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About the project

The International Economics program aims to explain developments in the international economy, and influence policy. It does so by undertaking independent analytical research.

The International Economics program contributes to the Lowy Institute’s core publications: policy briefs and policy analyses. For example, the program contributed the Lowy Institute Paper, John Edwards’ Beyond the Boom, which argued that Australia’s transition away from the commodities boom will be quite smooth.


Latest publications

The race to be next IMF chief

The race is on to see who will take over as Managing Director of the International Monetary Fund (IMF) following the nomination of the incumbent, Christine Lagarde, as President of the European Central Bank (ECB).

Will the informal gentleman’s agreement between Europe and America that has prevailed since the creation of the Bretton Woods institutions in 1945, and sees the IMF headed by a European and an American leading the World Bank, continue? Almost certainly. This, notwithstanding pressure that the governance structures of these international institutions should change in line with developments in the global economy, particularly the rise in importance of emerging markets.

Much of the commentary is about the candidate’s nationality rather than the relative attributes they would bring to the position.

Speculation over who will take over from Lagarde has produced a Melbourne Cup field of contenders. The prevailing view is that it will again be a European. The gentleman’s agreement continued with the recent appointment of an American, David Malpass, as President of the World Bank and as such it is assumed that America will not rock the boat and will support a European for the IMF position.

The European contenders include Mark Carney, the outgoing Governor of the Bank of England, who is a Canadian citizen but holds an Irish passport. Another is Benoit Coeure from France, a member of the Executive Board of the ECB. Still others include Mario Draghi, an Italian and the outgoing President of the ECB, Kristalina Georgiva, a Bulgarian who is currently Chief Executive of the World Bank, French Finance Minister Bruno Le Maire, former UK Chancellor of the Exchequer George Osborne, Jens Weidmann, President of the German Bundesbank, and Dame Minouche Shafik, an Egyptian born British/American who is the Director of the London School of Economics. There are many others.

Mark Carney with Legarde in Washington, 2017 (Photo: IMF/Flickr)

Non-Europeans are being mentioned as possible candidates, too. Agustin Carsten is one such name, a Mexican who is General Manager of the International Bank of Settlements. Also mentioned is Tharman Shanmugaratnam, Chairman of the Singapore Monetary Authority and Senior Minister, and Raghuram Rajan, former Governor of the Indian central bank. Again, there are many others.

In discussing the chances of possible candidates, much of the commentary is about their nationality rather than the relative attributes they would bring to the position. For example, the focus has been on such nationality matters as: is Carney sufficiently European because he obtained an Irish passport (as did many UK citizens following the Brexit vote)? Or can another French national (Coeure or Le Maire) get up given the previous two Managing Directors came from France? Or can a candidate from central Europe (Georgiva) gain sufficient support from the rest of Europe? Or is a UK national (Osborne) a realistic European contender given Brexit? Draghi’s problem is his age, at 71 he is over the IMF age limit.

As for the non-Europeans, the main handicap is that they are not European. Emerging markets have a very poor record in supporting an emerging market candidate. When Dominique Straus-Khan stepped down as IMF Managing Director in 2011, there were two candidates, Lagarde and Carsten. Carsten did not receive endorsement from emerging markets other than Mexico, and Australia and Canada were the only major economies to support him. It is hard to see the emerging markets getting behind one candidate this time.

The next IMF chief must wheel and deal with heads of state (Photo: IMF/Flickr)

While the political jockeying is well under way, the IMF continues with the fiction that there will be an open and merit-based selection process. And the IMF Executive Board continues with the fiction that it will play a decisive role in making the selection.

Against the background of long-standing angst that the governance processes of the IMF needed to be reformed, the Executive Board announced in 2016 that it had adopted an open process for selection of the Managing Director where individuals may be nominated by Fund Governors or Executive Directors, the Executive Board would draw up a short list, and the candidates would be interviewed by the Board to assess their relative merits. The Board would then make a selection, either by consensus or majority vote. Sounds good in theory, but it is irrelevant as to how the next Managing Director will be chosen. The backroom political deals will be done well before the Board gets involved.

To state the obvious, the aim should be to determine who is the best suited for the position, because it is a tough but important role. Chris Hafner from the professional services firm Grovelands, says the new Managing Director has to be “a tremendous communicator both politically and in the media, and able to take a far sighted view of markets and fiscal policy”.

Lagarde is widely considered to have been a successful Managing Director, although she has some critics. Peter Doyle, a highly critical former IMF employee, says her successor will have to deal with the messes she leaves behind, in particular a US$56 billion IMF loan to Argentina. In his view the criteria for the next IMF head should be “no European, no politician, no amateur”.

