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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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The tide is turning against US financial regulation

This article was orginally published on 7 February and has been reposted following legislative change this week in the US. 

For most of the decade since the global financial crisis, financial regulation has been strengthened. Now the tide is turning in America. Reform has come up against the combined forces of Wall Street lobbying and Donald Trump’s deregulation agenda.

It is beyond dispute that the financial crisis revealed not only serious deficiencies in prudential regulations, but also systematic gaming of the regulations by European and US banks. Alan Greenspan’s view that the self-interest of financial sector management would discipline their actions proved hopelessly out of touch with reality.

The reform efforts have been coordinated at the international level by the Bank for International Settlements, rewriting the Basel rules that focus mainly on ensuring the banks have enough capital to absorb losses. Within this global framework, national regulators have flexibility to modify and add to these rules in order to suit local conditions. Randal Quarles, Trump’s appointee in charge of supervision on the Federal Reserve Board, has foreshadowed changes to the US regulatory framework – all favouring Wall Street.

The first proposed change will weaken what has proven to be one of the most effective post-2008 measures: the requirement that banks undergo a stress test to simulate the impact of an adverse shock, such as a big fall in GDP, on the balance sheets of individual banks. Stress tests in 2009 were, in fact, the key to restoring public confidence in the US banking system after the crisis.

Since then, however, the banks have complained that they don’t know what the simulation shocks will be in advance, so can’t prepare themselves properly. This might sound a bit like students asking to be told what their exam questions will be ahead of time. Banks can tweak their balance sheets so that they look good in the context of these specific shocks. Nevertheless, Vice Chairman Quarles seems ready to make the stress tests more “transparent”.

The loudest of the bank complaints relates to the “Volcker Rule”, even the watered-down version of which was finally agreed upon in 2013. Until 1999 the Glass-Steagall Act separated banking from other financial activities, such as insurance and investment banking. The logic is simple: in a crisis, the banking sector is protected not only by depositor insurance, but also by the understanding that if a substantial bank gets into trouble, it will inevitably be bailed out by the taxpayers to ensure there is no general loss of confidence in the financial system.

The implicit downside of this guarantee is that it may make bankers less diligent and more risk-prone (moral hazard), and it certainly means that taxpayers subsidise the full range of risky activities. Thus, even though an implicit guarantee is necessary, it should be confined to the part of the financial sector that is really vital – simple deposit-taking and lending, and the payments system. The taxpayer should not be guaranteeing banks’ own-account trading in financial and commodity markets or risk-prone activities, such as derivatives and securitisation.

Of course, this comprehensive coverage suits banks. For a start, the government guarantee means that they can borrow more cheaply. All sorts of arguments, of varying merit, have been put forward in opposition to the Volcker Rule. But the need for this kind of separation has been recognised universally, with the UK and Europe moving to ring-fence traditional banking services.

The most powerful argument in favour of such a separation relates to the diverse nature of finance. A good financial sector should:

  • provide funding even for risky ventures
  • provide risk-management (such as underwriting IPOs, derivatives and forward cover)
  • participate in the full range of financial markets
  • be innovative.

All this is desirable and necessary. But providing a government guarantee for banks carrying-out this full range of services not only puts the taxpayer at risk, but also alters the structure of the financial sector. Core banking should be a dull part of finance, run by conservative, risk-averse managers. Without an enforced separation, banks expand their activities into these more exciting activities and are then managed by hard-driving, risk-loving Masters of the Universe. Didn’t we learn this lesson in 2008?

This prospective weakening of the Volcker Rule will not cause an immediate collapse of the financial sector. Memories of 2008 are still fresh enough to constrain management and stiffen regulators’ spines. But the lessons of the 1930s bank failures lasted for more than half a century. The lessons of 2008 look like they have already been forgotten, or erased.


2018-02-07 16:30:00 +1100

All’s not fair in US–China trade stoush

As tense trade talks between the US and China continue, a growing chorus of US commentators seem to have concluded that, whatever their misgivings about President Donald Trump, he’s right in taking on China for its unfair trade and being an economic cheat (for instance, see here and here).

But what exactly is unfair in international economic relations anyway? As Australia’s Productivity Commission has said about anti-dumping duties, so-called fairness arguments for protection often “ignore the fairness of outcomes for anyone other than those who benefit”.

Getting this right is about more than semantics. It matters for designing the right policy responses to the economic, security, and geostrategic concerns that lie at the heart of the current tensions. Witness the confusion over how sanctions against ZTE are being handled today, as the US mixes up unclear objectives.

So, what of the various American complaints against China?

The easiest thing to judge is state-sponsored cybertheft of commercial trade secrets. This is clearly unfair – being illegal and blatantly coercive. The US is right to challenge this forcefully, and has been doing so for years.

America’s biggest grievance is about state-sponsored Chinese outward investment targeting high-end US technologies. America has said it wants China to drop its Made in China 2025 plan under which this investment occurs. China has indicated that this is the one thing that is non-negotiable.

What of the economics? At the most basic level, if China wants to subsidise such acquisitions (for example, with cheap loans from state-owned banks or other implicit subsidies), this is effectively just a welfare transfer from China to America. The US receives a premium over the market price for its assets (which can theoretically be used to finance additional investment and thus support US economic growth).

