Lowy Institute

GDP growth. (Source: IMF WEO Chapter 1.)

The latest IMF World Economic Outlook (WEO) records a watershed moment for the global economy. In terms of purchasing power GDP, the emerging and developing economies are now clearly larger than the advanced economies. Moreover, they have accounted for three-quarters of global growth since 2009 and make up two-thirds of forecast global growth.

Since mid-2011, the emerging economies in aggregate have maintained a stable pace of expansion, with minor deviations, of around 5%. The Fund forecasts this to be a touch faster during the next two years (see graph above).

Yet the Fund continues to articulate concerns about the sustainability of emerging-economy growth. IMF Managing Director Christine Lagarde told the G20 meeting in September: 'Just as some advanced economies have begun to gather momentum, many emerging markets are slowing'. The latest WEO notes that 'downside risks to growth in emerging market economies have increased even though earlier risks have partly materialized and have already resulted in downward revisions to the baseline forecasts.'

This disconnect between the Fund's down-beat words and its actual forecast figures may be coloured by its interpretation of emerging economy evolution during the past two decades.

In the current WEO, the Fund devotes a whole chapter to examining the impact of the advanced economies on growth in the emerging economies. To do this, the Fund averages the growth of the main emerging economies over the period since 1997 and analyses the deviations around this average. The fundamental difference between the unsustainable pre-2008 period and the sustainable post-2010 period gets lost in this averaging process.

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The more nuanced narrative goes like this: in the decade or so leading up to the 2008 crisis, there was an atypical 'alignment of the planets'. China continued its head-long development pace, putting huge resources into government-sponsored investment while at the same time clocking up a massive export surplus. India, hobbled for decades by limitations encapsulated in the term 'Hindu growth rate', turned in a performance close to that of China. Brazil, which for decades had been disparagingly (or despairingly) called the 'country of the future', chronically unable to realise its potential, got its act together.

All of this, however, was unsustainable.

The world was not going to allow China to continue its disruptive external imbalance, running an export surplus equal to 10% of its GDP. Global saving was excessive and China was seen as the main culprit. India and Brazil flopped back into their traditional disappointing sub-par growth mode. To calculate a baseline growth rate by averaging these two fundamentally different periods is to miss the underlying shape of the growth profile.

The 2008 crisis represents the inflection point in emerging-economy growth. Once the advanced economies went into slump, the planets were knocked out of alignment. This was temporarily masked by the 2009 world wide stimulus. China, for example, recorded 12% growth in 2010, thanks to its enormous boost to credit. This stimulus couldn't be maintained and by mid-2011 growth in China, and in the emerging economies more generally, had fallen to a level substantially lower, but more sustainable, than the break-neck pace of the pre-2008 decade.

An alternative explanation for the Fund’s heightened risk-concern for the emerging economies is that it fears a big impact from the unwinding of US quantitative easing (QE). Given the US Fed's rhetoric, this is understandable. The Fed is going out of its way to emphasise that it will take a narrow, domestically oriented view of the unwinding, without any concern for other economies. Both Janet Yellen, the current Chair, and Ben Bernanke, her predecessor and the 'godfather' of QE, seem defiant on this. When Raghuram Rajan, the Indian central bank governor, complained again that QE was adversely affecting emerging economies, Bernanke is reported to have 'taken him to task' for his views.  

Whatever the merits of this argument (and Rajan seems to have the best of the analytical points), QE tapering last year didn't, in practice, do much harm. The shocks to exchange rates and equity prices in the 'fragile five' emerging economies were easily absorbed. If you are going to worry about the collateral damage from unwinding QE, you might worry more about the effect on Europe, with its under-capitalised banks, huge official debt burden and doubtful private-sector debts.

Perhaps the best approach is to focus on the Fund’s actual forecast figures for the emerging economies, rather than its articulated concerns about risks. Not only does the Fund's forecast of continuing good growth numbers seem well founded, but the accumulated growth performance in recent decades has given these economies the heft to remain, permanently, the main drivers of global growth. Today's China, growing at around 7%, contributes as much to global growth as the much smaller pre-2008 China did when it was growing at 10%-plus.  

Tony Abbott's Asian tour-team can hardly fail to have noted Australia's geographic luck. Now all we have to do is make the most of it.

3 of 3 This post is part of a debate on Snowden WikiLeaks and the future of espionage

I've already had the opportunity to argue that listening in on the wife of Indonesian president Susilo Bambang Yudhoyono (and the subsequent defence of these actions) is clear evidence that our intelligence people have lost that essential quality, their sense of judgment.

I was struck by Allan Behm's argument that revising the law will fix these problems. In everyday life, the law sets the perimeters on our actions, but we all have to constantly exercise judgment above and beyond the requirements of the law. Society can't function without the extra constraints imposed by good sense. International relations are just the same.

There are other judgmental issues. Is the intelligence valuable enough to justify both the cost and the risk of being caught out? Is there a cheaper or better way of gathering the information, say through conventional diplomacy?

We need an external inquiry to establish how our intelligence community lost its judgment and what ongoing supervision will be needed to make up for its demonstrated lack of common sense.


Prime Minister Abbott's team for his current visit to Japan, South Korea and China is certainly business-heavy. So too was his warm-up speech,  which one observer suggested might be seen as 'a tad too mercantilist'.  Nothing wrong with that. Concentrating on trade seems sensible given the many pitfalls on the security side, though let's not forget that this bright trade future depends on keeping the security issues under control.

The focus is on pending free-trade agreements (FTAs). These FTAs should properly be called bilateral preferential trade arrangements (PTAs), but if just about everyone else is ignoring the multilateral distortions involved, you have to follow along.

New Zealand has done particularly well out of its pioneering FTA with China. Fonterra's huge success in selling milk, riding in on the melamine scare, should be a case study on the premium that can be obtained by having a 'clean and green' reputation in Asia's middle-class food markets.

The Korean FTA has already been agreed, ready for signing. If the Prime Minister can resist the temptation to rush the unfinished negotiations with Japan and China, this will send a useful message to the negotiators on all sides.

For Japan, delay might allow better coordination with the Trans-Pacific Partnership. This is not the moment to undermine Prime Minister Abe's attempts to break down agricultural protectionism by signing up to an agreement which makes no progress in this area. For China, fuzzing the earlier commitment to finish the FTA by year-end might help our negotiators to get a better deal

Delaying these two FTAs would be no great loss. The biggest 'take-away' from the visit might instead be the 'being there' educational dividend for the participants themselves: the Prime Minister, the state premiers and the 600 businesspeople accompanying him. Of course, most already have exposure to Asia, some substantially so. But what contrasts there are among these three countries, what lessons are there to be absorbed and what opportunities to be imagined!

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First port-of-call is Japan. Here is a reminder that economic success can suddenly turn into stagnation and deflation. But the story is complex and nuanced. Allowing for Japan's demography, per capita GDP growth has not done so badly, and growth per worker looks better still. The visiting Australians might also observe how a society copes with the complex pressures of an aging population.

This sclerotic economy still managed a fundamental transformation by transferring much of its manufacturing capacity to cheap-labour neighbouring countries. It was the early mover in establishing the multi-country supply chains that have come to characterise manufacturing trade in Asia, a revolution largely missing in Australia's economic links with Asia.