While the IMF has many shortcomings, Lagarde has demonstrated that its head has to have well-honed political, diplomatic and communication skills and be someone with a significant international presence. The Managing Director is afforded head of state status and must go toe-to-toe with the leaders of the major industrial economies, emerging markets and the smallest and poorest economies as well have the skills to build a consensus in very difficult circumstances.

Among the crop of potential candidates, the one best suited and with the required international status is Mark Carney, former Governor of the Canadian Central Bank, former Chair of the Financial Stability Board, and current Governor of the Bank of England. Should he get the position, it would be unfortunate if this was seen as being mainly because he was technically a European and this was the best chance of Europe maintaining its hold over the position. Conversely, it would be unfortunate if it was seen as maintaining the gentleman’s agreement that the IMF head should always be a European. That said, Carney would make a very good IMF Managing Director.

The limits to global monetary policy

With forecasts of a slower global economy, central banks around the world are contemplating easier monetary policy. The problem is that monetary policy is already in “easy” mode and has been that way for a decade. This presents serious constraints on just how much more monetary policy can do. Other policies are needed.

The Bank for International Settlements (BIS, the central bankers’ club in Basel, Switzerland) has explored the quandary in its just-released annual report.

The conventional monetary instrument – short-term interest rates – is already close to zero in Europe. Even the United States, where the Federal Reserve funds rate is around 2.4%, doesn’t have much flexibility to move before it, too, runs out of room. In past recessions, interest rates have typically been moved down by around 500 basis points – in 2007, from over 5% to almost zero – and this shift isn’t possible now.

In any case the constraints go beyond the problem of the “zero lower bound”.

There is the commonly held view that monetary policy works more effectively in constraining expansion than it does in stimulating slow growth – in expansionary mode, it is “pushing on a string”. This is, of course, an over-simplification. The bold use of monetary policy after the 2008 global crisis was effective in preventing a repeat of the 1930s depression and fostering the recovery. But this experience also demonstrated that context matters: the expansionary setting of monetary policy had to battle against strong headwinds, as households and companies were constrained by their damaged balance sheets. Fiscal policy was also in austerity mode.

In short, monetary policy may be less effective in current circumstances, not because of some intrinsic weakness, but because the context in which it is operating is unhelpful. At present, for example, lower interest rates may not be powerful because consumers and businesses have used the low rates of the past decade to expand their borrowing, and many are now facing leverage limits.

Outside the US Bureau of Engraving and Printing in Washington, DC (Photo: Eva Hambach via Getty)

There is, however, a more powerful argument against unusually low interest rates, especially if maintained for a long period. Monetary policy works by setting the short-term interest rate below the equilibrium market-determined rate. This creates distortions which are generally helpful when the economy is weak, by bringing forward expenditure decisions. But if maintained for an extended period, the beneficial effect weakens, so that expenditures brought forward “leave a hole” in future expenditures. Low interest rates encourage excessive risk-taking, facilitating projects which are not viable when interest rates return to normal. “Zombie” firms remain in business, so resources don’t shift to better uses.

As evidence of these enhanced risks, there is mounting concerns about leveraged loans and the increased proportion of BBB-rated paper in bond-fund portfolios, only one downgrade away from no longer being eligible as “investment grade”.

Intuitively, the sort of zero or sometimes negative interest rates now seen in Europe don’t make much sense. Negative real (i.e. inflation-adjusted) interest rates are widespread. The doyen of economic textbook writers, Paul Samuelson, once remarked that if real interest rates were zero and expected to remain so, it would pay to flatten the Rocky Mountains to reduce transport costs.

In short, there isn’t much room to lower interest rates, and in any case, doing so has dubious benefits.

In short, there isn’t much room to lower interest rates, and in any case, doing so has dubious benefits.

If interest rates have done all they can, what about the “unconventional” monetary policy which Europe, America and Japan used over the past decade? There are still controversies over quantitative easing (QE): former Federal Reserve Chairman Ben Bernanke, who initiated this policy in America, said (in jest, to be sure) that “QE works in practice but not in theory”. Opinions differ, but the general view is that it did, indeed, work in practice to lower longer-term bond yields, which should have encouraged expenditure. At the same time, the common view is that it is an unreliable instrument, with its effectiveness depending on context.

A deeper concern is that QE fuzzes the border between monetary policy and fiscal policy. At the same time that the Fed has been buying long-term bonds in its QE operations, the US government has been running big budget deficits, funded by bond sales. These decisions are institutionally separate, so it can’t be said that this is “monetising the deficit” – with its long-held concerns about unconstrained budget profligacy. But QE has succeeded in keeping bond yields very low, emasculating the “bond-market vigilantes” who pressured then president Bill Clinton into budget restraint. Donald Trump clearly feels no compunctions about pressuring the Fed to lower interest rates, so Fed independence is under threat, and a readiness to return to QE leaves the Fed vulnerable.