A counter to this basic logic is that high-tech industries are somehow different to the rest of the economy. But if the argument is about economics, then one must explain in what way these industries are so special that isn’t reflected in market valuations, and also exceeds the value of any Chinese subsidies (premiums) that might be paid on top. 

That isn’t obvious. Remember, things such as future growth potential, intellectual property, rents from uncompetitive market structures, and so on would all be part of any market valuation. The onus is thus on those who think ownership in these industries is special to make a concrete case.

Yet, if that case can even be established, then the US should presumably still take issue with any Chinese takeovers, regardless of whether there are subsidies involved or not. In fact, America should object especially if there are no subsidies involved, as it would mean its assets are being sold for even less than their real value.

A similar argument goes if security or geostrategic issues are the real concern – if it is so problematic for China to access or control certain technologies, then what does it matter if the acquisition was subsidised or not? Chinese subsidies are not the problem. They are either a gift or a distraction.

What about forced technology transfers? This is more complex. Complaints about specific policy measures relate to foreign investment restrictions (notably joint venture requirements) and technology-licensing rules that disadvantage foreigners. But the problem also extends to more nebulous informal state pressure on foreign firms to hand over technology in exchange for access to the lucrative Chinese market.

It’s worth recognising at the outset that there’s nothing wrong with China seeking to maximise the domestic economic benefits of foreign direct investment (FDI). The transfer of technology and know-how are fundamental to this, especially for developing economies. China’s surplus savings also means it has little need to attract foreign capital purely to finance investment. 

However, just because the policy goal is fair doesn’t mean the approaches used are fair also. Cybertheft is inherently unfair. Other Chinese measures, though, might be more justifiable. A timely recent study, for instance, shows that joint ventures have delivered much more sizeable productivity gains to the Chinese economy than wholly owned foreign investments.

But if China is breaking rules it agreed to at the World Trade Organisation, this ought to be challenged as part of upholding a rules-based system. That may be the case with some technology-licensing rules and informal state pressure to transfer technology. Equally though, the rules require the US to challenge this at the WTO, not unilaterally. Currently it is only doing so on the first issue.

Joint venture requirements and other FDI restrictions, however, don’t run afoul of any existing rules. Here the US complaint is about a lack of reciprocity – the US is currently open to Chinese investment but faces extensive restrictions in the other direction. A similar complaint is made about Chinese import tariffs, which remain higher on average than in the US.

Ironically, this is only unfair if you think like a mercantilist. After all, there is nothing altruistic about US openness. America is more open simply because it has traditionally seen this as being in its own national self-interest, following the basic insights of international economics. It is in America’s self-interest to have access to cheaper imports and lots of foreign capital, regardless of what others do.

Of course, also having greater access to foreign markets would be even better. That is something to negotiate, and tariff threats are perhaps one way to do it. However, any tariffs imposed will also be self-damaging. So it depends on whether the realistic gains are worth the cost.

In any case, imposing tariffs if you don’t get what you want would not be some kind of correction back to a fairer state of affairs. It would just be a more compromised kind of self-interest.

Will Argentina’s problems destabilise Asian economies?

Argentina has taken the politically drastic step of calling in the International Monetary Fund for help, and is clearly in deep trouble. What does this mean for other emerging economies, particularly those in our region?

IMF Managing Director Christine Lagarde meets Argentine Treasury Minister Nicolas Dujovne in Washington on 10 May.

At the centre of this enduring narrative is the fickle nature of international capital flows. In Asia, capital flooded in before the 1997 crisis and then surged out suddenly. Argentina is experiencing a variant of the same whipsaw.

Compare Argentina’s current plight with the lessons Asia took from the 1997 crisis. In Indonesia, a deep recession and spectacular exchange rate fall were needed to switch the current account from deficit to surplus, eliminating the need for foreign capital inflow for several years.

Since then, Indonesia has been careful to prevent the current account deficit from exceeding 3% of GDP: policy is routinely tightened to slow growth whenever this benchmark is approached.

The budget deficit is similarly held in tight check. Indonesia borrows overseas to fund its external deficit, but much of this borrowing is denominated in rupiah (foreigners hold around 40% of rupiah-denominated government bonds). 

Following the 1997 crisis, Asian countries have allowed their currencies to depreciate when necessary to retain external competitiveness. They have used periods of upward pressure on exchange rates to build up foreign exchange reserves and resist over-appreciation.

The deep post-crisis recession halted inflation in its tracks. Overall, the Asian crisis countries have been prepared to live more modestly since 1997, with growth around 5% rather than the 7% that was normal before the crisis.

Contrast this with Argentina. There was a searing crisis in 2001, but populist governments then frittered away the opportunity for reform. It is an economic aphorism that crises provide the opportunity for change. The inflation problem was addressed by fiddling the official statistics. Even since President Mauricio Macri’s market-friendly government took over late in 2015, the pace of reform has been sedate, constrained by politics. 

Macri began with a big depreciation and resolved foreign-debt disputes, which set the scene for a return to foreign borrowing. Foreigner lenders responded, perhaps too eagerly. The budget deficit was readily funded by borrowing overseas in dollars (rather than borrowing at home in local currency), including a headline-catching 100-year bond in 2017.

Source: IMF

While the nominal exchange rate was depreciating steadily (and more quickly recently), inflation has outpaced this decline, eroding international competitiveness. The IMF estimates that the peso is overvalued by 10–25%. Exports have fallen from 24% of GDP in 2005 to 9% now, and the current account deficit is 5% of GDP.

