Monday 21 Sep 2020 | 06:23 | SYDNEY
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About the project

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

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


Latest publications

China’s economic gloom merchants

Markedly slower growth and imminent financial crisis have been the common dual predictions for China over the past decade. China’s growth has indeed slowed from its unsustainable breakneck pace in the two decades before the 2007–08 global crisis, but since then has settled down to a steady 6–7% per year, two or three times as fast as advanced economies.

Keeping growth going through and since the downturn has, however, required a big increase in domestic credit, raising the risk of a financial crisis. Can China continue to confound the pundits?

This depends on the intertwined but distinct issues of growth and financial stability.

Let’s start with growth. Michael Pettis, a professor at Peking University, has been perhaps the most vocal and persistent pessimist. In 2012, when China’s growth had already slowed to around its current pace, he bet with The Economist magazine that China’s annual GDP growth this decade would “barely break 3%”. The decade is not quite over yet, but it’s looking like a clear win for The Economist.

If you are at risk of losing a bet, try changing the terms. Pettis has an impressively ingenious take on GDP. Unlike many others, he doesn’t dispute China’s GDP data as such. Instead, he notes that this only records “national output”. He says that much of this output growth has been wasted on unproductive investment, which should be written off. Pettis says that in market economies this happens, reducing GDP growth through lower profits.

This, however, exaggerates the difference between Chinese and Western GDP. China is hardly alone in unproductive investment and tardy recognition of poor investment. And if we mark to market for poor assets, consistency requires that we revalue assets whose price has risen: housing booms would produce spectacular growth in GDP. 

In practice, the imperfect answer is that good projects boost GDP over time through higher output and stronger profits, while bad projects erode GDP. Pettis’s argument is only one more reason why GDP is an imperfect measure of living standards. That acknowledged, it’s hard to offer a much better measure. It’s harder still to see how his estimate of current (corrected) growth of 1–2% could reflect China’s reality.

Pessimism about China’s financial sector probably peaked more than two years ago, with Tyler Cowens confident prediction of an imminent and massive financial collapse, resulting in a long recession. Although he’s a smart and innovative economist, this was a miscall.

Since then, bank lending to the non-finance commercial sector has levelled out, but the more comprehensive “total social financing”, including non-bank intermediation and government debt, is now approaching 250% of GDP and still rising. This is not unusually high by general international comparison, but is high for a developing economy and has grown much too fast.


Thus the IMF remains pessimistic: “International experience suggests that China’s credit growth is on a dangerous trajectory, with increasing risks of a disruptive adjustment and/or a marked growth slowdown”.

But China’s credit situation is different from other countries. It has little external debt, big foreign exchange reserves, and capital controls, so won’t have a crisis like the 1997 Asian crisis. The main overextended borrowers are state-owned enterprises (SOEs) which have mainly borrowed from state-owned banks, so the situation’s “in-house”, and hence easier to restructure. Government debt is modest, allowing fiscal space to soften a crisis. Unlike the 1997 Asian and 2008 global crises, Chinese authorities know in advance that there is a problem and are taking action. China could (and probably will) have a period of painful adjustment as policy stabilises the high debt levels, but a major meltdown seems unlikely.

What does all this mean for policy? The thrust of the Pettis’s argument is that China is saving too much. His answer is to encourage consumption. This makes sense and shouldn’t be too hard: most governments have to wrestle with the opposite and more intractable problem of keeping the public happy while restraining consumption.

Pettis is surely too pessimistic about investment opportunities, recalling China’s low per capita capital stock. One of the characteristics of heavy infrastructure is that it is sensible to build excess capacity initially: think of the Sydney Harbour Bridge, which reached capacity thirty years after construction. New Yorkers wish the Second Avenue Subway had been built ahead of demand when it was first proposed in 1919.

China has an opportunity to restrain credit without harming growth by limiting SOE borrowing, which was responsible for 60% of the rise in corporate debt from 2008 to 2016. The SOEs produce only 15–20% of industrial output. The special focus should be on the “zombie” SOEs, which account for nearly 15% of corporate debt. The often-mentioned rise in the ratio of credit-to-growth should be read as a positive rather than a negative: cutting back credit growth shouldn’t damage growth much.

Of course, restructuring SOEs and reining in local governments present vexed political challenges. The IMF’s suggestion that China should accept lower growth rates in order to limit debt growth seems to be mistaken logic. If a key reform is to restructure SOEs, slower growth will make this more painful, and therefore less likely. Fiscal expansion could soften the restructure. China should be able to maintain the 6–7% growth of recent years as it deepens capital and moves towards the technological frontier.

At some stage, probably a decade or more away, China will run into the same growth-constraining factors that slowed Japan and South Korea. But not yet.

Don’t renegotiate the Trans-Pacific Partnership

Australia was quick to welcome US President Donald Trump's casual comment that the US might be prepared to join the Trans-Pacific Partnership if a "substantially better" deal could be struck.

Yet while making it clear that we would welcome US participation on the terms already negotiated, Australia needs to clarify that these terms are not open to renegotiation to shift the balance of benefits further in America's favour.

Some elements of the TPP fit the standard free trade agenda, and should be in each member's self-interest. There are also many "behind-the-border" issues that favour one party over another – intellectual property (IP) is the clearest example. While America is a big net exporter of IP, Australia is a net importer. Rules that grant more comprehensive IP protection therefore benefit the US and harm Australian consumers and researchers. Investor-state dispute settlement (ISDS) is another example.

Negotiations that enhance trade openness would be fine, but it is clear this is not what Trump (or his supporters) have in mind when he talks about "this horrible deal". If Australia accepts the idea of renegotiation, we would find ourselves in the same position we were in with the AustraliaUS Free Trade Agreement and the TPP before Trump pulled out. Political imperatives would make signing up to the renegotiated terms inevitable: not signing up with our closest and largest ally because of some obscure IP or ISDS issue is impossible to contemplate.

Australia needs to make its position clear at the earliest opportunity. New members are welcome in the TPP, but the hard horse-trading has already been done and we're not ready to give away any more. If you want to join a club, you can't insist on self-interested alterations to the membership rules beforehand.

Japan's parliamentary spokesperson Yasutoshi Nishimura has made this explicit on Japan's behalf. Ideally the 11 members of the deal should be lobbied to support this position collectively. But if some countries are reluctant, Australia should reinforce the point, together with any like-minded prospective members.