The BIS is a cautious institution, so its advice is hedged and nuanced. The message between the lines is that interest rates are already unusually low. The BIS sees a case for “normalising” policy – i.e. returning to equilibrium, but for the moment, given the fragility of the global economy, interest rates should be held steady. If they are lowered further (as seems quite likely) macroprudential policy needs to be active to avoid this leading to financial instability.

Given this message that monetary policy can’t do much more, the BIS steps outside its narrow central-banking remit to recommend that countries with fiscal space (i.e. not weighed down by excessive public debt) should use fiscal policy if the economy slows. Reprising Samuelson, they might have said this is a great moment to issue long-term public debt at essentially zero real interest rate, to fund projects which increase productivity – but maybe this doesn’t include flattening the Rockies.

Osaka G20: finding the right beat for hard conversation

A rap-style music video to promote the Osaka G20 leaders’ summit to be held on 28–29 June contains the lyrics “Let’s talk! Let’s dance! Here is Osaka wonderful city! Let’s conversation! Hard communication! Come on!”.

The promotional video was produced by an Osaka-based group made up of women with an average age of 66. One of the group members, aged 71, said “Up to now, we moved like we were undergoing rehab. But this time we nailed it”.

Can the same be said about the G20? How will G20 leaders respond? They will not dance, but will they engage in “hard communication”?

Many may say that “up to now” the G20 process was also moving as if it was undergoing rehab, but the big unknown is whether the Osaka summit will “nail it”. Much will depend on how you define “nailing it”. As we have seen with past summits, the higher the expectations on the outcome, the greater the prospect of disappointment.

It is 10 years since the G20 was self-described as the premier forum for international economic cooperation and global governance. Its greatest success was its immediate response to the global financial crisis in 2008–09 and the leaders-level forum started with great hopes that it presented a new platform for international economic cooperation. There is a widespread view that the forum has not realised the full scale of ambition that was thrust upon it. The criticism of the G20 includes the failure to maintain a common sense of purpose following the global crisis, a lack of focus with an ever expanding “Christmas tree” of agenda topics, and a membership that is too large and too diverse to reach common understandings.

The focus of the international community will not be on the outcome from the formal summit process but the success or otherwise of bilateral meetings dealing with global hot spots.

The main problem may be, however, that the expectations for the G20 summit were excessively ambitious. Matthew Goodman from CSIS rightly points out that the success of a summit should be measured by two metrics; whether they solve current problems and whether they set a credible agenda for future progress. However, the focus is generally on the first metric, namely the extent to which a summit deals with current problems.

With that in mind, some are setting high expectations for the Osaka summit. Andrew Hammond from the London School of Economics has suggested that the Osaka summit is potentially the most important since the 2009 G20 meeting in London, which took place in the midst of the global financial crisis.

The high hopes for the Osaka are not based on expectations of breakthroughs on the vast range of themes that Japan has identified as priorities for the summit. These range from strengthening global economic growth, promoting trade and investment as the engine for growth, driving innovation, acting on climate change, improving the governance of labour markets, advancing woman’s empowerment, renewing efforts in support of the Sustainable Development Goals, and achieving universal health coverage and responding to an aging society. The Osaka summit will not “solve” any of these issues, although as Goodman notes, the G20 will make a contribution if there is some future “agenda-setting value” on these issues in the leaders communique.

There are, however, two streams in a global summit – the formal meetings and a multitude of bilateral meetings between leaders. The focus of the international community will not be on the outcome from the formal summit process, regardless of any agenda setting value in dealing with global problems, but the success or otherwise of bilateral meetings dealing with global hot spots. It is on this basis that Hammond has suggested that the Osaka summit could potentially be the most important since the London summit in 2008, mainly because there are many hot spots they need to be resolved.

Paramount among these is the US-China trade war, and all eyes will be on the meeting between President Donald Trump and President Xi Jinping, assuming there is a meeting. Other flash points to be covered in the margins of the summit include reactions to the Hong Kong protests, developments in Iran, Syria and Ukraine, Turkey’s purchase of Russian missile systems, and Saudi Arabia’s involvement in the death of journalist Jamal Khashoggi.

Should the success or otherwise of the Osaka summit be judged on the outcome of bilateral meetings? Regardless of the outcome of these discussions, a value of the G20 process is that it provides the forum, and perhaps encourages leaders to discuss contentious issues. There is always the danger of expecting too much from the bilateral meetings in the margins of a summit. But the bilateral meetings in Osaka, particularly between Trump and Xi, are vital.

