As a follow-up to my earlier post on the limits to growth, it's worth noting this report released late last year by the McKinsey Global Institute. The report is an extended discussion on some of implications of the first of the two points on which I ended my post – that after a long period of falling prices appearing to signal easing resource constraints, recent trends look quite different:

There's a lot of material here, including some interesting bits relevant to the race between the cost-increasing effects of resource depletion and the cost-reducing effects of innovation: read more

Andrew Shearer's recent post on US-China comparisons prompted me to take a look at the paper by Michael Beckley he recommended. While I don't have anything useful to contribute on the specific subject of the US military/security edge over China, a couple of things did strike me.

First, I would summarise many of Beckley's points regarding the clear superiority of the US in measures of innovative capacity such as R&D spending and patent citations as reflecting the big difference in GDP per capita between the two countries. Given the close correlation between the level of a country's development and many of these variables, these results are exactly what we should expect when comparing a developed and developing economy. 

Or, to put it another way, countries at the economic frontier are likely to grow more through innovation while countries involved in catch-up growth will rely on a different growth model. 

This difference is one of the factors that lie behind concerns about so-called 'middle-income traps': the policies and institutions you need to deliver the growth that get you from low- to middle-income status may not map all that well onto those that get you from middle-income to high-income status. So while it's quite possible that the gap with the US on these innovation-style indicators will narrow as China develops and its GDP per head rises, it's not a foregone conclusion.

Second, I was surprised by the claim – at least with regard to economic variables – that the US lead over China has grown since 1991. That's certainly not what I would take away from the data. Of course, there are lots of potential variables to consider, and there are probably some data points that would support this story. 

Since some of my colleagues have been  setting out their thoughts on the Asian Century White Paper, I thought I might chip in with my two cents. I have three opening questions.

1. Shouldn't we try to go beyond old-school geography?

Granted, we know that there's lots of globaloney out there. Distance isn't really dead, the world’s not flat, and geography certainly isn't history. The real estate agent's mantra – location, location, location – remains an important feature of our world and of Australia's place in it.

Still, restricting ourselves to thinking about the world in old school geographical terms, especially when it comes to the international economy, seems just, well, overly restrictive. Perhaps, instead of starting from artificial geographic designations like 'Asia', we could start by mapping the evolving flows of goods, services, capital and people within which we are enmeshed, and then see where that takes us. At a minimum, in a world of international supply chains where traditional trade statistics capture only a small part of the underlying reality and which is characterised by increasingly complex financial networks, we need to supplement our traditional models with new ways of understanding our environment.

2. Can we find appropriate benchmarks?

It's probably inevitable that any study on our economic relations with a given region is going to generate claims that our ties with one country or another – or even the region as a whole – are underdone, or alternatively, that certain markets or modes of exchange are less developed than we might expect (I'm not immune to this kind of temptation). After which assertion we immediately and naturally skip on to the question, 'what is to be done to alter this deplorable state of affairs?'

I ended my earlier post by pointing out that economists typically think about resource scarcity differently than those who take a more pessimistic view, such the authors of The Limits to Growth and New Scientist magazine, which recently gave Limits a 40th anniversary appraisal. A neat way of explaining the difference is set out in this paper by John Tilton, which outlines two alternative models. 

Model one is the fixed stock paradigm. It starts with the common-sense observation that the earth is finite, from which it follows the supply of resources must also be finite, and hence can be represented as a fixed stock. Since the demand for those same resources is a constant flow variable, the flow must eventually deplete all of the fixed stock. Moreover, if demand growth then turns out to be exponential, depletion could occur quite quickly. This is a Limits-style world.

A second approach is what Tilton calls the 'opportunity cost paradigm', which assesses the availability of resources by thinking about what society has to give up to secure another barrel of oil or ton of copper.

In this model there are two forces at work. First, there is the same story of the depletion of existing stocks of a given commodity. This means producers must find new stocks which will often be harder to access or of lower quality, tending to push up costs and hence prices. Second, however, is the introduction of new technology which can offset this upward pressure on prices by economising on the use of an existing resource, by finding substitutes, or by reducing the cost of acquiring new stocks. 

Recently, New Scientist magazine ran an article (subscription required) marking forty years since the publication of The Limits to Growth. The piece both echoes and cites earlier positive re-appraisals of Limits, including this one by the CSIRO's Graham Turner, and shares a similar pessimistic tone.

