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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

Ten years after the GFC, are we safe?

Ten years ago this month, Northern Rock experienced the first depositors' run on a British bank for 150 years and failed shortly afterwards. This was not the first manifestation of the global financial crisis: French bank BNP Paribas had frozen withdrawals from mortgage funds the month before; US bank Bear Stearns had bailed out two of its hedge funds in June; and a large US sub-prime mortgage broker had failed earlier in 2007. The worst of the crisis was still a year into the future – the failure of Lehman Brothers and the rescue of insurance giant AIG in September 2008. But Northern Rock's failure revealed many of the vulnerabilities that were to prove widespread.

The decade since has seen major changes in regulation and prudential supervision. Everyone agrees that the financial system is much stronger. But one of the unexpected lessons of the decade was just how fragile and vulnerable the sector had been, how imperfect was prudential supervision and how ill-motivated were financial market participants. It's easy to say that things are better, relative to that dismal standard – there is less agreement on whether the global financial system is now strong enough to be immune from a new crisis.

The main global reform has been to increase substantially the capital which banks must hold. Shareholders' capital is the loss-absorbing buffer which is available to keep banks solvent when things go wrong. In the careless pre-crisis world, many banks operated with dangerously high leverage – small losses were enough to bring them, cap in hand, asking for taxpayers' assistance to avoid bankruptcy. Not only have capital requirements been raised but as well the measurement and definitional issues which banks had used to game the rules have been tightened.

But is this increase enough? Admati and Hellwig, Morris Goldstein, William Cline and others have argued that a crisis such as 2008 does so much damage that substantially higher capital is justified. Banks, for their part, are reluctant to expand expensive equity capital. The G20 was instrumental in achieving a compromise approach in which the biggest global banks would strengthen their balance sheets by issuing debt that could be converted into equity if needed. But if this loss-absorbing debt is held by vulnerable holders such as households or pension funds, governments will be reluctant to see those asset-holders bear the losses when a crisis arrives.

These measures to increase bank capital have been designed to address 'too-big-to-fail' (TBTF) – governments will not allow banks to fail, because one failure will trigger contagious runs on other banks. Thus, the taxpayers end up absorbing the losses of the financial system. TBTF has also been addressed directly by making it much harder for US and European central banks to provide 'lender-of-last-resort' support. This is an understandable response to the public anger at the bank bail-outs, but restricting the use of this powerful crisis-management tool has made the financial system more vulnerable in a crisis.

What of the many other regulatory changes incorporated on the 2010 US Dodd-Frank Act? These certainly put greater compliance obligations on banks, adding to their costs. Wall Street's powerful lobby inside both the White House and Congress is busy white-anting as much of this as possible. The key test here is whether the 'Volcker Rule' provisions survive. The original Volcker Rule enforced a separation between banking business and riskier financing (such as derivatives and market trading). It was repealed in 1999 at the behest of Wall Street, with the result that banks then took on a smorgasbord of high-risk exposures that proved an element in their 2008 undoing. Banks benefit greatly from being able to use their government-protected status to raise money cheaply to fund these high-risk activities, and will work hard to water down the Volcker provisions.

If the Volcker rule (and its European equivalents) holds, that still leaves a problem. Tighter rules on banks encourage more financial transactions to move into the less-regulated shadow banking sector, where many of the 2007-08 problems appeared. The Fed's Vice-chair Stan Fischer, while affirming that 'the soundness and resilience of our financial system has improved since the 2007-08 crisis', also acknowledges that 'we still have limited insight into parts of the shadow banking system'.

So much for the response through new rules and regulations. Far more important in avoiding another crisis are the environment and behavioural standards of the financial sector as a whole. The experience of 2008 revealed that banks were willing to finance borrowers without proper regard for capacity to repay; market operators were ready to bend the rules; credit rating agencies would put commissions ahead of competent evaluation; financial salesmen were looking to unload risky assets onto unsophisticated investors; risky derivatives became a game of 'pass-the-parcel'; and prudential supervisors were either too sanguine or too constrained to do a competent job. Low standards were contagious – if others were doing it, you had to join in.

Abetting these low standards was the prevailing doctrine of 'efficient markets' – financial markets should be allowed to operate with minimal regulation and light-touch prudential supervision. Former Fed Chairman Alan Greenspan has issued his mea culpa, but it's hard to see much change in Wall Street's mindset.