South Korea should stun the visitors by the sheer audacity of its development achievement (which so besotted Joe Studwell). Anyone who sees a large-scale manufacturing future for Australia should check out the competition.

In China, what lessons should the visitors absorb?  Relevant to the FTA negotiations (where China is looking for less discriminatory treatment for its investment in Australia), the central focus should be on the specific and idiosyncratic characteristics of the China-Australia investment relationship. This should not be an argument about differential treatment for state-owned enterprises (how do we think the SOEs will damage us?) but should aim to reach a common understanding on where the sensitivities lie and how to deal with them.

The overwhelming long-term issue is that we are small and they are big.

Both sides want to get the benefit of the synergistic natural comparative advantage between our two economies, but resource security for China has to be reconciled with the Australian people's sensitivity about 'selling the farm' (and the house as well) to foreigners. Over time, we may well want to re-balance the terms of investment (one day we will want to return to the idea of a counter-cyclical super-profits tax on resource exports). Global commodity price setting and transfer pricing issues will emerge. We need an adaptive framework if we are to maintain smooth relations.

The first stop of the visit provides relevant history. Japan had the same natural comparative synergy which led it to promote, fund and act as reliable customer for the first great Australian resources boom in the 1960s. This not only required vision and persistence, but also a recognition that there would be non-economic sensitivities on the Australian side. The 'one size fits all' investment clauses typical of FTAs will not cover these subtle issues, but dealing with them effectively will determine whether, in half a century, we will judge the China-Australia investment relationship to be as satisfactory as the Japanese relationship.

What might be the main 'take-away' from this visit? Given Australia's half-hearted mental engagement with Asia so far, at least some of the tourists might come to recognise the enormity of the Asian economic relationship. In our trade and investment flows, China occupies first place, with flows nearly twice America's, and Japan just behind America.

Asia's heft in global growth might come as an eye-opener on where the economic future lies. Even at its more moderate post-2008 pace, China is growing six times as fast as Europe and three times as fast as America. China accounts for nearly half of global growth. The 2008 global crisis demonstrated that Australia, whose GDP formerly cycled in lock-step with America, now depends more on Asia in general and China in particular.

And this is just three of our 'near north' neighbours. The members of Tony Abbott's business delegation should soon be re-packing their bags to visit the rest of Asia.

Photo courtesy of @TonyAbbottMHR.


Today the Japanese value-added tax (VAT: what Australians call the GST) rises from 5% to 8%. This seemingly mundane event is a key part of the 'Abenomics' program, the effort to shake Japan out of its decades-long economic lethargy. So how does Abenomics look after 15 months?

Exhibit 1 is the sharp rise in GDP growth. Comparing the fourth quarter of 2013 with a year before, GDP is 2.6% higher, a break-neck pace by recent Japanese standards. But was this a temporary boost reflecting a belated recovery from the 9% fall in GDP in the 2008 crisis and the 2011 earthquake and tsunami, or is it a trend-breaking reflection of a new growth-enhancing policy regime? 

Shinzo Abe's strategy has three arrows

1. Fiscal policy: Stimulus followed by deficit reduction

The fiscal arrow is intended to provide a strong stimulus in the first year or so, followed by measures to wind back the budget deficit, which is running at an unsustainable 8% of GDP. The initial stimulus was the 'heart starter' hopefully providing enough economic momentum so that even with the subsequent tax increases (the VAT will rise further to 10% in 2015), the economy would be healthy enough to absorb the contraction.

It's hard to be optimistic about this element. The stimulus (theoretically a boost of 2% of GDP, but in practice probably around half of that) should get much of the credit for the pick up in growth in 2013. But Japanese consumers have a tradition of anticipating VAT increases, bringing forward expenditure and then cutting back sharply (particularly on larger items such as electrical goods and cars) after the tax is increased. The economy now has to absorb the downside phase of fiscal policy.

One option would be to soften the restructure by delaying the 2015 increase, but there is not much room for manoeuvre.

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Implementing the two VAT increases would get the deficit down to around 5% of GDP, still not enough to reduce the official debt level. Japan's official debt is far higher than any other OECD country, well above the basket cases of the European periphery. This debt is sustainable only because the interest rate is so low: 0.6% on government borrowing. Also, the debt is predominantly held domestically. The Japanese owe this debt largely to themselves, protecting them from the usual external vulnerability of fickle foreign creditors.

That said, demographics present a formidable challenge for Japanese fiscal sustainability. The population has been declining since 2010 and, more relevant to the task of eroding the debt, the working age population peaked in 1995 and is now 7% lower.

2. Monetary policy:  Inflation up, interest rates down

The monetary policy arrow is being judged by some to be more successful. The Bank of Japan governor (hand picked by Abe) promised to get inflation up to 2%. His bond buying operations (similar to US quantitative easing) have been running at around the same rate as the US, an economy four times as large.

The immediate results are impressive, the more so because Japan's pioneering attempt at similar unconventional monetary policy a decade ago was so ineffectual. Inflation in 2013 was 1.6%, about the same as most advanced countries. True, much of this reflected the inflationary impact of the exchange rate fall, and the underlying rate is half this. But by any measure, inflation is up and as a result, real interest rates (nominal rates adjusted for inflation) have fallen.

Even if the inflation rate fell short of target, the psychological effect on market prices was spectacularly successful. The stock market rose 70% and the exchange rate fell 20%. This (and the fall in real interest rates) should help growth, but the connection to 2013's GDP increase is not clear cut, and thus can't be confidently extrapolated. The exchange rate should have boosted net exports, but there was no impact. The stock market and lower real interest rates should have given business a lift, but investment has been weak. 

The concern is that we are seeing Abenomics at its peak in its fiscal and monetary aspects. The positive phase of fiscal policy is ending. Higher inflation is trimming real interest rates, but this is neither sustainable nor desirable in the longer term. Negative real interest rates distort economic decisions and deprive retirees of their income. If higher inflation pushes up nominal bond rates, the task of fixing the budget will be harder. Higher bond rates would also impose capital losses on banks. If the lower exchange rate succeeds in substantially raising exports, there would be loud complaints of unfair exchange-rate manipulation from Japan's competitors, notably South Korea.

Thus Abenomics' success rests on elements not yet undertaken: the third arrow of structural change.

3. Structural change

The third arrow is targeted at Japan's long standing economic sclerosis. Agriculture is small-scale and inefficient; the construction sector relies on easy profits from government contracts; the service sector is weighed down by labour-intensive methods and uncompetitive practices; and female workforce participation is 10% lower than the OECD average. Reform comes up against tradition, vested interests and political horse-trading. Some hope that joining the Trans-Pacific Partnership will be the catalyst that breaks the political deadlock. But the TPP seems, at best, to be on a slow track.

The 'three arrows' imagery draws on Akira Kurosawa's epic tale (Ran), with the combined strength of three arrows creating resilience where individually the arrows could be easily broken. But the fiscal arrow has been fired off and is now falling to earth. The monetary arrow still has potential to boost exports and business confidence, but its strength will fade. Substantial structural change would demonstrate that a new regime has arrived, but time is running out. The three arrows are starting to look like a fable.

 Photo by Flickr user CSIS.


