Monday 21 Sep 2020 | 05:44 | 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

Central banks and the inflation conundrum

Inflation in the UK hit 3% for the year to September, but elsewhere it remains quite low, despite a strengthening global economy. Consumer price inflation in the US, for example, is sitting around 1.7%, yet output growth in the year to September was the strongest since 2015 and the unemployment rate is down to 4.2%. Australia was once an inflation champ, but no more. Headline inflation was a modest 1.8% in the year to September, and much the same on underlying measures.

If global output growth is strengthening, is low inflation a problem? Financial markets seem to think it is, at least for central banks. With each confirmation of continuing low inflation, global financial markets cut back expectations of future interest rate rises – despite the insistence of many central bankers that inflation will sooner or later rise, and so will central bank interest rates. In Australia, Reserve Bank of Australia Governor Phil Lowe has cautioned that markets may be shocked when wages and inflation start to pick up, a warning underlined by his predecessor Glenn Stevens in a note to clients of funds manager Ellerston last month.

A big question here is whether contemporary inflation is the right guide to what central banks are likely to do, and to the trajectory of interest rates. I am not at all sure it is the right guide, or at least not in the current circumstances.

For one thing, central bank policy rates in most advanced economies are super-low. They were intended to help economies faced with the demand collapse that followed the 2008 financial crisis; they were not intended for economies where employment and output are steadily increasing, as they are in many advanced economies today.

For another, while high inflation or very low inflation present threats to output and employment growth, the below-target but firm inflation rates evident today do not. Below 1% and above 3% inflation is a problem. But at 1.8%? What problem? It is after all around the usual rate of inflation in the golden years of economic performance, from 1950 to the mid-1960s.

The ultimate aim of monetary policy is not to achieve a particular inflation range, but to help stabilise the growth of output and employment. Targeting consumer price inflation has been found to be a useful way of doing that, but it is not actually the final objective. If, for example, output growth is close to potential and the workforce is more or less fully employed, most central banks would not be bothered if inflation was still below target. As Lowe asked not long ago, how hard should central banks push to get inflation up?

The actual issue facing central banks such as Australia’s is not, I think, a need to get inflation up to the target. The important decision framework is the trade-off between the risks to future financial stability that arise from leaving rates very low in a period of rising market confidence, and the risks that somewhat higher interest rates will slow the rate of growth of output while there is still spare capacity in the economy. It’s a tough decision with something to be said on both sides, and it is being debated in most central banks, including Australia’s.

In beginning to increase its policy rate two years ago (and earlier in halting the expansion of its balance sheet), the US Federal Reserve demonstrated its conviction that rates could and should begin to rise from their emergency settings well before inflation returned to the Fed’s informal target. The Bank of Canada has made the same judgement, and the Bank of England may well increase its policy rate later this week.

It is surely true, as RBA Deputy Governor Guy Debelle remarked last week, that there is still spare capacity in the labour market. Plenty of it. But that is not quite the same thing as saying the policy rate should remain at its record low of 1.5% until, say, unemployment returns to 4%.

Nor is it evident that small and well-spaced increases in the policy rate will set back output growth. They haven’t in the US. In the Australian case, two 25 basis-point increases through 2018 would now be considered quite startling. Yet at 2%, the RBA policy rate would still be one percentage point below the 3% the emergency policy rate it reached in the bleak aftermath of the 2008 US and European financial crisis. It would still be the lowest policy rate ever, excluding the last two-and-a-half years.

So one argument against putting too much faith in low contemporary inflation as a guide to central bank moves and the trajectory of interest rates is that it may not be as reliable a rule as markets suppose. Another is that while inflation is low, it is rising. This is evident in the US and of course in the UK (though inflation there may moderate through 2018). For all the celebration of low inflation attending last week’s third-quarter consumer price increase outcome (0.6%, against an expected 0.8%), it is also quite evident in Australia.

Inflation is low, but picking up. It is true that year-to inflation remains under 2% (at 1.8%) and may well remain under that rate for the fourth quarter, but the trend is decidedly towards high domestic price inflation. This is apparent in the year-to measures for the trimmed mean and the weighted median, both of which have moved solidly up since the low in June 2016. The weighted median was 1.2% in the year to June 2016 and 1.9% for the year to September 2017. Perhaps more importantly in the current context, it is apparent for non-tradables inflation, which the RBA rightly regards as a good measure of domestic price pressures. That series has doubled from 1.6% in the year to June 2016 to 3.2% in the year to September, the fastest annual rate in four years. Non-tradables inflation accounts for two-thirds of the total of the CPI.

