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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

What’s so strategic about baby-food?

The discussion about China’s bid for baby-formula supplier Bellamy’s Organic shows the usual confusion about just what should guide decisions on foreign investment in Australia.

Of course there will be some proposals that are defence-strategic. But baby formula is not one of them. Nor is Bellamy’s an iconic brand like Arnott’s biscuits, where it could be argued that we are selling off a chunk of our culture. Nor is it a dominant supplier of China’s vital raw materials, like Rio-Tinto. There isn’t any obvious intellectual property – no “secret sauce” ­– as there are many producers of similar products.

As China grows and diversifies its assets, its foreign investment in Australia will expand hugely.

Will production shift offshore? Maybe, but it seems that most of the raw materials aren’t produced in Australia anyway, with the milk powder inputs coming mainly from New Zealand and Europe. In any case, milk-powder is just another global commodity. The value-add is not so much in the production process itself, but in the ability to market the branded product to the 15 million babies born in China each year.

Bellamy’s penetration of the Chinese market was greatly aided by the melamine-scandals associated with Chinese-made formula. Since then, Bellamy’s roller-coaster share price has reflected the fluctuating prospects of enlarging its market position in China, against other foreign suppliers. The brand name is now well-established among Chinese mothers and the $1.5 billion bid is a reflection of the value of reputation. But its future value still depends on the whim of China’s byzantine regulatory structure. If the sale is blocked, Bellamy’s might find itself continually thwarted in China’s market. This might be unfair, but not much could be done.

China wants to ensure security of supply, especially for vital foodstuffs and the mess they make (Photo: Lyn Lomasi/Flickr)

The importance of this case comes from the likelihood that this dilemma will come up again and again in future. As China grows and diversifies its assets, its foreign investment in Australia will expand hugely. It will also want to ensure security of supply, especially for vital foodstuffs. The challenge for Australia is to make the most of this inevitability. Join ownership between the two countries might be the ideal: the Australian owners, still in charge of production, acting as guardians of quality and reputation, while the Chinese owners facilitate marketing in China’s commercial environment with its lack of transparency.

There is not much prospect of this kind of join-enterprise model coming out of the current Foreign Investment Review Board (FIRB) processes in Australia. It is difficult to see FIRB finding any good reason to oppose this bid on current criteria, so the case will be decided on whether the current owners see the offer price as a suitable reward for their past efforts and their guess of future prospects.

Perhaps FIRB processes should shift from emphasising the various negative hurdles which foreign bids must clear (e.g. not be a security threat, not be an icon), towards an emphasis on positive aspects which the proposed venture might offer. A proposal might recognise explicitly the long-held concern that Australians might become merely “hewers of wood and drawers of water”, with the interesting jobs and the big value-add going to foreigners. Retaining production in Australia and involving Australians in the development of the marketing in China would be seen as virtues for a proposal. Another positive might be a readiness to pay company tax in Australia, rather than shift the value-add to low-tax jurisdictions through transfer pricing.

This “positive characteristic” approach might be hard to implement and harder to enforce. But at least it addresses the overwhelming non-security issue facing China’s foreign investment in Australia, that China will want a far larger ownership stake in Australian enterprises than we are comfortable with. A deep rethink of FIRB objectives is needed.

China’s “currency manipulation” in context

Commentators are unanimous in noting the illogical nature of the US Treasury’s recent designation of China as a “currency manipulator”. It fits only one of the Treasury’s own criteria, and that one – a bilateral surplus with the US ­– makes no economic sense, either in fact or in theory.

Most of these commentators accept, however, that China was a currency manipulator in the first decade of this century, when China was running a huge current account surplus, which it was using to build up foreign-exchange reserves.

It was not called “currency manipulation”; it was called “export-oriented growth” and for many years was the accepted – indeed recommended – model for emerging economies.

But even this view needs qualification. China was doing just what successful economies had done at this stage of their development – Japan, Taiwan, South Korea, Hong Kong, and Singapore, for example. In those cases, it was not called “currency manipulation”; it was called “export-oriented growth” and for many years was the accepted – indeed recommended ­– model for emerging economies.

