.

Then there is the curious role of the financial sector. In advanced economies finance has doubled its share of GDP. Yet its performance before and during the 2008 crisis led the head of the UK bank regulator, Lord Turner, to describe some banks as 'socially useless'. Short-term focus has discouraged longer-term investment.

Perhaps if members of the financial sector spent less time trading with each other on borrowed money and more time linking the savers of the advanced world with the many investment opportunities in the emerging economies, the prospect of secular stagnation would recede into the far-distant future.

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The Australian Treasurer's rejection of the $3.4 billion take-over bid for grain handler GrainCorp by American firm Archer Daniels Midlands (ADM) has set a number of confusing and conflicting arguments running.

It looks like a narrow issue dominated by domestic politics, but raises wider national and international issues.

In grain handling, owning the key storage and port facilities creates a natural monopoly. The scale of operation puts this in the same category as water or electricity infrastructure, where it might be possible to have effective competition for part of the supply chain, but there will be network bottlenecks which are inevitably controlled by a single monopoly operator.

None of this makes for tidy market-based economics.

The usual answers are either regulation to ensure that the owner of these network bottlenecks makes them available to everyone, or government ownership. In this case, the Australian Consumer Competition Authority judged that there was enough regulation in place to enforce open access and thus made no objection to this bid on competitive grounds. This is, after all, just replacing a domestic natural monopolist with a foreign one.

There was, however, a wider issue of structural change that is harder to judge. International commodity trade is shifting into the hands of a small group of large global companies which exercise considerable market power. They are often sharp-elbow traders, ready to withhold supply and fix prices in their favour if they can. In minerals, Glencorp illustrates these issues. Read More


New Zealand's Fonterra demonstrates the positive aspects of this trend: a farmer-based cooperative that has achieved sufficient scale through effective marketing (especially to the burgeoning China market) to turn New Zealand's comparative advantage in growing grass into an important force in the global milk trade, to the benefit not only of New Zealand's milk producers but the nation at large. If there are pricing opportunities, they at least flow back to the nation.

Until five years ago, Australia had some similar elements in its favour in grain marketing.

This was achieved through the 'single desk' arrangements which coordinated overseas grain sales. This gave scale to develop new markets in Asia and the Middle East, but ultimately presented intractable governance issues. As this centralisation was dismantled, regional natural monopolies tended to fall into the hands of foreigners. For example Glencore, well known in minerals, took control of the regional network in South Australia. GrainCorp handles 90% of eastern Australia's bulk grain exports and owns seven of the eight bulk export grain elevators.

Given the complexity, it's not surprising that the Foreign Investment Review Board (which advises the Treasurer on these decisions) could not reach a unanimous recommendation. ADM will be one of five large global players in this market, and its scale might have helped foster new markets in Asia, where Australia's geography gives some natural advantage. It offered additional infrastructure investment in an industry which has demonstrated an unwillingness to upgrade facilities. It offered assurances that others would have access to its facilities, and offered some price reassurance to growers.

The Treasurer specifically rejected the option of approving the transaction subject to conditions (which might have addressed the natural monopoly issues). He mentioned that the industry was still in transition after the 'single desk' era, although he might also have had in mind his government's undertaking to reduce 'red tape' regulation — an objective which would conflict with detailed conditions. He held open the possibility that the issue could be revisited and explicitly allowed ADM to increase its ownership of GrainCorp to 24.9%.

It's unlikely that this consolidation story is finished.

Australia might regret that it has not been able to create a national champion, like Fonterra, in an industry where our comparative advantage would seem to be favourable. But this opportunity may now have passed, with the large international commodity traders having established strong ownership positions in domestic distribution.

Even more than usual, this debate was dominated by vested interests and narrow ideologies. Farmer-based interests swapped arguments with those whose thinking has never got past an enchantment with the 'magic of the market'. The government, which might have steered this politically-laden debate in a more useful direction, was constrained by its adjudicatory role. Also, the government was not able to treat this in an 'arm's length' fashion because of the power of its rural-based minor coalition partner.