These changes are far from anything that could be described as rapidly increasing inflationary pressure, but they are consistent with other measures of robustness in the Australian economy. Employment growth has been quite firm over the last year, especially for full time work. To my surprise, approvals sought for residential construction picked up this year after falling through much of 2016 in what I had thought to be the decline of the housing construction boom. Residential building is falling, but given the rebound in approvals the decline may be quite slow. Non-mining business investment is markedly stronger, and infrastructure activity is rising. Engineering construction, for example, declined sharply in the four years to the end of 2016 as the mining investment boom faded. By the middle of 2017, however, real engineering construction activity was 25% above the December low. Much of that is public infrastructure, and the pipeline suggests there is more to come.

Over the last five years Reserve Bank speeches and analyses have repeatedly drawn attention to flat non-mining business investment. In his excellent talk last Thursday Debelle mentioned revisions to the investment data late last year that show that, far from being flat, non-mining business investment took off from its low point in 2013. Apart from a flat patch in 2016 it has risen strongly since. The old figures showed that the volume of non-mining business investment increased by around 5% from 2013 to 2017. The new chart appears to show that it actually increased by nearly one-third.

Its level was lower, but non-mining business investment growth was much stronger than the RBA thought at a time it was cutting the policy rate through 2015 and again in 2016. Part of the pubic rationale for cuts was that non-mining business investment was flat, and the economy needed help from stronger consumption and residential construction, and a weaker Australian dollar. It was a useful ignorance, perhaps, because even with those cuts overall output growth is modest. But it is also one more piece of evidence that the Australian economy is in pretty good shape.

The future role of international financial institutions

The role of the multilateral development banks (MDBs) and other international financial institutions (IFIs) is back in the policy spotlight.

The latest attention comes via the G20 Eminent Persons Group (EPG) on Global Financial Governance, formed by G20 Finance Ministers at their meeting in April this year. The Group, chaired by  Singapore's Deputy Prime Minister Tharman Shanmugaratnam, was given the brief to review challenges and opportunities confronting the global financial system, the optimal roles for the IFIs, and recommend practical reforms to the functioning of the global financial system and how the G20 can provide continued leadership. The EPG is to provide a final report by October next year.

The international financial system is significantly different to the one that existed when the IFIs (particularly the IMF and World Bank) were established.

Some of the transformations include increased multipolarity (the growing importance of emerging markets and the private sector, new institutions, multinational corporations, and the influence of civil society); the rise of private capital's dominance over financial flows; and technological change contributing to financial integration and a reduced ability for states to influence factors affecting their economies. For the foreseeable future, the IFIs will also operate in an environment where shareholders have constrained public balance sheets and amid growing distrust in institutions and globalisation. Environmental sustainability and demographic challenges are two notable sources of future global pressure.

The EPG will need to assess whether the mandates, operations and governance structures of the IFIs are appropriate to deal with all these developments. The EPG provided an initial update to G20 Finance Ministers at their meeting in Washington earlier this month. The challenges identified included attaining sustainable and inclusive growth; investment in infrastructure and human development were characterised as 'key enablers' of this growth. Sustained economic reforms and sound domestic policies 'remain critical' to strengthening the investment environment, but the financing gaps in supporting needed investment are substantial. The EPG noted, however, that there was an opportunity for far more private and institutional capital to finance these investments, particularly given private capital flows far outstrip official development finance.

Another challenge identified was assuring financial stability. While greater financial interconnectedness has had many benefits, there were risks associated with volatile capital flows and exchange rates, and the transmission of shocks. What was required, according to the EPG, was an 'internationally agreed framework' to mitigate these risks, along with a 'resilient global financial safety net'. In addition to financial shocks, other processes were recognised as potentially having a major effect on growth and stability – the EPG noted pandemics, migration, climate change and cyber disruption.

The IFIs remain central to the functioning of the global financial system through their provision of policy advice, financing for development, global public goods, financial safety nets and rules-based framework for international economic activity. They have responded to developments mentioned above, but the EPG must assess whether their response can be strengthened.

The EPG will need to assess whether there should be a greater delineation of responsibility between institutions and greater specialisation based on comparative advantages, along with whether IFI mandates need to be updated.

For example, when the IMF was established, most cross-border transactions were in the current account or through the official sector. As such, the IMF's surveillance responsibility was limited to the current account. Given the subsequent dramatic rise in private capital flows, it has been suggested that the IMF's Articles should be amended so that it has jurisdiction over the capital account. This notion was raised some 20 years ago, but was overshadowed by the Asian Financial Crisis. The possibility of an expansion of the IMF's mandate has been raised again (such as by CIGI's Jim Haley) and it will need to be examined by the EPG. In regards to the MDBs, the EPG will need to consider proposals (such as this one from the Center for Global Development) that recommend the World Bank be given a new mandate to promote global public goods, and that more traditional development banking be left to the regional development banks.

There is also a growing recognition that the MDBs should be operating as a coherent system rather than independent institutions (or, as expressed by G7 Finance Ministers at their meeting in May this year, MDBs should 'operate as a system of complementary actors'). For this to be achieved, the MDBs have to attain coherence across their policies, along with their operational and shareholder positions. The latter is critical, for anyone involved in the MDBs can cite numerous examples where countries have taken very different positions on similar issues in which they are a shareholder.

