Monday 09 Dec 2019 | 18:07 | SYDNEY
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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

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.

A new era of leadership by the G19?

US President Donald Trump arrived in Hamburg for the G20 leaders meeting no friend of globalisation and multilateralism. Most of the analysis so far has focused on Trump himself and the uncertain future of the US-led international economic order. Yet the summit should also bring into sharper focus the importance of the kind of multilateral cooperation and leadership that mechanisms like the G20 offer. Paradoxically, and with some foresight by other G20 leaders, the presence of Trump in the White House could end up helping make the G20 relevant again.

The G20 has been struggling with relevancy for some years now. Almost a decade ago, it played a pivotal role in developing a coordinated response to the global financial crisis and avoiding a descent into beggar-thy-neighbor policies. It has had a few other wins, including spearheading some reforms to the International Monetary Fund, but has generally been struggling with its 'peacetime' role. Now, however, with no single country willing or able to lead the global economic order, the G20’s raison d'être has again become clear.

At its most basic level, America's ability to lead the international economic order stemmed from its status as the world’s largest economy which, until recently, it was by a wide margin. It has been the world’s single indispensable economy. Cooperative policy actions by the US can thus crowd-in cooperation by other countries. The US has also, again until recently, invested heavily in this role through its willingness to shoulder the burden of leadership. This, of course, is the part that is changing under President Trump.

As the US increasingly vacates its role in leading the international economic order, it is clear that no other single country is capable of filling its shoes. China and Germany have been cited as potential contenders. But neither is really up to it. China is not ready, and probably not as interested as it portrays. Germany’s economy, despite its strength, is too small on its own to corral others’ cooperation.  The EU has significant economic weight but, as a a group of nation states subject to their own domestic politics, it cannot make up for the absence of US leadership.

This is where the G20 comes in. The G20 has existed since 1999 but came into prominence in 2008 when it was clear that the G7 no longer carried sufficient economic clout to lead the international coordination of economic policy. The G20 stepped in, able to present itself as a kind of goldilocks grouping – large enough to carry economic clout, small enough to be effective, and diverse enough to be at least somewhat representative of both developing and advanced economies (certainly far more so than the G7).

For all the summit’s shortcomings, the benefits of the G20 were on display in Hamburg. Or perhaps more accurately, the benefits of the G19 (that is, all except the US). The communique, and comments from Germany’s Chancellor Angela Merkel, appear to make clear that the rest of the G20 maintained a common approach committed to the G20’s pre-Trump agenda. Most importantly, they committed to continue with the Paris Agreement on climate change, calling it 'irreversible', and clearly noted the US as the sole exception to this position.

The communique also largely kept the group’s stated commitment to open trade, the World Trade Organization, and the rules-based trading system; even if it contained compromises on wording to placate the US, and according to Merkel herself, was 'very difficult' to negotiate. That suggests that here too there was a good amount of unanimity amongst the rest of the group. Importantly, the communique also indicated that the G20’s role would continue on one of its other core mandates – to cooperate on promoting international financial stability through the work of the Financial Stability Board and the strengthening of the International Monetary Fund as the world’s financial safety net.

Thus the G19 have effectively acted as a counterweight to the stated agenda of protectionism and bilateralism being pursued by President Trump. We can question how effective this will ultimately be. But it has at least provided a forum for the rest of the world’s largest economies to tell the US, in a coordinated fashion, where they stand on the key global public goods in which they themselves, and many others, have a stake. Right now, that would appear to be the kind of leadership we need.

Trump’s slow adjustment to global trade realities

The most striking message of the Hamburg G20 leaders meeting is not that the US did not lead the discussion but that it clearly didn’t even wish to. President Trump is most comfortable as a belligerent outsider, not only in Washington but also among his fellow global leaders. His only friend on climate change was another outsider, Turkey’s President Recep Erdogan. Trump's most dramatic and evidently companionable meeting was with the most isolated figure at the meeting, Russia’s President Vladimir Putin. Trump's major speech, the event Trump he is said to regard as his greatest success, was delivered alongside Polish President Andrzej Duda, who is not in the G20. Quite how Trump reconciles his grand call for the defence of Western civilisation with his reluctance to lead it is anyone’s guess.