What a US–China trade war would look like

Sometime soon, US President Donald Trump will announce his plan to respond to what the administration calls China’s “economic aggression”. When he does, it is not only China that needs to be prepared to respond. Together accounting for well over a third of global output, the collateral damage of a serious trade fight between the two countries would be enormous, let alone the damage casued to the two nations directly.

The risk of a serious clash is quite high. At Davos on Friday, Trump will quite likely reiterate his determination to right the wrongs of world trade, even as he affirms an American commitment to global economic leadership.

Trade decisions this week set the tone. On Monday, Trump imposed higher tariffs on solar panel imports and washing machines. Encouraged by the rhetoric of the new administration, last year already saw a 50% increase in anti-dumping cases brought by business before the US International Trade Commission, many aimed at China. The Department of Commerce has also finished its investigation of steel and aluminium imports into the US, and is said to have recommended tariff increases and quotas.

These actions are the usual business of the US trade machinery, little changed from administration to administration. They are not much concern to China which accounts for only a little more than a tenth of solar panel imports to the US, and the washing machine tariffs are aimed at South Korea. As a result of earlier temporary action, higher duties on solar panels and washing machines were already in place. US restraints on steel imports will not bother China much either because it does not rank in the top ten steel exporters to the US – a list led by Canada, Mexico, Brazil, and South Korea.

The problem for the global economy is not what the Trump administration has done so far. It is what it may contemplate doing next. Trump’s campaign rhetoric promised a serious attempt to balance trade with China and, perhaps, a wider aim to check China’s rise to global economic pre-eminence. Neither goal is achievable, and the attempt would come at fearful cost the US, China, and the rest of us.

The most detailed and premonitory exposition of the Trump administration’s complaint about China is this month's 2017 Report to Congress on China’s WTO Compliance, by US Trade Representative (USTR) Robert Lighthizer.

Lighthizer complains, as his predecessor did, about the pressures China exerts to extract commercial technologies as the price for foreign businesses operating in China’s market. He also criticises several other measures, including protections for intellectual property, various constraints on foreign direct investment, certain remaining tariff and quota restrictions (especially in agriculture), and more.

But there is also a wider and stronger emphasis in Lighthizer’s report on the economic role of China’s government. The report asserts that at the time China entered to the World Trade Organisation in 2001, it agreed to cut back the influence of government on the structure and direction of industry. The report argues that, on the contrary, Chinese authorities have in many ways increased their influence, citing the Made in China 2025 plan in particular.

The US now explicitly objects not only to particular trade measures but also the entire approach of the Chinese Communist Party and the continuing importance of state-owned enterprises. This supports the Trump administration's objection to declaring China a "market economy" under WTO rules, a status that assumes China's export prices are market-determined. But the terminology also implies that the US thinks something akin to a regime change in China is the only way it can meet its WTO commitments.

At the same time, the administration has changed its emphasis on penalties and compliance. Where preceding reports of the Obama administration undertook to pursue national sanctions, such as countervailing duties as well as WTO cases, the Trump report switches the emphasis to national penalties.

The report suggests that the trading relationship between China and the US is woefully bad, and much worse than it was. The reality is distinctly different. In the decade from 2006 to 2016, the last year for which we have full-year data, US goods exports to China increased at nearly twice the rate of China exports to the US: 116% compared to 61%, using US Census Bureau numbers.

While the trade deficit with China rose dramatically in the early years of the last decade, it now pretty much keeps pace with the US economy. It was 1.7% of US GDP in 2006, and 1.8% a decade later, again using Census Bureau numbers.

Presumably the main point of trade negotiations with China is to increase US exports to that country. While cutting Chinese exports to the US contributes to closing the trade deficit, it can only do so by raising costs for US business and reducing real incomes for American households.

But the USTR report has bafflingly little to say about increasing US exports to China. There are objections to remaining restrictions on farm imports and complaints about provincial government procurement preference for local products, but there is no plausible story suggesting that changes in China might dramatically increase the rate of growth of imports from the US. (Nor is there a plausible story suggesting that any large part of China’s exports to the US are sold at less than the cost of production.)

Part of the problem is that the USTR report and Trump’s rhetoric are rooted in times long past. China’s current account surplus was just short of 10% of GDP in 2007. By 2016 it was down to 1.7%. The current US account deficit peaked at 5% of GDP in 2004. In 2016 it was half that share, and there have been comparable shrinkages of the trade balances of both economies.

Taken literally, Lighthizer’s report threatens what amounts to a sustained campaign of trade sanctions against China, one designed to force a change in China’s economic model. If attempted, it would certainly fail because China will not be dictated to on such fundamental principles of political and economic organisation. It would fail, and at great cost.

How likely is the Trump administration to make the attempt at all? The question comes at a time when US and global economic growth are both picking up after two years of a modest expansion in global trade. Like its predecessors, the Trump administration will go as far as it can in extracting trade concessions from China, but not so far as to risk the economic expansion upon which its political fortunes depend.

None of this is to deny the difficulties that could potentially arise if the Trump Administration goes hard on China with a blizzard of dumping actions, countervailing duties, and WTO complaints. But it does remind us that both China and the US have very different economies now compared to 2001 when the US, after prolonged negotiation, supported the entry of China into the WTO.

The Trump administration now says that US support was a “mistake”. In 2001 China’s output was little more than a tenth of US output, both measured in US dollars. It is now nearly two-thirds of US output in US dollars. On IMF purchasing power measures, China’s GDP is already bigger than America’s. The US is still a bigger importer than China, but they are now about equivalent as exporters. Together they account for nearly a quarter of global exports, and roughly the equivalent share of world imports. Mistake or not, there is no going back.

Behind the Australia–Canada ‘wine war’

Australia has formally lodged a complaint against restrictions some Canadian provinces have placed on the sale of imported wine in grocery stores, in what has been described, somewhat dramatically, as a 'wine war'.

Australia's action was described in the Ottawa Sun under the headline 'Sour grapes?'. Although this may have been no more than an editor's catchy phrase, the suggestion is that Australia acted in retaliation after Canada's last-minute decision not to sign a revamped Trans-Pacific Partnership (TPP) agreement at the APEC Summit last November.

