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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.


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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)

The sudden interest in Modern Monetary Theory

The decade since the financial crisis of 2008 has been unkind to conventional economics. The gap between the observed facts and mainstream theory opened an opportunity for alternative theories to take hold. Among them, Modern Monetary Theory (MMT) fits the American zeitgeist: “big-ticket” expenditure proposals from reinvigorated “progressive” Democrats could be funded by the magic-pudding promises of MMT.

What’s gone wrong with mainstream economics? For those who thought that the economy had a strong self-equilibrating capacity to return quickly to full employment after an adverse shock, the post-2008 recovery has been disappointingly feeble. The textbook “V” shaped recovery is missing. Even now that full employment has been reached in the United States, GDP is 10% below the pre-crisis trend projection, and the new trend is flatter than before.


The main instrument of counter-cyclical policy – interest rates – have had little apparent effect in boosting demand. Inflation, too, has behaved unexpectedly. It didn’t fall much during the sharp downturn in 2008, and now that full employment has been belatedly achieved, inflation remains persistently at the low side of the target.

The traditional relationship between government debt and longer-term bond yield has broken down. Bigger debt used to mean higher interest rates. The 1990s “bond-market vigilantes” forced austerity on George H. W. Bush and Bill Clinton. Despite consecutive surpluses which wound government debt back towards zero by the turn of the century, bond yields remained high. Then, early in the new century, Greenspan’s conundrum saw bond yields stay low even as government debt rose. The large budget deficits associated with the 2008 crisis saw bond yields fall rather than rise. Donald Trump’s deficit-enlarging company tax cuts in 2017 have not pushed bond yields up, even though government debt is now headed for 100% of GDP.

MMT is not new, but the confusions in macro-economics has given its proponents the opportunity to tell a story which fits the facts and appeals to the left-of-centre politicians who want to fund their big-ticket spending on climate, education and health.

Could America, with debt less than 100% of GDP, follow the Japanese example, where government debt is around 250% of GDP and bond yields are zero?

MMT can be slippery to tie down, but a central tenet argues that budget expenditure should be expanded while-ever there is spare capacity, provided this doesn’t trigger inflation. This is an attractive idea, as recent experience suggests that budget expansion is the most reliable way of stimulating the lack-lustre economy. And if the spare capacity would otherwise go unproduced, isn’t this an attractive “free-lunch”?

This expenditure has to be funded, but higher debt seems readily absorbed by savers and doesn’t seem to raise interest rates. If new debt can’t be sold, or old debt can’t be rolled over, MMT argues that this is not a problem for countries which issue debt in their own currency: they can issue currency to roll over debt or fund new expenditure.

As a source of “free lunch” funding, this narrative doesn’t stand up. Suppose the government pays for extra expenditure by issuing currency, obtained from the central bank. The public already has all the currency it wants to hold, so deposits the extra currency with a commercial bank. The bank, too, now has excess currency and so deposits it at the central bank, in the form of banks’ reserves. In most countries, the central bank pays a market interest rate on these reserves.

Thus, the additional budget expenditure is not a “free lunch” but is financed by forced borrowing from the banking system, on which interest has to be paid, just like any other government debt. Rather than force the banks to fund the expenditure (which might be considered a form of “fiscal repression”), it would be more sensible to issue more government debt, to be held by the public.

This knocks out the central plank of MMT: issuing cash is not a limitless source of funding. But one element remains. If there is spare capacity, why not find some way of turning this potential into actual output? The Keynesian answer is to stimulate the economy with pump-priming expenditure. But what if the problem is not a cyclical recession, but rather secular stagnation where the private sector chronically saves more than it wants to invest? Can the government go on running deficits, funded by debt, to fill the demand deficiency on a permanent basis?

Conventional economic wisdom says “no”, although some of the earlier dogmatism has gone. Olivier Blanchard has reminded us that if the bond interest rate is lower than nominal growth rate (which has prevailed for most of the post-war period), a balanced budget implies that debt/GDP will fall over time. The capacity of a growing economy to service debt is rising faster than the servicing cost. This implies that a country starting from zero debt could run a modest deficit continuously without debt/GDP rising or creating a burden for future generation.

Few countries – certainly not America – start with zero or even small debt, so the Blanchard analysis is not an open invitation for expanded deficits. But just how far (and how long) should governments go in issuing new debt, in an environment of low interest rates and an eager appetite among savers to take up extra debt? Could America, with debt less than 100% of GDP, follow the Japanese example, where government debt is around 250% of GDP and bond yields are zero?