Source: IMF

Now the inflows that funded this external deficit have dried up. If a country can’t attract new foreign capital, has to repay existing foreign debt as it is due, and must cope with outflows from nervous residents, it needs ample foreign exchange. The central bank still has reserves, but not nearly enough.

Raising interest rates (which has been done, to 40%) is necessary but not sufficient. When the market thinks the exchange rate might fall further in the near future, no interest rate is high enough to offset this short-term expectation. Tweaking the budget still leaves the overall deficit at around 7% of GDP, with depreciation adding to government debt servicing. There is no painless way out.

Will this crisis trigger a wholesale retreat of foreign capital from all emerging economies?

Argentina’s problems will be high-profile, as it is the current chair of G20. Market participants can behave like lemmings, shifting overnight from glib over-optimism to deep pessimism, driven by algorithms rather than real-world analysis. And there are other economies (notably, Turkey) that are similarly vulnerable because sensible economics has been ignored.

But in our region, the lessons of 1997 have been fully absorbed and incorporated into economic conservatism.

“Normalising” America’s monetary policy might justify exchange rates fluttering a few per cent as emerging economies adjust. But it would be a serious indictment of financial-market efficiency and maturity if global investors can’t distinguish between the policy deficiencies which led to Argentina’s current predicament and the sensible macroeconomic policies which prevail in the emerging economies of Asia.

Banks misbehaving everywhere

The current Royal Commission into Australian finance is uncovering headline-grabbing malpractices which have scandalised the community. These deficiencies will prove costly to the sector’s wealth and reputation. Because Australian finance largely avoided the dramas and tribulations experienced in America and Europe during the 2008 crisis, these weaknesses may come as a surprise.

But they shouldn’t. Over the past decade, the financial sector overseas has accumulated somewhere between US$240 billion and $320 billion (yes, billion!) in fines for regulatory breaches. This huge sum is not retribution for causing the 2007–08 financial crisis: these are penalties for rigging markets, breaking sanctions, money laundering, mis-selling financial products, misreporting, misleading investors, trading scandals, and similar operational misconduct.

Bank of America heads the line-up, with $76 billion (representing more than half of its market capitalisation), followed by JPMorgan Chase with $44 billion (including fines originating in Bear Stearns, which JPMorgan took over during the crisis at the urging of the Federal Reserve). These penalties are not confined to US banks: Deutsche Bank paid $14 billion; Royal Bank of Scotland and Lloyds each paid around $25 billion; while Paribas and Credit Swiss each paid approximately $10 billion.

The enormity and ubiquity of the fines suggest that the sector is prone to misbehaviour. Why is this so?

Financial transactions are often complex, long-lasting, and surrounded by esoteric legal issues whose outcomes are delayed until sometime in the unforeseeable future. Financial markets are volatile, with asset prices and interest rates changing over the lifetime of a transaction.

The consequences of mistakes or malfeasance can be life-changing for depositors, borrowers, and pensioners. Many customers deal in financial markets so rarely that they are not well-versed in the dangers or precedents. Some know this, while others count on governments to protect them when things don’t work out.

Transactions often involve an agent or broker who purports to guide the uninitiated through the financial maze; but these agents have their own priorities which may not coincide with those of the customer. Competitive pressures are intense, encouraging administrative cutting of corners. Bonuses distort incentives and judgement.

In response to these characteristics, the sector is heavily regulated. The more red tape, the greater the likelihood of transgressions. Banks must be prudentially regulated to avoid bank runs and to ensure that the payments system is not misused for illegal activity, such as money laundering. Beyond these systemic issues, consumer protection provides the rationale for another thick layer of rules.

If everyone agreed on the appropriate degree of regulation, and this was incorporated in simple unambiguous rules, the challenge might be manageable. But there are inevitably conflicts of interest, misinterpretations, and arguments about bureaucratic compliance costs. The rule book contains ambiguities, leaving regulators unsure of how to react to apparent infringements.

The public, on the other hand, expects to be protected from the rapacious aspects of finance. When things turn out badly they look for someone else to blame.

Big fines have not done much to impose personal responsibility and accountability on individuals in top management and boards: instead, shareholders bear the cost. Bonuses have been paid and golden parachutes have protected departing management. Hardly anyone went to jail this time (in contrast to the aftermath of the 1980s US savings and loan crisis).

When things go wrong, there is the usual sorrowful public contrition, acceptance of responsibility (whatever that means), undertakings to reform, and unanimous affirmation that trust is at the heart of an effective financial system.

What more should be done? It would be unrealistic to assume that, with these fines, incompetence and bad behaviour have been eradicated and that gimlet-eyed management will hereafter prevent repetition. Rather, the lesson might be that this sort of behaviour is endemic in the financial system as currently structured.

Disaggregating and simplifying the structure of the sector would help, with a move back to a Glass-Steagall world where banks do simple deposit-taking and lending, and are managed by conservative (even boringly dull) bankers. Expecting the public at large to make good decisions about their long-term pension portfolios is unrealistic, and professional advice has too often shown itself to be self-interested. A publicly provided alternative along the lines of Australia’s Future Fund or Singapore’s centralised pension funds would provide a default option appropriate for most pension savers.