Yet for all that, the weekend meeting did indeed continue the reluctant reintegration of the US president, begun in late May at the G7 in Taormina, Italy, back into the broad flow of the global economic discussion. If the G20 statement on trade was much the same as that agreed at Taormina, at least there was less quibbling about it.

That improved tone might reflect an increasing conviction among his fellow leaders that Trump’s trade bark is worse than his bite. It might also reflect Europe’s collective ability to demonstrably advance globalisation despite Trump’s rhetorical resistance. Well before the G20 leaders sat down Europe was able to announce a trade agreement with Japan, while for her part Germany’s Merkel had no hesitation in portraying a closer economic partnership with China.

But, more importantly, the declining clamour on global trade issues reflects a slow adjustment to reality.

Trump’s greatest rhetorical success continues to be his portrayal of the US as a global trade loser. The facts are otherwise, as other world leaders must know.

Unnoticed, unheralded, apparently with little impact on the US political debate, the American trade collapse complained of by Trump during the election campaign and since he came to office, has for some time been replaced with striking success.

As it happened, the success was most clearly evident under President Barack Obama. In each of the four years up to and including 2014, US exports were higher as a share of GDP than at any time in the last hundred years, and likely much longer. Even this year, US exports are running only a little below these records, compared to GDP.


To a lesser extent, the same is true of moderation in US imports, despite Trump’s complaints. Excluding the impact of the global financial crisis, by the time Trump won the presidency US imports compared to GDP were back down to where they had been a decade ago.

At 6% of GDP the US trade deficit was a big global issue in 2007. By 2016, the year Trump won the presidential election, it was half of that size compared to US GDP. (China’s trade surplus had fallen even more dramatically, from 9% to 2.2% compared to China’s GDP.)

The current account ‘imbalances’ said to risk the health of the global economy have likewise fallen, and also well before Trump became President. In 2007, during the administration of George W Bush, the US current account deficit was 5% of GDP. Last year it was half that, compared to GDP. China’s current account surplus, said to be the counterpart of the US deficit, has shrunk much more dramatically. It was one tenth of GDP in 2007, and under 2% last year.

So the US is actually doing very well in global trade – in exports, better than ever.

To a large extent, Trump’s election campaign ran on the memory of a deterioration in the US trade and current account balance that was already repairing itself. This was also true of output growth and employment. The US economy is now enjoying one of the longest upswings since the second world war. At 4.4% in June, the unemployment rate is just a tad above the recent and exceptional low of 3.9% reached just before the 2001 ‘tech wreck’ and otherwise the lowest in nearly half a century. The European leaders to whom Trump complains of trade troubles would regard these outcomes as brilliant, if attained in their own economies. 


They don’t say so, but European leaders probably also recognise that US presidents are usually difficult on trade issues, and for all his efforts Trump has yet to prove himself more unsatisfactory than his predecessors.

The recurrent motif of discussion of the trade policies of the Trump Administration is that they are new, hard-edged and disruptive to the global economic order. So far at least, that is not actually true. On the contrary, Trump is very much in the tradition of his predecessors, both Republican and Democrat, and distinguished from them only in the candour with which he advances US interests.

Trump has not only failed to match up to his own campaign rhetoric on trade, but also failed to match up to the trade belligerence of some of his predecessors.

His commitment to impose a 45% tariff on China and Mexico are long forgotten, along with the promises to declare China currency manipulator on ‘day one’, and to dump the North American Free Trade Agreement.

The Trump administration's more recent trade belligerence is also less distinctive than it appears.

According to Chad P Bown writing recently for the Petersen Institute of International Economics, if the administration does indeed follow through on threats to impose more protectionist measures, the share of US imports covered by anti-dumping protection and countervailing duties and so forth will increase.