Many (most?) economists have tended to have a fairly problematic relationship with this kind of thing, particularly when it comes to the supply of so-called non-renewable resources. When we start off as little, baby economists, we are frequently introduced to the Reverend Thomas Robert Malthus as a cautionary tale about resource pessimism. 

In 1798, Malthus published An Essay on the Principle of Population. Famously, he wrote about the inability of agricultural productivity to keep pace with population growth. Equally famously, he got his forecast wrong. As many subsequent critics have pointed out, Malthus turned out to be writing at a time just before a series of major developments. The acceleration of the Industrial Revolution, a dramatic expansion of international trade, the emergence of new agricultural producers in North America, Argentina and Australia, and the onset of the demographic transition allowed a series of countries, led by his own, to break free from the trap Malthus had just identified. 

Similarly, when Malthusian-style fears about binding constraints to growth reappeared in the late 1960s and early 70s as the world economy experienced a period of rising food prices, the Green Revolution and rising world agricultural productivity ended up allowing food output to run comfortably ahead of population growth, setting food prices off on a decades-long fall in real (inflation-adjusted) terms.

Economists often cite both Malthus' original predictions and the failure of the pessimistic forecasts of the early 1970s like The Limits to Growth as cautionary lessons about what happens when forecasters fail to account properly for the impact of technological change and the power of the price mechanism.

Part of what's going on here is that the economists and those who take a more pessimistic view typically think about resource scarcity in quite different ways. More on that in a follow-up post.

I've mentioned before on The Interpreter that I find reading science-fiction an interesting and enjoyable way to get some ideas about future trends, and here is Bruce Sterling, one of the genre's leading futurists, in his annual state of the world discussion. 

For a pithy view of the future around mid-century that brings together climate change, the demographic transition, and urbanisation, it's pretty hard to beat Sterling's 'old people in big cities afraid of the sky.'

And here is Charles Stross keying off Sterling to think about what the world might look like in 2032 and 2092.

Photo by Flickr user Ruff Made Art.

I'm in complete agreement with Steve Grenville's overall point — there is precious little evidence to suggest that the US blog debate has done much to 'winnow out dodgy arguments or produce a policy consensus.' But while that's probably pretty depressing for those who would like to think of macro as a purely technocratic business, I also don't find it particularly surprising.

As I've noted before, I think that political beliefs (and other values) have a significant influence on where many economists stand on some of these issues. And given that there is often a hefty political element to at least some of the policy choices involved, this also should be no surprise. What's perhaps more depressing is that — so far, anyway — the gradual accumulation of empirical evidence on some of these debates (few signs of so-called expansionary austerity; the absence to date of an inflationary surge) seems to be doing little to change minds, either.

It follows, then, that I don't think this lack of consensus is a particular failure of economic blogging: I am quite confident that the same inability to reach consensus would have prevailed (and indeed does prevail) in debates fought out in newspaper op-ed columns or policy briefs or wherever.

Moreover, I also think there is still some value in the debate. So, I would guess that economics students must find it quite useful (not to mention highly entertaining) to see policy arguments among the profession's great and the good diced and dissected: for a recent example, here is Brad DeLong taking on John Cochrane's views on fiscal stimulus.

Back when I first studied macro, I was taught about fiscal stimulus, the debate over the Treasury View and so forth in some rather dusty lectures on the history of economic thought. Now these debates are being fought out in real time against the backdrop of contemporary policy decisions. Again, this is perhaps (rightly) depressing for those who would like to think of macro theory as involving the forward march of a pure science. But if nothing else, at least it offers a much more interesting and engaging pedagogical tool.

Finally, there is some evidence that economic blogs do have some measurable positive effects. This series of posts at the World Bank from last year discusses some researchers' attempts to measure the influence of econoblogging: their final paper is available here.

Cartoon by XKCD.

Over 2003-2007 the world economy enjoyed something of a mini golden age. Economic growth was high, macroeconomic volatility was low, financial markets were buoyant, and the apparent probability of crisis was low. 

Since 2007, however, that mini golden age has been transformed into something that feels altogether more leaden: economic growth has slumped, macro volatility has soared, markets have turned manic depressive (with the emphasis frequently on the latter phrase) and the probability of crisis seems to be worryingly high. It's been a potent example of reverse alchemy – turning gold into lead.