Australia's Trade Minister Steven Ciobo says the two events are unrelated. But when relations between countries sour, isn't everything somehow related?

Action by Australia in the WTO against Canada's restrictive measures on imported wine is not going to convince Canada to change its views on the TPP. Notwithstanding Australia and Japan's recent commitment to signing a new TPP agreement by March 2018, Canada remains the great unknown; its demands for cultural and automotive exceptions from any deal continue to be a stumbling block.

Australia may only be standing up in support of its wine exporters. But our trade minister and trade officials are human, and given Australia's severe disappointment and annoyance over Canadian Prime Minister Justin Trudeau's last-minute snub of other TPP leaders when he failed to show up to what was expected to be a signing ceremony, Ciobo probably had no hesitation, and some satisfaction, in lodging a WTO complaint against Canada.

In fact, if Canada had not played hardball over the TPP, it is questionable whether Australia would have taken Canada to the WTO over wine restrictions by the provinces. The measures are not new and the US had already lodged two complaints in the WTO against restrictions British Columbia had on imported wine sales. Furthermore, Australia had joined this complaint as a third party (that is Australia, while it was not a complainant, registered that it had a significant interest in the outcome of the dispute). Australia has not been a prolific user of the WTO's dispute resolution processes. It has initiated a complaint on only 8 occasions; in comparison, Canada has initiated 38 cases, the EU 97, South Korea 17, Japan 23, and the US 123.

The other motivation cited for Australia's WTO action against Canada is concern that under a renegotiated North American Free Trade Agreement (NAFTA), US winemakers may obtain the same advantages as Canadian producers. The US already exports significantly more wine to Canada than Australia does, and any advantages provided to US producers would likely eat into Australia's market share in Canada. Australia's concerns may be justified, given that the US Trade representative Robert Lighthizer suggested that the US dispute with Canada over wine could be resolved in the NAFTA negotiations, and that the Canadian Trade Minister François-Philippe Champagne has said he will stand fast in protecting the interests of Canadian winemakers.

As with most trade restrictions, the biggest losers in this 'wine war' are wine consumers in Canada. This trade dispute occurs against the background of a highly restrictive alcohol market in Canada, where many provinces have a monopoly on the wholesale and retail market. At the most basic level, neither monopolies nor a lack of competition are good for consumers.

The 'wine war' involves the restrictions some Canadian provinces are placing on the availability and price of imported wine, notwithstanding that Canadian winemakers supply less than 50% of the market and there are limits on the extent to which domestic production can be expanded to meet consumer demand. As usual when it comes to trade disputes, the interests of consumers are at the bottom of the pile.

Rethinking macroeconomics: the missing financial sector

Past posts have examined how monetary policy has adapted since the 200708 global crisis and how fiscal policy is still unresolved. But neither monetary nor fiscal policy caused the 200708 crisis: the direct blame lies squarely with the financial sector. Financial regulations have been enhanced over the past decade, but at the economy-wide macro level, the asset price bubbles, credit cycles, and volatile expectations that characterise the financial sector have not yet been satisfactorily incorporated into academic theory or policy practice.

Shoring up the prudential framework was the first priority after 2008  a microeconomic task focused on the behaviour (or misbehaviour) of individual financial institutions. Although the Basel rules that guide national bank regulators have been revised, it remains to be seen whether these enhanced rules will get the political backing needed to be effective. Already in the US, only a decade after the crisis, the huge effort embodied in the DoddFrank legislation that imposed regulation on the financial sector following the crisis is under threat from President Donald Trump’s deregulation agenda. The political power of Wall Street seems as strong as ever.

However, the problems were not all at the level of individual financial institutions. The unfolding crisis also revealed misunderstanding at the macro level.

Of course, the financial fragility of 2008 did not come as a total surprise. The inherent systemic vulnerability in banking has long been understood: one tottering bank can cause contagious runs on the whole banking system. But the 2008 crisis demonstrated that financial-sector instability was more deep-seated. Standard economics says that markets have strong self-equilibrating processes: a fall in price encourages greater demand, thereby supporting prices. In textbooks, demand curves slope downwards. Aren’t markets like a marble in the bottom of a bowl, quickly returning to normal after being disturbed?

But in financial markets, investors common response to a price fall is to sell rather than buy, sending prices down further. Momentum traders, portfolio managers with fixed mandates, and even the risk-reducing rules imposed by the regulators all serve to give financial markets an unstable dynamic. These processes reverse eventually, but in the meantime collateral is inadequate, lenders call for more margin, and sound balance sheets can be in deep trouble.

These problems have become worse, rather than better, as financial markets have become deeper, globalised and more sophisticated. Financial investors ride waves of momentum and carry-trades, relying on liquidating their position ahead of other investors. This results in hair-trigger responses to minor news, and lemming-like investor stampedes. Sudden mood swings are the norm. Few financial investors can hold a position throughout the cycle, waiting for normality.

The result is a financial cycle with asset-price booms and busts. Pre-crisis, central banks argued whether they should respond to credit-driven asset-price booms and potential bubbles  the ‘lean or clean’ debate. Post-crisis, this quandary has been addressed with macro-prudential measures  actions taken to rein in overall bank lending by regulating loan-to-value and debt-to-income ratios. Micro instruments are being directed at macro problems. These measures, however, amount to ‘old wine in new bottles’. The regulations used to control bank lending before deregulation in the 1980s have been dusted off in recent years and reapplied. These regulations were abandoned three decades ago because they were discriminatory and distortionary, with the inventive energy of the financial sector being devoted to circumventing such constraints. Macro-prudential measures are likely to prove a weak instrument.

This unstable dynamic is driven by psychology more than economics, so doesn’t fit easily into economic theory or models. Even the most sophisticated models rarely incorporate a detailed financial sector. More seriously, models routinely envisage a self-correcting economy. Subjected to shocks, these models plot a return path to full capacity, without much need for policy action.

These macro models have been largely irrelevant for issues of financial stability. But even if prudential regulators can ignore such models, they still need ways of incorporating the inherent dynamic instability of the macroeconomy and cyclicality of finance into their largely micro-focused supervision of individual financial institutions. This needs to be embodied in a politically endorsed policy framework that can stand up against the pressures of powerful interest groups.