But Bown’s painstaking quantification of protectionist measures put in place by recent past administrations also demonstrates that Trump’s initiatives are nothing new. Starting in the last two years of the George W Bush administration and continuing under President Obama, the share of China’s exports to the US covered by barriers under US trade laws more than doubled, from 4.5% to 9.2%. On Boown’s reckoning, if all of Trump’s threats were carried out, the share of China exports covered by these protectionist measures would rise to 10.9% - a much smaller increase than that under Bush and Obama.

There would be a much bigger impact on imports from the rest of the world – including, prominently, Germany, Canada and South Korea. The share of non China imports covered by these measures (countervailing duties and anti dumping measures) could rise to 6.6%, from 2.2% now.

It is notable that the principal exporters of steel to the US are now Canada, Germany and South Korea, all close US security allies. They are the countries likely to be hurt most by the new import restrictions the Trump administration is threatening to invoke on ‘national security’ grounds. China is by contrast a minor source of US steel imports, not because it lacks capacity but because previous US administrations imposed tough restrictions on it. Those who are - according to the administration - the chief offenders now, are also some of America’s best friends. Turkey, Russia and Poland are fine friends, but they lack the long intimacy, strategic consequence, and capacity for retribution of Canada, Germany and South Korea. The likelihood of actually imposing such imposing new protections in a big way is surely very small.


Is the US economy at full employment?

After the painfully slow recovery from the 2008 great Recession, US unemployment is now 4.4%, well below the level commonly regarded as 'full employment'. This would suggest that the economy has reached capacity, with some arguing that the current lacklustre rate of growth is in fact faster than the long-term sustainable rate.

This raises important policy issues. On the immediate policy agenda, should monetary policy be moved more decisively away from the very accommodative stance of the past decade, even though inflation is still below the Federal Reserve's target? In the medium term, if full capacity has been reached after such a limp recovery, what does this say about the economy's underlying trend rate of sustainable growth? What does this mean for President Donald Trump's confident hope for 4% growth in the longer term, and his budget assumption of 3% growth? If the economy is already back to full capacity, what hope is there for the many Trump voters who find themselves without satisfying jobs? The interpretation of 'full employment' is central to these issues.

Of course, this 4.4% unemployment rate is not the only measure of the state of the labour market. Many commentators also look at the 'U6' measure, which includes part-time workers who would like to work more hours and some discouraged workers who are not actively seeking work. This measure is double the headline rate and not quite back to its pre-2008 level. The moderate rise in wages (around 2.5% over the past year) is perhaps a sign that the labour market is close to capacity.

Others focus on the fall in participation – the proportion of the population that is either employed or actively looking for a job. This suggests that there might be more slack in the labour market. The overall figure is now 4.5 percentage points below its peak in 2000, falling sharply during the recession and rebounding only slightly more recently. This overall ratio is affected by a variety of factors, such as demography and the aging of the population.

For a sharper focus, it is more useful to look at participation by prime-age workers (15-64 year-olds), and to disaggregate into men and women. Prime-age male participation has fallen consistently since World War II – in the immediate post-war period, almost all US men were counted as participants in the labour force, either working or seeking work. By 2000 this prime-age participation rate had fallen to 83.9% and was 81.7% at the start of the recession in 2007. By 2015 it was 78.5%: one in five of this prime-age group had dropped out, neither employed nor looking for a job.

Source: Peterson Institute for International Economics

Some of the sharp fall since 2007 reflected the drawn-out recovery – with jobs hard to find, some unemployed stopped looking actively for work. Spending too long in this category means that they won't join the labour force again – they lose skills, motivation and contact with the workplace. This 'hysteresis' effect would explain part of the current low participation.

But the longer-term trend demands a fuller explanation. While it is not unique, most other countries show increased participation or, at most, small falls. Distinguishing between men and women just deepens the US paradox. For most of the post-war period, female participation increased just about everywhere, including in the US. But since 1990 US female participation has fallen, while it has continued to rise elsewhere.