In terms of tapping private and institutional capital to finance development needs, this is well recognised by the MDBs, who have developed 'Principles of a MDB Strategy' for encouraging private sector financing. Many reports have been prepared on the issue, such as those by Brookings and McKinsey. However, Nancy Lee from Center for Global Development notes in an upcoming paper that progress by the MDBs has been slow due to 'a lack of collaboration within and across MDBs'; a lack of clarity on an overall strategy; the need to change incentive structures; and, most importantly, shareholders sending 'inconsistent messages' about risk tolerance, profit expectations and definitions of development impact. There is much here for the EPG to pursue.

Perhaps the biggest challenge confronting the EPG is to come up with 'practical reforms', given the nationalist attitude of the US and its veto power in the IFIs. Any reform proposal that requires approval by the US Congress would be dead in the water, at least for the time being. The challenge for the EPG is to outline the desired outcome, even if it isn't immediately achievable, along with some interim reforms that head in the right direction and hopefully increase momentum for more substantial governance reforms. All easier said than done.

Global growth: Choppy forecasts, but smooth sailing

It's been tough for those writing the IMF's World Economic Outlook in recent years. 'Is the Tide Rising?', the report asked in 2014, only to conclude later that same year that 'Legacies, Clouds and Uncertainties' still surrounded the global outlook.

The next year there were 'Cross Currents', and then 'Uneven Growth'. In 2016 the team declared that things had been 'Too Slow for Too Long'. It wasn't till April of this year that the global economy was thought to be 'Gaining Momentum', a trend cheered on mid-year with a 'Firming Recovery'. When it releases its next set of forecasts, timed to coincide with the IMF and World Bank meetings in Washington next week, the IMF may well conclude that the world economy is picking up – an announcement pre-empted in OECD forecasts two weeks ago.

Despite the mood swings among forecasters over the last three or four years, the actual pace of global growth has barely changed. World growth in 2014 was 3.5%. The following year on IMF numbers it was 3.4%, then 3.2%. In its June forecast the IMF expected global growth this year would be 3.5% again. The 'Firming Recovery', it turns out, means moving from 3.2% growth to 3.5% growth – recoveries used to have more bounce. While forecaster moods have been volatile, growth overall has been pretty consistent – and pretty good.

The US expansion is a case in point. It is surely among the least-noticed economic phenomenon of our time. Just short of 100 months since it began in June 2009, the current US economic expansion is already the third-longest since World War II. If all goes well it will be the second-longest expansion by this time next year, and the longest by this time the year after that.

Often deprecated as feeble, the average rate of growth has been pretty much the same as the US expansion from 2001 to 2007. And while output growth has been much the same, jobs growth has been much stronger. The last expansion added eight million jobs from the low point – this one has so far added 16 million. At 4.4%, the unemployment rate in the US is a tad above the low after the record-long expansion of the 1990s, and otherwise the lowest in half a century. It is true that business investment hasn't been brisk, but at 12.6% of GDP it is about the average of the last several decades.

The US stock market has not just recovered from the 2008 crash – it is now four times higher than it was when this long US upswing commenced.

Nor is this quiet expansion showing signs of age. As RBA Assistant Governor Luci Ellis reminded us recently, long expansions are no more likely to end than short ones.

It's only now that we're beginning to accept as reality a global expansion that has been continuing for several years. The Euro bloc economies and Japan emerged from recession three years ago. China's output growth has slowed from the peak, but at 6.9% for the year to June it remains very strong.

Thus we have entered what RBA Governor Phil Lowe recently called a 'new chapter' in the global economy, one marked by last month's decision by the US Federal Reserve to cautiously begin shrinking the huge holdings of US government bonds it accumulated to keep the lid on long-term interest rates.

New chapter or a continuation of what is now a familiar story, it seems to me that fixed interest markets are still well behind, or simply unbelieving. In Australia, for example, the 10-year bond rate is 2.6%. This is 1.1% above the cash rate of 1.5%, compared to a long-term average premium of the 10-year bond rate to cash of 0.8%. So there is perhaps some allowance for a rise in the cash rate over the ten years of the bond, but not much.

There is plenty of room for disagreement on how quickly the RBA might get to its announced new neutral or normal rate of 3.5%, but not much dispute that 3.5% or something not far from it will be the new normal. On present trends the RBA might be there in as short a time as two and half years or as long as, say, five years. Whether it is quick or slow, bonds are not priced for it.

If and when the RBA reaches the new normal rate, the 10-year bond rate should be around 4.3%. In principle it should already be heading up there, but it is not. Though it has gone up and down, the bond rate today is where it was a couple of years ago. That suggests to me that markets don't really believe the upswing story, even now.