Some of this was depressingly predictable: one lesson from past financial crises has been that the post-crisis period is typically one of sub-par economic performance. But there's little doubt that post-crisis economic malaise has been exacerbated by an extremely disappointing performance on the part of policymakers.

The consequence is that it's hard get too optimistic about a short-term economic outlook that is dominated by unfinished business from this year. On the other hand, the long-term outlook for the world economy continues to be shaped by the Great Convergence and remains very much the consensus view of the future.

Which raises an interesting question about the medium-term prospects for the world economy: just how are we going to transition from a gloomy short-term outlook to a much more optimistic long-term one? Well, as the old joke says, I wouldn't start from here...

Back in early 2010, I suggested that a key theme for the year ahead should be the pressing need for a range of economic actors to rebuild the credibility that had been so badly damaged by the financial crisis. In particular, I suggested that the image of competent Western economic management had been trashed, and was now in urgent need of repair.

Not quite two years on, and sadly, policy credibility remains in short supply. The debt ceiling debacle in Washington and subsequent sovereign ratings downgrade provided a sort of symbolic confirmation that the US could no longer boast AAA-quality policymaking. Meanwhile, developments in the eurozone over the past two years have signalled an even greater degree of policy failure, with expressions of disappointment and frustration with Europe's drift towards disaster now commonplace.

As a result, rebuilding policy credibility should – again – be a key theme for next year. Here's hoping the world's leaders do a better job of it this time.

Photo by Flickr user davidz.

There's been a depressing sense of déjà vu about the world economy over the past week. Once again, we are worrying about policymakers in the core developed economies failing to get to grips with a financial crisis; and once again we are fretting about the adverse spillover effects to the key emerging markets that have helped support Australian growth.

We know that our region will not be immune from developments in Europe. In this regard, it's important to remember that the key lesson from the previous global financial crisis was not that the emerging markets of Asia and elsewhere were safe from a downturn in the developed world: in fact, when the crisis went critical after the collapse of Lehman Brothers, both economic activity and financial markets crashed right across the world.

Rather, it was that the affected emerging markets were nevertheless able to aggressively use fiscal and monetary policies to offset the worst effects of the downturn, and had the policies and institutions in place that were able to deliver an impressive degree of resilience in the face of a severe external shock.

As the crisis in the Eurozone deepens, that resilience is now facing another major test. According to the World Bank's latest regional assessment for East Asia and the Pacific, weaker growth in the EU (and the US) will once again have a significant impact on the region, given continued high direct trade exposures to developed markets:

Euro-pessimism has taken (yet) another steep rise over the past few days: this week's Economist magazine asks whether this is the end for the euro; in the FT Gavyn Davies outlines some possible post-crisis scenarios; and the Wall Street Journal ponders some of the possible implications of 'eurogeddon'.

What's striking about this is that the degree of policy failure implied here is of truly epic proportions. After all, if just leaving the euro would prompt the 'mother of all financial crises' in the exiting country, consider the calamity that a full-scale collapse risks triggering.

Of course, if history is to repeat itself, then now is the time to start thinking about what the next phase of European currency cooperation might look like: and indeed Paris and Berlin are reportedly setting out their ideas. But after this latest debacle, will Europe's voters once again let their leaders play double or quits with the region's currency arrangements?

As is now commonplace to point out, Australia's alliance preferences link it to the US, even as its economic ties with China are dense and growing. 

Since Washington and Beijing are increasingly viewed as strategic rivals, this is supposed to present policymakers in Canberra with a potentially difficult trade-off – do you cuddle up closer to your most important customer and risk losing your lovely security blanket? Or do you chance diminishing your economic welfare by sticking with your traditional allies? 

Australia's situation seems tailor-made for testing this purported pull between matters of economics and security. If one were to look only at the increase in Australian-Chinese economic ties over the past few years, then these would seem to predict that Australia would also be pulled geopolitically towards China.

Under the Howard Government, Canberra clearly remained a close ally of the US, to the extent that Australia famously earned for itself the description of US 'deputy sheriff' in the region. But after some early diplomatic pain, the same government also worked hard to keep China onside: a recurring theme in Prime Minister Howard's speeches was that Australia could maintain good relations with both Washington and Beijing (a theme that is still familiar today). Meanwhile, analysts carefully watched ministerial pronouncements for any signs that economic gravity might geopolitically tilt Australia towards China.