Financial markets are worried about the Chinese financial sector, with some even talking about the possibility of a 'Lehman moment', which would set off a major financial meltdown, as occurred in America in 2008. This would be very serious not just for China but for the global economy. China still accounts for close to half of global growth

So just how likely is China to suffer a financial meltdown?

Today's story begins in 2009, when China offset the effect of the advanced-country financial crisis by administering a massive domestic stimulus, largely in the form of loosening the reins on credit. The flow of bank credit equaled 50% of GDP that year.

But the financial loosening was even greater than this figure would suggest. Until 2009 most credit had been in the form of bank loans, with much of this going to state-owned enterprises (SOEs). Since then, perhaps one-third of credit expansion has been outside bank balance sheets. Local government authorities have become large borrowers and the corporate bond market has expanded rapidly. Much of this lending was funded by 'wealth management products' and trusts rather than bank deposits. In short, detailed control over credit has weakened.

This freeing-up of the financial sector is by no means undesirable. The post-2009 expansion of the shadow banking system gave savers more opportunities to get a decent return, and provided funding for a wider range of expenditures.

The growth of the non-bank sector was, in fact, symptomatic of the breakdown of the tightly regulated financial system and mimics the path taken by financial sectors elsewhere. Large government-mandated reserve requirements constrain banks' lending and are effectively a tax on banks. The harder the authorities squeeze the banking sector, the more 'disintermediation' occurs. Savers find alternatives to low-interest bank deposits and unsatisfied borrowers eagerly use these non-bank funds.

To some extent the market is over-reacting to China's financial deregulation. When the People's Bank (PBOC; the central bank) tightened short-term liquidity in the middle of last year, some market commentators took this as a harbinger of a financial crash rather than a clumsy effort to move towards more market-oriented liquidity management.

That said, no matter how deliberate the deregulatory process, experience elsewhere suggests that financial deregulation is a delicate task. While borrowers and lenders gain experience, new institutions develop and the regulators learn how to do their new job, almost every country has experienced problems.

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No matter how helpful to global growth, the 2009 credit stimulus was a shaky base for deregulation; not every burst of credit growth presages a crisis, but just about every crisis has been preceded by rapid credit expansion. Sorting this out will require the same sustained clean-up effort that China applied to its banks in the decade before 2008, with large write-offs of bad debt.

Financial deregulation is also coinciding with a tricky period in China's overall macro progress. China needs to change the mix of its growth dynamic, reducing dependence on investment and boosting consumption. Those of us who have been confident that China will be able to engineer this transition smoothly have taken comfort from the panoply of policy instruments available to the authorities. But if keeping deregulation on a smooth path cuts too sharply into investment funding, the authorities' room to manoeuvre will be constrained.

Recent months have seen a tentative progress on one fundamental transformation: the shift from a command-and-control credit system to one where prices and bankruptcy are used to discipline borrowers and evaluate investments. Default have been rare in China, largely confined to foreign creditors. Chinese authorities missed a recent opportunity to change this dynamic, with the eventual bail-out of a defaulting creditor by China Credit Trust.  But now Chaori, a solar-cell maker, has been allowed to fail.

The trick is to create a threat of default which markets will see as idiosyncratic and associated with specific borowers, without triggering the over-reaction of a sudden systemic run on financial markets. China still has a lot more to do here (including introducing bank deposit insurance).

China has a few things working in its favour. The authorities have a tighter grip, and more instruments available, than the advanced countries had when they rushed headlong into deregulation, blinkered by the 'magic of the market'.

The market's hand-wringing should, in fact, give comfort that the Chinese authorities are 'on the job'. While it is true that deregulation has typically been accompanied by financial crisis, the historical experience is that crises were unexpected. Whether it was the US Savings and Loans crisis in the 1980s, the Asian crisis in 1997-8 or the 2008 financial crisis, these came as a surprise to financial markets and authorities alike.

The approach of the Chinese authorities is yet another example of 'crossing the river by feeling the stones'; cautious progress in deregulating interest rates, new rules on shadow banking, and permission for new financial institutions (including private banks). The strong macro position, with huge foreign exchange reserves, a current account surplus, low inflation and public debt less than 40% of GDP all suggest that this river will be safely crossed.

Photo by Flickr user Eric.

2 of 9 This post is part of a debate on A larger Australia

There are various possibilities for a Larger Australia. Michael Fullilove's path is to put more of our national resources into defence and diplomacy, as well as growing our population through increased migration and fertility, creating an Australia which walks taller on the world stage.

A very different path to bulking up physically would be to get together with New Zealand to make one country with 28 million people. First, let's see what this would look like and why it would be a good idea. Then the hard part: how it might happen.

Raising the population to 28 million doesn't make us stand out in world population ranking: it shifts us from around 50th place to around 45th, still smaller than Peru and Malaysia. Measured by GDP the placing sounds better, but adding New Zealand doesn't change the rankings much. Using purchasing power parity (the fashionable method) to compare countries, we currently come 17th or 18th, and adding New Zealand takes us up a place or two, around the same as Indonesia but still behind South Korea, Spain, Turkey and Canada. Still well outside G7/G8 territory.

Thus we wouldn't merge in order to elbow other countries aside with sheer physical heft. We'd mainly do it because of its intrinsic logic. Countries and economies do best with a mixture of diversity (to avoid putting all our eggs in one basket) and homogeneity (so that we don't use up too much energy getting along with each other). Putting Australia and New Zealand together would improve the mix.

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Looking first at our external positions, Australia has (sensibly) followed its comparative advantage into heavy dependence on resources and on a single customer: China. New Zealand's comparative advantage is in growing grass, so it dominates the global milk trade, again with China as main customer. This specialisation creates vulnerabilities which could be reduced by aggregating our export mix.

Perhaps because New Zealand, being less well endowed, has to try harder, it often seems to make more of what it has. It produces entrepreneurs: a residual New Zealand accent is common among Australia's top businesspeople. Fonterra, the milk cooperative, has become a globally powerful national champion in a way that eludes Australia in agriculture.

This sort of entrepreneurship turned the Chinese gooseberry into the Kiwifruit and re-branded a wine-making fault (grassiness) into the eminently desirable 'herbaciousness'. It looks like the New Zealanders might even beat us to getting a decent flag.  

Again, perhaps because it has less to work with, New Zealand has often been more ready to push the boundaries on ideas and overturn old ways. With fewer checks and balances (New Zealand has a unicameral parliament, for example) it's not surprising that some of these ideas were carried too far (the Lord of the Rings trilogy is eight hours too long). When 'free markets' became the economic vogue, New Zealand switched from inward-looking socialism to open-slather 'leave it to the market' without missing a beat.

Closer exposure to this 'just do it' attitude might embolden the same sentiments in Australia, to our benefit. The extra checks and balances of a larger economy and more inertia from complex governance might keep the ideas anchored to reality. The extra scale would help both sides. Think of the talent you would draw on in selecting the national cricket and rugby teams! The America's Cup would be a Down Under perpetual monopoly.