The reality is that there is little prospect of making progress on any of the many issues requiring a co-ordinated global response while the largest economy in the world, the US, continues to thumb its nose at any rules-based approach to international relations. Like it or not, the success of the G20 summit will come down to the whims of Trump and his Twitter finger. And no-one can predict which way Trump will go.

So we wait with baited breath to see if there is some constructive “hard communication” in Osaka.

Trump’s Mexico tariffs an ominous sign for global economy

Donald Trump’s tariff threat against Mexico may end up signaling a lot more than just the President’s latest twitter-launched policy tirade. By eroding any of Trump’s remaining trade negotiating credibility, it points to much darker times ahead for the global economy.

The Trump administration plans to impose tariffs on all imports from Mexico unless the latter takes action to dramatically reduce or eliminate illegal migration across the US-Mexico border, including migrants from Central America. Five per cent tariffs will be imposed as early as 10 June and, unless Trump is satisfied, will quickly ratchet up month-by-month to reach 25% by October. To implement his threat, Trump is invoking presidential powers under the International Emergency Economic Powers Act, a move open to legal challenge but otherwise giving him free rein to do as he pleases.

China will now conclude it has been right to resist American demands and allow trade negotiations to breakdown.

As usual, there’s a host of problems with Trump’s tariffs. It will do considerable self-damage, hitting American consumers, businesses and workers. The impact will be especially magnified given the intensity of bilateral trade in parts and components crisscrossing the border. Further, by damaging the Mexican economy, it may also prove entirely counterproductive, potentially encouraging more Mexicans to seek better economic opportunities in the United States, including illegally. There is also the deeper damage done by the President’s repeated and blatant abuse of executive power and spurious use of national security as a justification for tariffs that threaten to undermine US domestic institutions, global trade rules, and proper national security policymaking itself. The list of problems goes on.

Trump may be struggling to get his border wall. But he is doing an unfortunately good job of building a tariff one (Photo: Jonathan McIntosh/Flickr)

The broader issue is the immense damage this has just done to the credibility of conducting any negotiations with the Trump administration. Mexico, after all, had only just finished negotiating the US-Mexico-Canada Agreement (USMCA) under threat of unilateral American withdrawal from the North American Free Trade Agreement and with Trump’s steel and aluminium tariffs (officially imposed for national security reasons) only lifted recently. Now, before the USMCA is even ratified, “Tariff Man” is again beckoning at Mexico’s doors (or borders if you will) to extract more for his own populist political purposes.

The obvious lesson from all this is that, as the playground lesson goes, there’s no appeasing a bully. Mexico, Canada, China, Japan, Korea, Europe – all had nonetheless been trying to walk a tightrope with Trump, offering a fair amount of appeasement while also trying to protect their own nation’s interests. It’s hard to see how any of them could now conclude that appeasement is a sensible strategy. Japan and the European Union – seeking to avoid US national security tariffs on their automotive exports – now know there’s little to no point in appeasing Trump. Financial markets have been quick to impute the latest realities by downgrading exposed stocks and rushing to safe haven assets.

Worse yet, China will now conclude it has been right to resist American demands and allow trade negotiations to breakdown. That trade battle is also unhelpfully mixed up with genuine geostrategic issues, so the implications extend much further than trade. In addition to following through on its own retaliatory tariff hikes over the weekend, China is now retaliating to America’s blacklisting of Huawei by announcing plans to issue its own list of unreliable foreign companies and targeting America’s FedEx as the first cab off the rank.

The issues here are difficult enough. But Trump’s unreliability as a negotiating partner significantly reduces the scope for any compromise that might allow economic engagement to continue in some areas even as some kind of “decoupling” is increasingly pursued in sensitive areas, notably around technology.

Trump may be struggling to get his border wall. But he is doing an unfortunately good job of building a tariff one. All told, Trump is on his way to blanketing over 40% of America’s imports with 25% tariffs. Along with the inevitable further retaliation of US trading partners and rapidly escalating tensions with China, an already slowing world economy looks increasingly headed for the massive disruption to global commerce long threatened by the Trump presidency.


America’s fiscal policy rethink reaches Japan

Among some prominent policy wonks in America, a profound rethink of fiscal policy has been underway for the last couple of years, making the case for more-expansionary – or at least less-contractionary – fiscal policy. Japan, already with a mountain of government debt and substantial budget deficits, would seem to be an unlikely candidate for this revisionist thinking. Yet this is the message being promoted by one of America’s leading policy economists.