In the immediate post-war period, many newly independent economies had embarked on import-replacement strategies, attempting to foster domestic industrialisation through tariff barriers. In most cases, this was disastrous for growth and living standards.

A radically different development strategy was pioneered by Hong Kong and Taiwan in the 1960s, closely followed by South Korea and Singapore, emphasising global openness and export promotion through a variety of policies, including a competitive (undervalued) exchange rate. Influential Burmese economist Hla Myint set this out as the key message in the Asian Development Bank–sponsored book Southeast Asia’s Economy in 1972. By this stage, it was standard policy in the Asian miracle economies such as Indonesia, Thailand, and Malaysia.

It’s hardly surprising that China’s policy-makers, in their turn, adopted the same policies, with the same success – only on a huge scale.

Development economists continued to recommend export orientation as a key element of good policy. In 2009, when China’s current account surplus was peaking at 10% of GDP, this strategy was still endorsed by Harvard’s top development economist, Dani Rodrik.

Of course, this strategy couldn’t be maintained forever, and in China’s case it wasn’t. The speed of macro-structural change after 2008 has been dramatic. The current account surplus fell from 10% of GDP to close to zero today. Between 2007 and 2018, China’s real (inflation-adjusted) exchange rate appreciated by 35%, taking it to a level that the International Monetary Fund regards as equilibrium. China’s foreign-exchange reserves are judged by the IMF to be “adequate”.

Maintaining an undervalued exchange rate during the early stages of development, shifting only gradually from a fixed exchange rate to a closely managed rate, and building up substantial foreign exchange reserves as insurance in an uncertain world: all this just seems to be sensible policy-making.

Coordinating with America to pressure China on trade

While President Donald Trump’s bull-in-a-China-shop approach to reforming international trade doesn’t appeal, it is possible that some of his objectives might make sense. This was the logic behind comments by former Barack Obama adviser Daniel Russel, suggesting that Australia should join the US in opposing “unfair and predatory economic and commercial practices that we have seen for so long by the Chinese”, such as intellectual property theft and lack of reciprocity in trade.

While a united approach strengthens any argument, we may not agree on just what deserves to be included in the reform agenda. Reforming and reinvigorating the World Trade Organisation might be a good place to start. But reinforcing US objectives on intellectual property (IP) might be problematical.

It is worth remembering that when America was at the same stage of development that China now is, it copied English cloth-weaving technology without paying IP royalties and its citizens read English books (famously, Charles Dickens) without paying copyright.

The current IP system is a very imperfect way of encouraging and rewarding innovation. The patent and copyright framework has been so distorted by vested interests that the main beneficiary may be the army of patent lawyers and the legal process which support them.

The current framework offers incentive for future innovation by providing past innovators with a monopoly – and monopolies are never first-best economics. We are still giving copyright protection to Mickey Mouse, long after the creator died. Trivial inventions (e.g. single-click internet purchases) were given legal protection. Pharmaceutical patents are “evergreened” to extend their life by minor tweaks of the formulation.

It is worth remembering that when America was at the same stage of development that China now is, it copied English cloth-weaving technology without paying IP royalties and its citizens read English books (famously, Charles Dickens) without paying copyright fees.

Times have moved on, and China should pay legitimate IP charges, but before we get too righteous about China’s predatory actions, we might recall that we are promoting an imperfect system which is heavily weighted in favour of IP owners such as the US, and against countries which are predominantly IP users such as China and Australia.

What about demanding reciprocity on trade? Until now, it has been accepted that developing economies are not required to be as pure in open trade as advanced economies. As China’s manufacturing technology is now on a par with advanced economies, pressure for greater openness is legitimate. But is China a greater offender than, say, India ­– a chronical laggard in openness?

The fundamental element which stands in the way of cooperation with the Trump trade agenda is his bilateral mindset, while Australia’s interests are overwhelmingly multilateral.

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.


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