Similarities are crucial to success. To start with, successive Lowy Institute Polls show New Zealand to be by far our favourite country, with the thermometer so hot it borders on the indecent.  With a few minor tweaks, we face the outside world with the same foreign policy outlook. Again the differences on immigration are minor, and Australia is coming to share New Zealand's acceptance of heavy responsibilities in the Pacific. On economic policy, it's hard to tell the difference. New Zealand invented inflation targeting, but Australia improved it so that our now near-identical model is global best practice.

With essentially interchangeable legal systems, this would be one of the easiest amalgamations of all time. Australians shouldn't dwell on the fact that we offered New Zealanders the opportunity of inaugural membership of the Federation and for more than a century they haven't felt the need to take up our offer. The constitutional paperwork is still there, just waiting to be dusted off.

Some will argue that, as far as the economy goes, we already have seamless union through the CER Agreement . It's true that much has been done here: after a ninety-year wait, New Zealand apples have begun to infiltrate our markets. But just to give one counter-example, New Zealand's banking system is totally dominated by Australian banks, yet the difference in regulatory regimes is not just in the detail, but about the philosophy.

Of course, a union wouldn't be easy or quick. For a start, New Zealand is significantly poorer than Australia, and many Australians would fear that New Zealand would be a larger version of mendicant Tasmania. On top of this, amalgamations always produce redundancies, most notably in this case a whole parliament, though New Zealand might be content to make its Beehive the equivalent of a state parliament. 

Despite the compelling logic, neither side shows the slightest enthusiasm for union. The 2012 Lowy Institute Poll showed that most Australians are against it and almost as many New Zealanders agree with them.

The key is to see this as an evolutionary process rather than a revolution. And the way to maintain progress is to be ready when opportunity presents itself.

Here's an example: unifying the currency would be a huge step, unlikely to be taken under normal circumstances and not being recommended by anyone. But in a real crisis (the Kiwi dollar going well over parity?), it might well be seen as sensible.  In 1997, when the Reserve Bank of New Zealand handled the Asian crisis with less finesse than its Aussie counterpart, there was a strong interest among New Zealand businesses in linking the currencies. Our then Treasurer, Peter Costello, told them they could adopt the Aussie dollar but an Anzac currency was not on.  

To build a Larger Australia, why not start by declaring a contest for the new currency design, drawing on icons of shared heritage to decorate the new notes? The list is endless: Phar Lap, Russell Crowe, Crowded House and the pavlova for a start.

Photo by Flickr user South Canterbury NZ.


One of the many lessons of the 2008 financial crisis is that emergency bailout funding (such as an IMF-orchestrated rescue) seriously distorts the operation of financial markets.

Emergency funding helps both the insolvent country and its foreign creditors, improving their repayment prospects. But this creates moral hazard: in future both debtor and creditor will underestimate funding risks.

With five clear examples from Europe since the 2008 crisis, you might think that such a fundamental problem would have been addressed. In practice, the prospects of a solution are receding.

The clearest examples are the European peripheral countries such as Greece. When these countries joined the euro, financial markets began to treat their debt as if it was as safe as other euro-denominated debt. Greece could borrow almost as cheaply as Germany. With this availability of easy money, Greece ran up large budget deficits.

The euro rules were explicit: an insolvent country would not be bailed out by other euro countries. Financial markets ignored this, and took a chance.

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By and large, this turned out to be a good bet. When Greece collapsed in 2010, the initial bailout left the bondholders unscathed. These creditors argued that, if there was default, contagion would spread to Spain, Portugal and Italy (which happened anyway). Many of the creditors were able to redeem their bonds before the second bailout imposed some haircut on the remaining debt.

The outcome has been that Greece's remaining debt burden — grossly unsustainable and headed for yet another debt rescheduling — is now almost entirely in the hands of governments, the European Central Bank or the IMF. European taxpayers will bear a cost that should have fallen on the initial investors.

The huge over-borrowing of Ireland's banks was treated the same way. Under pressure from the euro-authorities organising the rescue operation, the Irish Government guaranteed all the private bank debt, letting the bondholders off scott free.

The lessons seemed to be learned for the last of the bailouts — Cyprus in 2013. But the effort to bail-in the creditors (ie. making them take a 'haircut' which writes off some of their debt) was so comprehensively botched by the 'troika' (the ECB, the European Commission and the IMF) that Cyprus is now being used as a case study in why creditors can't be bailed in. The Economist editorialises that Cyprus 'should serve as a warning against strict solutions that smack of puritanism rather than pragmatism.'

Just as religion without some form of hell loses its discipline on behaviour, bailing out creditors leaves them with less reason to exercise care in making future loans. In a normal bankruptcy, the borrowers and lenders can be left to their own devices (within the law) to work out a settlement involving the remaining assets. But where an insolvent country is given the benefit of additional funding through a bailout (such as an IMF rescue), it is totally unacceptable that these new funds should be used to repay the initial creditors.

Thus this issue has been left in a most unsatisfactory state. The IMF has been tentatively exploring solutions, but has to do so without seeming to revive the earlier Sovereign Debt Restructuring Mechanism, which was rejected nearly a decade ago by IMF members, thanks to America's dominant voice.

Wall Street's proxies are busy undermining these efforts to find a better resolution. All the time-worn arguments are being revived by Peterson Institute researchers. Sure, any automatic bail-in process may not be a perfect fit for the specific circumstances of a crisis, but the alternative is inaction.

Of course bail-ins will make lenders more cautious in providing funding in the future; this is the principal objective. To argue as if debt contracts are somehow sacred ignores the universality of bankruptcy processes, which are designed specifically to achieve an equitable bailing-in of creditors when bankruptcy is unavoidable.

It's hard to see how a better resolution will be achieved. While the debate (and the US vote) is in the hands of investment bankers, the prospect is slim for an orderly bail-in (the Peterson Institute researchers are both former investment bankers). Even debtor countries are unenthusiastic about change: it would raise the cost of their borrowing.

This might be an opportunity for Australia to take the initiative, on the side of the Fund staff, based on the firm principle that if our money is to be used in a bailout (as it has been in Greece and elsewhere in Europe), then we require a resolution framework which always ensures adequate bail-in of creditors.

This is not a new issue. When Thailand was bailed out in 1997 with a combined package from the IMF and regional countries, Australia argued that our funds should not be used to bail out careless creditors who had contributed so much to the 1997 Asian crisis. IMF Deputy Manager Sugisaki, chairing the rescue group meeting, said that if we pursued this line of argument the meeting would fail and he would ensure that Australia would be blamed. That's over fifteen years ago and IMF thinking has progressed.

It's time to fix this problem.

Photo by Flickr user Miguel Villagran/Sueddeutsche Zeitung.


The Trans Pacific Partnership

The Trans-Pacific Partnership (TPP), repeatedly described as the 21st century platinum-standard trade agreement, is in trouble.

The latest round of negotiations has ended in Singapore without agreement, putting yet another deadline for completion beyond reach. Meanwhile, the 'fast track' Trade Promotion Authority President Obama needs to give his negotiators the authority to make deals is being undermined by the President's own supporters in the House and Senate. 

Paul Krugman says we shouldn't 'cry for TPP. If the big trade deal comes to nothing, as seems likely, it will be, well, no big deal'.

His arguments will be familiar to regular readers of The Interpreter: the trade benefits of the TPP are much less important than behind-the-border issues such as property rights for makers of pharmaceuticals, movies and software. These are rights designed to divide the spoils of intellectual-property monopolies rather than enhance the benefits of freer trade, and they comprise 24 of the TPP's 29 draft chapters.