A consensus is emerging in America that productivity-enhancing additional expenditure – such as active labour policies and infrastructure – might be undertaken, tentatively exploring the room for deficit expenditures funded by issuing long-term bonds. But Federal Reserve chair Jay Powell sums up the mainstream consensus on MMT : it’s “just wrong”.

What might a US-China trade deal look like?

Perhaps they will, perhaps they won’t, but if China and the US do reach a trade agreement in coming weeks it will likely be very long. Meeting to seal the deal, President Donald Trump and China’s leader Xi Jinping will be able to display to the cameras a document of at least a hundred pages.

A deal will confirm that economic globalisation will continue and that the very difficult and very productive relationship between the two giant economies will remain at its centre. 

For all its size, however, the substance of the agreement is likely to be straightforward. The real interest will not be the deal, which is likely to be humdrum. It will be in what it signifies, which could be immense.

China has already agreed to buy more US goods and services, perhaps $200 billion a year more or $1.2 trillion over six years. It has already removed most foreign investment barriers in manufacturing and will commit to a faster schedule of liberalisation in services. Visa and Mastercard, for example, will be permitted to compete in domestic payments, and some US financial businesses may be able to offer more services in China as wholly owned subsidiaries. China may reduce automobile tariffs below 15%.

Useful, but not history-making changes.

China will also be able to meet many US demands on intellectual property. It will commit to cracking down harder on intellectual property theft. It will probably commit to disciplining provincial authorities where they require foreign corporations to transfer intellectual property into joint venture vehicles with a local partner. But foreigners are now permitted to enter almost all China’s manufacturing sectors without a local partner, so the “forced transfer” issue is of declining significance. Formally or informally, China may restate its adherence to the 2015 agreement between the US and China not to use state-sponsored cyber attacks to steal business secrets. (Stealing state secrets remains OK).

Again, not big changes.

US officials claim the agreement will cover industry subsidies, but it will probably reference only a small subset of subsidies. World Trade Organisation rules discipline many subsidies which directly affect other countries’ trade in a serious and specific way. In the forthcoming agreement, China may commit to more prompt WTO notification of subsidies that fall into the disciplined category. In July last year, China submitted a 170-page list of these programs to the WTO.

Most subsidies are not now covered by WTO disciplines. In his new book The State Strikes Back, US economist Nicholas Lardy estimates that direct subsidies to state-owned or controlled firms in China totalled around US $80 billion in 2015. An International Monetary Fund estimate, which also takes into account concessional or forgiven loans, offers an estimate three times higher.

Most of the direct subsidies are intended to promote government policies such as higher use of natural gas or electric vehicles. They are on a larger scale in China, but many governments offer such subsidies – including in the US and Europe. China would probably insist that if there is to be negotiation it include industrial and farm subsidies in the US, Europe, and Japan as well as in China.

Enforcement issues are said to have complicated finalisation of a deal, and may well yet wreck it. The most recent US position appears to be that penalty tariffs will be reimposed if, in the US opinion, China has not fulfilled the commitments it will make. China might let that through because, after all, the Trump administration would do it anyway. But China is unlikely to agree not to reciprocate, which is the US demand.

As to the wider issues that were earlier thought to be among the US ambitions, they would have proved non-negotiable. China will not accept any agreement to limit the role of the Communist Party, the role of state planning, or its technological ambitions, any more than the US would permit discussion of comparable institutional arrangements.

The likely deal will not alter the trajectory of the relationship between the US and China in any major way. It will do the opposite. It will imply that economic separation (“decoupling”) of the US and China has not been pursued. It will confirm that economic globalisation will continue and that the very difficult and very productive relationship between the two giant economies will remain at its centre. After more than a year of increasing danger to the global trade system, that would be a very important outcome.

The deal will also remind us that the economic trajectory of the US and China depends far more on decisions the US and China make about their own economies than agreements they reach with each other. As Lardy’s timely new account of China’s choices makes clear, most of the challenges to China’s growth are posed by its internal policies. Much the same can be said of the US.

China’s economic growth, Lardy persuasively argues, has been hampered by the poor performance of many of its state-owned enterprises. Some are subsidised to continue producing too much, at too high a cost. Yet in recent years, he shows, the share of total investment by state-owned enterprises has been rising, along with their share of loans from China’s largely state-owned banking system. This is inevitably at the expenses of the far more efficient private sector which provides nine-tenths of China’s exports. 