As RBA Governor Phil Lowe warned last week, those who 'continue to expect a continuation of low rates of inflation and low inflation, despite quite low unemployment rates in a number of countries' might be in for a 'difficult adjustment'.

Markets in Australia and in other advanced economies are perhaps looking at inflation, and rightly reckoning that it might be quite a while before wages and consumer prices growth picks up. Maybe so, but if output growth is satisfactory the RBA may well begin to tighten – even if inflation is below the target. One reason is that very low interest rates at a time of firm economic expansion invite trouble. As Ellis said in a speech two weeks ago, we may see productivity picking up in the advanced economies. In that case we may have higher output growth without an acceleration of inflation. She added that if 'inflation stays low despite reasonable growth in a range of economies, policymakers will face a challenge'. This because policy 'still needs to remain appropriately expansionary while avoiding a further build-up of leverage and financial risk'.

To my mind, Ellis is alluding to the possibility that if growth is OK, rates may need to be increased even if inflation is below target. There is otherwise too great a risk that the price of assets like houses and shares may get too far out of whack with what prove to be sustainable levels.

Speaking shortly after Ellis, Lowe affirmed his expectation that GDP growth will be 3% over the next couple of years, and also affirmed that 3% is a bit higher than the sustainable or potential growth rate as now calculated by the RBA. Why would the RBA long maintain a cash rate at 1.5% (or for that matter 2.5%) with the danger of prolonged asset bubbles that setting presents, if the economy is going as fast as it can sustainably go? Lowe, after all, was one of the earliest central bankers to point out that asset prices could become perilously high even if general inflation was low, and policymakers needed to take that into account in setting interest rates.

It is true that Australia has higher household debt than it did, and this will make the RBA a little cautious in raising rates. Households overwhelmingly borrow on floating rates that move fairly promptly with the cash rate. Interest rate changes accordingly have more impact than in, say, the US.

Households are doing okay

All that said, I am not sure the household debt issue is quite as limiting as the RBA now suggests. Since the 2008 financial crisis in the US and Europe, leverage and debt have increased relatively slowly in advanced economies, including Australia. Over the last seven years, total credit outstanding in the Australian economy (including securitisations) has increased by 39%. In the seven years to the end of 2008 it grew by 140%, or three and half times the recent rate.

This is true even of housing debt in Australia. From 2001 to 2004 housing debt increased from 72% of household disposable income to over 100%. In the last four years it has increased from 120% of household disposable income to 135% – less than half the increase, as a share of disposable income, than the increase at the beginning of the century. Total housing debt increased 35% in the five years to July 2017, little more than a quarter of the rate of increase in the five years to January 2005.

The build-up of household debt in Australia is interesting and important, but often misinterpreted to suggest Australian households collectively are in a fragile position. They are not. Collectively, households in Australia have never been better off. Household net wealth in nominal terms is more than seven times greater than it was when the long Australian economic expansion started in 1991.

About two thirds of that wealth is in land and buildings, but even putting that aside households are in a very strong position. Total household liabilities – home loans, car loans, credit card debt and so forth – stand at around $2.4 trillion. It is an enormous sum but more than offset by household deposits at banks ($1 trillion), shares ($824 billion), various other financial assets ($645 billion), and $2.3 trillion in superannuation and pension assets.

Kapunda, South Australia (Photo: Flickr/denisbin)

Even excluding all of super and pension assets and the value of land and homes, the total owner-occupied and investor housing debt of households (around $1.6 trillion) is easily exceeded by the value of household bank deposits, shares, and other financial assets.

There should be nothing amazing in this. Households lend money to banks, and the banks then lend to other households to buy homes. That is the basic pattern. Through banks, households lend money to other households. This is why the total of household deposits at banks is usually nearly equal to bank lending for owner-occupied housing, and is today. Banks have outstanding loans to households of around $1 trillion for owner-occupied housing. Households have around $1 trillion in deposits with banks.

There might be a macroeconomic issue were household borrowing to increase consumption, an issue raised in IMF research released this week. But in Australia this is not the case. The growth of consumption spending over the last eight years has been well below its growth in the previous 12 years. As a share of GDP, household consumption is at the lower end of its long-term range. Overall, households are now saving around one seventh of their disposable income – not quite as high a share as immediately after the financial crisis, but well over the average of the last quarter century of economic expansion.

The economic issue or the financial fragility issue is how the financial assets and liabilities are distributed across households. We know from earlier RBA research that around one third of households rent, one third own their homes outright, and one third are buying homes and have a mortgage. This is the third that is vulnerable to higher interest rates, though most of that third have had a mortgage for long enough for repayments to decline as a share of their income. We have also learned the hardly surprising information that big mortgages are almost always held by households with big incomes.