The other critical factor is the macro-environment. After a decade of abnormally low interest rates and massive quantitative easing, investment decisions and portfolio choices have been biased and prices distorted. Low interest rates have encouraged 'search for yield', down-playing risk. Earnings in pension funds have been inadequate. If a new crisis arrives, monetary policy is in no position to offer further stimulus and fiscal policy is constrained by accumulated debt. And in most countries credit has continued to grow faster than GDP, leaving borrowers more exposed.

Considering this compendium of imperfect reforms and unaddressed vulnerabilities, why does Fed Chair Janet Yellen say that another financial crisis like 2008 is 'not likely in our lifetime'? The short answer is that memories of the post-crisis trauma are a powerful antidote against a repeat, strengthening the hand of prudential supervisors and restraining the risk-takers. Yellen is affirming that, for the foreseeable future, there will still be enough people around in positions of authority who remember 2008. Memory, however, offers limited protection against new crises with different characteristics (perhaps beginning with China's over-extended financial sector or Japan's huge government debt). It won't be like 2007-08, but the tirelessly ingenious financial sector will find new ways of getting into trouble.

Addressing global capital flows

International capital flows present serious policy challenges. In textbook economics, such flows are unambiguously beneficial. But volatile flows were a key cause of the 1997 Asian crisis, cross-country financial linkages exacerbated the 2008 global crisis, and capital flows were once again central in the 2010 Greek crisis. There has been substantial shrinkage of financial flows since 2008 – the McKinsey Global Institute sees these reduced flows as strengthening the benefits and reducing the risks. But the policy challenge of coping with volatility remains. The International Monetary Fund should do more to make capital-flow management a routine element in the toolbox of policymakers in emerging economies.

It's hardly surprising that the 2008 crisis changed global capital flows. In the period leading up to the crisis, the unrestrained expansion of financial balance sheets often involved complex layering of transactions with multiple institutions in different countries. These excesses have been wound back, with overextended banks retreating to their home turf and contracting their balance sheets, spurred on by fear of insolvency or by the requirements of prudential supervisors. Banks have had to raise their capital ratios substantially, which has meant abandoning non-core operations, with their foreign adventures the first to go.

McKinsey analysts, ever the optimists, see this retreat as beneficial.

These developments do not signal an end to financial globalization—although there will be risks. Rather, we see a healthy correction from pre-crisis excesses, and a return to a potentially more stable and risk-sensitive era of financial globalization.

The gross flows are now 65% below 2007. Most of the fall is in bank lending, leaving foreign direct investment (FDI) and investment in equities stronger than before, with these two components now making up 69% of flows.

The aberrant period was the 2008 crisis and the pre-crisis period. In this pre-crisis period European banks, in particular, became lenders to the world, caused a 'global banking glut' and got themselves into trouble. Flows have now returned to a more normal pace, but with FDI a much larger component. FDI has long been considered to be notably more stable than other flow components. McKinsey sees this as a more stable environment, and probably more beneficial as well: FDI brings with it technology and managerial know-how.

One of the lessons of the past two decades is that it not just the flow that can be volatile ('sudden stops'): when things go wrong, the market focus turns to the stock of liabilities – the accumulation of the flows. The stable elements (FDI and equity) account for around half the stock of foreign liabilities, so there is still plenty of room for the other volatile elements to cause problems.

For the emerging economies, the vulnerability from capital flow reversals remains a policy concern so long as a country is running a significant external deficit. In the textbook world, emerging economies should run external deficits to enable them to invest more than they save, speeding economic development. In the real world, external deficits have to be kept within whatever bounds the financial markets impose. In aggregate, the total global external deficit has shrunk since 2007, from 2.5% of global GDP to 1.7% in 2016. Not only has the composition of current flows become more stable, but the smaller deficit suggests that the global system is safer – at least in aggregate.

But even with bank lending greatly reduced, both the flow and the stock of volatile portfolio flows are still substantial. Government debt is now much larger than before 2008, and more is held by foreigners – 22% in aggregate. For countries like Indonesia, the percentage is higher still – over one third. McKinsey understands the ongoing vulnerabilities:

However, risks remain. Gross capital flows—particularly cross-border lending—remain volatile. Since 2010, in any given year one-third of developing and two-thirds of advanced economies experience a large decline or surge in total capital inflows. The median change is equivalent to 6.7 percent of GDP for developing countries and 10.8 percent for advanced economies. These fluctuations create large swings in exchange rates and could reduce macroeconomic stability. Cross-border lending is particularly volatile. Over the past five years, more than 60 percent of developing countries and over 70 percent of advanced economies experienced a large decline, surge, reversal, or recovery in cross-border lending each year, making volatility the norm rather than the exception. New tools to cope with volatility are needed.