It follows from Lardy’s argument that if the US was successful in its broader aim of reducing industrial subsidies in China, of reducing the role of state-owned enterprises and of state planning instruments, China would become a more formidable competitor to the US than it already is.

Even with the portending deal, the tensions between China and the US will certainly persist.  Economic competition between the US and China will increase as China becomes technologically more advanced. There will be less symbiosis and more competition. At the same time, each will continue integrating into a global economy in which mutual dependence and prosperity are bound together.

An orthodox economic take on climate change shocks

In a debate as politically fractious as climate change, it is useful to have credible voices joining the fray. On Tuesday night, the Reserve Bank of Australia (RBA) waded into the waters with a speech by Deputy Governor Guy Debelle. It has immediately been seen as an urgent call to action.

More frequent and severe climate shocks thus mean the cost to the economy is not only greater but also less likely to prove purely transitory.

Some might question what the role of the central bank is to weigh in on such matters. Debelle’s answer is simple and notable – because climate change has a significant bearing on the macroeconomic outcomes, such as growth and inflation, which are the RBA’s core mandate.

An especially useful contribution was to place climate change within a very orthodox macroeconomic framework. We are used to thinking of climate-related shocks as transitory – cyclical occurrences around the trend. What is changing with global warming, however, is that such shocks are becoming more frequent and more severe.

Even temporary shocks can have permanent effects. For example, if workers drop out of the labour force and never return or their skills atrophy. More frequent and severe climate shocks thus mean the cost to the economy is not only greater but also less likely to prove purely transitory. As Debelle puts it:

The supply shock is no longer temporary but close to permanent.

The problem with negative supply shocks is that they raise the spectre of “stagflationary” effects, with inflation rising even as growth slows and unemployment worsens. This directly complicates the central bank’s job, as it is responsible for keeping all three close to their equilibrium levels. Yet, it can only manage the tensions and trade-offs between these policy objectives. It cannot make them disappear. That means households and businesses risk being caught in the worst of all worlds, facing both higher prices and weaker incomes, or one extreme or the other.

Financial fragility is also an issue. Extreme weather-related events pose a major challenge for insurance markets, while companies in carbon-intensive industries are at risk of finding themselves left with large assets on their balance sheets that suddenly become nearly worthless as economies shift in low carbon directions.

One bright spot is that the RBA expects a solid pipeline of investment in renewable energy over the coming years as these are now more cost-effective energy sources.

Aside from that though, it remains a gloomy picture. Human-induced warming has already increased global temperatures by 1 degree above pre-industrial levels and, after so much global dithering, keeping this below 1.5–2.0 degrees will require truly heroic efforts to cut emissions to zero over the coming decades.

Political leadership and international cooperation are obviously the two key ingredients required. Debelle, of course, avoided discussing these topics directly. Nonetheless, there were some interesting points here, too.

On international aspects, he pointed out the ways in which China’s efforts under its latest five-year plan to green its economy is actually benefitting Australia in terms of the increased demand for relatively cleaner coal, natural gas, and battery inputs like lithium. That’s uncontroversial but it makes a useful contrast to all the bluster coming out of the Trump administration that China’s industrial policies writ large are inherently damaging to other economies and must be curtailed. This is especially important to consider given China’s central importance to the trajectory of global emissions. Within reason, we should care more about where they are going rather than how they got there.

On politics, Debelle also made an interesting comparison between climate change and trade liberalisation. Both create winners and losers. But at least with open trade, it is a positive-sum game where it is, theoretically, possible for the winners to compensate the losers and for everyone to still be better off (even if in practice this often doesn’t occur to the extent needed). By contrast, the impact of climate change is a zero-sum affair and so more difficult to manage.

With such distributional issues a key driver, and target, of populist politics around the world, one can only expect that things are likely to get even messier. Hopefully, though, this will be with an eye to more action, rather than less.

Book review: Winners take all

Book Review: Winners Take All: The Elite Charade of Changing the World, by Anand Giridharadas (Knopf Doubleday, 2018)

Anand Giridharadas, TED talking-head, columnist, and former McKinsey consultant has used his insider status as a “thought-leader” in the world of the Davos elite to lob a bomb among them. The subtitle gives the flavour: “The Elite Charade of Changing the World”.

As the elite fly into Davos to discuss climate change or meet on a luxury cruise ship in the Bahamas to mull global poverty, they are an easy target for Giridharadas. Recording their extravagances, rationalisations, inconsistencies, and self-satisfaction takes up much of the text. If you like poking fun at pretensions, you’ll enjoy this.