The Treasurer quoted the public's unease with foreign investment as one factor in his decision. Incorporating the public view into decisions is part of the politician's job, but in this case the public at large was given little guidance.

The Business Council of Australia said that the decision 'risks undermining the federal government's statement that Australia is open for business'. This seems overstated as this is the new government's first rejection out of more than 130 approvals (and only the third in the past decade).

We are learning that fashioning a set of rules to set the operational environment for the market is a complex task, and that in foreign investment, neat solutions don't exist. There are more vexed cases ahead.

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Infrastructure is high on the agenda for G20, yet most aspects of infrastructure are essentially domestic policy matters, with little need — or room — for international cooperation. So what exactly might the G20 do? 

There is a disconnect between the many viable infrastructure projects in emerging economies and the many investors in advanced economies facing low yields at home. Public-private partnerships (PPPs) are held out as the answer to this disconnect, but the promise is oversold. The G20 could, instead, help connect investors with projects by bringing together the official multilateral development banks and the private credit rating agencies to produce better assessments of infrastructure debt.

Whenever infrastructure is discussed, PPPs always feature prominently, holding out the hope of a rich funding source. Foreign Minister Julie Bishop made this argument in setting out the agenda for Australia's chairing of the G20. Emerging economies also see PPPs as the answer to shortages of official funds and government inefficiencies. For example, Indonesia looks to PPPs for well over half of its planned spending, despite the minuscule share provided by the private sector at present. 

The history of PPPs demonstrates why this reliance is unrealistic. In the initial PPP model, the private sector in theory took the risk. The idea was that this would make them vigilant gatekeepers to filter good projects from bad, with the profit motive ensuring accurate project appraisal, proficient execution and efficient operation. PPPs promised to protect the taxpayer from repeating the many past examples of extravagant white elephant projects run by governments.

The practice has turned out rather differently. Read More

The private sector has often been skillful in shifting risk back to the government. In Australia and elsewhere this initial PPP model saw successful construction of important infrastructure, but with high funding costs and fat management fees. With the high level of uncertainty in emerging-economy infrastructure, a funding model where the private sector takes on the full risk will have limited application.

The PPP model is evolving. When bureaucrats eventually learned how to counter risk-shifting, the private sector became unenthusiastic about taking on risky infrastructure. The current Australian PPP model envisages that the government will do the risky part — project appraisal, construction and providing a take-or-pay contract — with the private sector taking on some low-risk funding after the project is operational.

To give the private sector this funding role is puzzling at first sight. Governments can raise funds far more cheaply than the private sector. If the government takes the project-assessment risk and can achieve operational efficiency through contracting-out to the private sector, why shouldn't the government simply fund the infrastructure by issuing its own bonds?

The answer is that governments are often constrained in the amount of debt they issue. Budget history demonstrates why governments feel constrained: short-term populism can promote overspending, yet the democratic process makes it hard to unwind such excesses or raise taxes. Further discipline comes from the credit rating agencies; concerned about a ratings downgrade, governments refrain from borrowing as this would reflect badly on their competence and popularity.

The result is that infrastructure has fallen victim to sovereign-debt phobia. In advanced countries viable infrastructure projects are either left unimplemented or funded with more expensive private borrowing. In emerging economies the result is a debilitating lack of vital infrastructure.

The first step in addressing this problem is to separate spending on physical infrastructure from routine budget expenditure (social welfare, public sector salaries and so on). A separate balance sheet, perhaps in the form of a development bank, can be judged in the same way that a commercial balance sheet is judged, weighing assets against liabilities, earnings against funding costs and risk versus return. 

The second step is to get the credit rating agencies – the gatekeepers for funding – to make competent assessments of these infrastructure balance sheets. Their rating performance to date has been woeful. In the run-up to the 2008 crisis, the CRAs gave entirely fictitious AAA ratings to mortgage-backed securities. They have done little better with sovereign ratings, being pathetically slow to identify the debt problems in the European peripheral countries before 2010. Having been too lenient before the crisis, they are now too tough on emerging economies.