The IMF, previously a vocal advocate of unrestricted free capital flows, has now accepted that these flows create vulnerabilities. The IMF even accepts that capital-flow management (the acceptable term for what used to be condemned as 'capital controls') may be appropriate in some circumstances. But this possibility is right at the bottom of the policy toolbox, and there is no discussion how it would be applied in practice. The implication is that such measures still don't have a full endorsement by the IMF, and hence will be seen by financial markets as a measure of policy weakness. It's time for the IMF to develop some operational guidelines for capital-flow management for emerging economies and promote them as a normal element of good policy-making.

Taxing global capital

Over the past quarter-century, global capital has become far more mobile and some foreign investors have become more sensitive to company tax issues. Much ingenious effort has been devoted to shifting company profits to tax jurisdictions with low rates and to avoiding company tax entirely. Perhaps in response, the global trend has been to reduce company tax rates. Australia has lagged this downward trend, although the current government has used substantial political capital to begin moving in this direction. But why bother? The reductions envisaged won’t have much effect on foreign investment.

In international comparisons of company tax, Australia is always shown as having a rate of 30% (compared with an average OECD level of around 25%). But nothing is simple in the world of tax. Since 1987 Australia has had a system of company tax imputation, whereby Australian shareholders get a credit or refund for the tax which their company has paid: for Australians, the effective company tax rate is zero. Foreigners, however, cannot claim these imputation credits. Thus a foreign company contemplating investment in Australia might be tempted to shift its investment to a country with a lower rate.

For some, this anxiety about discouraging foreign investors might be a hangover from the days before the 1983 float of the Australian dollar, when funding our chronic current account deficit was a constant policy concern. Since 1983, if the attraction of Australia for foreign investors diminished for whatever reason, the exchange rate would adjust, depreciating to keep the current account and the capital inflow balanced.

The 2010 Henry Tax Review was concerned about Australia’s attractiveness for foreign investors, but put forward a more esoteric argument for reducing company tax. In a world of perfect capital mobility, the cost of capital would be set in global financial markets and any corporate tax imposed by Australia would impinge ultimately on the other factors of production: labour and land.

We are very far from this world of perfect capital mobility. Foreign companies invest in Australia for a variety of reasons. They identify above-average investment opportunities (where ‘economic rents’ are available), often based on their own profitable know-how and intellectual property. For portfolio investors, they similarly identify characteristics of the Australian market that they find attractive. Separated from global financial markets by our exchange rate (and a multitude of other factors), the real world is far distant from the textbook-perfect capital market.

Of course there are many other real world factors at work. To start with, it looks like the large tech companies such as Facebook, Amazon and Alphabet (and perhaps many others as well) don’t pay much tax here anyway. Offering a lower rate will make no difference. And for those foreign investors who pay tax in their home country, lowering our company tax rate would often just mean that foreign investors pay more tax at home.

Whatever the intellectual attraction of this ‘global capital’ argument, even its economist proponents accept that the effect of lower company tax on Australian national income would be minuscule.

Instead of lowering the company tax rate for everyone, why not give the foreign shareholders the benefit of imputation, allowing them a credit against any income tax they might pay in Australia? After all, the core logic of imputation is that the company structure is just a legal veil: to tax both the company and the shareholders amounts to double taxation. In practice this would be complicated and probably few of them pay Australian tax anyway.

If the foreign shareholders pay little or no Australian tax, then taxing the foreign company here seems a good - if imperfect - answer. Foreign companies have the benefit of Australia’s governmental and administrative infrastructure, protecting their physical security and providing legal backing for their contracts and intellectual property. They should make a contribution to the upkeep of this system, just as Australian shareholders do.

So the status quo might be judged to be a reasonable and fair outcome, with little reason for the government to assign such priority to reducing the corporate tax rate (and finding replacement revenue). Could there, however, be other motivation?