The impact of lower participation is big. If the US now had the same participation as it had in 2000 (which would, coincidentally, make it the same as Australia's current participation) combined with its current level of unemployment, GDP would be around 10% higher, using a traditional rule of thumb linking employment and GDP. Think how many of America's problems could be addressed with production one-tenth higher! Think also of the societal advantages of taking seven million people out of the unhappy state of idleness (where surveys show they spend increased time watching day-time television and playing computer games). The shocking mortality increase of US white men (while just about everyone else in the world is living longer) can't be just a result of joblessness, but there clearly is a major link.

Thus participation may be a dry statistic, but behind the US trend lies an alarming story that cries out for remedial action. It would be wrong to think that these damaging trends are immutable – Japan has dramatically increased female participation, so that it is now higher than in America.

It goes without saying that this has been the focus of serious analysis, and the diagnosis and prescription vary. Cutting through these differences, the following seem to be important factors:

  • The US is paying a heavy price for the slow recovery after 2007. Long-term unemployment was still high six years after the recession began and after this long a period out of work, the chances of ever working again are slim.
  • Chinese imports took away some low-skill jobs directly, and had a larger indirect effect in forcing US manufacturing to regain competitiveness by automation – robots and computers replacing low-skill workers.
  • Most of the new jobs are in services, where the majority of workers are female (77% in services, whereas women account for 25% of manufacturing jobs). Men aren't readily taking up these 'girly' jobs.
  • US active employment policies were always small and ineffectual, and have been reduced further.
  • The high US incarceration rate means that many low-skilled men have a criminal record, which hinders job prospects.
  • The US minimum wage may be so low that idleness is a rational alternative to work, at least for those who can get by on social security and hand-outs.
  • US labour rules are about as family-unfriendly as can be, with zero paid maternity time off. Trump is promising the equivalent of 2.8 weeks (when expressed in terms of a full-rate wage).

There is clearly great potential here to address the blue-collar discontent that swept Trump to victory and to get many more back to work, with all the societal benefits involved. But there are no quick fixes here. More to the point, Trump's mindset is fundamentally antithetical to the policy options this parlous situation demands.

Quick comment: Sebastian Mallaby on Trump, the Fed and the global economy

After reviewing Sebastian Mallaby's 700-page biography of former US Federal Reserve Chairman Alan Greenspan late last year, Lowy Institute Nonresident Fellow Stephen Grenville sat down with Mallaby (a Council on Foreign Relations Senior Fellow) on Friday to discuss how US President Donald Trump is likely to influence the Fed, the prospects for the US economy (and thus the global economy), what lessons the Reserve Bank of Australia might draw from the US experience, and how Trump is likely to interact with the Bretton Woods institutions.

Capital flows to emerging economies: Still unresolved

This year marks the 20th anniversary of the Asian Financial Crisis. Many factors were involved in that disaster, but grossly excessive foreign capital inflows were the key macro-economic problem during the boom years preceding the crisis. These flooded out when 'euphoria turned to panic without missing a beat'. Much analysis has gone into finding the right policy response, but the answer remains elusive.

This policy lacuna is likely to be tested further over coming months, when US President Donald Trump's tax reforms may bring US capital back onshore and the US Federal Reserve begins to unwind its bloated balance sheet resulting from quantitative easing.

The textbook answer is to absorb the inflows by letting the exchange rate rise. Policy-makers in emerging economies, however, find this an unappealing response. Their relatively tiny financial markets can be overwhelmed by the inflows from much larger volatile portfolio adjustments in advanced countries. The exchange rate appreciation required to equilibrate the inflow would often be very substantial, undermining international competitiveness and shrinking the export sector. Why would it make sense to contract what is often the most dynamic part of the economy, to make room for foreigners to flood into asset markets (shares and property), setting off a disruptive asset-price boom, only to have these inflows reverse when foreign sentiment changed?

One response is to offset the inflow by intervening heavily in the foreign exchange market, restraining the exchange rate appreciation and building up reserves to handle the later outflow. But this means that the central bank is effectively buying up the inflow and reinvesting it at a lower interest rate in foreign reserves, ready to facilitate the foreigners' later flight. That can't be a profitable deal for the host country.