Krugman again: 'So what I wonder is why the president is pushing the TPP at all. The economic case is weak, at best, and his own party doesn't like it.'

The TPP, however, has more diplomatic content than Krugman acknowledges. It is the economic component of the 'Asia pivot', tying together America's East Asian friends. Japan joined the negotiations last year. Singapore, Vietnam and Malaysia have been in it from the start and the Americans have been trying hard to get Indonesia and other East Asians to join in. Korea is a de facto party, having recently completed a comprehensive bilateral preferential trade arrangement (PTA) with the US. 

The TPP clearly has a substantial geopolitical element, but does it get this tricky topic right?

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The conspicuous exclusion is China. American policy insiders are adamant that this is not part of a process of containing China, but this would certainly be the outcome, whether intended or not. An alternative (or additional) explanation is that the objective is to get the rules set before inviting China to join the party, thus giving China an invidious choice: remain outside the top tier trade club or agree to a set of rules you had no part in developing and which will be a poor fit for your way of doing business.

This seems a strange way of encouraging China to become a 'responsible stakeholder' in the international economy. 

The TPP might still go ahead. To the extent that US vested interests can influence Congress, perhaps those which benefit from stronger intellectual property rights (for example, Hollywood and the pharmaceutical companies) might be able to swing Democrat opponents around. 

But why the tearing hurry? President Obama has a political imperative to produce some achievements during his final term. But leaving that powerful personal motivation aside, some delay in order to get the rules right might be a price worth paying. 

At present there is a Catch 22: Congress will not give the necessary support unless the rules are heavily skewed in America's favour. On the other hand, other countries may either not sign up or, more likely, sign up but feel unhappy that they have been steam-rolled into a treaty which distributes the benefits inequitably, thus diminishing the geopolitical dividend.

They may sign up even if the TPP is unfavourable to them, seeing it as part of a wider relationship with the US. Australia is probably in this category: we will sign up because of the need to be seen to be a 'team player' in a larger game.

Yet there is a powerful economic case for persevering with a truly comprehensive TPP, even if it takes longer to hammer out.

In addition to the extra market access that should come, a multi-country agreement would help untangle the noodle bowl of bilateral PTAs. Of course you don't want to adopt a WTO-like timeline. After over a decade of effort with the Doha Round, the WTO in December gave birth to a wimp of an agreement in Bali to smooth some administrative procedures.

But a high-standard agreement reached without time pressures might, for example, give the Japanese the opportunity to put some substance into Abenomics' third arrow (structural change), thus allowing for some progress in the opening up of previously sacrosanct areas such as rice. The Japanese joined the negotiations only recently, and need time to get the domestic politics aligned.

Perhaps our negotiators ought to start exploring this idea, starting by proposing that China be given a welcoming invitation to join in the negotiations. It is, after all, our largest trading partner. Doubtless this would put any agreement on a slower track. But the outcome might be an agreement which truly brings together economic and geopolitical objectives.

Photo by Flickr user Caelie_Frampton.


The business press is full of dire predictions about sudden capital outflows from emerging economies, with a growing list of 'fragile' countries. Few commentators can resist making some reference to the disastrous 1997-98 Asian crisis, just to add an element of frisson to the story. But a repeat of 97-98 is extremely unlikely. 

In recent years, particularly after the 2008 global financial crisis, we've come to revise our understanding of the Asian crisis. 

Initial explanations identified the key cause as 'crony capitalism': monopolistic chaebols in South Korea, self-interested financiers in Thailand and the Soeharto clan in Indonesia. 

These early explanations also blamed dirigiste economic policies, at variance with the internationally fashionable Washington Consensus. If a country was in trouble, it must be because it had strayed from the free market path. To restore order, budgets should be cut back and interest rates raised.

The 2008 global financial crisis showed that even advanced economies can get into trouble. Perhaps the best demonstration of the rethink was that the remedial policies of 2008 were, in general, the polar opposite of those practised in 1998.

The revised narrative of the Asian crisis gives a central role to the grossly excessive capital inflows in the five years prior to the crisis. At the time capital flows were widely seen as unambiguously beneficial. The IMF tried to have free capital flows written into its articles, accorded the same status as free trade. Any policy measure which tried to manage or limit these inflows was roundly condemned as 'capital controls'.

The graph in this post tells the story. In the early 1990s, global financial integration brought a flood of capital into the fast-growing emerging economies. 

Thailand, the first domino to fall, had inflows equal to 13% of GDP in 1996. As a result, the exchange rate came under inexorable upward pressure. This, together with the inflow-fueled booming economy, opened up the external deficit to 6% of GDP.

With an uncompetitive exchange rate and an asset price boom, Thailand was a house of cards, set up for a fall. Its neophyte financial regulators were not up to the task of protecting it. When the baht went into freefall in mid 1997, the contagion spread first to Indonesia and then Korea, which had both also been the recipients of excessive capital inflow. 

There is much more to this story (particularly the inadequacy of the IMF-led rescue operations). But the point to be made here is that pro-cyclical volatile international capital flows played a central role in the Asian crisis.

How does this relate to today's fragile emerging market economies?

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Financial flows to emerging economies are now larger than in the 1990s and just as volatile (again, look at the graph). But most of the emerging economies have learned the lesson.

Indonesia provides an example. Having been singled out by financial markets as a member of the 'fragile five,' Indonesia trimmed the budget deficit by reducing petroleum subsidies, tweaked its interest rates higher, allowed the exchange rate to depreciate significantly, allowed the slowing economy to improve the external deficit, and backtracked on some of the economically dubious policies that accompany pre-election populism. Similarly, India and Brazil have tweaked policies to reduce vulnerabilities. 

In short, most emerging economies are in far better shape than in 1997: scarred, wiser and far more experienced.

Can the same thing be said about the foreign providers of the capital? To make sense of the global financial sector's current on/off capital flows, we have to understand that their country-specific knowledge is shallow. Portfolio managers are guided by simple rules of thumb, with their main attention focused on other players in the same market: when their fellow lemmings start running in the opposite direction, everyone wants to be immediately behind the pack leader. 

The rules of thumb are crude. They include simple limits on external deficits, budget deficits, foreign debt and inflation. This crude evaluation system disciplines behaviour in emerging economies, perhaps unnecessarily. Bolder policies might boost infrastructure spending and speed growth. But most emerging-economy policy-makers accept that global markets won't understand the subtle detail of more optimal policies — one day the lemmings will be spooked and run, taking their money with them.

Not all countries accept this externally dictated discipline. Countries like Argentina and Turkey are walking a tightrope. If, like Thailand, you want to have a political crisis, you need to be running an external surplus (as Thailand is). If you want to administer a huge credit stimulus that raises domestic debt sharply (as China did in 2009, saving the world from a much deeper recession), then you need a government with untrammeled policy powers, capital controls, an external surplus, and more foreign reserves than it knows what to do with.

Most emerging economies, however, accept the discipline. Their best tactic is to loudly proclaim their own virtuous prudence in the hope that foreign investors learn that emerging markets are not all the same.  