Ken Henry, who led the review, noted that it had long been a desirable tax principle that the top marginal income tax rate should be close to the company tax rate, so as to negate the incentive for high-tax-bracket Australians to shift their personal income into a company or trust structure, in order to delay taxes (benefiting from the time value of money). Some measures were taken to address this, but they seem to have left considerable loopholes. Perhaps some of those lobbying for lower company tax rates are the beneficiaries of such schemes.

The other conclusion we might draw is that, as this is a global problem reflecting the rootlessness of mobile capital, then a global solution may be needed. There are vexed issues of deciding where the tax obligation should lie: in the country of the shareholder; where the goods are produced; or where they are sold. As a starting point, however, we can leave aside this complexity to make a simple point: an enterprise that benefits from the deep social and legal infrastructure needed to make its operations possible should pay a fair tax somewhere. This is clearly not the case at present, with daily press reports of derisory amounts of company tax paid by large multinationals because of transfer pricing and accounting arrangements in tax havens and low-tax jurisdictions.

The OECD has struggled valiantly with its Base Erosion and Profit Shifting (BEPS) measures. It may be that this G20-promoted effort to force greater transparency on some of the most blatant tax havens - such as Switzerland, Luxembourg, Singapore and Ireland, to name just a few - might have some impact over time. But vested interests, particularly in the large economies with loud voices in the BEPS negotiations, will delay and limit what can be done. As globalisation becomes more deeply entrenched, the paucity of consistent global rules will limit equitable solutions to problems such as company tax. In the meantime, awaiting these global rules, there seems no strong case for lowering the company tax rate in a misguided attempt to attract more foreign investment.

Indonesia: ‘Twin deficits’ still a brake on high growth ambitions

Things are gradually improving for Indonesia’s economy. Policymakers have successfully assuaged financial markets of their macroeconomic stability credentials (for now) and economic growth seems to have stabilised at a still robust 5%.

Hopes are high that the bottom of the cycle has been reached and growth will start to accelerate. Some expect growth to lift towards the mid 5% range over the next few years. President Jokowi is of course hoping to do much better to reach the 7% plus target he originally set upon winning office.

His agenda of deregulation and infrastructure investment is certainly on the mark in terms of policy focus - there’s no doubt these are among the most pressing issues. Much will depend of course on successful implementation. So far there appears to be good progress on the former while progress on the latter may be improving.

This gives some hope. But even if Jokowi is very successful in this agenda, the economy may quickly run into another constraint – its current account (balance of trade and other income) and fiscal deficits. These ‘twin deficits’ played a key role in the growth deceleration that started a few years ago and have so far only been partially unwound.

The fiscal deficit is now the problem

The current account deficit (CAD) has fallen from a peak of 3.2% of GDP in 2013 to just under 2% today. A common rule of thumb is that Indonesia needs to keep the CAD below 3% of GDP to avoid instability risks, so there is now some head room but not a lot. Meanwhile the fiscal deficit has become even bigger and is now virtually at the legal limit (3% of GDP), expected to come in at 2.6% of GDP this year. 

The two deficits are of course interrelated. Many blame the still large CAD on supply side problems limiting the response of manufacturing exports to a more competitive exchange rate. That’s certainly part of the story. However, the fiscal deficit seems to be the bigger culprit.

To see why, recall that a current account deficit implies that national savings are insufficient to finance total investment, with the difference made up by tapping foreign savings. A fiscal deficit means the government is a negative source of net savings in this equation.

The chart below shows how Indonesia’s CAD has evolved, including how different sectors have contributed. The sectoral breakdown for 2016 is not yet available so I have just shown the overall CAD and the government contribution as these are readily available. The relative contributions from corporates and households in 2016 probably did not change much in any case.

As the chart shows, a large deficit emerged in 2012 following the end of the commodity price boom in late 2011. At first the deficit was driven primarily by the corporate sector, as ultra-easy global liquidity conditions allowed Indonesian firms to binge on external debt. Government net savings also worsened as lower commodity prices weighed on resource-based public revenue.

Markets were willing to finance the CAD for a while. But Indonesia’s inability to sustainably finance a large CAD quickly reasserted itself with the ‘taper tantrum’ that began in May 2013. Indonesia managed the adjustment quite well (through tighter monetary policy and allowing the exchange rate to fall) but this was of course achieved through slower growth.