A recent IMF paper captures the state of policy disarray. The high-profile authors see a 'natural mapping' that suggests tailor-made policy responses, depending on the nature of the inflow. The old recommendation (just let the exchange rate appreciate) is no longer put forward as the panacea, though it is still a firm favourite among many of their colleagues at the IMF. Perhaps endorsing the old jibe that 'IMF' stands for 'It's Mainly Fiscal', these authors see fiscal tightening as the most-likely logical answer. More in sorrow than in anger they observe, however, that in their empirical study of 30 emerging economies, hardly anyone does this:

The orthodox policy prescription to tighten fiscal policy in the face of capital inflows was the least used instrument in practice, with no strong evidence that EMEs systematically tightened fiscal policy in response to large capital flows.

Why don't policy-makers in the emerging economies share this preference for fiscal tightening? Tighter fiscal policy might be appropriate if the domestic economy was already overheating. But as a response to excessive capital inflow, it doesn't make much sense. Why so? Tighter fiscal policy increases overall domestic saving – this reduces the current account deficit (the current account is equal to the savings-investment balance, by national accounts identity). The capital inflow has to equal the now-smaller current account deficit, and this can be brought into equilibrium only if the floating exchange rate appreciates, discouraging both capital inflow and exports. Thus we are back with the same old problem: the dynamic export sector has to make room to accommodate the foreigners. As well, the fiscal tightening will have a cost in terms of foregone expenditure or higher taxes. All this just to allow foreigner investors to come in, pushing up asset prices and setting off a credit boom!

Perhaps practical policy-makers might be tempted to cut the Gordian knot by imposing capital controls, especially for short-term volatile capital inflows (leaving characteristically-stable foreign direct investment untouched). The IMF has come some distance from its earlier free-market dogma on these issues. Before 1997, capital inflows were seen as unambiguously beneficial to all. Capital controls, whether on inflows or outflows, were anathema. Now they are included in the policy tool-box, but only on a last-resort basis.

There is still a long way to go, and any policy-maker tempted to use 'capital flow management' (the acceptable face of 'capital controls') would get lukewarm encouragement from the IMF. For some of us, the puzzle raised by this study of 30 economies is not why they failed to use fiscal policy, but why they remain reluctant to use capital controls vigorously, starting with substantial taxes on short-term footloose inflows.

China’s financial concerns

The China bears have been around for years, continuously predicting the end of China's stellar growth story. In 2012 Michael Pettis expected annual growth to average 3% over this decade and in 2015 Tyler Cowen warned of an imminent disastrous financial collapse. So far, so good. China's unsustainable double-digit growth came to an end in 2008, coinciding with the global financial crisis. Growth was artificially stimulated for a couple of years but only by huge fiscal and financial stimulus. Since then growth has settled to a still-outstanding 6.5%, but credit has grown much faster than nominal GDP – a classic forewarning of a financial crisis. The International Monetary Fund and the OECD have both identified this as a priority policy concern. Just about everyone (including the Chinese authorities) agree, but there is a wide range of views on how all this will play out.

China's debt to GDP ratio isn't all that extraordinary by simple global comparison: it is about the same as many OECD countries (including Australia). The danger comes from the rate of growth and the fact that the debt level is much higher than other countries at China's stage of development. As countries grow, their financial sectors deepen and higher debt ratios are normal. But China, only half-way through the development process, has the debt levels of a mature economy, and the ratio is still growing. The level of corporate debt, especially, is way out of line.

That said, comparisons with other financial crises take us only some way to understanding how this is likely to evolve. The IMF makes comparisons with financial crises in Japan (1990), Thailand (1997) and Spain (2010), but these were quite different from China's current situation. Take Thailand, devastated by the Asian crisis. Many things went wrong, but the driving macro-economic factor was excessive capital inflows in the years leading up to 1997 (capital inflows equaled 13% of GDP in 1996). This overwhelming inflow inflated asset prices, pushed up the exchange rate to uncompetitive levels and opened up a large current account deficit. When the foreign investors realised what was happening, they left in a rush ('capital reversal'), triggering a plummeting exchange rate, collapse of asset prices and bankruptcy of the financial institutions which depended on the capital inflows.