In the years following the Howard Government, China's relative importance to Australia as a trading partner has grown, even as that of the US has declined. Granted, the US remains a far more important investment partner. But even there, China's status as an overseas investors has risen sharply from what used to be negligible levels. And of course, at least to date, the aftermath of the GFC has served to reinforce perceptions that there has been a big shift in relative economic fortunes between the two great powers in favour of Beijing.

In response to Anton's Reader Riposte, I'm not sure Mrs Thatcher's macro policy makes for a good case study in support of the existence of the confidence fairy. 

The early years of her first term saw the implementation of very tight fiscal and monetary policies, and the result was a severe contraction. When macro policy was then loosened, economic recovery followed. When looking at the fiscal position over this period, it's important to look at the cyclically adjusted fiscal stance to see whether policy was stimulatory or contractionary.

Two other quick points.

First, Mrs T was happy to use tax increases to get her fiscal consolidation. In particular, she hiked VAT to such an extent that it's been estimated the overall tax take levied on labour increased relative to the previous government and stayed above it until the late 1980s. Indeed, noted supply-sider Arthur Laffer took to the pages of the Wall Street Journal to denounce her approach.

Second, the success in restoring fiscal health to the UK economy over the period owed more than a little to the good luck of a nicely timed windfall from North Sea oil.

Photo by Flickr user cseeman.

It's hard to stay optimistic about the G20.

Getting a big success out of last week’s summit was always going to be a tough ask and in the end, the initial take on Cannes has been that it largely lived down to expectations. Some have gone further and described the meeting as 'comically irrelevant'.

Initially, pessimists had worried about the ambitious agenda of the French presidency and whether, as a result, the G20 was in danger of heading down the APEC route of combining a rapidly expanding agenda with a failure to deliver. But as the crisis in the eurozone deepened, it became clear that the meeting would end up being judged on its contribution to dealing with Europe's overlapping debt, banking and growth problems.

To a large extent, this was inevitable: after all, it would be very strange if the self-designated 'premier forum' for international cooperation did not having anything to say about one of the most pressing challenges to global economic stability. In this regard, criticisms of the euro crisis 'hijacking' the G20 rather miss the point. 

The introduction to Arvind Subramanian's new book Eclipse begins with a description of international economic events taking place during a future February 2021.

In a story designed to illustrate the changing balance of financial power in the global economy, Subramanian imagines a newly inaugurated US president en route to a meeting with the Chinese director of the IMF, where he will sign an agreement to get US$3 trillion in emergency financing in return for the US submitting to Fund conditionality.

Meanwhile, back in today's world, Eurozone leaders are reportedly hoping to set up a special fund, possibly managed by the IMF, to attract investment from cash-rich countries like China and Brazil to help out with the current crisis.

As William Gibson said, the future is already here, just unevenly distributed.

In its recent briefing for the G-20 Finance Ministers meeting, held in Paris last weekend, the IMF was blunt about the risks now clouding the economic outlook. 

According to the Fund, the 'global economy has entered a dangerous phase', 'downside risks are severe' and the 'immediate risk is that the global economy tips into a downward spiral of increased uncertainty and risk aversion, dysfunctional financial markets, unsustainable debt dynamics, falling demand, and rising unemployment.' Indeed, it thinks that the best we can hope for is an 'anaemic recovery in major advanced economies and a cyclical slowdown in emerging economies.'

What's particularly striking about the precarious situation in which the world economy now finds itself is that it comes as no surprise. Observers have been contemplating doom and gloom for months now, and pretty much everybody knows that global economic risk is dangerously high. Yet, despite the fact that many of the current set of economic problems are well understood, there is remarkably little confidence that policymakers will be able to do much to deal with them. 

If the best we can hope for is to avoid the worst, that's a pretty disturbing message about the overall health of international policymaking in the world economy.

In a previous post, I noted that one alternative to asking the question of whether the manufacturing sector in the US was now too small was to ask whether other sectors have grown too large. The financial sector is one obvious candidate — over the last thirty years, the US financial sector has grown some six times faster than US nominal output.

Before the onset of the global financial crisis, many would have found the suggestion that finance was too big an implausible one. After all, the level of a country's financial development seems to be positively correlated with its growth prospects, and there is a large empirical literature investigating the workings of the finance-growth nexus. Then there are all those lovely high-pay, high-skill jobs on offer, which governments both national and local are extremely keen to attract and retain.