There is certainly a risk that younger households have borrowed more than they will be able to service if rates are markedly higher. This is why APRA has imposed the rule that new borrowers must be able to service the loan if rates are 200 basis points higher, or 7% – whichever is more demanding. No doubt lenders fudge the rules where they can, but overall there should be considerable resilience to the 200 basis point increase in mortgage interest implied in a new normal cash rate of 3.5%. If the cash rate did increase to 3.5%, it would still be the lowest nominal cash rate in recent history, other than the last five years and the brief emergency setting after the 2008 financial crisis.

‘Choosing Openness’: Why haven’t we won the argument yet?

Putting his economist hat on, Andrew Leigh's new Lowy Institute Paper revisits the case for Australia to still choose openness in an age of rising populism and proposes some ideas for how to do it better.

Around the world we see populism on the rise and globalisation in retreat. Among so-called 'globalists', there is a lament that the arguments for openness have failed to cut through with the general public and the policy battle must be continually fought.

Leigh's contribution is less to go over the arguments in favour (though he does cover them with flair and in an accessible way, which might help persuade detractors). Instead, it is to show where the headline argument doesn't necessarily hold up and to suggest ways to correct this.

In doing so, perhaps a more nuanced argument can be made, better policies put in place, and the kind of populist pressures that have emerged so forcefully in other countries avoided.

The basic arguments for globalisation are well-rehearsed. For trade openness, there is Ricardo's theory of comparative advantage. For openness to foreign capital, the need to fund investment and bring in new ways of doing things. For immigration, the ability to attract foreign skills and ideas and grow the workforce.

Underpinning all of this is the premise that the net gains are sufficiently large that the winners could (theoretically) compensate the losers and still be ahead. Many are also quick to point out that advances in technology are far more to blame than trade for the loss of manufacturing jobs in advanced economies.

So why doesn't this argument cut through?

One reason is that globalisation's proponents often downplayed the fact that there are indeed losers and adjustment costs involved and, unsurprisingly, this imbalance often carried over into the relative policy emphasis. Recent research has also shown that the costs are much deeper than many originally thought. Globalisation's losers were thus never sufficiently compensated.

In the wake of populist uprisings, this imbalance in thinking is slowly being corrected – though there is a long way to go to translate changed rhetoric into substantive policy changes, let alone landing on the right solutions. Australia, luckily, has done better in this area thanks to our strong and targeted social safety net, but taking better care of displaced older workers that, quite understandably, struggle to adjust is one gap Leigh rightly identifies.

A second reason is that while the distributive costs of openness were at least acknowledged, legitimate non-economic costs have too often been left out of the basic pro-globalisation analysis.

Foreign investment that makes housing unaffordable or sharply increases wealth inequality is clearly socially undesirable. Leigh notes that policy in Australia already directs the majority of foreign residential real estate investment into new housing stock, but a residual issue is that a large number of residential properties remain vacant and thus in net terms don't add to available supply.

Another area is the (temporary) effect of immigration on social cohesion. Leigh puts forward evidence that while immigration tends to make society more innovative, particularly due to the benefits of diversity, it also in the short run reduces our sense of community (in the long run, this effect dissipates as new migrants integrate and we effectively redefine our in-group).

Citing research based on how teams of people interact in solving problems, Leigh notes that 'those in diverse teams said that they felt socially uncomfortable and were less certain about their solution to the puzzle. Performance went up, but enjoyment went down'.

A third reason why there is continued doubt is that it actually isn't clear that some recent forms of globalisation are indeed in the national interest. While foreign investment is needed in aggregate, if certain investments carry security concerns (in critical infrastructure, for example) or lower tax revenue due to aggressive tax avoidance by multinationals (with the profits shipped overseas) this can sometimes muddy the cost-benefit analysis (though not necessarily overturn it). The rising influence of both China and foreign technology giants heighten these concerns.

Similarly, while the case for trade liberalisation is sound, the arguments for some of the other things that have been tacked on to trade negotiations, such as investor-state dispute settlement mechanisms and expanded intellectual property (IP) protection, are much less so. The former inhibits policy for little to no benefit (it was originally intended to help developing economies with weak legal systems attract foreign investment). Meanwhile, expanding IP rights further would hurt Australia as a net IP importer, and it's unclear whether it would actually enhance innovation rather than hurt it or simply increase monopoly profits for patent holders at the expense of everyone else.

None of this lends validation to the many misplaced arguments against openness, from fears about employment to emotional calls for Australian business icons and agricultural land to stay in local hands. The arguments about the significant net gains from openness in trade, investment, and migration still stand. But unbalanced policy rhetoric and practice don't help and neither does the automatic acceptance or advocacy for all forms of globalisation, when some may not actually pass the national interest test.

The case for openness is thus compelling, but also more nuanced than many proponents tend to make it. That makes winning the argument all the more difficult in an age where people seem to want simple and direct answers, are often flooded with bad information, and don't know who to trust.