Importantly, the entire adjustment was borne by the corporate sector while the government fiscal position continued to worsen. Recent reforms to cut energy subsidies have only contained, rather than curtailed, the fiscal deficit.

Source: Indonesia Central Statistics Agency

No easy ways around stability-growth trade-off

Thus, Indonesia has basically stuck to the confines of the well-worn trade-off between maintaining stability and pursuing faster growth. If markets have been assuaged, it largely reflects the continued adherence by Indonesian policymakers, particularly the central bank, to a paradigm which prioritises stability over growth. Much has changed, but memories of the Asian Financial Crisis still loom in the background for policymakers and markets alike.

So what does this mean for Jokowi’s hopes of using deregulation and infrastructure to spur much faster growth? In a nutshell, it would likely see the CAD quickly returning to the warning territory of 3% of GDP. Unless, there is deep fiscal reform and in particular tax reform to significantly raise public saving.

Consider Jokowi’s infrastructure agenda. The World Bank estimates this will involve an increase in public spending of about 2.6% of GDP a year. But government ambitions are much higher. Recognising its limited fiscal resources, even more is to be financed via capital raisings by state-owned enterprises and public private partnerships.

This ostensibly gets around the budget constraint but it does nothing about the CAD constraint. Regardless of the funding source, the increase in investment will directly add to the gap between national investment and savings, and thus the CAD. To prevent a rise into danger territory, or alternatively a significant crowding-out of private investment, national savings need to rise.

The same logic means that thoughts of relaxing the legal budget deficit limit to allow more growth enhancing investment (sometimes suggested since public debt levels are quite low) will also not work.

Increasing government saving through fiscal reform is thus the obvious solution. Cutting poor quality spending like energy subsidies is a useful starting point which government is pursuing. But there is simply not enough there to provide the level of funding needed. Especially once the need to increase funding for other growth priorities like education is added to the mix.

Increasing Indonesia’s low tax take will thus need to be a big part of the solution. Currently it sits at a mere 11% of GDP. It should be several percentage points higher. There is plenty of scope through both policy changes and better enforcement. Unfortunately, reform in this area is progressing slowly, undoubtedly due to the politics involved.

What about higher private net savings? If anything, this would likely deteriorate in the event of a marked growth acceleration. Faster growth would increase the return on investment, encouraging higher investment, and higher expected future incomes would reduce the imperative to save. This same dynamic would likely hold if the growth acceleration was primarily driven by successful deregulatory reforms.

Accelerating the development of the financial sector could help mobilise higher private savings, but takes time to bear fruit, especially without sparking instability risks of its own.

All this means that even deeper fiscal reform would be needed if the CAD were to be contained while creating room for a private sector response to any significant growth acceleration.

Risk it?

Perhaps Indonesia doesn’t need to worry so much about the current account? For instance, greater reliance on foreign direct investment (FDI), rather than more volatile ‘hot money’ portfolio flows, could provide much more stable CAD financing. Deregulation and better infrastructure should help attract more FDI, though the liberalisation of FDI restrictions themselves has been limited so far. Still, a large CAD would require large portfolio inflows, with their attendant risks.

Markets might be more lenient towards Indonesia in the future. It has built up some policy credibility and a reform-driven widening of the CAD would be interpreted more positively. Global liquidity conditions are also still very accommodative.

But the problem with a large CAD is not that it cannot be financed at all. Rather, it’s that sudden changes in market sentiment are common and tend to have destabilising effects. A large CAD leaves the economy exposed. For instance, uncertainties about the path of future monetary tightening by major central banks means the prospects of a re-run of the ‘taper tantrum’ is a real risk.

As long as stability is prized over growth, twin deficits it would seem are still a binding constraint.

How the IMF evaluates the Asian financial crisis

With this month marking the 20th anniversary of the forced floating of the Thai baht, the IMF has joined the numerous commentaries looking back on the Asian crisis and the lessons learned. The tone of a recently published blog post by IMF Deputy Managing Director Mitsuhiro Furusawa is one of quiet satisfaction, both with the recovery and the reforms that have made these countries much safer. But a different narrative can be told.

The recovery from 1997 is described by Furusawa as 'nothing short of impressive'. In fact, it took five painful years before Indonesia's GDP returned to its pre-crisis level. In per-capita terms, restoring the 1997 level did not happen until 2004. It took even longer (until 2012) for Indonesia's share of world GDP to return to the pre-crisis level.