Not long ago Olivier Blanchard was chief economist at the bastion of fiscal probity, the International Monetary Fund. Now at the Peterson Institute, he has co-authored a paper arguing that Japan should abandon its plan to get the budget into balance by 2025. Instead, it should wait until the economy has clearly reached potential output, with inflation rising from the current 1% to reach the target of 2%.

This is a radical message. Japan has run substantial budget deficits since the “lost decades” began in 1990. Japan’s gross public debt now equals 240% of GDP. In a world where most advanced economies are concerned about their public debt levels, Japan has well over twice the norm of the countries in the Organisation for Economic Cooperation and Development.

Moreover, there don’t seem to be powerful reasons for policy adjustment. Unemployment is a low 2.5%. At first sight Japan’s recent growth rate might seem weak at around 1%. But its working-age population is falling by around half a million each year because of aging demographics: growth in output per worker is among the highest in the OECD.

Why, then, would Blanchard favour delay in addressing Japan’s chronic budget deficit and huge public debt? He sees the combination of low interest rates and low inflation as a sign of secular stagnation. Continuing deficits are needed to maintain demand. Running the economy “hot” – keeping demand strong – will encourage older workers to stay in the work force, continue the process of encouraging more women to enter the labour force, and might even give women higher-skilled, full-time, better-paid, more-productive jobs.

Japan’s vigorous quantitative easing since 2012 has seen the Bank of Japan’s bond-holding equal to a year’s GDP output (Photo: narumi-lock/Flickr)

Perhaps just as important, it would correct a notable imbalance between monetary and fiscal policy. Since Shinzo Abe came to power in 2012, the budget deficit has been reduced by 3% of GDP – a strong contraction. Looking ahead, to restore budget balance by 2025 implies continuing budgetary contraction. At the same time monetary policy has been in energetic expansionary mode. Not only has the policy interest rate been essentially zero for a decade, but policy has anchored long-term bond yields at zero. As a result of Japan’s vigorous quantitative easing (QE) since 2012, the Bank of Japan’s bond-holding is equal to a year’s GDP output.

Loose monetary policy creates distortions in financial markets: BoJ’s QE operations have purchased equities and other financial assets, as well as nearly half the stock of government bonds. It biases investment decisions and sets up longer-term problems when interest rates return to normal.

If such expansionary policies are seen as necessary, why is it sensible for fiscal policy to push hard in the opposite direction? Zero interest rates mean that monetary policy has done all it can do to promote growth, but at the same time offer the opportunity for low-cost fiscal expansion.

The received wisdom of conventional economics says that Japan’s austerity is necessary because public debt is too high.

The received wisdom of conventional economics says that Japan’s austerity is necessary because public debt is too high. Governments should observe the “golden rule” of balancing their budgets over the course of the cycle. Here Blanchard’s earlier analysis provides the counter-argument. When interest rates are low (or, for Japan, zero) the economy can run a modest budget deficit without debt/GDP rising.

In Blanchard’s example for Japan, with current interest rates and growth, Japan can continue to run budget deficits close to the current level without debt/GDP rising. The deficit is adding to debt (the top of the ratio) at the same pace as growth is adding to the denominator. Why risk growth by raising the value-added tax?

Blanchard’s powerful caveat is that deficits are justified only if the expenditure is put to good use ­– in particular, to ensure stronger growth in potential output. No more bridges-to-nowhere! Blanchard suggests that measures to increase labour-force participation (e.g. child-care) and make workers more productive are the justification for ignoring the golden rule, at least until higher inflation signals that capacity has been reached.

Blanchard has taken his US-based arguments and applied them to another country: Japan. Is this part of a global-wide rethink of fiscal policy, that might apply, say, even to Australia? The policy interest rate here is low and many expect it to go lower. The government can now borrow long-term for well-under 2%. The critical relationship in the Blanchard argument – the difference between the nominal growth rate and the interest rate – implies that a modest deficit is consistent with an unchanged public debt ratio. And Australia starts with a low public debt ratio by OECD comparisons. At the same time, both major political parties in the recent election firmly pledged to return the budget to surplus quickly (with the inescapable implied commitment to undertake budgetary contraction). Japan’s out-of-kilter monetary and fiscal policy mix is mirrored in Australia.

Trump’s tariff tussle

As predictable as Big Ben striking the hour, as subtle as a battering ram, the final stages of the US-China trade negotiations involve upping the ante with a further tariff increase, as seen last week.

Tariffs are the negotiating instrument, not the objective. For financial journalists needing an attention-grabbing headline, US President Donald Trump’s tariff threats are a gift that keeps on giving. But for most observers, tariffs are not the key issue. The new round of tariffs is, after all, only the same tariffs that Trump threatened to impose a year ago, with a barely perceptible GDP effect even on the two countries most affected. In any case the increase will not be imposed on goods currently in transit, so it will be a couple of weeks before there is much actual impact.