The G20 has the heft to encourage the CRAs to think differently. Instead of conservative rules-of-thumb driven by concerns about repeating pre-2008 mistakes, they could develop the specialised capacity needed to evaluate complex infrastructure projects. They will also need to judge the intricate intersection between budgets and these infrastructure balance sheets.

They won’t have capacity to do this by themselves. They need the active involvement of the IMF, World Bank and other multilateral development banks (eg. the Asian Development Bank), all of which have expertise to offer. Bringing together this expertise would establish a public dialogue which will inform investors, giving them confidence to make the right investment decisions.

This won’t happen without a kick-along from G20. None of these institutions is currently thinking beyond its traditional role. But the benefits from restructuring infrastructure funding would be considerable. No one disputes the need for substantially increased infrastructure spending. In the process, the increased investment will boost a global economy in sore need of additional expenditure.

(Ed. note: An incomplete version of this post was published yesterday and later taken down when the error, which occurred in the editing process, was discovered.)

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We have blundered.

The Wise Heads are saying that we should tough this out, simply asserting that everyone does it. In fact we've gone a bit further. We've confirmed that we think if you can do it, then you should: 'The Australian government uses all the resources at its disposal'. They say the relationship has mutual benefits and will fix itself in time.

No, the relationship is the accumulation of all the pluses and minuses, perceived slights and recognised good deeds. This adds to the wrong side of the ledger. The memory recedes over time, but it remains. 

No, you shouldn't do things just because you can. Society works because people exercise restraint. International relations are no different.

What should we do?

First, we should see this as an opportunity to take a hard look at the cost/benefit balance of intelligence activities. In return for a load of gossip and the rare insight that could have been more easily gained by open diplomatic activity, we have not only offended an important neigbour, but made ourselves look foolish.

What did we hope to learn that couldn't be learned another way? The post-9/11 atmosphere has given the security industry a huge boost and it's time to rein it in, with fewer resources and more common sense. Let's put most of those saved resources into conventional diplomacy. That way you not only hear what people say, but have a dialogue on which proper understanding is based.

Second, let's apologise (always a good move when you are wrong). An apology by itself doesn't mean much. In addition to saying that we now realise that some of what we were doing was an unfriendly and unnecessary act, we should try to define in general terms the new, smaller, perimeter of our efforts. Just where these boundaries are would come out of the first action, above: let's look at the value of what we have been collecting and weigh this against the cost.

Third (probably the hardest part, because it is unfair), someone's head has to roll. When the Department of Immigration was widely (perhaps unfairly) perceived to be incompetent, the head of the department was relieved of his job and shifted elsewhere. He got more blame than he deserved, but had to make the sacrifice (and the downside wasn't too bad: ambassadorship in Jakarta, actually).

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Convergence – the catch-up process whereby poor economies grow substantially faster than the mature economies – may be the most important economic story in the past fifty years. It is transforming the world, shifting hundreds of millions out of abject poverty while simultaneously shifting the globe’s economic centre of gravity.

There have always been dissenters from this narrative. Some saw the fast growth as a temporary spurt. Others predicted that countries would stagnate in the ‘middle income trap’, unable to progress further after they had picked the low-hanging fruit of development.

Larry Summers, one of the biggest names in economic policy-making, has joined the dissenters, aiming to deflate the ‘Asiaphoria’ that foresees a continuation of Asia’s remarkable growth.

Summers (former US Treasury Secretary and member of the 1998 ‘Committee to Save the World’) and his Harvard colleague Lance Pritchett argue that the correct growth story is ‘reversion to the mean’: economies might have a purple patch where they grow faster than normal, but just as a gambler can have a lucky streak before reverting to the mean over time, growth rates will revert to the mean too. Moreover, this is not the mean of their own past growth (which might make intuitive sense, and would leave the convergence story intact), but the global growth mean.

