Wednesday 11 Dec 2019 | 01:04 | SYDNEY
What's happening on

About the project

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

The International Economy 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

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.

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.

Pages