G20 in Washington: Waiting for 'Hell to Freeze Over' won't Solve the Problem  [<]

In April 2011, a G20 meeting in Washington again demonstrated that, despite hopes to the contrary, progress was not being made in resolving difficulties associated with international financial imbalances. This implied that it was likely to be futile to further pursue solutions solely through G20 negotiations in the face of apparent obstructionism, noting that some major economies (eg those of Japan and China) appear to depend on those imbalances and thus can't easily adjust to allow them to be reduced.

Rather those who are economically constrained by imbalances (especially, but not only, the US) need to take even stronger action than that associated with the Federal Reserve's quantitative easing to put pressure for substantive reform on countries whose financial systems are structured to depend on the imbalances that put global growth at risk - even though those economies might then be disrupted. Options to increase such pressure are outlined in China may not have the solution, but it seems to have a problem.

Some Observer's Comments

IMF is developing a framework to help countries manage large capital flows as countries recover from the global crisis. Studies have been released on country experiences and on tools that can be used to manage capital inflows. This is part of a process whereby the IMF evaluates advanced economies where the crisis began. The 'push' forces that originate capital flows are being studied, and on the spill over effects on others are being studied for China, euro-area, Japan, the UK and the US. While capital flows are generally beneficial for receiving countries, surges can create problems (eg through currency appreciation and increasing financial system frailties associated with asset bubbles or rapid credit growth, or the risk of sudden reversal of inflows). The management of inflows involves many economic issues. Suggested principles are: no 'one size fits all'; capacity to absorb capital inflows should be increased; good macro policies are vital; capital controls may need to be used;  remedies must be designed to suit to problem; and others' positions should be considered. [IMF develops framework to manage capital flows, 5/4/11]

Deep divisions over sources of global economic fragility intensified before the G20 meeting. US emphasised inflexible exchange rates, while China argued that inadequate development of emerging economies was the key issue. G20 is expected to agree on technical methods to measure imbalances, though there is not expected to be agreement on enforcement [G20 gulf widens on source of fragility, 14/4/11]

G20's bickering seems like stalled Doha round of world trade talks. Five G20 members (Brazil, Russia, China, India and South Africa) have scheduled a rival meeting, and the G7 organised the currency intervention to force down Yen after Japan's earthquake. Last G20 meeting failed to even agree on how to assess whether imbalances existed = because China did not concede that current account position and foreign exchange accumulation were relevant to this. Major countries do not share an economic analysis of trade imbalances, or agree on effects of policies to address them. US believes it has run current account deficit to maintain world economic activity in the presence of China which saves too much and spends too little - partly because of undervalued exchange rate. China complains that US does not take into account the development deficit of emerging economies - and seeks to export inflation using $US's reserve currency status as a weapon. Without a shared analysis of the problem, no solution is possible. None-the-less the effort of addressing this is vital, because unattended imbalances raise strong possibility of another crisis at some time in the future. The best outcome to hope for is that collapse of G20 can be avoided. From US / European perspective there is also a hope that emerging economies (especially China) will share their view about the inadequacy of export-oriented growth [Struggle to keep G20 train on the tracks, 14/4/11)

After years of calls for China to play a responsible role in international affairs, Beijing has started to comply - but in an unexpected way. BRICs group (now including South Africa) is becoming China-dominated forum. The “Sanya Declaration”, was full of sort of language China uses at home - and embodied agreement that 21st century should be one of peace, harmony, cooperation and a century of scientific development'. Harmony and scientific development are Communist Party's slogans in China. One thing off the agenda at this meeting was China's currency controls, which are believed to give China's exporters an unfair advantage. Other BRIC members mainly agree on the imbalances in their trade with China (ie they export resources, and import manufactures). China's emphasis is however on building consensus, toning down differences and finding areas for cooperation [China cements its role as top of the BRICs, 14/4/11]