 

There is, however, a more important point to be made about the post-crisis growth trajectory. Perhaps the most important lesson these countries took from the crisis was that, if they wanted to be avoid a repeat, they would have to grow much more slowly. Hence Indonesia's annual growth has been just over 4% over the past twenty years. Thailand's figure is a little more than 3%. Even leaving out the trough of the crisis, annual growth has averaged around 5% for Indonesia, less for Thailand. Even the poster-child of global development, South Korea, has grown slowly.

If Indonesia had continued to grow at the 7% annual average achieved during the three decades of the Suharto era, Indonesian GDP would now be more than 60% higher than it is. These countries are paying a high price for the safety of a more sedate pace of growth. The difference between 5% and 7% may not sound like much, but it is the difference between doubling income in 15 years or doubling in just a decade.

Thus the key issue in evaluating the post-crisis period is not to laud the 'impressive' recovery, but to ask whether this slower growth was and is inevitable, and if not, what should be done to remove the constraints. If, as Furusawa's post asserts, there has been much progress in making these countries safer than they were, why is it necessary to grow substantially slower than before?

In the case of Indonesia, the critical constraint is provided by the current account deficit. If this approaches 3% of GDP, the authorities apply the brakes through tighter fiscal and monetary policy, for fear of alarming foreign exchange markets. At the same time, foreign exchange reserves are over US$120 billion – in effect Indonesia borrows this amount from foreigners and re-invests the proceeds back in foreign assets (mainly US government securities) with an interest rate return one-quarter of the cost of borrowing these funds. This is the insurance premium which Indonesia pays so that it is ready for a reprise of 1997, when foreign capital fled the country.

If the new post-crisis world was so much better than before, this kind of insurance would not be needed. In this ideal world, the floating exchange rate would remove the external constraint. Capital flows would be less volatile, and if a shock occurred, Indonesia could rely on being able to draw immediately on the shared insurance provided by the IMF's facilities, the Chiang Mai Initiative Multilateral (CMIM), and the various bilateral swaps the IMF sees as now being available for such eventualities.

The reality is that Indonesia (and its neighbours) recognise that they live in a world of flighty capital. Exchange rates still show an unaccountable degree of volatility, even for the big countries with deep financial markets. Exchange rate flexibility doesn't remove the external constraint. Financial sectors (both domestic and overseas) are still fragile. The 2008 financial crisis demonstrated what can go wrong, even in developed economies. And, left unsaid in the IMF commentary, there is still a deeply held stigma about drawing on IMF programs.

Indonesia could become less reliant on these fickle sources of foreign funding if its own financial sector had developed breadth, depth and resilience. But the banking sector, as a percentage of GDP, is half its size before the crisis – it has never fully recovered and still has many fragile banks. Other elements of finance (equity markets, corporate bonds, insurance, and pension funds) are still embryonic.

Is the IMF more prepared to help in the next crisis? Certainly, its assistance programs are more readily available than the 1997 programs, which were inadequate in size and ill-suited to the nature of the crises. But the top-of-the-list of foreseeable problems in Asia (excessive domestic debt in China and Japan) aren't amenable to IMF programs, and any crisis would have to be largely handled by the domestic authorities. The IMF was largely irrelevant in the 2008 financial crisis. The ongoing 2010 Greek debt saga, not foreseen, has left the IMF with its operating principles badly stretched, the recipient of the program with its GDP down 25% and foreign debt levels that the IMF itself describes as 'unsustainable'. It still has no procedures for 'bailing-in' foreign creditors. Capital flows are now so large and potentially volatile that the IMF's own resources seem puny, and coordination with other sources (CMIM or US Fed swaps) remains untested.

The IMF has a thankless task – by the time its assistance is called on, the problems are already out of hand and crisis medicine is inevitably bitter. Perhaps the only way to keep morale high is to overstate how much has been achieved since the last crisis, and hope for the best when the next one arrives.

Safeguarding competition in a cyber economy

The European Commission in Brussels has fined Google €2.4 billion for using its dominant position in search to advantage the Google price-comparison service. The internet giant has yet to give a substantive response, but this case illustrates the challenges that new technology poses for competitive markets everywhere.