Fortunately, there are few signs that Australians in general are actually disenchanted with globalisation. In fact, the latest Lowy Institute polling presents quite a sanguine picture. A reasonable majority of Australians think globalisation is mostly good, are in favour of free trade, think immigration is about right or if anything too low, and see China mostly as an economic partner rather than a military threat. Attitudes to foreign investment are the least positive, but still doesn't rank as a top concern.

How can this positive disposition be sustained and built upon? Since making a better case for openness is mostly about the nuances, Leigh perhaps unsurprisingly mostly suggests a series of sensible enough policy tweaks rather than a complete overhaul. The key lies in strengthening public confidence that decisions are indeed being taken in the national interest, that those who lose out will be properly helped to adjust, and that checks and balances exist and are working effectively.  

Leigh also points to two areas where much more ambition is needed: addressing Australia's stagnating educational quality and taking an experimental approach to facilitating greater social capital at the community level.

Success in these areas would do more than just manage the downsides of globalisation. It would make Australia both more productive and more socially resilient in a world which is being increasingly disrupted. And as we know, the reasons for this go well beyond globalisation, though it is often the scapegoat.

Politics slows Saudi reform plans

Even to the Saudi leaders looking at the consultants' PowerPoint presentation last year, Saudia Arabia's 2020 'National Transformation Plan' must have looked improbable. Unemployment to be cut by a fifth in just three years, 1.2 million additional jobs in five years, half of the Saudi workforce to have jobs in the private sector by 2020. In total, Saudi ministries were given 346 firm targets to achieve. All part of a complete transformation of the economy by 2030 at a cost of at least US$72 billion and probably much more.

This was an action plan to move towards the wider Vision 2030, with goals, dates and (of course) key performance indicators. Much of this is to be funded by the public sale of 5% of Saudi Aramco, a move that would require for the first time the publication of detailed and correct accounts for the vast moneybag that sustains the Saudi political system and its international influence.

To many, these targets looked ambitious, and over the last few months the Saudi leadership has reached the same conclusion. The unemployment target is to be cut back, and individual ministries have evidently asserted an authority to run their own reforms rather than obey central direction. An amended draft is to be presented next month. In planning, the Saudi leadership is reminding itself, the more the target deadlines can be pushed out, the more likely they are to be achieved (or, if not achieved, amended).

The postponements aren't just the result of good sense reasserting itself in Riyadh (with some hard-headed economists evidently going over the numbers); there is also the slowdown in Saudi growth. The urgent problems of 2017 require more attention than the ambitions for 2020, let alone 2030. Add to this the unpleasant reality of oil prices well below the average of the last two decades (and for that matter the somewhat below-average real price of the last half century), and it's clearly getting harder for reformers to argue that now is a good time to start selling Saudi Aramco.

But while economic disappointments are important, the overwhelming reason for the plan's revision is that too many political challenges have bunched up at once. Crown Prince Mohammed bin Salman sees the wisdom of slowing the pace. There is the family resentment at Prince Mohammed supplanting his uncle as heir to the 80-year-old King, the ongoing conflict in Yemen, the easing of global sanctions against arch-enemy Iran, the continuing irritation of Shia protests in nearby Bahrain, and now Qatar's so-far successful defiance of the Saudi-run Gulf Cooperation Council.

For a ruling family that has survived many worse dangers, these challenges are not particularly troubling. The Saudi royal family manifestly kept its grip during the Arab Spring, the brief rule of the Brotherhood in Egypt, the zenith of Islamic State authority in Syria and Iraq, and the collapse of oil prices in 2014 (largely engineered by the Saudis themselves).

But at the heart of the Saudi regime, and of its wealthy neighbours, is discretionary access to very, very large amounts of money. The family's unspoken pact with Saudi citizens is that they will be provided with health and education services, helped with housing, given undemanding and well-paid public service jobs, taxed lowly or not at all, and given early retirement. It is a very expensive compact. And within the ruling family itself, vast wealth is distributed in a manner calculated to reward loyalty and punish disaffection.

This is why the brightly titled and altogether standard McKinsey packages of the National Transformation Plan 2020 and the wider Vision 2030 pose a political challenge to the regime like no other. The former may, as it claims, employ 'global best practices in strategy implementation', including the 'launching (of) performance measurement indicator dashboards and implementing (of) the project portfolio management methodology', along with 'the deployment of rapid intervention measures of government bodies should initiatives stall'. Offered as technocratic reforms – with targets, KPIs and indicator dashboards, and all the affectless language of the business school and modern management – the plans cannot be implemented without amending Saudi Arabia's political configuration. There will be winners and losers, but the winners are in the future, while the losers are here right now.