Foreigner investors who can’t come to a mutually satisfactory agreement with China about protection of their IP should stay at home.

The real issue is whether this negotiating tactic will have any success in resolving America’s substantive and permanent objectives: a smaller bilateral trade deficit; fuller recognition of American intellectual property (IP); protection against China’s cyber snooping and stealing; better investment access (including the right to invest in China without relinquishing IP); protection against an over-competitive renminbi exchange rate; and fundamental changes in China’s state-capitalist system, with its ubiquitous subsidies and favouritism.

Some of these issues are relatively easy for China to accommodate. China can reduce its bilateral deficit by redirecting its imports away from other suppliers, to favour American exports. Tough luck for countries such as Australia, with its gas and beef exports.

Intellectual property shouldn’t present an insurmountable sticking point. In principle, innovation should be rewarded so as to encourage more of it. In practice IP has become a patent lawyers’ goldmine, where trivial and obvious ideas are monopolised (remember Amazon’s patent on “one-click” purchases, which expired only a couple of years ago?). China already accepts the broad idea of paying for IP: in 2017 China paid nearly $US30 billion for technology transfer. Doubtless part of the current deal will be higher royalties.

Cyber-theft is something else again. Attempting to steal each other’s official secrets has long been standard practice, more recently extended to commercial secrets. It is up to the owners (including governments) to protect their cyber property. Any deal is unlikely to have a clause requiring that “gentlemen don’t read each others’ mail”.

China should be able to sign up to some kind of not-too-binding undertaking to avoid an overly competitive exchange rate (it hasn’t sinned in this regard for the past decade), although it won’t leave itself open to the sort of damage which the Louvre and Plaza agreements did to Japan in the 1980s.

What about more foreign investment access? A presumption that foreigners have the right to invest in another country might have been part-and-parcel of the 19th century view of globalisation (as practised vigorously by the colonial powers in China), but the world has moved on. Most countries (including Australia) now require foreigners to make the case that their investments are a net benefit for the recipient.

Similarly, foreigner investors who can’t come to a mutually satisfactory agreement with China about protection of their IP should stay at home. China will continue the process of international integration which has been underway for decades because it understands that this is in its own interests, but it will choose its own pace: there is not much to be negotiated away here.

The most clearly non-negotiable item is the central role of state-capitalism. It is absurd to think that the Chinese might negotiate this away, or draw back from the idea that they will actively direct policy at becoming a major industrial power, with cutting-edge technology across the full spectrum of industries.

Not only is it futile to expect China to abandon (or even modify) its core economic model, but the argument undermines America’s own cherished beliefs in free enterprise. If subsidies, state-ownership, bureaucratic direction, financial favouritism, central planning, industry protection, manipulated exchange rates and regulation are grossly inefficient, America should be delighted that its rival is handicapping itself by adopting these policies. Wouldn’t it be enough to wait for the inevitable collapse of socialism, reassured by the example of the Soviet Union?

Vice President Mike Pence at a steel mill in Minnesota (Photo: White House/Flickr)

What should the rest of the world say and do while this histrionic drama runs its course?

For those countries directly damaged by tariffs (mainly China and Europe), the priority is for restrained retaliation designed to inflict maximum political harm to Trump’s constituency and minimum harm on its own economy, as has been successfully demonstrated so far.

For the rest, every opportunity should be taken to support the multilateral system. The damage to this and to the Pax Americana is far greater than the trivial impact of Trump’s tariffs. This means protesting loudly if China fixes its bilateral imbalance with America at our expense, or agrees to American demands to weaken the World Trade Organisation by shifting dispute-settlement to a bilateral basis.

The success of the 11-country version of the Trans-Pacific Partnership is a poke in the eye for Trump’s misguided bilateralism, so countries should do all they can to support it. Early ratification and active expansion of its membership would be a good place to start. What about seeing if China might be interested in joining?

The first rule of a trade war: know thine enemy

If the US and China do manage to reach agreement on their current economic dispute, what happens next?

Forebodingly for the government that Australia elects on 18 May, all of four recent US think-tank papers* on the US economic quarrel with China urge that America organise a coalition of its like-minded allies to press China for major changes to its economic system. Prime Minister Scott Morrison may believe, as he has said, that Australia “does not have to choose, and won’t choose”. Many Americans clearly think otherwise.

Before America can successfully recruits allies, however, it must convince them that China’s economic arrangements are the threat to the global economy the Trump administration believes them to be.