This is not an ideal world. Over time, emerging markets need to find more 'patient' capital, such as foreign direct investment and long-term bond-holders. When they do, this will give them the freedom to actively discourage the volatile short-term capital flows that have proven so damaging. 

 Photo courtesy of Wikimedia Commons.


The meeting of the G20 finance ministers and central bank governors in Sydney next weekend provides an excuse to turn the spotlight inwards, towards the domestic economy. The IMF begins its new report on Australia this way:

The Australian economy has performed well relative to many other advanced economies since the global financial crisis. However, a transition phase has now been reached as the terms-of-trade-driven mining investment boom of the past decade has peaked and the economy is moving to the production and export phase.

'Performed relatively well' is a rather downbeat assessment for an economy which came through the 2008 crisis substantially better than other advanced economies (see left; source: IMF). The longer-term record is no less impressive: Australia has had 23 years without recession.

Of course there is never room for complacency; no matter how well a country has done, forecasters can always find plenty to worry about. The transition from the mining investment boom to normality is, as the Fund says, the main challenge. Ten years ago, mining investment was less than 2% of GDP. As coal and iron ore prices rose, mining investment quadrupled. This boom was so intense that resources accounted for over 1% of the total annual 3.3% GDP growth — around one-third of our growth over recent years.

Since late-2011 resource prices have fallen. They are still four times higher than before the boom, but iron ore and coal investment has largely halted (LNG investment still has a couple of years to run). Mining investment is headed back to its pre-boom level.

The coming fall in investment will be softened by the fact that about half the spending was on imports. At the same time the capacity-enhancing results of past investment will produce more exports. The net effect is that, instead of accounting for 1% of our GDP growth, resources will add 0.4%. That's still helpful, but it leaves a big gap if we want to sustain our accustomed pace of growth.

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Even if we maintain a good pace of growth, we'll all feel poorer because the terms of trade have fallen and may well fall further (see below; source:RBA).

The terms of trade compare export prices with import prices; it's a measure of how much we can buy with our export earnings. Australia has a long history of huge swings in the terms of trade, but 2001-2011 beats all others in size and duration. As the terms of trade rose, so too did the floating exchange rate. In 2001 an Australian dollar bought less than US50c; by 2008 the Aussie was well over parity. The purchasing power of our income rose because imports (everything from petrol to overseas holidays) were cheaper. Our income benefited by 12-15%. Now that windfall is being unwound, although the terms of trade remain historically very high.

Thus the Fund is right in flagging some serious transitional adjustment ahead. How are we placed for this? We'll be relying on the same combination that got us through 2008: competent policy and good luck.

The centrepiece of our luck in 2008 was China's amazing growth. This single-handedly drove the terms-of-trade bonanza. If the Chinese economy had fallen over in 2008, we would have fallen with it. But when its massive 2009 stimulus took growth to 12% in 2010, the terms-of-trade party continued unabated, even though the advanced world was in deep recession.

Of course any sensible forecaster does some ritual hand-wringing about the risk that China might slow dramatically. One day the pessimists might turn out to be correct, in the same way that the stopped clock is sometimes right.

Many observers have misread the China growth profile. Once you recognise that the 12% growth in 2010 was a stimulus-boosted aberration, then you see that the growth inflection occurred five years ago, when China shifted from its pre-2008 unsustainable double-digit growth to grow at an underlying and sustainable 7%. The constant predictions of further slowing made over the past year or two miss this basic point: the slowing happened some time ago and we have already experienced the impact. China has good prospects of maintaining this 7% underlying pace for some years.

If so, it will need even more iron ore, coal and LNG. And as Chinese get wealthier, they'll want more of the sort of clean-and-green agricultural products Australia produces, together with the services (professional, education, tourism) we can offer.

The terms of trade suggest that this is the path we are on – they are off the peaks of 2011, but the fall is moderate so far. We used to export iron ore and coal profitably when prices were a quarter of the current level. Many of our resource exporters are still doing very nicely indeed.

Australia has always been a bit uncomfortable that our luck might be covering up some deeper inadequacies, waiting to bring us down. Sure, we've been lucky. But we’ve built on that luck. Our financial sector never made the egregious errors of America and Europe. Our housing sector never did the mindless overbuilding that has delayed the recovery in America. The budget was in good shape before the 2008 crisis and responded in textbook fashion: a strong stimulus which is gradually wound back afterwards when the economy is growing sustainably again.

Monetary policy was ready to lend a hand when the banks needed liquidity, and has steered a neat path between stimulus and inflation control without resorting to the unconventional monetary policies now proving so problematic to unwind.

The never-ending task of restructuring the economy will deliver more transition pain (we’ve just said a sad goodbye to the car industry). We bemoan our mediocre productivity performance (ignoring the difficulties of measurement) but the key is not just in tweaking the production line to go faster, but in the ability to shift resources into the expanding sectors. We're not too bad at this tricky task of flexibility. In the face of inexorable international pressure, we've trimmed our manufacturing sector back from over 20% of the economy to around 8%.

Export composition illustrates Australia's capacity for adaptation (see graph below; source: RBA). The quadrupling of mining investment without triggering inflation provides another example of flexibility. Despite all this disruption, the unemployment rate has only recently reached 6%.

We’ll need to work hard on making sure the now-dominant service sector has a substantial component of high-skill jobs and that the low-skill end is protected by a reasonable minimum wage (ours is more than twice America's). Education needs to ensure universal opportunity for individual advancement. A still-lower exchange rate would help. Budget commitments to expand welfare spending will require more taxes.

And we'll have to have another go at extracting an equitable return from the minerals sector. The Australian people should have received a bigger share of the resources windfall of the past decade (the sector is three-quarters foreign-owned), ideally through a resource-rent tax used to build up a sovereign wealth fund. A country with our commodity-price dependence should have a tax system that helps to smooth out the enormous price volatility.

We should welcome the Fund's reminders that there is much left to do. But 'performed relatively well' seems like faint praise.


Treasurer Joe Hockey at the Lowy Institute

In his speech at the Lowy Institute last week, Australian Treasurer Joe Hockey made a clear case for international policy coordination: 'in a globalised world every policy action taken in isolation has a spillover'. Specifically, this month's G20 meeting of finance ministers and central bank governors in Sydney will have on its agenda the tapering of quantitative easing (QE) by the US Federal Reserve, which is causing concerns for some emerging market economies.  

There is vigorous international debate on this question. When America's QE and low interest rates fostered capital flows to emerging economies (pushing up exchange rates to uncompetitive levels), the Brazilian finance minister complained about 'currency wars'. Now that the 'taper' stage of QE is underway, financial markets have responded by reversing these flows. This has been especially painful for emerging economies with political or macro-economic weaknesses (Argentina, Turkey), but the outflows have administered sharp movements in exchange rates, interest rates and equity prices for a much wider range of emerging economies, even those with competent policy settings.

Raghuram Rajan, governor of the Indian central bank, added to the debate when, in the course of a long interview focused mainly on domestic Indian monetary policy, he called for more international coordination of monetary policies such as QE

In response, the former US Treasury attack-dog Ted Truman came out of retirement to give his usual over-the-top defence. A couple of prominent academic economists joined him in punching out at Rajan's comments, calling this a 'victimhood narrative'. Case proven: Rajan's central point that international monetary cooperation had broken down was well demonstrated.