Why are these dissenters so gloomy? There were earlier episodes of Asiaphoria which ended badly: Japan before the ‘lost decades’; the rest of Asia until the 1997 crisis. What's more, the mature economies got rich slowly but steadily while the fast-growing emerging countries stumble more frequently. And the institutions (economic and political) in emerging countries are much more fragile.

But the dissenters' evidence is tailored to fit their story.

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Their statistical analysis shows that, for all countries taken together, one decade’s growth is not closely correlated with growth during earlier decades, suggesting fast-growing Asian economies could find themselves growing more slowly later. But this is the aggregate story, and no one said every country is on a convergence path.

Their data analysis also shows that one year’s growth rate is not a good predictor of growth over the following twenty years. But this just confirms that fast growth tends to be variable; a combination of some fast growth and some average growth will still leave the country ahead of the pack.

More generally, if reversion to the mean is the rule, how did so many countries come so far along the catch-up path?

The dissenters are also unimpressed by China’s thirty years of almost 10% annual growth in per capita income, pointing out that this is an outlier. This is a stand-out performance, although South Korea and Taiwan come close. Moreover, they note 70 episodes where per capita income has grown one standard deviation faster than the average (4% instead of less than 2%) during a period of at least eight years. The dissenters don’t bother to note that this growth differential is the difference between doubling income in 35 years or doubling in just 18 years.

The counter-evidence is compelling. It begins with the four Asian tigers: Taiwan, South Korea, Hong Kong and Singapore. Then came a raft of other countries which started later and didn’t do quite as well but easily outpaced the advanced economies. Indonesia averaged 7% per year growth for 30 years under Soeharto, and Thailand and Malaysia did just as well.

The post-1960 history also shows plenty of poor countries that didn’t get on the convergence path. India was so slow getting its act together that the term ‘Hindu growth rate’ was coined. Others got onto the path, only to fall off. By the 1970s Brazil was identified as the ‘country of the future’; it then spent 22 years with unchanged per capita GDP. Pakistan was the star pupil of the Harvard Institute for International Development in the 1960s.

Even the most cock-eyed optimist doesn’t argue that convergence is inevitable. But anyone observing Indonesia in the 1970s saw how little it took to shift a basket-case onto a path which doubled income every decade. With political stability, competent macro-policies and a bit of borrowed foreign technology, the economy will bound forward, with entrepreneurs coming out of the woodwork to seize opportunities, shift low-paid workers into more productive jobs, make a buck and then reinvest in the next opportunity.

It’s easy to understand why Summers and Pritchett might rail against simple extrapolation of current growth rates. Forecasting is hard. Just as it’s easiest to forecast that the weather will go on doing what it’s doing now, simple extrapolation is the lazy way. But serious forecasters do better than this. Of course China will slow – the convergence story implies it and demographics alone make it almost inevitable. But it’s unlikely to revert to the global average any time soon. 

The emerging economies are likely to go on growing at around twice the pace of advanced countries. Within this aggregate, some will do much better, some much worse and the fast growers are likely to suffer set-backs. Trying to understand the reasons for these differences is still the central challenge for development economists. This task seems more fruitful than simple ‘reversion to the mean’ analysis.

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WikiLeaks has turned its attention to the Trans Pacific Partnership. The press, in Australia and overseas, has noticed. 

The Interpreter has previously drawn attention to the complex issues (some would say the downside concerns) of the Trans Pacific Partnership. The negotiations can be seen as America’s attempt to establish the trade segment of Tom Friedman’s 'Golden Straitjacket' — the rules which will govern international economic relations.

These negotiations are different from the usual trade bargains, where the starting point is a strong presumption that reducing trade barriers is a good thing, a win-win.

The TPP negotiations, however, are more a zero-sum arm-wrestle about what price we pay for things like intellectual property. Of course the owners of intellectual property deserve a reward and, more importantly, there needs to be an incentive for producing new intellectual property. But how much should we pay, for how long and in what form? Intellectual property rights create monopolies, and monopolies are never a good idea.

There is a real risk that the biggest players in the negotiations will get their way, and Australia, as a medium-sized player, will lose out. We, the public, don’t know how this is panning out because the negotiations are confidential. The consultations that do take place are with industry, which has vested interests and may not represent our wider interests. These leaks open this issue up, and for this we should be grateful.