China's macro-economic challenge is quite different. It has no dependence at all on foreign savers to fund its investment. It runs a current account surplus, with modest net capital outflow for most of the past three years. Foreign exchange reserves have fallen but are still around $US3 trillion. China retains capital controls which would limit any sudden dramatic exodus. Thus capital reversal is not the concern.

Nor does China have much in common with America's financial crisis in 2008: the hair-trigger liquidity funding that doomed Lehman Brothers or the complex layers of securitisation that brought AIG down are not present in China's simpler financial sector.

China's problems are more like the financial deregulation experience in the advanced economies a couple of decades ago – the US with the S&L crisis in the 1980s and Australia in 1990. The intrinsic nature of deregulation results in credit (and the financial sector) outpacing the growth of the economy, with financial institutions misusing the newly deregulated freedom to get themselves into trouble. In this heady transition of financial deepening, some poorly-managed financial institutions emerge and some bad lending decisions are made. This has been the universal experience, and has inexorably led to some kind of financial crisis.

Thus the issue for China is not whether it will repeat the Thai experience of 1997 or the Spanish experience of 2010. Solving China's financial-sector problems doesn't depend on the fickle favours of the global financial sector. Instead, China has to address some domestic problems: the non-performing loans and the flawed financial institutions that made them.

In facing this task, China has a big advantage: this challenge doesn't come as a total surprise, as the Thai crisis, the S&L crisis and the 2007 global financial crisis did. Policy-makers have time and opportunity to ameliorate the crisis. What should the Chinese authorities do?

First, there is the micro-level problem of resolving the accumulated bad debts. The IMF estimates that potential losses from bad loans may amount to around 7% of GDP. This will be painful to absorb but can be spread over several years. It will be a fraught political issue to allocate the pain between those who funded the loans (who may see themselves as bank depositors rather than 'at-risk' investors), the financial institutions that made the bad lending decisions, the borrowers who can't pay back, and the taxpayers via the budget. But this is no more difficult than the adjustments China has made over the past couple of decades.

The key challenge is to ensure that the financial sector emerges from this process stronger and better able to perform its intermediation function. China's saving remains huge (well over 40% of GDP) and financial deepening offers the promise of shifting these funds more efficiently into the most profitable investment opportunities. In an underdeveloped financial sector, investment is largely self-funded. For example, state-owned enterprises put their retained earnings into the management's pet projects, rather than channeling these funds to the higher-return projects in the wider economy. China should recall the advice of Rahm Emanuel and (supposedly) Winston Churchill: never let a good crisis go to waste. They should use the impending painful adjustment to achieve a more efficient financial sector. Without wanting to sound too starry-eyed, just imagine if the authorities used the opportunity to drastically restructure zombie state-owned enterprises that have too much debt. History would record this not as a damaging crisis, but as a policy-making triumph.

The second challenge is at the economy-wide macro level: to maintain the pace of GDP growth while trimming back the rate of credit expansion. Derek Scissors of the American Enterprise Institute predicts 'years of stagnation'. But it's not as if credit growth has to be drastically curtailed: it needs to be trimmed back so that it rises no faster than the pace of nominal GDP growth (thus keeping the debt to GDP ratio from rising further). If China succeeds in its structural switch to consumption-driven growth, this would reduce the need for credit expansion. If, as well, the financial sector does a better job of intermediating saving and investment, this would allow growth to continue with less credit expansion. All this will be tricky to implement, but it is worth recalling that China achieved its pre-2007 double-digit pace of growth in a period when credit was growing only modestly.

Asia now dominates world growth (accounting for 70% of the IMF's World Economic Outlook growth forecast and nearly as much in the latest ADB forecasts). How well China succeeds in reforming its financial sector will be important for global growth, and vital for us here in Australia.