It's not easy to steer a balanced path through these now heated arguments and counter-arguments.

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The emerging economies certainly made a huge contribution to global growth during the 2008 crisis by continuing to expand strongly, thanks to vigorous fiscal stimulus. China's huge stimulus in 2009 (amounting to close to 10% of GDP, including the boost to credit) kept its growth in double digits in 2010 when the advanced economies were, collectively, in deep recession (Australia owes China special thanks for this). Of course the emerging economies did this in their own interests rather than just to help the world economy, and it's a stretch to hope for a quid pro quo on monetary policy now. Countries will set their policies according to their own interests. 

But it's also disingenuous to argue, as (now former) Fed Chairman Ben Bernanke has done, that QE has been unambiguously beneficial for emerging economies because it helps US growth.

There have been (at least) two potential external effects of QE. If in fact QE delivered a quicker US recovery, this helps the whole world. But the excessive and volatile capital flows have been disruptive for many emerging economies, both when the inflows were occurring and when they reversed. The net balance of these two effects is unknowable.

To tell the emerging economies that they should respond by reforming their own policies seems gratuitous, to say the least. Some have indeed made policy mistakes, but the majority have policy in pretty good shape, which is why they have been able to come through this volatile period without severe problems.

If the issue is policy deficiencies, the argument could well shift to America itself. The debate on just how effective QE was in promoting the still feeble US recovery is unresolved. But there can be no doubt that the US recovery has been held back by Congress' recalcitrance on fiscal policy and bloody-mindedness on debt ceilings.

Will the Treasurer, as chairman of the forthcoming meeting, be umpiring a vigorous punch-up on this topic? Rajan will surely be present, and others who share his view might back him up. US representatives have never been shy to defend their position. 

This is, however, a debate without the prospect of a useful outcome. Rajan, former Chicago professor and former IMF Chief Economist, is accustomed to being on the unpopular side of an argument. In 2005 at the central bankers' annual jamboree at Jackson Hole, he highlighted deficiencies in international financial markets which three years later turned out to be prescient. He was shouted down in 2005 and he knows he would be again.

Moreover, despite all the talk of the benefits of international cooperation, monetary policy offers few opportunities for such collaboration. There are spillovers, but these very spillovers are one of the principal channels through which monetary policy works: a country easing monetary policy expects to get the advantage of a more competitive exchange rate, at the expense of its trading partners.

The valid criticism of the US is not that it was prepared to experiment with extreme measures such as QE when the disaster of 2008 occurred, but that it allowed itself to get into this parlous position in the first place.

Photo by Peter Morris/Lowy Institute.


The income-inequality debate is an old one, but it’s getting renewed interest, most recently from President Obama in his State of the Union address, where he advocated raising the minimum hourly wage from $7.25 to just over $10. He also spoke of the closely related issue of social mobility (a 'ladder of opportunity').

This is just one element of a wider inequality debate. At the other end of the income spectrum is the debate about the 'one percent', the rich apex of the income pyramid. This is starkest in the US. In the past three decades, the top 1% have increased their real after-tax income by close to 300%, doubling their share of total income to 16%. The very top (0.1%) have done even better: this tiny cohort gets 7% of total income. The rest of the top quintile (the richest 20%) have done OK, but the bottom 80% have lost income share, with median real wage unchanged for three decades.

There is no single, simple explanation. Economies have become more complex, with more capital and high returns to technological innovation and intellectual property. Technology has certainly not favoured unskilled labour.

Globalisation is also blamed. International trade has risen from 19% of global GDP in the early 1990s to 33% now (what one commentator calls 'hyperglobalisation').

The vexed issue is how, in this increasingly integrated world, traded goods can be profitably produced in advanced countries where even the meagre US minimum wage is ten times China's minimum and one hundred times Bangladesh's minimum. Of course the American worker is much more productive, but that gap is closing. When, in the not-too-distant future, China's automobile production lines are essentially the same as America's, will the wage of Chinese auto-workers rise to keep America competitive?

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The experience of countries which have already made a rapid economic transition suggests that wages do tend to equilibrate. We no longer worry about low-wage competition from Japan, Singapore or South Korea. But the outlook is bleak for producers of standard manufactured goods in high-wage economies. There have already been big shifts in where traded goods are produced, and more are in store.

High-wage countries need to restructure in two directions. First, towards traded goods where they have a clear comparative advantage (Australia in minerals and agriculture; New Zealand in milk) or a sustainable niche market providing unique products. Second, towards services for the domestic market (ranging from hamburger flippers to heart surgeons), which fortunately are in higher demand as economies get wealthier. These restructurings are painful, and a market-determined unskilled wage in this environment is likely to be below socially acceptable norms.

One compensation for those at the bottom of the ladder comes from the prospect of mobility, always a central part of the American dream, and strong social glue everywhere. The widespread perception is that mobility has become worse, although recent research argues otherwise. Even if mobility hasn't changed much, it's still best to pick your parents carefully: 30% of low-income children who do well at school go on to finish university, while 74% of high-income high-score children do.

Globalisation isn't the whole story. Technology fosters more 'winner takes all' outcomes (eg. in sport and entertainment a mass audience can watch the very best, with little demand for the second best). Network externalities often produce a dominant product or technology, with the same sorts of supreme winners: Bill Gates, Steve Jobs and Mark Zuckerberg come to mind.

Tyler Cowen sees more of this coming. The winners in Cowen’s world will be individuals who can harness the power of technology to complement their natural talents. His model is chess: the player-plus-computer easily beats either the player or the computer alone. Angus Deaton has a similar message, particularly for the developing world: 'inequality is the handmaiden of progress'.   

But are the extreme income disparities seen in the US intrinsic and necessary? They don't seem to be essential as incentives to motivate the talented elite. After all, sports stars and entertainers rose to the top long before huge rewards were on offer. For business, salaries and bonuses are central to self-esteem and status, but are more about relativities than absolute need. Gates, Jobs and Zuckerberg would have done what they did for less.

This change in income distribution is not just technology-driven. It is a product of the institutional environment. The return on technology and intellectual property is supported by the quasi-monopolies created by patents. The complexity of modern society has created many rent-seeking opportunities, with income earned from holding a license (eg. taxi plates) or protected by regulation (eg. the professions).

Like all countries exposed to international competition, Australia will have to trim its sails to this international wind. Australia's minimum wage (nearly US$17) is over twice that of America. We have a better society because of that. The challenge now is to demonstrate that this can remain viable. This means we can't afford to sustain uncompetitive industries, tie up production with unnecessary red tape or reward rent-seekers whose returns exceed their contribution to society.


Gary Hogan brings a light touch to explaining the otherwise depressing oscillations of the Australian-Indonesian relationship, but his sine-wave theory conveys the wrong policy message. It's as if the oscillations are inevitable, even pre-ordained.

Of course there is a fair bit of reversion-to-mean in the Australia-Indonesia relationship – it's hard to sustain the extremes. But there are three reasons why Gary Hogan's imagery is unhelpful.