All the cutting-edge, exciting, and innovative activities would be separated in “buyer-beware” entities, quarantined from bank balance sheets. Market-making, investment banking, derivatives, commodity trading, high-frequency trading, risk management, and financial-product development would all take place in these overtly risky institutions, with the Masters of the Universe largely trading with each other. The casino-like aspects should be handled by those who understand that finance is a big gamble in which you may lose your shirt.

This would make the financial sector much smaller than it is at present, and the smart talent which is currently employed there might go elsewhere, doing something useful for society.

All this seems a long way from the Australian Royal Commission, which will likely leave the financial sector embarrassed and chastened, and a few institutions punished. While memories are fresh, management is likely to be more careful with compliance. But the structure seems unlikely to change.

Trump and “currency manipulation”

The central tenet of US President Donald Trump’s economic world view is that bilateral trade imbalances are bad for the deficit country. In this mindset, imbalances are believed to come about because the surplus country is cheating on its exchange rate to promote exports and restrict imports. Hence, Trump’s recent tweet:

One of the few things economists agree on is that bilateral trade balances aren’t a sensible macroeconomic target. If Trump bargains hard enough with China, he might be able to change the bilateral balance, but this will have little or no effect on America’s aggregate external balance – its current account.

A country’s current account equals the difference between its saving and its investment. There are many factors behind this simple national accounting identity, but America’s current account will change only when its savings/investment balance changes. The US needs to save more if it wants to reduce its external deficit. But Trump’s tax cut is taking government saving in the wrong direction, causing a larger current account deficit.

Misplaced as Trump’s bilateralist fetish may be, his concern about policy that results in undervalued exchange rates is shared by mainstream economists at the Peterson Institute in Washington, even if they disagree with almost every other aspect of Trump’s economic agenda.

Fred Bergsten and Joe Gagnon have been pounding away at the issue of “currency manipulation” for years. Until a decade ago, China was a perfect target, with a current account surplus close to 10% of GDP and spectacular growth driven by exports.

Now that China’s current account surplus is less than 3% of GDP, however, growth relies on investment rather than exports, and China’s intervention has been to shore-up the renminbi. So the targets have broadened to include Hong Kong, Israel, Macao, Norway, Singapore, Switzerland, Taiwan, and Thailand.

Bergsten and Gagnon are both smart economists, so their logic is more sophisticated than Trump’s. For a start, they focus on overall current account surpluses, ignoring bilateral balances. They recognise that not all current account surpluses are caused by foreign exchange intervention.

There are legitimate reasons why countries might want to run either deficits (such as Australia, so that we can invest more than we save) or surpluses (so that resource-based economies can accumulate foreign assets, preparing for later resource depletion). Others, such as Japan (with an average annual surplus of 3% of GDP) and Singapore (nearly 20%!) are excused because they are accumulating official foreign assets for future pension payments.

Germany, with its external surplus of nearly 10% of GDP, is excused because it membership of the eurozone means it has no control over its exchange rate. It’s also apparently acceptable to have a decade of accommodative monetary policy, where low – or even negative – interest rates keep the exchange rate depreciated. Switzerland, with negative interest rates, has a sustained current account surplus of 10% of GDP.

In short, in the Bergsten/Gagnon framework, you can run any imbalance you like provided you don’t actively intervene in foreign exchange markets.

In any case, the focus on exports and imports is too narrow. The external balance is driven by capital flows as well. Emerging economies are on the receiving end of volatile capital inflows, reflecting fickle sentiment in world financial markets rather than domestic factors.

Exchange rates in emerging economies are not well anchored and are subject to waves of optimism and pessimism. These economies have a legitimate interest in intervention to smooth their international competitiveness. When favourable terms of trade result in a current account surplus, it’s not exchange rate intervention which is causing the surplus: it’s the surplus causing the policy response of intervention.

Doctrine creates strange bedfellows. The free-market economists at Peterson find themselves advocating the same policies as a president who thinks running a complex, interconnected macroeconomy is the same as running a micro-level enterprise, deal by deal.

These misperceptions are apparent in two mistaken policies.

First, the US Treasury is obliged to report to Congress on foreign exchange policies, identifying trading partners with large current account surpluses, substantial foreign exchange intervention, and large bilateral surpluses with America. Currently no large trading partner offends on all three counts, so the unspecified penalties have not been triggered. But the threat remains.

Second, American trade agreements are now routinely accompanied by a side-letter requiring that the parties avoid intervention. The original Trans-Pacific Partnership negotiations included such a side-letter. The recent free trade agreement with South Korea includes one, even though South Korea went through a traumatic currency crisis in 2008 which not only included much-needed currency intervention by the Bank of Korea, but also was brought under control only through substantial intervention by the US Federal Reserve supporting the Korean Won.

The International Monetary Fund has, belatedly and reluctantly, come to accept that intervention may sometimes be the appropriate policy. These Congressional reports and side-letters reflect a mistaken mindset. 

Misunderstandings about “currency manipulation” are not the only danger here. Trump’s tweet sees the recent modest interest rate increases by the US Federal Reserve as part of his perceived exchange-rate problem. The Fed will have to maintain its full independence, ignoring such tweets as it normalises the stance of monetary policy.


Photo via Flickr user photosteve101

Less is more? Employment rates and economic growth

Labour market participation, the proportion of a country’s population that is either working or actively looking for a job, seems like a boring statistical constant. In advanced economies it has hardly changed in recent decades.