Rethinking macro-economics: Fiscal policy

My recent post on rethinking macro-economics argued that monetary policy did all it could (and maybe was overstretched) during the weak recovery from the 2007-2008 crisis. The blame for the failure to achieve a robust recovery lies elsewhere, mainly with fiscal policy. The background for this failure is explored here; if there are any lessons to be learned from this experience, they don't seem to have influenced US President Donald Trump's current tax changes.

In April 2009, the G20 met in London and endorsed a multilateral fiscal policy stimulus. The financial crisis threatened a repeat of the 1930s Great Depression. Simultaneous stimulus meant that each country could be assured that its expenditures were not just leaking overseas, boosting foreign demand. This G20 decision probably represents the best example of international policy coordination since the Louvre/Plaza Agreements two decades earlier.

Within a year, however, the thrust of macro-policy had reversed: fiscal policy went from expansion to contraction. This sequence shows on the graph below as the expansionary 'fiscal impulse' of more than 2% of GDP for the advanced economies in 2009, succeeded by a contractionary impulse of around 1% of GDP in 2011, 2012 and 2013. The recovery, which looked to be on track in 2010 with 3% growth in advanced economies, fell to half that pace over the next three years.

Why did the same policymakers who saw the need for substantial fiscal stimulus in 2009 reverse their stance so dramatically in subsequent years, despite the serious damage this seemed to do to the recovery? Explaining this policy about-turn serves to set out the controversies and confusions that have beset fiscal policy, still unresolved.

The 2009 stimulus confirmed that traditional Keynesian-style fiscal stimulus works well. The recovery from the most serious crisis since the 1930s seemed to be well underway, despite headwinds from the still-unfinished repair of bank and corporate balance sheets. But government debt levels were clearly going to be pushed up if the stimulus continued. Meanwhile, the US political process was wrestling with the Congressional debt ceiling and impending debt cliff. Germans, never believers in Keynesian policies, led the push for fiscal austerity in Europe. By the end of 2009 the Greek debt disaster was unfolding. The specific problem of unsustainable debt in the European periphery was generalised into a concern about government debt everywhere.

This alarmist climate allowed a range of pro-austerity voices to dominate the policy debate. Keynesian counter-cyclical policies had, in any case, gone out of fashion after the 1970s stagflation. The 2009 joint stimulus was an aberration, provoked by the enormity of the apparent danger. As soon as this passed, there was a ready acceptance of reversal and austerity.

All main international financial institutions (the IMF, the OECD and the Bank for International Settlements) came out strongly in favour of austerity. As usual, the IMF explored a range of caveats, but its policy modelling and forecasts were based on a fiscal multiplier of around 0.5. This implied that the typical fiscal tightening of around 1% of GDP per year would take only 0.5% off a recovery, which in 2010 seemed to be going well, with the threat of another Great Depression averted.

The first of these institutions to twig to the problem was the IMF, which was coming under criticism for consistent over-optimism about the pace of recovery. Tucked away at the back of the opening chapter the October 2012 World Economic Outlook was a text-box noting the close statistical correlation between under-forecasting of growth and the size of the budget contraction.

This was followed early in 2013 by a more analytical piece co-authored by the IMF's chief economist Olivier Blanchard, which acknowledged that the implicit budget multiplier in earlier policy analysis had been unrealistically low. It might be true that in an economy operating at full capacity, fiscal action would be largely offset by automatic changes in interest rates and the exchange rate. But in an economy with ample spare capacity, interest rates already at the zero lower bound and widespread global weakness, neither lower interest rates nor a depreciated exchange rate could offset fiscal contraction.

The piece from Blanchard said 1.5 would have been a better estimate than 0.5 (and that substantially higher multipliers might have operated), which would mean the typical 1% per year austerity was taking at least 1.5% off growth in each of the critical years from 2011 to 2013, followed by somewhat less in the next two years. The limp recovery should have been no surprise.

Were there any regrets for underestimating this key parameter by a factor of three? Not many, it appears:

In particular, the results do not imply that fiscal consolidation is undesirable. Virtually all advanced economies face the challenge of fiscal adjustment in response to elevated government debt levels and future pressures on public finances from demographic change. The short-term effects of fiscal policy on economic activity are only one of the many factors that need to be considered in determining the appropriate pace of fiscal consolidation for any single country.

At about the same time, some high-profile economists were suggesting that the government-debt concerns were, in any case, misplaced. Brad Delong and Larry Summers argued that the slow recovery had permanently reduced the economy's productive capacity. Unemployed workers lost skills and their connection with the labour force, so did not rejoin when the recovery occurred ('hysteresis'). Labour force participation figures support this view.

This familiar graph illustrates the issue: the gap between the initial forecasts of potential output and the actual performance represents, in part, the 'long shadow' of hysteresis. With plausible parameters, Delong and Summers demonstrated that budget expenditure that facilitated a more rapid recovery would raise tax revenue enough to actually reduce government debt: a 'fiscal free lunch'.

After three years of strong austerity, the budget contraction eased and the recovery has now picked up pace. Urgent concerns about government debt were hard to maintain when the period was characterised by historically low long-term bond rates.

Common sense would suggest two lessons. First, the size of the fiscal multiplier depends on the state of the economy. Second, whether debt is a problem depends on what is done with the borrowed money. This common sense doesn't seem to be guiding current US fiscal policy.

Trump has now persuaded Congress to agree to tax changes (mainly a reduction in company tax) that he promises will squeeze more GDP out of an economy already at full employment. Businesses, however, say their investment will be little changed: most of the tax saving will be returned to shareholders as dividends or share buybacks. By common agreement, income distribution will be worse and government debt significantly higher. Earlier concerns about rising government debt have disappeared.

There is still enough disagreement and confusions about fiscal policy that an effective counter-argument was not mounted. We're still confused, but confused at a higher level.

The Bitcoin bubble

With Bitcoin trading at more than US$10,000 and suggestions it is not just a technological breakthrough, but also an exemplar of how to get around the failings of the nation state, it's time to try to sort out the various claims. Is it the next Amazon or tomorrow's Ford Edsel – a dismal flop? Is this just another financial bubble? Or even worse, a Ponzi scheme to rip off a gullible public?

At the start in 2009, Bitcoin was seen as an alternative to national currencies, potentially providing the three functions of a conventional currency: a medium of exchange, a unit of account, and a store of value. If it performed these three functions better than existing currencies, it would benefit society and be a commercial success. Does it – or could it – do the currency job better?