G20 will address details of a plan from February 2010 to determine when debt levels, trade deficits or other indicators point to systemic risk - with a view to naming and shaming countries that pose the biggest risks [G20 to plan global financial crisis warning system to 'name and shame' risky countries, 14/4/11]

RBA Governor suggested that US is wrong about China, and should not just focus on itself. China's imports into US have mainly displaced those from other Asian economies, while China is a large market for US. Thus populist China bashing (based on the view that China is stealing US jobs) is wrong. China has been final cheap labour assembly point for goods owned ny Japanese, Taiwanese and Korean companies - and China will now outsource that work as it moves up the value chain. RBA has become good at putting rise of China into perspective, since realizing that Australia's economy is Asian. RBA argues that it is wrong to focus on bilateral US-China relationships, as 20 years ago the focus was on US-Japan relationship. US trade deficit has been widely spread. Issue must be resolved in multilateral setting - which makes international financial institutions and G20 important. [RBA to USA: Wake up, yer drongos, 15/4/11)

G20 efforts to bolster global growth are floundering. In September 2009, efforts to rebalance global growth was agreed, but US deficit and Chinese surplus have remained unchanged. Agreement on continuing this effort is likely in Washington - but the process has become bogged down. The best that can be hoped for is a process to measure whether countries' policies are worsening imbalances [G20 plan to kickstart global economy is floundering, 15/4/11]

IMF recognised that it was wrong to always advocate free international capital flows, and has now set out a research framework. Some forms of capital controls are now part of approved tool kit, as a last resort. For the past decade capital flows into East Asia have been strong but not overwhelming - and reversals during GFC did limited damage. Inflows were handled with reserve accumulation and exchange rate appreciation. Reserves are now adequate. The IMF analysis sees flows in terms of temporary capital surges - but the problem may be more structural. Emerging economies will grow faster than mature economies - and need higher interest rates for equilibrium.  This will encourage greater capital flows, and huge financial portfolios in North America and Europe only need to be shifted slightly to create disruptively large inflows.  IMF has not yet put forward a convincing policy answer, but after a wasted decade, has at least made a start [The IMF's emerging capital idea, 18/4/11]

Agreement by G20 has been seen as major step towards more sustainable global growth. Finance officials also agreed to look at currency misalignments. Change came as rising food prices, joblessness, Middle East turmoil and weak finances in advanced economies seemed likely to derail recovery. Polices of 7 major economies will be reviewed by IMF (US, Japan, Germany, China, France, UK and India. Countries would be examined for economically destabilizing policies such as large budget deficits, high personal savings and debt, and big trade surpluses / deficits. Methods for evaluating causes of imbalances and barriers to reducing them. However G20 can't enforce any findings [Reddy S., and Davis B., 'Deal to avoid another GFC', The Australian, 18/4/11]

Emerging economies rejected IMF proposals to guide them on managing huge capital inflows - seeing this as a constraint rather than a help. Proposal was reversal of IMF's traditional objection to capital controls (because of the effect of huge hot money flows in recent years), and would have viewed this as last resort. Various emerging economies have adopted capital controls over past year to limit inflows. This debate comes amid controversy about who causes flood of capital from sluggish advanced economies into emerging economies. Emerging economies blame Fed's QE, while developed economies blame China's tightly controlled currency and to tendency of capital to flow into fastest growing economies [Emerging nations rebuff IMF, 19/4/11]

CPDS Comments on the situation and reasons for the above suggestion include:

  • the G20 initially did nothing to address the problem of financial imbalances (see G20: Avoiding key Issues, G20: Peace for our Time'? and Too Hard for the G20), despite imbalances' apparent role in generating the GFC and in constraining global economic growth;
  • Some progress was being made because that problems now seemed to be officially recognised [1]. Moreover the IMF, which long objected to constraints on the free flow of capital, seemed to have recognised that capital flows could be disruptive [1], and suggested principles to manage such flows [1]. This, it was suggested, was a start even though not a solution [1];
  • However the situation remained highly unsatisfactory. For example:
    • despite agreement a year earlier [1] that the problem required action, nothing had been achieved [1]; The G20 was seen to be becoming bogged down [1]'
    • There was disagreement over the source of the problem [1]
    • Emerging economies rejected IMF proposals for managing capital flows [1];
    • Agreement was reached to measure the problem, but not to enforce any conclusions [1];
  • Western observers appeared to remain ignorant of the way in which East Asian financial systems contain distortions which contribute to the problem. For example:
    • the US appeared to focus on China's artificially low exchange rate [1] - though the latter was only a symptom of a much deeper issue;
    • Japan's role in generating imbalances was similar to China's - yet the US said nothing about this;
    • Australia's reserve bank didn't understand the problem either. It reportedly suggested that the US was wrong about China - as the latter's economy was primarily prospering at the expense of others in Asia [1]. However the RBA did suggest that the US needed to take a multilateral perspective on the problem, not a bi-lateral US-China view [1];
  • China seemed to be adopting obstructive tactics - namely:
    • refusing to acknowledge the factors that affect imbalances [1]; and
    • seeking to establish its own international forum [1, 2];whose main purpose seemed to be to frustrate the G20;
  • the IMF, which had a mandate from the G20 to investigate problems associated with the international monetary system, seemed to be adopting a very superficial approach (ie one that attempted to deal with the symptoms of international imbalances without considering in depth the characteristics of East Asian models of socio-political economy (see below).  Moreover: (a) the IMF's proposals for dealing with capital flows reportedly suggested that the financial crisis was generated  in advanced economies [1], whereas this was only half of the problem as capital flows directed towards the US played a major role in the genesis of the GFC; and (b) its proposals for managing capital inflows seemed to be geared only / mainly towards the difficulties facing emerging economies.

The Asian Connection in the Public Debt Problems Facing Developed Economies (email sent 13/4/11)

Carlo Cottarelli,
Director, Fiscal Affairs Department
IMF

Re: Crashing the US debt party, 13/4/11

Your article outlined the challenge of reducing US government debts (and those in many other developed economies).

May I respectfully suggest that public debt problems such as those facing the US probably cannot be resolved in isolation – because they have been incurred partly to sustain global economic growth in the face of macroeconomically unbalanced economic strategies in some other countries (eg Japan and China). There appear to be structural demand deficits (‘savings gluts) in the latter economies (see Understanding East Asia's Neo-Confucian Systems of Socio-political Economy), and these have required that trading partners (mainly, but not only, the US) be willing and able to indefinitely incur current account deficits and increase their public and private debt levels. This situation played a significant role in the global financial crisis (see Impacting the Global Economy). And now, it will be incredibly difficult for others to reduce their overall debt levels until fundamental reforms are made in economies with large structural demand deficits. The moment that countries whose excess demand has been vital to compensate for structural demand deficits face up to the need for austerity, global demand and economic growth must collapse.

Thus, as with the international monetary system as a whole, it seems likely that no satisfactory solution may be able to be found unless reforms start in Asia (see Should Fixing the International Monetary System Start in Asia?)

I would be interested in your response to the above speculations.

John Craig


CPDS Reply to Brief Response from Carlo Cottarelli (email sent 14/4/11)

Thanks for your response. I have no doubt that the IMF takes a global view of the problem. However financial practices under major East Asian systems of socio-political economy appear to make it unsafe for such countries to increase domestic demand to the point that reliance does not have to be placed on trading partners’ willingness and ability to sustain large current account deficits and increasing debts.