In the aftermath of the crisis, however, there has been a greater willingness to ask whether the financial sector may have grown too large in the US and some other developed economies. Certainly, the sheer scale of the financial pollution suffered by the world economy over the past couple of years suggests that our assessment of the relative costs and benefits of the sector merits a rethink, something which would also require that we do a better job of measuring both of these things.

It also requires thinking about whether the large public subsidies implied by government backing for the sector have distorted the structure of at least some developed economies. Indeed, there is now widespread agreement on the proposition that, not only did implicit government support lead to the creation of 'too important to fail' institutions in the run-up to the crisis, with destabilising consequences for risk-taking behaviour, but also that the problem has since grown worse. What is true for individual institutions may also apply to the sector as a whole.

One result of the crisis is going to be a tougher regulatory environment, including requirements for more capital and more liquidity. All else being equal, this will imply some reduction in the size of the financial sector relative to its post-crisis high in countries like the US. Mind you, given uncertainties about some of the trade-offs involved, not to mention the past success of financial lobbyists in shaping the industry's regulatory environment, just how big any reduction will turn out be remains an open question.

Photo courtesy of TaxBrackets.

I've been following the Interpreter's debate (1, 2, 3, 4, 5) on US manufacturing with interest, not least because it took my mind back to some old debates about development and deindustrialisation. And of course we are also starting to see a fair bit of discussion here in Australia about the merits of supporting our own manufacturing base.

Economists (especially development economists) and economic historians, have spent a lot of time thinking about how the broad structure of economic output changes with the level of development. Based on this work, the 'typical' pattern of economic development is usually assumed to involve a transition from a low-income, agrarian economy to an industrial economy with a higher level of income, with big relative shifts in the share of output and employment, away from agriculture and towards industry in general and manufacturing in particular.

In other words, at the lower end of the international income distribution, development is often treated as synonymous with industrialisation, albeit with significant variations across time and space in how that industrialisation plays out. (This is one reason why there has been so much interest in India's development path, which to some observers seems to offer the possibility of an alternative path to development.)

In contrast, for countries with higher levels of income per head, the lessons of the twentieth century seemed to be that structural change typically involved deindustrialisation, or alternatively 'tertiarisation,' as industry's share of output and employment shrank, and resources were transferred into the services sector. The big drivers of this shift were relative productivity growth, the associated changes in relative prices, and shifts in the structure of demand between manufacturing and services.

For example, since labour productivity tended to grow more rapidly in manufacturing than in services, while output growth across both sectors was similar, lagging service sector productivity meant that the services sector account for a growing proportion of employment. At the same time, the demand for services has grown more rapidly than the demand for manufactured products. It's also likely that international trade has played a supporting role in the process, although the main drivers appear to have been domestic.

So, my caution as to whether the US debt deal would be enough to stave off a downgrade proved well founded. On Friday, Standard & Poor's (S&P) announced that it was downgrading the long-term US debt rating to AA+: the coveted AAA rating is no more. To rub salt into the wound, S&P said that the outlook on the new long-term rating is negative, signaling the possibility of further downgrades. (Moody's still has the US at AAA, albeit with a negative outlook.)

S&P cited two main reasons for the action. First: '...our opinion that the fiscal consolidation plan that Congress and the Administration recently agreed to falls short of what, in our view, would be necessary to stabilize the government's medium-term debt dynamics.'

And second: '...our view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges to a degree more than we envisioned when we assigned a negative outlook to the rating on April 18, 2011.'

Since (1) is largely a consequence of (2), I think it's fair to interpret the downgrade as a product of the current US political situation, with its disastrous consequences for the quality of US policymaking.

Some initial thoughts:

While the world has been distracted by the saga of the US debt ceiling, the Eurozone crisis has taken another turn for the worse: Spain and Italy, the two largest PIIGS (and a telling indicator of how bad things have got is that it is now PIIGS rather than PIGS), have seen their borrowing costs blow out in a new bout of market contagion that has regional policymakers sweating in Europe's  August heat.

As we've heard before, there are good reasons to distinguish both these economies from the countries that have already succumbed. Yet it's been striking just how ineffective the region's policymakers have been in stemming the crisis as, one after another, economies and metaphors have tumbled. 