But the latest IMF World Economic Outlook devotes a chapter to labour market participation, and it is a key to understanding current US monetary policy.

It is sometimes said that economic growth depends on the “three Ps”: productivity, population, and participation. The overall participation rate may not have changed much, but the combination of ageing populations, social change, higher educational attainments, the business cycle, and rapid technological development has substantially altered the components that make up the aggregate figure.

Men have been dropping out of the labour force, offset in the aggregate figures by increased participation by women. Variation between individual countries’ rates (shown by the shaded areas) has narrowed over time, especially for women’s participation.

This might seem to be a universal social trend, but in fact there are big differences between countries, with participation holding up for both men and women in Germany, Sweden, and South Korea, while rates for both fell in the US and Canada. Japan and Australia followed the more typical trend, with men’s participation falling and women’s rising.

Further disaggregation shows a drop in participation of the younger population (15–24 year-olds), with many spending more time in study. Participation by older workers (especially the 55–64 cohort), particularly women, has risen strongly.

The divergences between countries and characteristic differences at the two ends of the age spectrum suggest that outcomes are amenable to policy action. Greater participation by women, for example, reflects family-friendly policies, as well as social trends and wider educational attainment.

Those who are marginally attached to the labour force (usually the young and the old) are more likely to respond to financial incentives such as tax/benefits interaction.

Getting more of the population into the labour market (and into employment) is not only good for GDP, but also contributes to how satisfied people are with their lives. The dismal story of America’s falling longevity among older white men has multiple causes, but the absence of satisfactory work opportunities is one important factor in these “deaths of despair”.

In addition to influencing longer-term economic growth, participation is a key factor in current monetary-policy deliberations. The US debate illustrates the issues, and the same considerations are relevant in Europe.

How does the Federal Reserve know when to tighten policy to keep inflation in check? The headline rate of unemployment has fallen to 4.1%, which many would consider to be below “full employment”. Why is the Fed still on a gradual path to normalising policy if the economy is already running at full capacity?

The 2008 recession and subsequent slow recovery not only put people out of work, but discouraged some to the point that they dropped out of the labour force altogether – no longer actively looking for work, so no longer counted as unemployed. The recovery has, however, lured some of these discouraged workers back into the labour force.

If this process has further to go, the Fed should maintain its accomodative policy stance. But how can the Fed tell how much of the 3-percentage-points fall in participation since 2007 reflects changing age composition, as the baby boomers reached retirement age? These (and other compositional factors) are not responsive to monetary-policy action.

The graph below decomposes the fall in US participation since 2007 into two parts: the blue area shows the fall in participation that can be explained solely in terms of age-composition changes, assuming that 2007 participation rates for each of the component groups remained unchanged. The residual, the pink area, might be attributed to cyclical effects.

It looks like most of the cyclical fall in participation has been recovered, which would suggest that the labour market is tight, with little prospect of encouraging more non-participants into work. But steady GDP growth and appropriate policy measures could bring in more young workers (some have been studying because they can’t find a suitable job), encourage more older workers to stay in employment, and reverse the atypical fall in women’s participation in the US.

Women’s participation rose strongly after the Second World War. These additional workers added 14% to GDP in the three decades after 1970. But women’s participation peaked in 2000 and is now lower than in 1970: for 25–54 year-olds, it has fallen from 77.3% to 75.2%. Japan, usually associated with low female participation, has now overtaken the US.


Photo via Flickr user @mjb

Biding time: the G20 Eminent Persons Group on financial governance

Watchers of international financial markets have focused in recent months on the possible ramifications of an escalating trade war. The World Trade Organisation recently warned that rising trade tensions are impacting business confidence and investment decisions.

Against the background of rising protectionism, described by the International Monetary Fund (IMF) Managing Director as a “dark cloud” looming over the global economy, there is a touch of irony to G20 finance ministers meeting in Washington on Thursday to consider a status report from a G20 Eminent Persons Group (EPG) that largely revolves around proposals to promote greater international economic cooperation.

Is this a positive sign that may help counter the tit-for-tat tariff war unfolding currently, or another instance of the G20 increasingly becoming a talk shop divorced from reality?

The status report was authored by the EPG on Global Financial Governance that was established in April 2017. The EPG was tasked with reviewing challenges and opportunities confronting the global financial system, the optimal roles of the International Financial Institutions (IFIs), and to recommend practical reforms. Its final report is due in October 2018.

The EPG is chaired by Singapore’s Deputy Prime Minister, Tharman Shanmugaratnam, and its membership consists of distinguished academics. The group has not sought nor received much publicity.

Nancy Birdsall from the Center for Global Development (CDG) described it as a “relatively obscure and quiet group”. The meagre public attention may mean the group can have meaningful discussions with ministers on a wide range of issues without those ministers feeling pressure to immediately oppose anything controversial.

This status report will update relevant ministers on the group’s key findings and the direction of its thinking. The issues identified include an ever-growing multiplicity of international players; the increasing role of private capital flows and the challenge of harnessing these to promote growth; and threats to the “global commons” – climate change, pandemics, money-laundering, terrorism financing, tax evasion, and cyber-related risks.

The breadth of these challenges brings into play many international organisations, particularly the United Nations, but in keeping with its terms of reference, the EPG has focused on the Multilateral Development Banks (MDBs) and the IMF.