An effective medium of exchange has three attributes: widespread acceptance, convenience, and credible stability of purchasing power value over time. But Bitcoin's acceptance hasn't gone beyond novelty value - its 10-minute processing time and limited processing capacity are unacceptably inconvenient, and its value fluctuates wildly.

To outcompete existing means of exchange, Bitcoin has to be better or cheaper. PayPal, for example, succeeded because it processes some transactions more cheaply and conveniently than conventional payments systems. But Bitcoin's computationally-heavy processing, involving the dead weight cost of processers (the 'miners') competing with each other for the right to process the transactions, is intrinsically far costlier than conventional payments systems. For the same reason, it can't compete with PayPal's advantage for small transactions.

Miners are currently receiving Bitcoin as payment for processing transactions. This is effectively giving them the seigniorage (the profit that accrues to the issuer of currency) from the Bitcoin issue, which will end after just under 21 million Bitcoins have been issued and production (‘mining’) of Bitcoin ceases. As mining returns fewer and fewer Bitcoins, owners of the expensive computational resources used in verifying transactions will become more reliant on charging user fees for this task, and the business case for Bitcoin as a medium of exchange will become increasingly tenuous. Its remaining transactional advantage of anonymity (attractive for drug dealers and terrorists) isn’t enough for a viable business.

Lack of stable purchasing power also makes Bitcoin a poor unit of account. Imagine using Bitcoin as the numeraire for a home loan contract, with your liability varying manyfold depending on the whims of the Bitcoin market. Similarly, for company accounts, a stable numeraire is essential.

What about as a store of value? Almost everyone who bought and held Bitcoin has done well. Doesn't that make it a good store of value, just as many unusual and idiosyncratic things (rare postage stamps, Rembrandt paintings) have turned out to be effective stores of value?

To be a good store of value, an asset should have an assured stable price over time, low safe-storage costs and a liquid market, so that the holder can sell the asset at any time at a predictable price. Bitcoin doesn't have these attributes.

But is it overly fussy to expect a store of value to have a stable price? What about gold, which many would argue has been a good store of value? Let's not pick a fight with the gold bugs. Instead, we should wish them good luck with their risk-laden gold holdings, and explain why Bitcoin is different. The gold price is anchored, within a wide band, by the usual rules of supply and demand. On the demand side, gold's specific attributes give it intrinsic real-world uses (jewellery, industrial uses): it is not just a token or a digital string. On the supply side, there is a well-established long-run cost of production, which influences the price. These fundamentals are often overridden by speculative demand. But the fundamentals provide a long-term anchor and assurance that the gold price will not go to zero.

Bitcoin, without gold's anchor, has nothing to stop it going to zero. The better analogy is with Silicon Valley start-ups. Their ability to attract investors rests on the stunning success of tech giants such as Amazon, Alphabet (Google), Uber and Facebook: if you can link the right idea with the right technology, fabulous success will be yours. But for every Facebook, there were many start-ups that spent the investors' funds in the 'cash-burn' phase and fizzled out, valueless.

If this is the right analogy, then Bitcoin is not a Ponzi scheme, even though it has the key Ponzi characteristic of relying on attracting a continuing stream of new investors. A Ponzi scheme also has an element of fraud, which is not necessarily the case with Bitcoin. It is more like a bubble. There is nothing novel or surprising in the unhappy sequence of a corporate bubble: the 18th century South Sea Company left its investors with nothing.

This analogy is missing just one element: Bitcoin's lack of a viable business model has not yet registered with its investors. The narrative has become an enduring fairytale.

Why has Bitcoin's price remained aloft, like cartoon character Wile E. Coyote, suspended in mid-air after running off a cliff? Most Silicon Valley start-ups are being constantly evaluated by sharp-pencil investors who want to be the first to get out when the business plan is revealed as unviable. These enterprises survive the 'cash-burn' period only if they can maintain a convincing narrative of future success.

Bitcoin has managed to maintain its narrative, perhaps because it has a different set of investors: gamblers, those relying on the 'greater fool' theory of investment, and true-believers rather than gimlet-eyed analysts. The anarchic starting point appeals to libertarians, with currency freed from the shackles of intrusive government. Scepticism is for bean counters and small minds. The anonymity of the founder (or founders) creates an aura of mystery: the more secrets there are, the easier it is to evade rationality. Linked to the undoubtedly revolutionary blockchain technology, investors are participants in an epic technological adventure. Open-source software and competing miners suggest that this is a community endeavour, open to all. The excitement generated is akin to the thrill of being at the head of the queue to buy the latest iPhone: investors are early adaptors of the latest technology, pioneers of the future. As if this isn't already enough, Bitcoin has celebrity endorsements.

It was unkind of JP Morgan's Jamie Dimon to say that any of his staff found trading Bitcoin should be sacked, implicitly on the grounds that they were demonstrably dim-witted. After all, wasn't Sir Isaac Newton one of those taken in by the South Sea bubble?

The digital age has produced many surprising successes, outside the constraints of conventional thinking. Wikipedia, Uber, and Amazon all provide something that is demonstrably better than the existing model. It is also true that governments make huge seigniorage profits out of their currency-issue monopoly and that opening up government monopolies to private competition has often been beneficial for society.

Thus it was not irrational, in principle, to attempt to establish a competitive payments platform (recall PayPal's success). But Bitcoin has used up most of its seigniorage potential in subsidising the expensive costs of its transaction processing model without being able to establish acceptability as a universal payments system. It can serve none of the three functions of a currency. The narrative loses its credibility as the 21 million issue-limit is approached.

Can the Bitcoin experiment be justified in terms of its exploration of blockchain technology, which is already proving to have profitable applications elsewhere? Perhaps Bitcoin investors get satisfaction from this aspect of their investment, in the same way that contributors to Wikipedia have the satisfaction of advancing the greater good. This is, however, a stretch. It is like justifying the moon landing expenditure by pointing to peripheral spin-offs, such as non-stick cookware. It's not as if the Bitcoin adventure will be a costless example of 'dust to dust': all those computers and all that electricity represent wasted real resources.