Vision 2030 cannot be financed at the scale intended without opening Saudi Aramco's books to the untiring scrutiny of global markets and of Saudi citizens, enhancing the authority of its professional management and raising endless questions about quite how the revenues are spent. The plan's objective is to shift Saudi employees more rapidly from the public sector to the private sector, a transition already straining the goodwill of younger Saudis observing older generations enjoying benefits denied to them. The plan imagines new taxes and fewer subsidies, and requires central control over ministers and ministries accustomed to running their own shows.

These are not religious issues, not issues of freedom or democracy or even of regional foreign policy or the Saudi alliance with the US, all customary points of discord in the Saudi polity. The economic issues are deeper than all of these because they are at the core of the regime's power. Little wonder the pace of reform is slowing. But Prince Mohammed is also young enough to know that some viable alternative to an oil-dependent economy must be developed within his lifetime, if the House of Saud is survive a generation or two beyond his own.

‘Choosing Openness’ grapples with the big questions

In Choosing Openness, Andrew Leigh makes an important and timely intervention in the Australian debate about globalisation, free trade and immigration. This is, of course, a debate raging around the world, one that has seen Britain exit the EU, Donald Trump elected US President, Marine Le Pen challenge for the French Presidency, and Nazi sympathizers enter the German parliament.

From the outset, Leigh provides the perfect contrast of the winners and losers of globalisation. Nathan, a shift worker in an automotive glass plant in Geelong, lives in an area with 20% unemployment. A barrister living in the eastern suburbs of Sydney charges $10,000 a day. Leigh meets them both, in the same country, within weeks. Yet their experiences of the modern economy could be separated by thousands of miles and several decades.

Building on his earlier work on inequality, Leigh notes that over the past decades the incomes of the top 1%, and even more so the top 0.1%, have risen strongly. Meanwhile, income for those in the middle have seen much less impressive growth. Indeed, in the US, the median worker's income has not risen in real terms for around 30 years. Australia is doing a little better, Leigh reminds us, but there is a glaring disparity between the experience of the top of the income distribution and the middle.

But the real gist of Leigh’s contribution is to link these economic forces to social ones. He wants to explain why 'openness makes us uncomfortable', and he contends that, though economic forces play a role, there is more to it than that. According to Leigh, to explain Trump and Le Pen we need to think more broadly. He identifies four forces.

The first is the terrible economic outcomes for a large share of the population. Second, he points to technology. This is in part linked to economics, through automation and the impact on jobs. But Leigh is more interested in media technology — how we get our information. For Leigh, the 'new media ecosystem' allows us to choose our news and our facts, and provides fertile ground for conspiracy theories. Third, he gives due credit to 'political entrepreneurs' like Trump. Finally, he points to the vacuum left by the shrinking centre.

This strikes me as a pretty good diagnosis. But Dr Leigh is rarely content with understanding a problem. He wants to solve it. And in his characteristically persuasive and upbeat fashion, he goes on to make the case for trade, migration, and foreign investment. And, as is his style, these arguments are filled with compelling evidence.

The unifying theme running through the case for all three things - trade, migration, and foreign investment - is that they make the 'pie' bigger. Trade allows us to benefit from comparative advantage, selling our resources, agricultural products, even education, to a burgeoning Asian middle class. It also allows us to buy things from overseas much more cheaply. Migration fills skill gaps and enriches Australian society socially. Foreign investment provides a capital-thirsty Australia with the fuel to develop our good ideas and take them to the world.

The real question is how to make sure everyone benefits from this expanding pie. In my opinion, this is the great political question of our time, and Leigh grapples with it. In the final chapter, Leigh outlines a range of specific ideas to help re-slice the pie and keep Australia open. From tying skilled migration to labour-market needs to reviewing thresholds for foreign investment, Leigh has a policy tweak for seemingly every problem.

If I have a criticism of Leigh’s brilliant monograph, it is here. He wants to tinker. A little less of this, a little more of that. An adjustment here, an adjustment there.

Perhaps that’s the right answer, but I suspect it will take more. There is a battle of ideas raging that arguably requires a bold call to arms, not a series of technocratic innovations. Leigh leaves me wondering if, while we rewrite Australia’s foreign investment review process, a Le Pen type will capture a chunk of the Australian public by appealing to its gut rather than its mind.

It is ten years since Thomas Friedman’s now classic characterisation of globalisation in The World is Flat. In those ten years the winners and loser from globalisation have become even clearer, and the predictable backlash has gained political traction. It has taken an ugly tone at times.

In this wonderful monograph Andrew Leigh has provided us with a clear and compelling reminder of the challenges involved in remaining open — with all the benefits that ensue — while addressing the concerns of those hurt by openness.

Managing economic risk in Asia: A strategy for Australia

Barry Sterland’s new Lowy Analysis explores the possibility of a future economic crisis in our region – this is not today’s problem, but something we should be prepared for. The paper benefits from his years of experience in the Australian Treasury and the International Monetary Fund. It sets out the weaknesses demonstrated by the historical experience, judges that things are much better now, and argues the case for further improvements.