A case in point is industry subsidies in China. According to the Financial Times’ Gideon Rachman, “China’s system of state subsidies for industry” is “the most fundamental way in which Beijing disadvantages foreign competitors.” Cutting “rampant” subsidies to Chinese industry is said to be a key US goal, in the current talks and beyond.

So how big are these subsidies, which industries benefit from them and what impact do they have on global trade?

As to how big they are, the US administration seems to know surprisingly little. The US Trade Representative’s office Report to Congress on China’s WTO Compliance published in February is very indignant about China’s industry subsidies. It is also unspecific about their size, incidence or impact.

(Photo: Soheb Zaidi/Unsplash)

What we do know suggests the subsidies to state-owned industries are very big. An International Monetary Fund paper in 2016 estimated that subsidies and support of all kinds to state owned enterprises may be as big as the equivalent to a whopping 3% of China’s GDP.

But according to by US economist Nicholas Lardy in his recent book The State Strikes Back, around 85% of industrial production in China is from the private sector. Other analysts estimate that 90% of China’s exports are from privately-owned businesses rather than state owned businesses. So as far as China’s exports are concerned, the key issue is the extent of subsidies to the private sector, not the state sector.

For the private sector, subsidies appear to be much smaller. Lardy examines data from the reports of publicly listed firms in China. They disclose direct subsidies of RMB 157 billion for 2015, the year Lardy examined. Of that, two thirds or RMB 111 billion went to 966 listed state-owned companies, leaving RMB 46 billion for 2000 or so listed privately-owned businesses. RMB 46 billion is US$6.9 billion (AU$9.5 billion). At an average of US$3.45 million per listed company that is quite substantial help, but not the kind of money that makes a difference to the global export performance of a large business.

For comparison, Australia’s Productivity Commission estimates that on-budget and tax concession support for Australian industry in 2016–17 was around $12.5 billion. This is around one third more than the support the Chinese government gave publicly listed privately owned listed businesses in China, though China’s economy is more than 11 times the size of the Australian economy.

Nicholas Lardy’s analysis also suggests that most of the subsidies to private businesses in China are of a kind frequently provided in Europe, the United States, and other advanced economies such as Australia.

Lardy’s analysis also suggests that most of the subsidies to private businesses in China are of a kind frequently provided in Europe, the United States, and other advanced economies such as Australia. They are not, he finds, provided to support loss-making businesses. Instead they support research and development spending, encourage the use of energy efficient technology, and in other ways support government policy objectives, just as they do in Australia and the US. (Another relevant comparison – according to the OECD’s Science, Technology and Industry Scorecard for 2017, US government support for business research and development as a share of GDP in 2015 was around twice the ratio in China.)

This data is not at all complete. There are millions of privately-owned businesses in China that are not publicly listed, although listed businesses are likely to account for most exports. Presumably subsidies for private unlisted businesses are, like those for listed private businesses, akin to those provided in advanced economies.

Subsidies to Chinese industry, privately or publicly owned, may also hinder the competitiveness of foreign imports, and no doubt do. A complete picture, were it possible to make one, would have to take that into account. A comparison would also be neeed between subsidies in China to import competing industries with those elsewhere, for example in the US and Europe.

There is little doubt that subsidies to state owned businesses in basic industries such as steel, aluminium, cement, ship building and glass sustain higher production and lower prices than a private market would permit. They unfairly impact on commercial production elsewhere. Those subsidies and others in China could well be addressed by a coalition of World Trade Organisation partners. Last year the US, Japan and the European Union discussed just such an approach. Before it could become a concrete proposal to China, however, the parties would need to reflect on which of their own comparable industry subsidies they were prepared to forgo.

The recent USTR report suggests the US is more concerned with what might happen with subsidies rather than what has happened. It is particularly concerned with the China 2025 high tech industry plan. There is, it warns, a danger of  “disastrous consequences of severe excess capacity in the world of the future” from state support of high tech industry.

As to the level and incidence of subsidy, however, the report is not informative. It repeats several times that “by some estimates” government support for China 2025 could be as high as RMB500 billion. It notes elsewhere “some” subsidies “appear to be prohibited” under WTO rules (while also pointing out that the US can and does impose countervailing duties if complaints by American businesses are upheld). The USTR has evidently not made its own assessment.

If indeed the US is to successfully enlist its security allies in pressing China to change what former USTR deputy Wendy Cutler describes in her recent report as China’s “state-led economic model” and what Charles Boustany and Aaron Friedberg label as China’s “mercantilist Leninist” economy, the US will first need to assemble a compelling set of facts.