The EPG has identified six areas for reform to strengthen the development impact of the MDBs: the development of a set of core principles to coordinate all MDB operations; country-owned platforms as the basis of the MDB country operations; MDB collaboration to support system-wide risk insurance; collaboration on securitisation to mobilise institutional investors; governance structures and internal incentive arrangements that reorient MDBs towards achieving a greater development impact; and transparency of responsibilities and complementarities between institutions.

Regarding the challenges of securing the benefits of open financial markets, the EPG emphasises the importance of developing a framework, managed by the IMF, for assessing and mitigating excess volatility of capital flows and exchange rates, which would guide national policies.

The group also asserts the need to achieve a resilient, predictable, and adequate Global Financial Safety Net, as well as more integrated financial surveillance and institutionalised early warning systems involving the IMF, Financial Stability Board, and Bank of International Settlements.

The direction of the reforms identified by the EPG are neither radical nor particularly novel. The IFIs are unlikely to disagree with the EPG’s thinking to date. Many will likely argue that they have been advancing various initiatives along these lines, although with mixed success. They would probably also say that the attitude of some shareholders has been the major hurdle in making greater progress.

At the core of the EPG’s approach is the need for greater collaboration between the IFIs based on a system-wide approach to governance. The aim is to ensure that they operate as coherent and complementary parts of a system, rather than as independent institutions. But this in turn requires shareholders to adopt a system-wide approach to their participation in each and all of the IFIs.

Birdsall described the EPG’s status report as “disappointing but still hopeful”. She supported the group’s broad approach, but was disappointed that it had not endorsed some proposals contained in the 2016 CDG report on the MDBs, such as the recasting of the World Bank with a specific mandate to advance global public goods, and the MDBs being given a mandate (and funding) to provide grant financing in support of investments with positive spillovers.

The problem with the CDG’s proposals was that they exceeded the MDBs’ shareholders’ appetite for reform. This is the challenge facing the EPG. As noted, many of the issues raised in the group’s status report have been discussed in various forums for many years.

The question the EPG should be focusing on is: what has impeded implementation of the reforms?

IFI governance is a problem, but reforms will not be achieved unless they are driven by major shareholders who would need to forgo their desire to control individual institutions and be more responsive to the advice offered by the IFIs.

There is currently little to suggest that shareholders have an appetite to advance significant IFI reforms, particularly if it involves having to convince their electorates of the merits of increased financial support for an IFI.

There is certainly no such appetite in the US. The US Treasury Secretary Steven Mnuchin recently defended proposals that would sharply cut or eliminate American support for the MDBs, and new National Security Advisor John Bolton previously advocated for the IMF to be shut down and the MDBs privatised.

Thankfully, the work of the EPG has flown under the radar, avoiding the build-up of unrealistic expectations that significant reform of global financial governance is near at hand. The EPG must play a long game. Rather than focusing on specific reform measures, its immediate task should be to convince a group of key shareholders to be the champions for reform.

This is easier said than done.

Global monetary policy returning to “normality”

Former US Federal Reserve chair Janet Yellen promised that unwinding quantitative easing would be “the policy equivalent of watching paint dry”. Not everyone agrees.

Jamie Dimon, head of JP Morgan, the most successful of the big American banks in the past decade, has voiced his concerns about the process of normalising US monetary policy:

Many people underestimate the possibility of higher inflation and wages, which means they might be underestimating the chance that the Federal Reserve may have to raise rates faster than we all think. While in the past, interest rates have been lower and for longer than people expected, they may go higher and faster than people expect.

Part of the widely expressed hand-wringing comes from a misunderstanding about the effects of quantitative easing. When US quantitative easing began in 2008, many were worried it involved “money creation” and inevitable inflation, based on half-understood recollections of the credit multiplier model and Milton Friedman’s dictum that “inflation is always and everywhere a monetary phenomenon”.

These inflation fears were comprehensively refuted by the actual experience, with inflation below target everywhere. The extra liquidity quantitative easing provided to bank balance sheets did little to encourage them to lend more: some potential borrowers were still weighed down by legacy problems from the recession.

As well, the slow recovery discouraged others from borrowing to expand production capacity. Rather than expand output and push up wages and prices, credit flowed into asset markets, driving up equity and property prices.

Most of the quantitative easing expansion of base money simply sat unused in the balance sheets of banks, as excess reserves.

In its expansionary phase (2008–12), quantitative easing worked through two channels. First, via portfolio adjustments, with the Fed’s bond purchases causing investors to rejig their balance sheets, changing asset prices and interest rates in the process.

Second, quantitative easing provided some signalling messages about future Fed policy. Now that normalisation is underway, what is the likely impact?

The Fed has already begun unwinding its quantitative easing bond holdings, not by selling them in the market, but by allowing its bonds to mature over time – the least disruptive way of running down its bond holdings. Longer-term interest rates have started to move up, but are still lower than during the 2008 recession. The common view is that rates will not return to pre-crisis levels because the long-term equilibrium interest rate (the “neutral” or “natural” rate) has fallen, perhaps because of demographic shifts, low productivity performance, excessive saving, or a shortage of riskless government bonds in a risk-sensitive world.


The second quantitative easing channel, policy-signalling, was probably more powerful during the confused period of the early recovery. Expansionary quantitative easing demonstrated to financial markets that the Federal Reserve was concerned about the slow recovery and would keep its short-term policy rate low for an extended period of time.