Following the Asian financial crisis, the IMF pressured countries in the region to improve their financial systems. However doing so faced cultural obstacles (see Understanding the Cultural Revolution, 1998). The latter referred (for example) to: fundamental differences in way information is used; the need to change economic goals from economic 'power' to financial returns; the inseparability of economic issues from questions of social / political power; and the lack of appropriate legal systems. In practice, the general response was quite different to the IMF’s suggestions and counter-productive ie large foreign exchange holdings were widely sought as the best means of defence against financial crises (noting that Japan and China had not suffered from the crisis because they had this protection). An account by Mikuni of why Japan’s financial system could not be reformed is in Why Japan cannot deregulate its financial system (2000).

An attempt to draw these issues together in relation to their effects on international events is in An Unrecognised Clash of Financial Systems. Unless and until the international community starts to consider the problems ‘Asia’ faces in increasing demand from an ‘Asian’ viewpoint (instead of just assuming that Western practices can be applied), it seems unlikely that the problem of global imbalances will be resolved.

John Craig


Economic Recovery is Constrained by Dead Weight Economies (email sent 10/5/11)

Maurice Newman,
Chairman
ABC

Re: Hope is not an option when the stimulus runs out, The Australian, 20/4/11

While the gloomy economic outlook portrayed in your article (which is outlined below) is unfortunately probably realistic, I should like to suggest another way of viewing the problem that might lead to initiatives that produce better outcomes. In brief it is suggested in more detail below that:

  • The economic constraints implicit in the high debts of many developed economies are not only due to the costs of meeting community demands and responding to the GFC. The ‘dead weight’ of structural demand deficits in economies such as those of Japan and China (which require trading partners able to continue increasing their debt levels indefinitely) is also a factor;
  • While the G20’s efforts to address the constraints posed by the resulting international financial imbalances are being frustrated, there are options available to encourage more serious reforms in countries whose underdeveloped financial systems currently require large demand deficits and excess savings;
  • As your article suggested, serious economic dislocation is likely over the next few years. However no matter whether or not the particular scenario suggested in your article emerges, Australia needs much higher levels of Asia-literacy to cope with its environment.

I would be interested in your response to the above speculations.

John Craig


Outline of Article and Detailed Comments

My interpretation of your article: An economic price is about to be paid for the GFC. The world economy remains on life support despite a huge fiscal stimulus and monetary easing. US performance is feeble, while public debts mount. It is much the same in Britain, Europe and Japan. Social unrest (eg in UK, Spain and Greece) result from spending cuts. The UK and Japan faced huge public debts even before the GFC. Japan’s rapidly aging population has lived off its savings, and its PM has suggested that Japan could face a mess like Greece if its swelling national debt is not fixed, and the tsunami will make the situation worse. European peripherals (as well as UK, France and Italy) are in a poor state. Sovereign risk is increasingly priced into bond markets. Investors will face losses eventually. Stockmarkets don’t agree (and downplay sovereign risk, Middle East tensions, rising oil prices and natural disaster) because the Bernanke put is in place. In the West, governments have been major employers, and growth rates vary inversely with private sector to government ratio. The dilemma now is to move to smaller government share in stagnant economies without making unemployment / growth worse. Many governments are in minority positions, and have trouble making long term decisions. After easy money and fiscal stimulus, there is little to show but speculative rally in risk assets and inflation. What will happen when, as now seems inevitable, stimulus is withdrawn, How can democracies grow, tax or inflate their way out of monumental obligations with aging populations and high welfare dependency. The endgame is nearing (as a result of policy failures, rising social costs and market action). A fundamental international settlement will be inescapable – with widespread trade and capital market dislocation. Afterwards the BRICs will be stronger in G20 and IMF, while Australia, Canada and Korea also benefit. $US will cease to be reserve currency. To prepare it is necessary to: de-risk portfolios (ie good balance sheets with limited leverage); be aware of possible ‘black swan’ events; seek policies to improve industrial competitiveness (eg structural balance in budget; no new taxes; reform complex laws; rethink IR; and maintain comparative advantage in cheap energy). This will be difficult because of community dependence on government services, income redistribution and consumer protection. It is not enough just to hope for the best.