One offshoot takes the form of Initial Coin Offerings (ICOs). Start-up tech companies offer their investors some version of cyber-currency instead of a share script. The attraction of this example of crowdfunding is that it provides an opportunity to cut out the fat-cat financial intermediaries who get rich from conventional Initial Public Offerings. It also bypasses the heavy hand of government regulation. The problem, of course, is that these intermediaries and government intrusions are what give investors some protection against business-plan narratives that make no sense. To issue some form of pseudo-cybercurrency that has no use in transactions just confuses the issues. Perhaps this is the promoters' purpose, helping to evade rational scrutiny. But it is just such rational scrutiny that protects investors from fairy-tale stories of future profits.

Does any of this matter or require policy response? So far the authorities in most countries have seen Bitcoin and ICOs as too small to do any widespread harm. At more than US$10,000, Bitcoin is no longer so small: with 16.7 million Bitcoins already issued, the current value of the outstanding stock would be more than US$167 billion. While this is far from trivial, the losses when they come will be spread over the globe; many holders bought their Bitcoins at a much lower price, so should think 'easy come, easy go'; and others might have acquired their holdings via the various hacking scams that have occurred, so might have no real grounds for complaint.

For these investors, a digital printout of their holdings can decorate their wall, alongside their pre-1949 Chinese government bonds and Weimar Reichsbanknote marks, as a worthless memento of their selfless contribution to the advance of the valuable technology of the blockchain and a reminder of the 'madness of crowds'.

Converging approaches on Chinese investment

This article is part of a series for the Australia-UK Asia Dialogue, co-hosted by the Lowy Institute and Ditchley Foundation, and supported by the Department of Foreign Affairs and Trade and the Foreign and Commonwealth Office.

Although both have been very open to foreign investment, Australia and the United Kingdom have for decades championed quite different regulatory approaches. In the UK very few foreign investment proposals require government scrutiny. In Australia, at least in principle, a great many do – though the result in both cases is to permit the vast majority of investments.

Increasingly, however, the UK and Australian approaches to foreign investment are becoming more alike, driven in both countries by the same policy perplexity. Both recognise the increasing importance of China's economy, both wish to welcome a growing global surge of China direct investment into their economies, and both wish to do so on terms that take account of the special character of China investment. That is, investment from China is often from state-owned industries, is assumed to be part of a larger strategic and government-directed plan of economic expansion, and, whether rationally or otherwise, is sometimes troubling to not only Australian and UK national security agencies, but also the major security partner of both countries, the US.

Since China is such a big, fast-growing economy, UK and Australian attitudes to Chinese investment are necessarily a part of their approach to the world's most flourishing economic region, Asia. On the regulatory control of foreign investment and especially foreign investment from China, therefore, Australia and the UK have much to discuss. It is one of the tender spots in both countries' adjustment to China's increasing economic weight.

Australia's economic relationship with China is now deeper and more extensive than the UK's. Australia since 2005 has received very much more Chinese foreign direct investment, largely because China's early interest in offshore direct investment was predominately in minerals and energy. According to the American Enterprise Institute, at US$101 billion Australia has received over twice the US$48.3 billion received by the UK over the 2005-2017 period (these AEI numbers may disagree in detail with the national authority numbers, but they have the advantage of being easily compared).

Australia is now second only to the US in the stock of China's outward direct investment, and in earlier years was often in front of the US. In both the UK and Australia the relatively low level of investment stock compared with older investors such as the US obscures the rapid nature of its growth. On Australian official numbers, a decade ago China direct investment in Australia was still negligible; since then China direct investment has grown 80-fold. Today the stock of Chinese investment is a quarter of the stock of US direct investment in Australia, compared to an eightieth ten years earlier.

Reflecting differences in their economic structure, Chinese investments in the UK and Australia have taken different directions. In Australia it is principally about resources (including farming), though it now importantly includes harbours, energy generation and distribution, and property development. In the UK, by contrast, it is principally about property. That industry accounts for nearly a third of Chinese direct investment in the UK, compared to one sixth for energy. Financial services are also important, with the standout China Development Bank investment of US$3 billion in Barclays.

For all the warmth of recent UK-China economic relations, China is also a far more important trade partner to Australia than it is to the UK. China accounts for a third of Australian goods exports, and a very considerable share of customers of its tourism and education services. For the UK, the US is by far its largest export market, followed by the large European economies. China is still well down the list.

While Australia has long insisted that all major foreign investment proposals must be presented to the Foreign Investment Review Board (FIRB), the UK has maintained far less intrusive scrutiny. The most important control is through merger laws, which apply equally to domestic and foreign businesses. The tests include national security, stability of the financial system, media quality and plurality and standards. There are regulatory rules on transport, energy and banking and insurance, applied usually in a non-discriminatory way by the applicable regulators. Defence-related proposed acquisitions have typically been dealt with by exception. Even under the 2002 Enterprise Act, intervention requires 'exceptional public interest grounds'. By contrast, the FIRB may recommend the Treasurer refuse any major merger or acquisition or for that matter greenfield investment on undefined 'public interest' grounds, with no substantive appeal to a court.

For all the differences in form, Australian and UK foreign investment regimes are closer than they appear. Though it scrutinises most major foreign investment proposals, the FIRB refuses very few of them and publicly portrays itself as a very light regulator. And while the UK regime is formally largely non-discriminatory, in recent years foreign investment proposals have met with greater scrutiny. In June the May government announced a new regulatory framework specifically to apply national security considerations to critical infrastructure proposals. The merger public interest test on national security, formerly applied only in the defence industry, has now been extended to non-defence industries. Both changes in the UK may presage a move to a specific foreign investment scrutiny regime closer to the Australian model.

The recent unease in both countries is driven by increasing security concerns over Chinese investment, especially in critical infrastructure. In 2016 the Australian Treasurer refused a Chinese investor proposal to acquire NSW energy distributor Ausgrid. In the UK there was considerable debate over the Hinkley Point nuclear project, in which a French Chinese consortium is a major investor and developer. The UK has now responded with greater scrutiny over 'critical infrastructure' foreign investment proposals. For much the same reason and in the typically translucent style of Australian foreign investment regulation, the Turnbull government in April appointed David Irvine as the chairman of FIRB. Irvine was formerly the head of Australia's foreign and domestic intelligence agencies. Earlier, the Turnbull government created a Critical Infrastructure Centre tasked to protect against hostile disruption, including through foreign ownership.