First, Brussels and Frankfurt tried to build a firebreak between Greece's debt problems and the rest of the region, only for the flames to engulf Ireland. Then there was supposed to be a line in the sand dividing Greece and Ireland from Portugal. But that was washed away. Now the crisis is attacking the two largest southern European economies – the two that are 'too big to fail and too big to bail'. Should they fall, they would probably take the Euro project with them.

If this is the Eurozone's last stand – and it’s starting to look like it is – let's hope that Brussels has better luck with this metaphor than it's had with the others...

Photo (of the Lion's Mound at Waterloo, Belgium) by Flickr user Ben Heine.

One modest benefit of the extreme — indeed extraordinary — economic times in which we are living is that we get to see the results of a series of dramatic economic experiments in action. 

Want to see what happens when you let your financial institutions get too big and too connected to fail and then let one fail anyway? Roll the Lehman Brothers experiment. What about testing the resilience of countries to huge external shocks when they have no exchange rate flexibility and monetary policy is set elsewhere? Roll the Eurozone periphery test. Can partisan politics and boneheaded stupidity help a country lose its AAA status? Cue the US debt ceiling experiment. And so on.

Yet another in this growing line of...shall we say 'interesting'...experiments is the debate over expansionary fiscal austerity. This is sort of the reverse of the Keynesian debate  we have occasionally touched on here on The Interpreter, which asks whether regular expansionary fiscal policy can be effective. 

The expansionary fiscal austerity argument is the somewhat counterintuitive proposition that tightening fiscal policy (cutting spending, raising taxes) will boost economic growth. There are some (limited) circumstances where this effect might be expected to work, and there has been some empirical evidence of these kinds of non-Keynesian effects working in the past, although under current circumstances (in particular, where interest rates are already very low) I have been sceptical as to the relevance of these argument as applied to, say, the US or the UK. 

Apropos of thoughts about a potential US ratings downgrade, my colleague Steve Grenville had a nice piece in Monday's AFR looking at the ratings agencies. He lists many of the problems with current arrangements – ratings tend to be a lagging rather than leading indicator, they encourage investor herding, there are significant incentive issues and potential conflicts of interest – but also notes that the search for alternatives has not been particularly fruitful. 

Steve reckons that one solution might be to rate the raters – that is, for an independent institution to provide a public assessment of the agencies' own ratings record, and so encourage investors to be more discriminating in following the ratings agencies' decisions.

While that seems like a sensible approach, would it be enough to encourage the agencies to try to distinguish themselves from one another by injecting more diversity into their ratings, or would we still see the same kind of group-think they are currently sometimes accused of? 

It may be that the structure of the ratings market – where just three agencies account for more than 90% of all ratings – turns out to be an important constraint here. If so, then another important part of the reform process might be figuring out how to inject more competition into the market for ratings by encouraging new entrants or otherwise breaking down the existing oligopolistic market structure.

Alternatively, it might be that ratings by their nature are doomed to be nothing more than lagging indicators of changing creditworthiness that only amplify market cycles. If so, perhaps the best we can hope for is to downplay their significance by reducing our reliance on them.

Photo by Flickr user Gabriel Madrigal Photography.

So, as Steve predicted, a last-minute deal over the US debt ceiling has been achieved. 

The good news is that we will avoid throwing one more straw onto the back of the poor old camel that is the world economy. The not-so-good news is that the camel is already burdened by several bales' worth of other straws, and the poor beast is not looking too good. So, for example, yesterday, to balance against the welcome news that US lawmakers had decided not to shoot themselves in the foot just yet, we also got a series of readings warning us that the world's manufacturing sector could be running out of steam.

Still, at least we can stop worrying about a potential US debt downgrade and the uncertainty that the loss of AAA status might entail, right? Well, maybe. It's pretty hard to interpret recent events as a strong sign that all is well with the management of what is still the world's largest and most important economy.

Photo by Flickr user The.Rohit.

I'm just back from an extended trip overseas where I caught up with a bunch of family members, and for a surprisingly large part of it I had little access to media, electronic or otherwise. As a result, I'm now occupied by a second round of catch-up – this time with what's been happening in the world economy while I was busy been reconnecting with some of the branches of my family tree.