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The unwinding of quantitative easing (QE) has been postponed for the moment. Financial markets have regained their composure and their panicky flight from emerging economies (notably India and Indonesia) has reversed. But the ‘taper’ of QE must inevitably occur: the emerging economies have a reprieve, not a pardon. The external spill-over of domestic macroeconomic policies, such as QE, seems a suitable case for treatment at the G20.

The US Fed’s attitude on the collateral damage from its monetary policy is straightforward: it says these effects are minimal and whatever the minor inconvenience of QE to foreign economies, the world is better off with a quick US recovery and stronger growth.

As far as it goes, this makes sense. But one reason the US recovery has been so sluggish is that the fiscal brakes are still on: the budget is subtracting nearly 2% from growth this year. America did have an urgent need to get the budget deficit down from its crisis-induced peak in 2009, but enough has already been done. The current austerity doesn’t reflect good policy-making. Rather, it reflects Congressional battles on the debt ceiling and sequestration, a random expenditure-cutting process.

Foreigners adversely affected by QE might agree that they want a quick US recovery, but the optimal policy mix would have involved less extreme settings for monetary policy and a fiscal policy which was softer while the economy was still weak, combined with a strongly articulated commitment to address the longer-term budget problems as soon as the economy is back on track. What America has delivered, instead, is fiscal confusion. Monetary policy is in overdrive in an attempt to compensate.

The immediate problem in emerging economies has passed. Panic buttons have been reset. In India and Indonesia, exchange rates have depreciated moderately, improving international competitiveness. Interest rates are a tad higher, but not enough to stifle growth, and inflation will be better contained. Some hot air has gone out of property and equity bubbles. There is always a long list of necessary structural reforms, and it is only when the pressure is on that reformers can break though the political resistance and get some of these done. The ongoing threat from QE unwinding might keep politicians’ feet to the fire.

With all these positives in mind, should QE be seen as mostly silver lining and not much cloud?

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That would be going too far. Without doubt QE caused excessive inflows of foreign capital into emerging countries whose financial markets are not deep enough to absorb these flows smoothly. Then markets panicked and the inflows reversed at the prospect of a QE taper. What is needed is a serious international discussion about the external ramifications of abnormal policy settings.

International forums have often discussed the need for international policy coordination. Use of the exchange rate as an active policy instrument has been on the international agenda repeatedly, particularly aimed at China’s export-promoting ‘manipulation’ of the yuan.

What’s different about monetary policy? The convention of setting the short-term interest rate (the near-universal instrument-of-choice of central banks) is just as much an interference with markets as setting the exchange rate. Moreover, the manipulation of longer-term interest rates (which is the objective of QE) has, until recently, been universally accepted by central banks as undesirable: the longer end of the yield curve should be left to the market to determine, to avoid distorting underlying price signals.

Nor can it be argued that the extreme settings of monetary policy seen over the past few years have had no effect on other countries. One of the main channels of transmission of QE is via depreciating the exchange rate, improving competitiveness, promoting external surplus and boosting domestic growth at the expense of foreigners. No one is disputing that QE in the US, the UK and Japan weakened the dollar, sterling and the yen. And now we are seeing the whipsaw effect on capital flows to emerging countries as policy is imposed and then, prospectively, unwound.

Thus manipulating exchange rates is on a policy-making par with setting longer-term interest rates. Both are helpful to the domestic economy (and this could be used as a justifying rationale), but at a global cost. In both cases, the world is entitled to complain about over-use and to request – even require – some policy coordination to moderate the global impact.

So far, the international discussion of this topic has been unsatisfactory. At G7 meetings, with a majority of the members implementing QE and no emerging economies present, monetary policy has been judged to be a purely domestic issue. This formula was repeated at the G20 meeting in St Petersburg in September. Disruption to other countries was acknowledged, but emerging economies were advised to address the problems by improving their own domestic policies. The issue didn’t get a mention in the October G20 Finance meeting communique, though the Russian press note recorded that concerns had been expressed. We might hope for a more substantive outcome at G20 in Brisbane next year.