Adam Smith recognised the tendencies towards monopoly 250 years ago. But the nature of monopoly has changed greatly. In many ways technology has made competition stronger, reducing barriers of distance and improving information. At the same time technology has produced more examples of natural monopoly.

The traditional example of natural monopoly is the provision of water and electricity. It doesn’t make sense for electricity cables and water pipes to be duplicated in the street, so it is inevitable these services will have strong monopoly elements. The same inevitability applies to many technology services. The normal operation of the market will tend to produce a single dominant operator, such as Facebook, Airbnb and Uber. Facebook is hard to displace because all your friends are using it. This kind of monopoly gets stronger as more people use it, which makes it hard for a competitor to break into the market.

Google’s dominance in search is more complex than the traditional view of natural monopoly based on water and electricity. To start with, it invented a hugely useful product and should be rewarded for that. No government regulation stops rivals from attempting to take over Google’s dominant position (90% of European searches), and if Google exploits its dominant position too blatantly, rivals could get a foot in the market as disgruntled searchers move to other search engines: the market is to some degree ‘contestable’. To complicate things further, Google's service to customers is free. Who can complain about a provider, even a monopoly provider, who gives away the product for free?

But of course Google does charge for the product – it charges advertisers who value its ability to target potential customers. And consumers using Google also pay, in two ways. First, they may be paying more than they should for their purchases because they are offered a restricted choice. Second, they are parting with something which, when collated, is valuable: the data on their preferences and behaviour.

Even when giving away free access to their services, these market-dominant positions are very valuable. This might be judged by the size of the fine imposed on Google, which was scaled to represent the excess profit which Google had made from its biased shopping guidance. Or firms might be judged by the astronomical value that equity markets place on companies like Google, Facebook or Uber, whose main assets are not physical capital, but rather their market dominance.

What might be done? The traditional answer to natural monopoly was government ownership or close regulation. But government enterprises often lack the dynamism of private ownership and regulation can be clumsy and costly. Thus there will be heated debate on whether the solution is worse than the problem. When the American authorities examined Google’s dominant position in 2013, they agreed there was a problem but decided not to do anything.

Monopolies have an advantaged position not based on superior ability, but because of market structure. Why not change the market structure? Just as the portability of phone numbers greatly increased competition among telecommunications suppliers, Google might offer its service in a more neutral way. This would, of course, undermine its value to advertisers, but competition would be enhanced and consumers might get a better deal. Perhaps this is the European Commission’s aim. Its earlier prosecution of Microsoft forced that company to give greater access to its platform. Opening these technology platforms to competition might be analogous to earlier market-structure experiments that opened rail lines and telecommunication cables to competing users.

The issues go beyond monopoly. Who should have property rights to the data which Google and other technology companies collect? Who should have the right to use or on-sell it? What constraints should be put on its use? Somewhere in all those unread pages of conditions most of us agree to with a quick click of the mouse, there are answers to these questions, and the answers favour Google. Perhaps these kinds of data should be seen as a public good, like the data collected by government statistical bureaux, available to everyone.

There are also a host of security issues.  With our greater dependence on the services provided by the technology companies, should governments have more say in how reliable they are, and how hack-resistant? Should these services be safeguarded as closely as the payments system, because failure would be critical, perhaps catastrophic? Should Apple have the right to protect encrypted messages, even if they threaten the nation’s wellbeing? Should Facebook be the gatekeeper on what for many is their only news source?

The European authorities are setting the pace in this unexplored territory, tentatively developing a framework for markets where the tech giants operate. What they have done so far is just a beginning: they have two other cases pending against Google and a wider agenda under development. Of course there are concerns about too much interference. After all, while Brussels has abandoned its attempt to regulate the shape of cucumbers, it still has a well-deserved reputation for activist rule-making. On the other hand, should this be left to the United States, with its dominant free-market ethos, driven by the power of vested interests that have self-serving reasons for minimising regulation?

Australia has the same interest as Europe in ensuring markets have the appropriate degree of regulatory infrastructure, ensuring that firms don’t abuse their market power, while encouraging them to innovate and fostering appropriate scale. Of course we have our own competition authority and other market-regulating authorities as well. There may be room for different rules in different countries but, for a medium-size country like Australia, the room for setting our own rules is limited. In a world where global rules are scarce and under pressure, Brussels’s tentative rule-making in these new areas of market power should be applauded as an attempt to provide some de facto global rules for the technology giants.

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