But Giridharadas is not interested only in the social interactions of the elite. Nor is he much interested in recording how they got their wealth. Instead, his interest is how they use it to try to make the world a better place.

Andrew Carnegie’s century-old “Gospel of Wealth” provides a starting point. The raw competition of untrammelled capitalism is the powerful dynamic that drives production. If one industrialist took a softer approach (say, by paying workers more), that producer would make less profit and would in time be displaced by a more ruthless competitor. Once earned, however, the profits should be given away: “I should consider it a disgrace to die a rich man”.

Recall Adam Smith:

It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest.

David Hume would remind us of the benefits of free trade: these are voluntary exchanges, which must make both parties better off. In short, “win-win” has always been a central theme of economics.

By the 1980s, Margaret Thatcher noted that “there is no such thing as society”. Ronald Reagan identified the nine most terrifying words: “I’m from the government and I’m here to help”. Free markets had won the economic debate.

Technology has added a further element, broadening competition geographically and greatly increased the advantage of scale – enhanced by the “winner-takes-all” of network effects. Conglomerates and de facto monopolies are acceptable.

With all this in mind, it’s hardly surprising that the elite of this free-market system – these hugely successful, mostly self-made entrepreneurs – are comfortable with the idea that their wealth is a just reward for their entrepreneurship. Like Carnegie, their philanthropy is not driven by a guilty conscience about the manner of accumulation. They don’t feel personally responsible for the maldistribution of income and other deficiencies in current America. Their desire to do good is not an atonement for earlier sins.

Some give charitable donations. Others build public infrastructure – museums and libraries – as memorials to themselves.

By transferring a little of their expertise, the benefactors will address society’s problems without cost to themselves and bask in the praise of like-minded benefactors. What a win-win!

Giridharadas’ special interest is benefactors who want to promote enterprise among the poor, rather than just give them handouts. This is the favourite focus of Silicon Valley’s tech billionaires and their counterparts in finance.

These entrepreneurs often see the business formula that worked for them as a universal panacea for poverty and society’s other ills.

All the poor need is technical advice and some capital. By transferring a little of their expertise, the benefactors will address society’s problems without cost to themselves and bask in the praise of like-minded benefactors. What a win-win!

What’s so bad about this? For Giridharadas, the problem is that these benefactors have narrowed the array of options and want to dictate the outcomes. They don’t want to do anything which would threaten their own favoured position. Like Lampadusa’s embattled nobleman in The Leopard, they want change only “so that everything can remain the same”.

Like Carnegie, modern entrepreneurs can’t contemplate softening their own management to provide, say, better wages and security for “gig workers”: this would undermine the dynamism of competition. Their monopoly positions are justified as technically inherent. They talk of poverty reduction, but not the reduction of inequality. Higher taxes (or even reduction of the many distortions which favour the elite) are not part of the agenda. All the proposals are win-win: none of the elites lose personally.

The elite focus on the narrow agenda at the micro-level (usually a new business enterprise or foundation), when what is needed is systemic change. Systemic change requires politics, not another meeting in Aspen. And it is rarely win-win.

Having broached the topic of politics, Giridharadas doesn’t say much about the way politics has been subverted by the wealthy. The elites are not politics-free, relying solely on the free market for their success. They use their considerable political power to advance their interests. Should we be surprised by this? Only to the extent that the political system allows them to have a much louder voice than others.

That raises the awkward question of how Americans, each armed with a vote, have failed to use this to bring about the required systemic changes: progressive taxes to reduce inequality, tight limits on political donations and lobbying, equal education opportunities, minimum-wages, and an effective social safety net, including for health. When Donald Trump is the outcome of the political process, the deficiencies identified by Giridharadas seem beyond political solutions.

Undoubtedly, America has many challenges. But has the market-based system really turned out so badly? Hasn’t post-war globalisation lifted a billion people out of poverty, even as it made lots of billionaires and created some losers? Are successful entrepreneurs solely responsible for the overall failings of the political system?

More specifically, would the world be a better place if Bill Gates and George Soros were spending their fortunes building civic memorials instead of fostering enterprise, social initiatives, and political reform? Have their efforts really diverted more deep-seated systemic reforms?

Even with all their own delusions and conceits, these business-oriented benefactors may still be net-positive for welfare.