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You can't read a paper or watch TV in Indonesia without coming to the conclusion that Joko Widodo ('Jokowi'), the mayor of Jakarta, is a shoe-in for the 2014 Indonesian presidential election.

Not only is he the front runner in most polls, he is ubiquitous, getting footpaths fixed, sorting out street vendor logistics, shoring up Jakarta's flood defences and restarting construction of the city's monorail.

How does someone who a year ago was just a small-town mayor become the likely leader of Southeast Asia's largest country? The US experience provides a clue. Presidential systems can elevate a peanut farmer to the POTUS role. And the other current candidates seem fatally flawed for one reason or another.

The runner-up in most polls, and front-runner until Jokowi appeared on the scene, is Prabowo Subianto, the subject of an in-depth interview in last week's Tempo magazine (subscription required, but worth $3 if you have any interest in Indonesia). Former top general, former son-in law of President Soeharto, and drummed out of the army for kidnapping Soeharto's political opponents, Prabowo answered some of the many criticisms aimed at him and set out his political platform.

The economic elements make a depressing read.

He sees a much more active role for the state in running the economy, a more self-sufficient and inward looking economy, alongside resistance to market-oriented policies. This would reverse the successful economic policies of the past forty years and seems like a return to the failed economics of Sukarno, but it plays well to a popular audience.Read More

Prabowo is the son of Sumitro Djojohadikusumo, the intellectual father of Indonesian economics. Sumitro started out a traditional socialist but his interventionist leanings were tempered by the reality of Indonesia's limited administrative and governance capacity when he was trade minister under Soeharto. If he were still alive he might inject some of this reality into his son's economics. He would certainly endorse the tilt at the presidency: the story goes that he once said Indonesia should be run by his family, using his brains, Prabowo's guns and Hashim's (Prabowo's brother) money.

Of the other contestants, former president (and Sukarno's daughter) Megawati Sukarnoputri is a proven loser in the presidential stakes. Prominent businessman and bank-roller of the Golkar party, Aburizal Bakrie, seems to be demonstrating that money alone is not enough to win. He can't shake off the reputational damage from the Sidoardjo mud disaster. 

Still, Jokowi has a few hurdles to clear.

He has no political party of his own and would probably have to rely on nomination by Megawati's Indonesian Democratic Party – Struggle (PDI-P), so in order to clear the way she might decide not to run. Amazingly, his appeal seems to carry weight well beyond Jakarta, but will that last when the other candidates get their well-funded publicity machines going? And if Jokowi appears like a shooting star in the night sky, so could an as-yet-unidentified candidate, although time is running out fast.

Looking ahead, it's hard to judge what sort of president Jokowi would make.

He has said almost nothing in public about his vision for Indonesia, either at home or abroad. Indeed, his current (and very convenient) stance seems to be 'shucks, I'm just the mayor of Jakarta'. Further, one of his main challenges would be to get legislation through parliament without much control over his presumptive party, which in any case won't have a majority. The weight of popularity would doubtless help, provided the enthusiasm survives the challenges of running a country as difficult and diverse as Indonesia. But the Indonesian parliament has proved just as quarrelsome as the US Congress and, in recent years, has often made life very difficult for the Indonesian administration. Even President Susilo Bambang Yudhoyono, whose party won an outright parliamentary majority 2009 who was elected with an absolute majority in 2009, has never found it easy to get legislation through parliament.

Indonesia has had an extraordinary range of presidents, from the flamboyant Sukarno to the blind cleric Abdurrahman Wahid. It matters a lot who gets the job, both for Indonesia and the whole of the Southeast Asian region. Australians ought to be taking more interest in this, and our media ought to be doing more to help us understand what is unfolding next door.

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Do we learn from economic crises? The 2008-10 crises in America and Europe and the Asian crisis a decade earlier present a rich source of contrasting experience to examine.