First, it's clear that even if particular events fade from memory, they don't disappear. Timor is no longer the hot issue between the two countries that it was in 1999. But nor has it been forgotten on the Indonesian side. When we say that we absolutely accept the Indonesian position on Western Papua, many Indonesians remember that we said the same thing about Timor.

Second, the sine-curve view says that it makes no difference what we (or they) do: we'll always cycle around the same mean. Why bother to try? A more positive (and, let's hope, realistic) view is that the mean can be raised through skillful diplomacy, greater understanding, more person-to-person relationships and all the things that people like Gary Hogan have done over the years. Why assert that none of this matters?

Third, it implies that the oscillations don't matter. But it's just like human relationships: life is more pleasant and productive if you can keep things on an even keel.

It's more useful to think of the relationship as a balance sheet, the sum of all the accumulated events that tie our two countries together, good and bad, with particular events depreciating (but not written off) through the effluxion of time.

Photo by Flickr user DFAT photo library.


'Storms gather over emerging economies’. So says the Financial Times editorial. This latest alarm reflects a concern that the tapering of the US Fed's quantitative easing (QE) policy will set off sudden capital outflows. The World Bank spells out this QE risk in hand-wringing detail in its latest World Economic Prospects

Just how worried should we (and the emerging economies) be? The problem is not QE as such, but the volatility of international capital flows.

If we look back at the last QE scare (in May last year, when US Fed Chairman Bernanke hinted that QE bond purchases would be tapered off), the volume of outflows was actually quite small. The Institute for International Finance (the global bankers' lobby group, which does some excellent research) estimates that the 'taper tantrum' caused outflows of US$73 billion in stocks and bonds from emerging economies. This is equal to just a couple of months' inflow. Developing economies hold US$9 trillion of foreign exchange reserves. The foreign exchange reserves of Indonesia alone are well in excess of the outflows from all the emerging economies taken together.

The wider concern is that if such modest outflows can cause large changes in exchange rates, equity prices and bond yields, and dampen the 'animal spirits' which drive growth, what if the outflows were much larger, as they were in the 1997 Asian crisis? This graph shows gross private capital inflows into developing countries since 1990:

The taper tantrum hardly registers here (it's in the last two observations), overshadowed by other huge fluctuations. The main driver is wide (it's tempting to say 'wild') swings of market optimism and pessimism. Note the huge surge in credit inflows driven by the mindless optimism of 2004-2007, then the sudden reversal in the face of the 2008 financial crisis, followed by the speedy revival when financial markets recognised that the emerging economies were not much affected by the crisis, retreating sharply again when Greece hit the wall in 2010.

There's not much policy-driven narrative here. Policy (whether QE or monetary policy) has a substantial influence only in as far as it triggers changes in global confidence.

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The central issue is that much of this inflow is flighty short-term credit and portfolio flows responding to 'risk-on/risk-off' signals, with the investor-lemmings all looking for some sign of when to turn around and run in the opposite direction. Even relatively trivial news (such as Bernanke's May speech) is enough to trigger a reversal in confidence. The investors are not looking at the fundamentals, but just looking sideways at each other, ready to get out ahead (they hope) of the crowd.

What might be done? As usual, the emerging countries will have to find their own solutions, even if the volatility is often driven by global events such as the Greek debt collapse. There are plenty of 'black swans' out there waiting to startle the global investment community. For example, the euro is being held together by ECB President Draghi's promise to 'do whatever it takes', a promise which remains untested. And of course the QE taper is just one small aspect of the far weightier task of actually unwinding QE and getting interest rates back to normal levels.

No one is arguing that emerging economies should cut themselves off from global finance. That said, emerging economies that chronically run into domestic problems (often political, as is happening currently in Argentina, Turkey and perhaps Brazil), can expect no sympathy (or patience) from foreign investors. If a country can't run a tight ship and live strictly within its means (small budget and external deficits, low inflation, stable politics), then it would be better off without the short-term foreign flows.

The volatility in the graph explains why capital flow management (what used to be derisively called 'capital controls') is being added to the policy armoury in emerging economies. Credit and portfolio flows (shown here in yellow and darker blue) are so ephemeral as to be of dubious value. The valuable inflow is from foreign direct investment (light blue), rising pretty steadily through all the financial market's flip-flops of confidence.

The free-market doctrines which dominated financial thinking in the pre-2008 decades are no longer going unquestioned. Regulations which would put some sand in the wheels of international capital flows are finding high-level support. Adair Turner, former head of the UK financial supervisor, identifies the problem as 'too much of the wrong sort of capital flow'.

Direct controls (usually called macro-prudential measures) which might reduce the marked pro-cyclicality of finance are finding widespread favour, although their effectiveness is yet to be properly tested. However these work out in practice, intervening in foreign exchange markets and actively discouraging volatile components of capital inflow no longer seem to be such heretical ideas.


The press has always played a key role in forming public opinion on international relations. An earlier generation of journalists (Peter Hastings comes to mind) brought informed and sympathetic understanding to the task of bringing Australians up to speed on Asia. How times have changed!

The national broadsheet, The Australian, has taken a leading role on the current tensions with Indonesia. Based on a 'well-connected insider who asked not to be named', the paper made the case that the phone tapping of President Susilo Bambang Yudhoyono's wife was just a normal part of commonly accepted practice. SBY shouldn't feel insulted by the justification given: we had to do it because she is the power behind the throne.

More recently, The Australian gave prime space to the argument that the 'boats policy (is) a boon for Jakarta as well.' 

How can we make any sense of this? Are naval intrusions into Indonesia’s territorial waters actually helpful for SBY? Is his palpable anger at this and the phone-tapping just part of the usual shadow-play? 

SBY's principal political challenge is how to maintain his family's reputation and influence through the 2014 election process and beyond. After two terms, he cannot run again for president, but he has political aspirations for other members of his family in the future, and of course he would like history to see him as an effective president. It is absurd to argue that looking impotent in the face of personal insult and ineffectual in the face of territorial infringements (given the history, a super sensitive issue for the Indonesian public) is somehow in SBY's own interests.

Perhaps the explanation lies elsewhere, possibly in The Australian's editorial attitude to Indonesia.

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In an on the record conversation with the Australian Financial Review late last year, The Australian's Chief Editor Chris Mitchell offered his opinion that Indonesia is 'probably the most corrupt country on earth' (the commonly-accepted measure, from Transparency International, rates more than 60 countries as more corrupt than Indonesia). He also argues that Indonesia has been soft on terrorism: 'the official view from Jakarta and the Indonesian papers all through 2003 was Jemaah Islamiyah was a charitable organisation and that Abu Bakar Bashir was a holy man.'

It's true that Bashir has a vocal support group in Indonesia but to see this as the 'official view' is an amazing assertion, given the record. Bashir was imprisoned without trial from 1978 to 1982 and then spent the next 17 years in exile in Malaysia to avoid re-incarceration. In April 2003 he was charged with treason and given a three-year jail sentence on other offences. In 2004 he was charged with involvement in bomb attacks and was sentenced to two and a half years jail, overturned by the Supreme Court in 2006. In 2010 he was charged with involvement in terrorist activities and sentenced to 15 years in jail. In the democratic post-Soeharto era, it was harder to find judicial cause to jail Bashir but you can't seriously argue that the authorities weren't trying.

Image courtesy of Reuters/Beawiharta.