There seem to be two primary causes of the predicament outlined in your article (ie the poor fiscal position of governments in many developed economies which threatens future economic growth).

The first is the economic dead weight that the global economy suffers as a result the structural demand deficits that characterise some major economies (such as Japan and China), which were ultimately a major factor giving rise to the GFC. An attempt to explain the reasoning behind that suggestion, which unfortunately is anything but simple is in The Asian Connection in the Public Debt Problems Facing Developed Economies.

In brief, the point is that: (a) global demand must equal supply, if economic growth is to be maintained; (b) the systems of socio-political economy in major East Asian societies involve financial systems that provide capital for state-linked industrial investment with limited regard for profitability; (c) financial crises (like those experienced in much of Asia in 1997) can only be avoided if demand is suppressed to the point that current account surpluses are achieved, and there is no need to borrow in international markets; and (d) this requires that trading partners (in practice especially the US) be willing and able to run large current account deficits, and accumulate debts. Growth was sustained for a long time despite the dead weight of large demand deficits by asset inflation which encouraged very strong consumer spending, and that asset inflation ultimately contributed to the GFC. Though other factors are also involved, recovery (though monetary and fiscal stimulus) continues to be constrained by the dead weight of demand deficits in countries such as Japan and China, and the consequent current account deficits that the US (mainly but not only) experiences. It can be noted that many emerging economies have also adopted similar necessarily-short-term economic tactics (ie export driven growth to protect their poorly developed financial systems, because of the success of this tactic in protecting some major crony-capitalist economies in Asia (see Who’s Got Superman?)

The second major cause is the difficulty your article identified in the dependence of democratic societies on high levels of public spending in an environment in which governments will be forced to constrain public spending by the high debt levels they suffer as a consequence of (a) community expectations; and (b) the cost of trying to recover from the GFC in the face of external ‘dead weights’. The fact that truly democratic government first emerged in the UK at the time of the industrial revolution, partly as a means for redistributing the wealth generated by capital in industrial economies, can also be noted. (see comment in Economic Solutions Appear to be Beyond Politics).

The outcome suggested in your article is not necessarily the only one that is possible. While the G20 and the IMF continue to be frustrated by the intransigence of countries whose structure demand deficits provide a drag on global recovery, there are probably unilateral actions that could be taken to encourage them to get serious about reform (see G20 in Washington: Waiting for Hell to Freeze over won’t Solve the Problem).

There is none-the-less little doubt that a chaotic international environment is likely to emerge (and probably in much less than eight years)

Irrespective of what outcome emerges Australia requires a much higher level of Asia-literacy and more effective methods for economic development in order to be able to cope (see Finding Australia's Place in the International Financial System). There are fundamental obstacles to economic growth by major East Asian economies (and emerging economies with poorly developed financial systems elsewhere) if the US loses the ability to be the world’s ‘consumer of last resort’ (see Are East Asian Economic Models Sustainable?), and serious incompatibilities between Australia’s institutions and society and the sort of ‘world’ that could emerge under the scenario your article outlined (see Babes in the Asia Woods).


Note: An email interchange that arose from one observer's response to receiving a copy of the above email suggests the complexities that seem to be involved in seeking to understand East Asian economies in terms of Western economics


Counter-cyclical policy can't solve structural problems - email sent 31/8/11

Martin Wolf,
Financial Times

Re: The great contraction struggle, Business Spectator, 31/8/11

Your very useful article points to the risk of an extremely deep recession because the combination of high private debt levels and weak asset prices makes recovery difficult (ie attempts to boost growth can’t to lead to ‘lift off’ if private demand faces those constraints).

While that point is important, might I respectfully suggest that the problem can only be properly understood by also mentioning the international financial imbalances that have required deficit countries to incur ever increasing debt levels simply to maintain economic growth? When there is a large current account deficit, national income is well below national expenditure and the demand required to sustain economic activity can only be provided by increasing public / private debts. And in practice this can only continue so long as asset values increase faster than debt levels (so that net private wealth is rising).