* Asia Society Policy Institute April 2019; Brookings and AEI policy brief February 2019; Asia Society Center on US-China Relations February 2019, National Bureau of Asian Research February 2019.


The useful myth of central bank independence

One of the sustaining myths of modern economics is that central banks are independent, able to pursue monetary policy free from the pressures of politics. This makes monetary policy more effective: it gives confidence that the economy will be kept on a steady path unaffected by the exigencies of the election cycle.

President Donald Trump is undermining the credibility of this valuable myth. How much can he interfere with the US Federal Reserve before the myth is seriously devalued?

The subtlety of this issue has been demonstrated over recent months. The Fed raised interest rates in December despite the President’s clearly articulated opposition. The Fed’s Open-Market Committee knew that its actions would offend Trump, but members had little choice. Throughout 2018 the Committee had signalled its intentions through “forward guidance”, with specific prediction of four rate hikes in the year.

Independence, like beauty, is in the eye of the beholder, or in this case the sceptical judgement of fickle financial markets.

Thus, to miss the fourth increase in December would have been tantamount to announcing a return to the Arthur Burns/Richard Nixon era, when Burns, then Fed chairman, saw his role being to carry out whatever Nixon deemed necessary to facilitate the president’s 1972 re-election. The result was the inflation of the 1970s, only brought to an end by the painful Volcker Shock in 1979 (Can the Fed resist Trump’s pressure?)

After December Trump had been quiet, at least on this topic. This gave the Committee the opportunity to use its March meeting to reset the policy environment. No change in the Fed funds rate had been expected, so leaving the policy rate unchanged was no surprise. But the forward guidance of the “dot-plot” was reset, with masterly inaction being the watchword for this year. As well, the unwinding of quantitative easing (QE) will be slowed, then paused.

The immediate risk of an independence-sapping confrontation with the President was deferred. At the same time the risk of the Fed losing credibility through overly-tight policy has lessened. Fed independence has been maintained for the moment.

Now Trump has renewed his criticism, with the Fed blamed for the economy not being even stronger than it is. He is urging that expansionary QE should resume. Two names of potential new members of the Committee are now circulating – both with very close connections to the President and neither with expert knowledge of monetary policy.

It’s unlikely that Trump expects Fed Chairman Jay Powell to cave in and quickly lower the policy rate or resume expansionary QE: to go down in history as another Arthur Burns would be too humiliating. But if this sort of active criticism becomes the norm (as his economic adviser Larry Kudlow asserts it should), then resignation might be a serious option for an embattled Chairman at some stage.

That would leave the way clear for Trump to have a second go at appointing a pliable chairman. Depending on who was chosen, this might turn the Fed into another instrument for Trump’s unique brand of economic policy.

Fed Chairman Jay Powell in March (Photo: Federalreserve/Flickr)

Independence, like beauty, is in the eye of the beholder, or in this case the sceptical judgement of fickle financial markets. There are three key elements that influence the judgement: appointment of senior central bankers; the decision-making process for monetary policy; and the political skill of the chairman.

Central banks can’t be independent in the sense of being autonomous institutions, free to do what they want and choose their own leaders. Governments always have the right to appoint top central bankers. It is only established precedent, public scrutiny, and in the US the Congressional confirmation process that can ensure that appointees will be technically competent and politically neutral, rather than pliable.

Although it is a well-established norm for US presidents to appoint people of their own political persuasion, they have almost always chosen a well-qualified economist as chairman. Jay Powell, Trump’s appointment, was an exception: he is a lawyer, but had served on the Open Market Committee since 2012. Markets would take little comfort from the two new candidates, whose main qualification is seen as closeness to Trump.

An operational rule – such as inflation targeting – provides a decision framework which can resist political pressure. The Fed has an inflation target, but its model is the most-flexible variety, with the mandate giving as much weight to unemployment as to inflation. This gives more room for subjective judgment – enough to accommodate political objectives.

This leaves an essentially political task for the chairman: to demonstrate a readiness to resist the wishes of the politicians if necessary, but without being so defiant as to lose the job. This is the task Powell now faces.

Former Fed chairman Alan Greenspan provides the role-model. His reputation was severely tarnished by the 2008 crisis, but his record is peerless as a consummate political operator, glad-handing and smooth-talking the Washington politicians and opinion-makers. Greenspan dominated the Committee, politely but firmly out-arguing or over-riding any divergent views.

It will be hard for Powell to assume Greenspan’s mantle of “the Maestro”, as this came from decades spent poring over the entrails of esoteric economic data. But let’s hope Powell can reprise some of the political technique.

Former chairman Alan Greenspan (right) speaking with another former Fed chair Paul A. Volcker in 2014 (Photo: Federalreserve/Flickr)