Among the big stories are, of course, the continuing debt crisis in the Eurozone and the deadlock over proposals to increase the debt ceiling in the US. The former is obviously no surprise and is a story which has been rumbling for quite some time.

On the surface, at least, the latter is much more surprising, since it involves what looks like a wholly self-inflicted and quite easily avoidable sovereign debt crisis. US political analysts may well disagree with that assessment, since many of them have been warning for some time of the growing inability of the US political system to function effectively in an environment that is now ferociously partisan. Even so, this still looks like a particularly bizarre case whereby the victim is thinking seriously about shooting himself in the foot or (more worryingly) in the head.

Back in early 2010, I suggested that a major theme for the year ahead would be the return of sovereign risk. This has been one of those nice predictions that just keeps on giving, and one which still shows little sign of losing relevance. To be fair, it was also a pretty easy bet to make, given past experience with financial crises. Both of the big stories mentioned above fit comfortably into this narrative.

One of my long-running themes for the International economy program here at Lowy has been the importance of the Great Convergence in shaping the international economic environment.

Via Felix Salmon, here's a paper (pdf) looking at the evolution of beer consumption over time and between countries:

'...there have been major changes in beer consumption in the world... per capita consumption has decreased in traditional 'beer drinking nations' while it increased strongly in emerging economies....Beer consumption initially increases with rising incomes, but at higher levels of income beer consumption falls'. 

Turns out that globalisation is also contributing to a great beer convergence across countries.

Cheers!

Photo by Flickr user indi.ca.

Until the onset of the Asian financial crisis, the term 'contagion' typically referred to the spread of a disease: July 1997 changed all that. Once the currency crisis in Thailand went regional (Indonesia, Malaysia, South Korea) and then global (Russia, Brazil and the Long Term Capital Mangement (LTCM) company), we started to get used to the idea of thinking about contagion in terms of the international spread of financial market collapses. 

The GFC provided another powerful example of this process in action, as problems in the US housing market spread rapidly throughout, first, the US financial system and then the financial sectors of much of the developed world, even as the real economy fallout triggered abrupt falls in trade and industrial production across the world economy (although, see this). More recently still, sovereign debt problems across the periphery of the Eurozone have again prompted much talk about the dangers of financial contagion.

Mind you, although the term is now thrown around quite freely, economists continue to disagree over what it means, or even whether it actually exists. Some economists like to define contagion in quite narrow and specific terms, as an increase in cross-market linkages that occurs during a crisis. Others prefer a broader definition which captures international spillovers more generally, whereby a shock to one market or country spreads to others.

Along with seeking to define and measure contagion, researchers have looked at possible channels through which contagion or spillover effects might operate, including trade linkages, financial linkages, and the presence of common economic and financial fragilities. Interestingly, one study looking at past crises — the Latin American debt crisis, the Mexican Tequila crisis and the Asian financial crisis — found that there are strong 'neighbourhood' or regional effects. That is, geographic proximity seems to be an important factor (hence the Latin American debt crisis and the Asian financial crisis, I suppose).

As political unrest spreads across the Middle East and North Africa, I'd be interested to know if there is an equivalent political science literature that looks at contagion-style effects. At least at a superficial level, something like the neighbourhood effect seems to be playing an important role, and there are also some obvious common factors (the nature of the political regime, demographic youth bulges and high unemployment, the role of food prices) at work.

Presumably there are also some interesting things to be said about common transmission channels (the role of Al-Jazeera, perhaps?). Also, are there any other examples of political contagion? As a non-specialist, the Revolutions of 1989 in Eastern Europe would seem to be one possible example, and maybe the shift to democracy in southern Europe in the mid-1970s (Greece, Portugal, Spain) would make for another? 

Perhaps Interpreter readers can point me in the right direction.

Photo by Flickr user Foshydog

Yesterday the IMF's Independent Evaluation Office (IEO) released its report on the Fund's performance in the run-up to the financial crisis.

According to the executive summary '...the IMF provided few clear warnings about the risks and vulnerabilities associated with the impending crisis before its outbreak.' The report goes on to note:

The IMF's ability to detect important vulnerabilities and risks and alert the membership was undermined by a complex interaction of factors, many of which had been flagged before but had not been fully addressed. The IMF's ability to correctly identify the mounting risks was hindered by a high degree of groupthink, intellectual capture, a general mindset that a major financial crisis in large advanced economies was unlikely, and inadequate analytical approaches. Weak internal governance, lack of incentives to work across units and raise contrarian views, and a review process that did not “connect the dots” or ensure follow-up also played an important role, while political constraints may have also had some impact.