Sterland makes the sensible case for the centrality of the IMF in any crisis management preparations. The Fund has the experience, expertise and objectivity to play a central role. But this may not be enough.

First, the next crisis might not be caused by external-sector problems which is the type the IMF has traditionally faced. In the days when most exchange rates were fixed, crises often took the form of current account unsustainability. More recently, with most exchange rates floating, the problem has been volatile capital flows: excessive inflows followed by sudden reversals, such as the 1994 Mexican Crisis and the 1997 Asian Crisis. But economies can get into trouble for reasons which don’t fit the IMF crisis protocols. The Fund was largely irrelevant in the 2008 financial crisis. It’s hard to see a key role for the fund if China’s financial sector gets into serious trouble or Japan’s huge government debt proves unsustainable (although in both cases the spill-over onto other countries might see a role for the Fund).

Second, in those cases where the problem does originate in the external sector, the Fund’s resources are quite modest, considering the size of current global capital flows. The Greek rescue in 2010 illustrates that even a small country can require far more support than the Fund can provide (its contribution is just over 10% of the total, with the bulk of the funding coming from the European Commission and European Central Bank). Asian economies’ own reserves-holdings are far greater than the Fund drawings that might be available to them in a crisis. Indonesia, for example, has reserves four times its potential IMF drawings.

There are additional resources potentially available – from the Chiang Mai Initiative Multilateralization (CMIM) and various other bilateral arrangements, set out in Table 2 of Sterland’s paper. However the formidable operational problems of coordinating these different sources have not yet been settled.

Third, even 20 years after the Asian financial crisis, memories of the Fund’s errors still rankle. Perhaps if a crisis is serious enough, a country in trouble would have to bear the political cost of going cap-in-hand to the Fund, but by that stage the crisis would be way beyond low-cost solutions. Speed is of the essence in responding to a crisis. The stigma of 1997 will prevent the Fund from being in the forefront of the response.

Keeping the focus just on external-sector crises, what more might be done? Prevention, of course, is better than cure. Much more active capital-flow management would reduce the likelihood of crisis. The Fund has come a long way in acknowledging a role for capital-flow management, but still sees this as being at the very bottom of the policy toolbox, to be used only when all other measures have failed. This lukewarm acceptance needs to be replaced by extensive exploration in policy papers of all the operational issues involved, to make it clear that the Fund endorses such policies. Pre-crisis, what types of foreign inflows have the best risk/benefit trade-off, and what can be done to tip the mix of inflows to favour these? What domestic borrowers are likely to attract stable foreign inflows and which borrowers are the most likely to get into trouble? What are the most effective forms of capital-flow management?

If the crisis does arrive and, as suggested above, there is not enough assistance to fund the outflow, what next? The answer in 1997 was that GDP had to fall far enough to turn the current account deficit into a surplus big enough to fund the outflow. This is, to say the least, not ideal.

The better answer is to take measures which reduce the volume of crisis outflow. A temporary stand-still on foreign capital outflow is enough to solve a liquidity crisis. This was the measure taken, belatedly, in the case of South Korea in 1997. Where the foreign debt is unsustainable, the amount has to be reduced with a ‘bail-in’ of creditors, reducing the size of the liabilities through a ‘haircut’. This was the still-incomplete response in Greece, again arrived at only after a two-year delay which made matters much worse.

This type of response is hardly novel, but has often been resisted, including by the Fund. At the August 1997 donors’ meeting, Fund Deputy Managing Director Sugisaki, chairing the meeting, specifically banned discussion of this possibility, whether because of Fund doctrine at the time or to help Japanese creditor banks. In 2010, pressure from European authorities prevented a timely bail-in of Greek creditors.

Morris Goldstein summed this up in his post-mortem of the Asian crisis:

Relying more and at an earlier stage on ad hoc debt rescheduling to handle private sector debt insolvencies is the only way to get these rescue packages back to a reasonable size.

Sovereign debt ought to be the easiest to resolve in a crisis, but the Fund’s strenuous effort to put in place rescheduling procedures has fallen afoul of the Wall Street lobby, which wants to see debt as sacrosanct, always repaid in full. This is a fine principle, but every country has its domestic bankruptcy procedures, which allow a failed enterprise to restructure debt. Why not have the same for international debt? We are still a long way from any proper resolution process: just last year Elliot Management, a so-called ‘vulture fund’, successfully used US courts to obtain full repayment (with interest) for the Argentine defaulted debt that Elliot had purchased at huge discount.

Effective international debt-resolution procedures would also discipline the pre-crisis excessive inflows, reminding investors of the risk of default. The German and French banks which invested so enthusiastically into Greek government debt before 2010 might have been less eager if they had been more conscious that they might lose some or all of their money.


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