What a divergence there is between the 2008-10 policy responses and 1997-8! In 1997 IMF funding, even supplemented by additional bilateral rescue funds, was too small to offset the capital outflow that was driving down exchange rates. The Asian crisis countries received support equal to less than 10% of GDP, while in 2010 the European crisis countries received support equal to 50% of their GDP. The Fund component was 800% of IMF quota for the Asians, and 2230% of quota for the Europeans.

The adamant advice on monetary policy in 1997 was to tighten strongly, pushing up interest rates. In 2008, central banks not only pushed interest rates down to zero, but have also spectacularly expanded their balance sheets with innovative support for financial markets.

Swift closure of troubled financial institutions was mandatory practice in Asia. This was supposedly necessary to avoid ‘moral hazard’ from guaranteeing bank depositors or bailing out banks. This concern was forgotten in 2008. It wasn’t just banks that were saved by taxpayers’ support: insurance companies (AIG), the money market and the car industry were all rescued. In Europe, even clearly insolvent countries such as Greece were bailed out.

Fiscal policy was tightened in both episodes, but in 2008 it was because countries were starting with large deficits and unsustainable debt levels, while in 1997 the crisis countries had budget surpluses and low debt. The 1997 tightening was a macro blunder, crunching countries whose output was already in freefall.

How could the prescription be so different?

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First, the problem in 1997 was misunderstood by the outsiders who tried to help. At the time, a central role was given to ‘crony capitalism’: Soeharto in Indonesia and the chaebols in Korea.

Now, fifteen years later, the central macro-economic issue can be seen as the sudden reversal of foreign capital, triggered by concerns about over-heating economies, overvalued exchange rates and excessive foreign borrowing, all of which were symptoms of the pre-crisis period of hugely excessive capital inflows. This was a liquidity problem which required the sort of treatment given to the European peripheral countries in 2010. Balance of payments support was needed, foreign debt had to be reduced through rescheduling and banks had to be kept going, not closed.

Policy was also confused by the doctrinal belief that free markets would deliver the right answers. In the middle of the 1997 crisis, the Fund was trying to amend its Articles to give free capital movements the same compulsory status as free trade.

Those involved in 1997 don’t seem to feel at all sheepish about the mistakes made. Many of them are still around (some were at a recent Peterson Institute conference which compared the two crises), and many were involved in both crisis periods. The nearest the IMF has come to a mea culpa is a 2012 speech by David Lipton (now IMF First Deputy Managing Director, but then one of the US Treasury bovver boys standing over the IMF), where he said that it all worked out for the best, as the result was stronger financial sectors able to withstand the 2008 shock.

Larry Summers, one of the ‘Committee to Save the World' (no, this wasn’t derisory or ironic) has shown more introspection. In 2010, deeply involved in Obama’s response to the 2008 crisis, he said:

There have been moments, certainly, when I understood better some of the reactions of officials in crisis countries now than one was able to from the outside at the time. It is easier to be for more radical solutions when one lives thousands of miles away than when it is one’s own country.

It seems that policy-makers have to learn for themselves. No-one in advanced countries thought that the Asian crisis had any lessons for them, even though the pre-crisis circumstances in the European peripheral countries had the same excessive capital inflow, with the same loss of international competitiveness.

When the 2008 crisis unfolded, policy-makers responded with ad hoc common sense rather than by drawing specific lessons from the Asian experience. The IMF has come to understand that foreign capital flows present big macro challenges for emerging countries, and that free-floating exchange rates can fluctuate widely. But this belated recognition came much more recently.

The 1997 crisis countries learned some lessons (which helped them weather 2008), without always finding satisfactory answers. They have taken out expensive self-insurance through big foreign reserves, exacerbating international imbalances in the process. Unhappy with the IMF, they created the Chiang Mai Initiative but have not been able to make it operational (it remained unused in 2008).

Even now, if we ask ‘have the problems been fixed?’, the answer is clearly ‘no’. We don’t know where or when the next financial crisis will occur, but we can be sure that there will be more.

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