When markets received the correct message that short-term interest rates would stay “low for long”, this acted to keep longer-term interest rates low as well. The current signalling is pretty clear: the Fed funds rate is on the way up, with the only argument being whether there will be three increases this year or four – a relatively trivial issue of timing which will be settled as the Fed assesses the evolving economy. Thus, it’s hard to see any great surprises via the signalling channel.

The US recovery is more advanced than elsewhere, with the unemployment rate already quite low. Are the rest of us ready for any spillover tightening from the US?

If we are searching for things to worry about, then two possibilities come to mind. First, asset prices (particularly US equity prices) might have overshot the equilibrium, with the possibility of a sharp correction. If so, financial markets elsewhere will do the usual knee-jerk imitation.

Second, the low interest rates over the past decade might have tempted some borrowers to overextend their balance sheets. The main concern here is for borrowers in emerging economies who have borrowed in US dollars to fund activities in their domestic economies, leaving them at risk not only of higher interest rates, but also from adverse exchange rate movements.

As US interest rates rise, ours may too. It is not easy to explain exactly why there is a strong connection between US long-term interest rates and rates in other countries and currencies, but sentiment seems globally contagious and the long-term rate is influenced by the volatile term-premium – the difference between the short and long interest rates.

Longer-term rates everywhere appear to play follow the leader with the US. That said, countries seem to be able to set their own short-term policy interest rates, and there is no strong reason why floating-rate mortgage rates in Australia should respond to US interest rates.

Janet Yellen in no longer at the Federal Reserve to supervise the boring normalisation process she promised. But the new Federal Reserve Chairman, Jerome Powell, is a safe pair of hands, with six years of experience on the Fed board. He promises a continuation of the same gradual normalisation process which has already been underway, uneventfully, for three years.

American trade policy returns to “aggressive unilateralism”

America’s new haphazard and confrontational approach to trade policy under President Donald Trump is rapidly taking shape.

Risks of escalating protectionism and a damaging trade conflict between the US and China are rising. The two have already exchanged tit-for-tat moves with regard to Trump’s steel and aluminium tariffs. Now, following US allegations of Chinese technology theft, the focus has shifted to potential tariffs on US$50 billion of each other’s exports, with Trump threatening to raise this to US$150 billion if China retaliates. Tense negotiations are also ongoing with Canada, Mexico, the EU, and others.

Critics widely condemn Trump’s approach as inherently damaging, based on flawed economics, leading only to protectionism and a potential trade war, and otherwise undermining the rules-based system built around the World Trade Organisation (WTO). The 1930s descent into global protectionism provides the cautionary frame of reference.

Yet Trump’s unorthodox and unpredictable style make it difficult to take anything at face value. The hope remains that this is all just negotiation bluster and that a deal will be struck that limits the damage. Indeed, Trump walked back his steel and aluminium tariffs partially by granting (temporary) exemptions to most allies, though not all. And top administration officials have been publicly making this argument in an effort to calm financial markets. Trump’s threats of further escalation, however, have not helped.

But did such a strategy ever make sense? Rather than the 1930s, proponents often point to the 1980s and early 1990s as the relevant historical precedent, when the US engaged in what economist Jagdish Bhagwati dubbed “aggressive unilateralism”.

That period saw the US deploy similar tactics to those on display today to pursue its grievances with a rising Japan, and others, as well as to force through changes to the multilateral trading system. In particular, threats of unilateral sanctions were frequently deployed as a negotiating tactic to prise open foreign markets. The primary tool was the same Section 301 provisions in US trade law used to justify the current set of tariffs being considered against China.

So-called “voluntary export restraints” were also frequently negotiated, most famously to limit Japanese car exports to the US. That move is also being replicated today, with the US considering quotas as the price to pay for permanent country exemptions from Trump’s recent steel and aluminium tariffs. American requests that China reduce its bilateral trade surplus by US$100 billion (about a quarter) suggests similar tactics may also be employed in its negotiations with China.

Useful questions to ask about this past experience are whether or not it lends support to Trump’s current approach, and what insights it can provide for today.

According to one systematic study, Section 301 investigations, America’s primary unilateral tool, were somewhat effective in prising open foreign markets. Almost half of 72 cases were judged at least partially successful against their stated objectives, although the gains were modest overall. At the same time, there was no descent into escalating protectionism or full-blown trade wars, with only a few instances of countries actually retaliating against unilateral US actions.

Also in contrast to criticism at the time, American unilateralism did not ultimately undermine the multilateral system. Instead, it arguably played a key role in strengthening it. Previously stalled negotiations under the General Agreement on Tariffs and Trade (the WTO’s predecessor) were reinvigorated. This eventually led to the creation of the WTO in 1994, which helped address US concerns at the time and, from the perspective of others, provided the basis to contain future American unilateralism. New rules governing a broader range of areas were agreed on, and the dispute settlement mechanism was given more teeth.

So far, so good. Yet several other factors suggest things are much more concerning this time around.

First, retaliation and tit-for-tat protectionism looks very likely and is already happening. That will magnify the damage of any unilateral actions and create risks of further escalation, of which there are already worrying signs. Global supply chains are also now distributed across many countries, so tariffs aimed at China will invariably hit others along the way, including the US. That will not only reduce their effectiveness as a threat but also set other trading partners offside.