Photo: World Economic Forum/ Flickr

A Tobin tax: an idea whose time has come for Indonesia

It is almost half-a-century since economist James Tobin proposed a small transaction tax to stabilise volatile global capital flows.

Tobin’s proposal followed the breakdown of the Bretton-Woods fixed exchange rate system in 1971. A tiny once-off transaction tax wouldn’t have much effect on medium and longer-term flows but would impinge more heavily on short-term flows. Tobin described it as “throwing sand in the wheels” of the speculative flows that had caused regular crises during the pre-Second World War gold-standard period.

Among the policy-wonks in Jakarta, the focus is on how to make the portfolio flows more ‘sticky’ so that funds stay put when global sentiment turns.

The idea fell on barren ground. It was overwhelmed by the ascendency of the “efficient markets” doctrine – financial markets were efficient in price discovery. Any transaction tax, no matter how tiny, would be distortionary and thus, by definition, a Bad Thing. For more self-interested reasons, professional currency traders opposed such a tax wholeheartedly. This doctrine was incorporated into the Washington Consensus, with the International Monetary Fund becoming the defender of free capital flows.

Many countries (such as Australia) adapted over time to the post-Bretton-Woods world. Crises were common enough – such as sterling in 1992 – but were not attributable to volatile capital flows as such. For emerging markets, however, flighty capital flows were a key vulnerability. Excessive inflows followed by sharp reversals were the central element in the 1997 Asian financial crisis.

Some academics retained doubts about “efficient markets” (including some who vigorously promoted deregulated financial markets while in policy roles), and the 2008 global financial crisis encouraged a re-think.

Over the past decade the IMF has belatedly come to accept that “capital flow management” (what formerly was dismissively termed “capital controls”) was a legitimate policy response for those emerging economies, which have from time-to-time been whip-sawed by volatile short-term capital flows.

Indonesia illustrates the issues. The response to the disaster of the 1997 crisis was to restrain growth and accumulate foreign exchange reserves. Even this was not enough to insulate Indonesia from the 2013 “Taper Tantrum”. 2018 saw another episode of capital flow reversal. A year ago, foreigners owned 42% of government bonds on issue. When the market mood shifted six months ago, what had been regarded as a sign of confidence in Indonesia morphed to become a vulnerability, with foreign bond-holding falling below 37%.

Around half of Indonesia’s capital inflow is in the form of portfolio investment – the restless money constantly scouring the globe for the highest yield, ready to react to the latest shift in risk-on/risk-off mood.

Indonesian policy-makers have learned how to handle these swings in foreign sentiment. They raise interest rates, tighten fiscal policy, and stand ready to intervene to defend the currency from extreme movements.

They did this last year and the drama was soon over. But this policy has a cost. Investment is discouraged, growth is trimmed, important budget expenditures are delayed, and financial markets are disrupted.

There ought to be a better way. If this short-term capital is so volatile, is it worth having? You can’t fund longer-term investment with money that is withdrawn on a market whim. Indonesia gains little benefit from these fickle funds, as it has to maintain substantial foreign exchange reserves to cope with the incipient outflow. The priority should be for stable flows rather than maximum inflow.

What might be done? First-best is an increased role for foreign direct investment – not only more stable but more beneficial. By international comparison, Indonesia’s FDI inflow is small: less than 2% of GDP. In dollar terms, FDI to Indonesia is not much larger than to Vietnam – a much smaller economy. In recent years Indonesia has encouraged FDI, shifting from 129th in the World Bank’s ranking on “ease of doing business” to 73rd. But a post-colonial nationalistic sentiment is never far below the surface when the going gets tough on the hustings, so vigorously promoting foreign ownership is not going to win April’s election.

Among the policy-wonks in Jakarta, the focus is on how to make the portfolio flows more “sticky” so that funds stay put when global sentiment turns. Hence the interest in some version of a Tobin tax.

Now that the Washington Consensus is (properly) seen as a general policy framework rather than a dogmatic doctrine, such ideas can be discussed without derision from Washington, although financial markets are still very ready to pour cold water on any idea which constrains their flexibility and profits.

The lead-up to a presidential election is no time for esoteric economic debates. Neither of the presidential candidates shows much interest in macroeconomics. As well, the precondition for such a tax is to find alternative inflows or reduce the current account deficit that has to be funded.

For the immediate future, Indonesia will have to accept the unpalatable deal which global financial markets offer: “we will lend you money in good times, but we’ll take it back whenever we have a fit of nerves”. But some variant on a Tobin tax seems an idea whose time is coming for Indonesia.


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