The UK and Australia have to some extent converged on foreign investment scrutiny, and largely in response to national security concerns over Chinese direct investment. But that is certainly not the end of the policy discussion, or of the issues which give rise to it. Neither country wishes to discourage direct investment from or slow the growth of trade with China. In both countries, economic officials recognise that China will become the single biggest national economic power in the world, if it is not already. They recognise, too, that it is China and not the West which will decide whether, when and to what extent China is prepared to privatise state-owned industries or loosen the central role of the Communist Party, and that China's economic model will not change on the West's say-so. And, finally, they recognise that while Australia may be the number two recipient of China direct investment and the UK number eight, the US has since 2005 received considerably more China direct investment than the UK and Australia put together, and continues to accept it in large volume. The US may scold its allies, but has had little hesitation in its own embrace of China's vast economy.

Rethinking macro-economics: Monetary policy

For the countries affected by the 2007-08 financial crisis, the recovery has been lacklustre. There was no self-equilibrating 'V'-shaped return to the pre-crisis GDP growth trajectory (see the familiar graph below, or here). Nearly a decade on, the recovery may be more assured, but the performance of these economies raises doubts about the conventional macroeconomic wisdom that had guided policy for a generation. The implications for monetary, fiscal and financial policy are far-reaching. Top international bureaucrats and heavyweight economists are calling for a fundamental rethink.

This post focuses on monetary policy, leaving other aspects – fiscal and financial ­– for another time.

In the two decades before 2007, monetary policy was seen as the main counter-cyclical macro-instrument. Fiscal policy was left on auto-pilot – relying on just the cyclical variations in revenues and expenditures. Even monetary policy had modest objectives – the conventional wisdom was that monetary policy affected nominal magnitudes (prices) but had no impact on real output in the longer term. Thus, monetary policy should be directed at achieving price stability,  especially after the debilitating experience with 'stagflation' (the simultaneous existence of inflation and slow growth) in the 1970s.

Political pressure to over-stimulate the economy with low interest rates was seen as the main threat to price stability – the answer was to give central banks independence and an inflation target. The 'Great Moderation' (low inflation combined with good growth) in the fifteen years before 2007 seemed to validate the self-equilibrating nature of real growth and the minimalist price-stability role for monetary policy.

The post-crisis period has undermined this neat simplicity. Near-zero policy interest rates in the crisis countries weren't enough to ensure a strong recovery, or to encourage inflation to return to target. Huge expansion of central bank balance sheets through quantitative easing didn't rev up the economy. Even when the lacklustre recovery eventually brought unemployment rates down to full-employment levels, wages have remained somnolent. The Phillips curve relationship between unemployment and wages (low unemployment produces higher inflation), at the heart of macro-economic thinking and modelling, seems to have vanished.

All this is hardest to explain for the economists of the free-market-oriented Chicago School. 'Masterly inaction' has always been their firm policy recommendation. This view was reflected in early versions of inflation targeting, notably the pioneering New Zealand approach, which had a rigid focus on the inflation target and studiously ignored any real-economy variables such as GDP.

Not all economists had this belief in the self-equilibrating nature of the economy. For less single-minded economists, the monetary experience of the past decade requires some recalibration and footnoting, but can be explained within a less rigid version of conventional theory.

Why has monetary policy been so powerless to stimulate the weak recovery? There have always been doubts about the power of low interest rates to stimulate demand – 'pushing on a string' is an old simile. With the feeble recovery, demand was growing so slowly that few businesses wanted to borrow, even at low interest rates. More important, headwinds from crisis-damaged balance sheets (lending banks and borrowing enterprises) have been intense. Fiscal policy was tightened sharply during the recovery in response to debt concerns, a serious policy error that hobbled the recovery. When quantitative easing is judged with hindsight, it will be seen as a feeble instrument that flattened the yield curve but weighed down the balance sheets of banks with unwanted government debt. In short, low interest rates may well have had the expected stimulatory effect, but this was not enough to offset strongly contractionary factors.

But why has there been no appreciable rise in US inflation, when unemployment is now well below the level usually associated with full employment? Part of the answer may be that the usual measures of unemployment are no longer accurately measuring 'full employment' and pressure on wages. The most recent US figure shows historically low unemployment, just over 4%. But this partly reflects falls in labour market participation – workers dropped out of the labour force, no longer counted as unemployed. Participation is 62.8%, compared with over 66% before the crisis. There may be no great pressure on labour markets yet, as some of these drop-outs may return when demand is stronger.

Structural changes (especially increasing globalisation) has dampened both price and wage rises by offering alternative sources of supply. The success in stabilising inflation over recent decades has also anchored inflation expectations – one of the main drivers of ongoing inflation. This explains the flatter short-term Phillips curve. But it doesn't remove the longer-term constraint embodied in the Phillips curve: if demand pushes strongly against capacity constraints (which hasn't occurred yet), wages and inflation will rise.

If some combination of these factors can explain what has happened since 2007, what's the problem? Why so much agonising about ineffectual monetary policy? There seems no danger of generalised deflation – when negative inflation encourages people to delay spending, waiting for cheaper purchases. The current below-target inflation seems to leave room for further expansion, perhaps even closing some of the output gap with the pre-2007 growth trajectory.

This leaves two problems – one minor and one substantial.

The minor problem is that conventional inflation targeting relies on using inflation as the indicator of when the economy had reached full capacity. Without this, inflation-targeting central banks don't have a simple indicator for policy tightening.

The answer is that central banks should look at a wider range of indicators. To use inflation prospects as the sole criterion for policy-setting was always a convenient simplification. Now central banks need to add other indicators of economic slack, while retaining the two huge benefits of inflation targeting: its shield from political interference, and its ability to anchor inflation expectations.

One further tweak to the policy framework is needed. Monetary policy works by setting the short-term policy rate away from the long-term equilibrium neutral interest rate – lower when stimulus is needed and higher when contraction is appropriate. But leaving the policy rate well below the neutral rate for an extended time (as has occurred since the 2007 crisis) introduces persistent distortions. Asset prices are bid up; risk-taking is encouraged; projects are undertaken that would not be viable with normal interest rates; balance sheet valuations are muddled; and pension plans are put in disarray. Central banks have to weigh the benefits of stimulatory settings against these distortions. The US Fed's gradual policy rises, even when prospective inflation is still below target, reflect these concerns.