Second, while both periods involved a misguided belief that trade deficits reflect unfair trading practices (rather than macroeconomic factors), the policy response has been very different. In the 1980s, the Plaza Accord was used to correct the real source of the US trade deficit at that time – an overvalued US dollar – and thus head-off protectionist pressures primarily emanating from Congress. US protectionism was thus partly only an outlet for blowing-off political steam.

Today, by contrast, it is the president who is leading the charge on trade deficits and protectionism. Yet he is also delivering a large fiscal stimulus that will further widen the trade deficit significantly, potentially fuelling additional protectionist pressures.

Third, the US seems more interested this time around in paring back the multilateral trading system rather than strengthening it. In particular, it sees the WTO dispute settlement body as engaging in judicial activism and has been blocking the appointment of new appellate judges.

The US essentially wants the WTO to limit itself to areas where the existing rules are clear-cut. But with negotiations to update those rules stalled, the WTO’s ability to mediate disputes and keep a lid on protectionism is at risk. America’s steel and aluminium tariffs are a case in point, utilising what it sees as a loophole in WTO rules to self-declare an issue of national security, no matter how spurious the argument.

Concerns about China are of course central to US complaints about both trade deficits and the WTO, particularly over its ability to deal with China’s unique party-state capitalist model. There are strong parallels with Japan in the 1980s, reflecting similar US concerns about a large bilateral trade deficit and Japan’s state-guided keiretsu (conglomerate) economy, as well as fears that America might be eclipsed both economically and technologically by a rising power.

Of course, the situation with China is likely to be far more difficult. Most obviously, China is not an American ally, which will make a meaningful compromise more difficult to reach. More importantly, Japan’s financial crisis in the early 1990s and ensuing economic stagnation meant the challenge it posed to American economic primacy never really played out. Although China’s economy faces some short-term risks, it is unlikely to fade into the background so easily.


Photo: via Flickr user A.Davey

Profit shifting: digital fat cats in national tax gaps

Company tax is in the news again. While the Australian Government attempts to garner Senate approval for its corporate tax-cut proposals, the EU is moving in the opposite direction, searching for ways to raise corporate taxes. What’s driving these two diametrically opposite policies?

Since 2000, multilateral company tax has fallen from 34% of profits to 24%. This reflects a variety of factors. Some countries have reduced their corporate tax rate to attract enterprises, and others have responded competitively. The extreme examples are the zero-tax havens, but Singapore, Switzerland, the Netherlands, Ireland, and many others offer very low tax rates. Ireland has been so successful that these footloose profits now make up 23% of its GDP, mostly from companies with no substantial presence in the country.

Companies have become much more adept at shifting profits to these low-tax* jurisdictions. While globalisation, the greater importance of intellectual property, and the burgeoning digital economy have all facilitated such shifting for digital companies, more conventional companies may be able to achieve similar outcomes through inter-company borrowing, tax deferral, and transfer pricing.

The OECD has long recognised these issues. The Base Erosion and Profit Shifting (BEPS) initiative has laboured to find a solution which can be applied globally, or at least uniformly in the OECD, with a further report to be published in April. Unsurprisingly, achieving consensus among OECD members, with so many varied and vested interests not only between countries but also within them, is proving very challenging.

Without globally uniform solutions, various countries, including Australia, are taking their own measures. This option is clearly second-best, but understandable. Perhaps hoping to head off the complexity that would come from these disparate and inconsistent national solutions, EU bureaucrats in Brussels have been working on their own Common Consolidated Corporate Tax Base (CCCTB) for some years, with prospective application in the EU only.

But the CCCTB is on a slow track, held back by the same factors that constrain the BEPS initiative. Thus, the EU Commission has developed a proposal to tackle just one aspect of this problem: the difficulty of taxing the burgeoning digital economy.

Companies such as Facebook, Apple, Netscape, Uber, eBay, Airbnb, and Amazon accrue large revenues from advertising, sale of data, platform revenues, and subscriptions which are readily channelled to low-tax jurisdictions. Tech-based companies are the fast-growing sector. In Europe they pay less than 10% company tax, compared with 23% for conventional companies. Value-creation through interaction with customers takes place in one country, while profits accrue in another.

The EU proposal is to impose a 3% tax on total revenue (rather than profits), distributing this to the countries where the product earns revenue. This is seen as a temporary measure pending the arrival of the CCCTB.

Recognising the likely long wait for CCCTB, the alternative view is that the EU proposal might prevent similar proposals being developed among individual EU countries (France and Germany in particular), in the hope of at least getting some intra-EU consistency in taxing the digital economy. Even this lesser objective seems beyond reach as it needs agreement from the 28 EU members, including some (for example, Ireland and Luxembourg) that do very nicely out of the existing defective system.

Australia’s proposed tax reductions have a different motivation: the fear that the global tax reductions noted above will adversely affect capital inflow. These fears seem grossly exaggerated, but the business lobby is campaigning strongly.

The proposed modest cut to 25% doesn’t mean that we are leading the charge in the “race to the bottom” to attract footloose global capital. If tax was the dominant investment determinant, companies would still have an incentive to go to lower-tax jurisdictions (for an anecdote on Singapore’s use of low tax to attract enterprise, see here).

Nevertheless, BEPS and the EU objectives seem a far more worthwhile goal: to put in place a tax system which requires companies to make a fair contribution to running the countries in which they create their value and earn their profits.


* An earlier version of this article referred to “low income”.


Photo by Flickr user Mr Thinktank.


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