The Fund's Managing Director has broadly endorsed the reports findings. The Fund staff response is here.

It's a useful exercise, and the IEO report makes several sensible suggestions, including the familiar urging to encourage the Fund to better 'speak truth to power'. It's also noticeable that several of the problems identified by the IEO are the kind of structural issues you might expect to bedevil any large organisation (eg. the dreaded 'silo mentality' gets a mention).

One final thought. Despite the pre-crisis shortcomings identified here, the fact is that the crisis has actually been rather good for the Fund. Before the financial earthquake hit, the IMF appeared to be drifting into irrelevance. Now it's back in a prime position in the international financial architecture. Not champions of the world, perhaps, but at least no longer subject to jokes about IMF standing for 'It's Mostly Firing' .

Photo by Flickr user International Monetary Fund.

• As a follow-up to yesterday's post, here is Nouriel Roubini warning of stagflation.
• Richard Baldwin says the Doha Round is likely to conclude this year.
• This collection of papers on the future of central banking looks interesting.
• Michael Lewis continues with his financial disaster tourism, following up his earlier pieces on Iceland and Greece with a look at Ireland.
• Nick Crafts and Peter Fearon with more lessons from the 1930s. (H/t Free Exchange.)
• A touch of geo-economics: back in 1956, the US used economic diplomacy to bring the UK to heel over Suez. Barry Eichengreen asks whether China could repeat the trick with the US.
• The McKinsey Global Institute thinks the era of cheap capital is over.
• According to UNCTAD, last year saw developing and transition economies absorb more than half of global FDI flows for the first time:

Until events in Egypt brought political risk back on to investors' radar screens, there had been signs of some cautious optimism regarding the world economy.

In the IMF's latest forecast update (released on 25 January) to its World Economic Outlook (WEO), the Fund noted stronger than expected global growth in the second half of 2010, thanks to consumption doing better than forecast in the US and Japan. The IMF also upped its forecast for global growth for this year. After growing by an estimated 5% last year, the world is predicted to grow by 4.4% this year and 4.5% in 2012. (PPP weights for countries; on a market exchange rate basis, the IMF thinks world growth was 3.9% last year, and forecasts 3.5% and 3.6% for 2011 and 2012, respectively). 

The WEO update says that the long-running gap in growth rates between advanced and emerging economies will persist: advanced economies are forecast to grow at 2.5% this year and next, while growth in the developing world is pegged at four percentage points faster. We're still living in a divided world economy.

Set against the depth of the preceding downturn, growth rates of 2.5% for the developed world are relatively weak. They will also do little to bring down unemployment. But given the previous degree of uncertainty about when any return to growth would eventuate, and taken together with the continued good growth performance of emerging markets, the prospects for global growth have allowed some increase in confidence.

This change in mood was picked up by attendees at the recent Davos meetings. See for example these two blog posts by the FT's Martin Wolf, where he notes that even Nouriel 'Dr Doom' Roubini has become less pessimistic. Notably, the world's bankers were also feeling much more sure of themselves than they were at last year's event.

Two themes I emphasised over the course of last year were (1) the return of geo-economics; and (2) the challenges facing global governance in general and the G-20 in particular, in a world divided between faltering developed economies and overheating developing ones. One interesting take on some of these issues is Ian Bremmers's idea of the G-zero, which is ranked first in the Eurasia group's top risks for this year. 

According to the Eurasia report, G-zero is their name for an era in which the world's major powers set aside any aspirations to global leadership and instead look inward for their policy priorities, and where the institutions of global governance 'become arenas not for collaboration, but for confrontation.'

The developed economies no longer have the clout to run the world economy – hence the eclipse of the G7 and its replacement by the G-20. But in the G-zero view of the world, the G-20 has proved unable to deliver an effective replacement. Instead, 'domestic constituencies will become increasingly effective in pushing populist agendas on trade, currency, and fiscal policy' and geo-politics will take on an increasingly geo-economic hue.

It's an interesting take, and I have a lot of sympathy with much of the diagnosis – although I'm not ready to write off the G-20 just yet, in spite of all the very real difficulties it faces.

Photo by Flickr user jonas_k.