This leaves a more important and intractable challenge. Why is the pre-crisis GDP trend-line apparently unattainable now? Why is the growth trajectory flatter? Did the crisis reduce the effective labour force through hysteresis? Did the slow recovery discourage investment, dampen innovation and stifle productivity growth? Has an adverse shift in income distribution or demographics reduced the economy's dynamism?

Resolving these issues is more important than the headline-grabbing perpetual debate about interest rate settings. Too much was expected of monetary policy over the past decade, perhaps encouraged by Ben Bernanke's activism and confidence that deflation could be avoided. It is a limited tool that can't be held responsible for diminished growth prospects.

So, what's holding back growth? We'll return to these issues another time.

The first global supply chain

The city of Ternate in eastern Indonesia seems forgotten by time. Its quiet bustle is confined to the coastal fringes of Mount Gamalama, with its imperious presence. The most prominent building in the low-slung city is a monumental new mosque, minus two of its four minarets that fell down in a recent earthquake. The seat of provincial government has been moved onto the larger nearby island of Halmahera.

The stone skeletons of four substantial forts, however, bear witness to a turbulent past. Ternate was the legendary spice cornucopia that Portuguese sailors set out to find. Here grew fragrant cloves, and the Sultan also exercised sovereignty over the Banda Islands to the south, the world's sole source of nutmeg. For centuries Arab traders had brought these spices to the Middle East, with Venetian middle-men taking them onwards to Europe, at huge mark-up. When the Portuguese discovered the trade route via the Cape of Good Hope, the way was open for them to collect their own spices direct from the Sultan of Ternate, who became their treaty ally. They went on to establish their trading entrepôt at Malacca early in the 16th century to oversee the spice trade: 'whoever is Lord of Malacca has his hand on the throat of Venice'.

The nutmeg fruit and seed (Photo: Author)

But directly commanding the source of the spices was better than a deal with a fickle sultan – hence the battles for possession of Ternate and the other spice islands over the next several centuries. Everyone was here, battling it out for influence and cargoes: the Spanish, the Dutch, and the English. Magellan's surviving commander on his pioneering voyage around the world passed through here, as did English privateer-hero Francis Drake

Here, surely, was a very early, fully operational manifestation of international integration, the embryonic form of today's ubiquitous globalisation. We would recognise its constituent elements. Here was the tenuous but well-structured supply-chain, extended all the way from Banda to Amsterdam, via numerous ports and functionaries, administered with brutal efficiency by the Dutch East India Company, perhaps the first business organisation that bears resemblance to today's multinational corporations. The company raised money by issuing shares. It had the first widely-recognised commercial logo. Even without today's computers, the company's officials were linked through a hierarchy of regular detailed reporting and accounting. Production was brought together in plantations and processed in 'factories'. Near-subsistence agriculture was replaced with scale and quality control, supervised by the perkeniers with an incentivising profit-sharing deal with the company. Customer feedback was insistently relayed to producers: 'small nutmegs are of no value'.

This mighty machine produced 3000 tons of nutmeg annually and transported it across hazardous waters to deliver it to the burghers of Holland and on to the rest of Europe's spice-hungry upper-class. Ad hoc trade between nations, with goods passing through many hands, many owners and many markets, was replaced by 'straight-through' processing by a single entity – the Dutch East India Company

One key characteristic of the Dutch trade might serve as a reminder that globalisation is not always exactly the same as the 'free market' expounded in economic textbooks and extolled by business. The central organising principle of this Dutch trade was that it would be a monopoly. The Dutch East India Company had a royal charter – a government-endorsed monopoly. Today we would call it a 'national champion', taking on the world on behalf of Holland. It fixed spice prices and manipulated supply. This monopoly not only involved fighting the opposing colonial powers tooth and nail and reaching territorial deals such as the 1667 Treaty of Breda that swapped Manhattan for Run, a tiny British possession in the nutmeg-rich Banda islands. It also involved the elimination of native populations that had not joined the Dutch supply chain. Sometimes this was by mass execution, bordering on genocide. At other times the natives fled to safer islands beyond reach of the Dutch (and beyond spice-growing territory). Whatever the means, the outcome was the same: a strict Dutch monopoly. As has remained true of monopolies ever since, the organiser of the monopoly reaps the fat profits, not the producer.

Of course, the days are long gone when this sort of behaviour was condoned (although as recently as World War II there were shocking atrocities in these islands). Forced removal of inhabitants and replacement by imported slaves is no longer standard business practice. But businesses still crave after monopoly and constraints on competition. The favoured businesses are those with a natural monopoly or one created by government regulation. Today 'network externalities' (being the dominant player in an industry where technology gives a huge advantage) and having 'first mover advantage' are the keys to business success in many industries, notably information technology. These companies are so highly valued in equity markets because investors believe the future will allow continuing dominance of their sectors.

Perhaps the history of the Dutch East India Company might give us hope that such monopolies don't last forever. By the end of the 18th century the company was bankrupt and its charter expired. Good managers are replaced by time-servers; far-distant staff become indolent; markets change; governments come and go; rivals disrupt; and wars intervene. If all this seems too random, the modern answer is government-enforced competition regulation.

At the same time, modern trade treaties contain elements of monopoly. Even the now-ubiquitous free-trade agreements are sub-optimal because they are a restraint on trade with parties excluded from the deal. Plurilateral treaties, such as the unachieved Trans-Pacific Partnership, lay down behind-the-border rules that benefit one party at the expense of others – on IT, environment and labour requirements. Well-entrenched supply chains often hold out competitors with exclusive deals with their component suppliers.

Of course, this is a long way from the brutal restraints on competition practised in 17th century globalisation. And Indonesia's spice islands might ruefully contemplate how, when they finally got rid of the Dutch monopoly, free trade took away the source of riches before the traditional owners of the spice islands could work out their own form of beneficial monopoly on exclusive products, with regionally-branded nutmeg and cloves. Instead, the colonisers (especially the British) took plants and spice-growing to other parts of their own empires. Nutmeg-growing so dominates the Caribbean island of Grenada that the nation has put the nutmeg fruit on its national flag. Meanwhile the fabled Indonesian spice islands have remained mired in genteel poverty.


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