International financial imbalances seem very likely to be a significant (though not the only) factor in the current constraints facing:

  • the US because of its long term geopolitical ambition (ie to promote the worldwide spread of market economies and democratic capitalism by supporting global growth as the ‘consumer of last resort’). This goal required compensating for the demand deficits (ie ‘savings gluts’) that have been structural features of the ‘economic miracles’ achieved in major East Asian economies (see Impacting the Global Economy) and have also also been a feature of other export-driven economies (such as Germany and many emerging economies). Maintaining growth through ever-increasing debts was possible for many years, but (as your article implied) this can’t be continued if asset values are weak;
  • peripheral European economies whose export competitiveness was inadequate to cope with the strong currency they were tied to (ie the Euro), so that again the demand to sustain economic growth could only be achieved by increasing (mainly public) debt levels – and the tax revenues required to support this were simply not available.

Purely counter-cyclical policies (ie stimulating growth by fiscal or monetary policies) in countries facing large current account deficits cannot overcome the constraints implicit in financial imbalances unless asset values recover strongly (as current account deficits must continue to force public and / or private debt levels higher, thus reducing net private wealth and demand if asset values remain weak). Preliminary speculations about structural (rather than counter-cyclical) steps that might assist in overcoming the obstacles to economic recovery are referred to in Preventing Economic Stagnation – though there is no doubt that the issue is extremely complicated.

John Craig


Sustainable World Growth Requires More than Counter-cyclical Policies - email sent 23/5/12

Professor Thomas Clarke,
University of Technology Sydney

Re: Why do our world leaders cling to the dismal politics of economic austerity?, The Conversation, 22/5/12

I should like to submit for your consideration that the ‘austerity’ issue is more complex than your article indicated – because structural problems that have given rise to international financial imbalances mean that sustainable economic growth can’t be achieved by traditional counter-cyclical stimulus.

Your article suggested that:

“In responding to this crisis originating in the Western finance markets, the G20 revealed considerable resolve in employing public funds to rescue the private financial institutions facing bankruptcy. As the global financial crisis has morphed into the sovereign debt crisis, this resolve to apply a counter-cyclical stimulus has disintegrated, as self-interest has taken hold, and widespread austerity measures introduced to reduce public deficits.”

The current situation needs to be seen in context. ‘Austerity’ has been practiced for many years (sometimes decades) by countries whose economic growth strategies have relied on suppressing domestic demand in order to achieve current account surpluses, and thus avoid the financial crises that would otherwise affect their poorly developed financial systems. The main offenders have apparently been:

The demand deficits that this involves (and the demand deficits associated with the current account surpluses that major oil exporters and also Germany achieve) have had to be compensated for by excess demand elsewhere (or else the global economy would stagnate). That excess demand (ie the stimulatory measures that have been in place over the past couple of decades) has been provided by:

  • Consumers in the US (mainly) and other developed economies who (prior to the GFC) enjoyed rising asset values that were the result of very easy money policies (sustained by Reserve Banks and carry trades) that gave rapidly-increasingly-indebted households the impression of growing net wealth (eg see Financial Imbalances, 2007 and Impacting the Global Economy, 2009);
  • Governments, in the second phase of the GFC, after the ever rising asset values needed to sustain perpetually increasing debts ceased (eg see Comment on the European Sovereign Debt Crisis). It can be noted in passing that the ‘sovereign debt’ crisis is likely to migrate from peripheral Europe (and Japan) to the United States after it goes over its so-called ‘fiscal cliff’.
    • [Note added later: The 'fiscal cliff' involves expiry of authorization for many US federal spending programs which would have significant adverse effects on demand / economic growth, unless approval is gained for significantly increasing: (a) taxes - which would have similar macroeconomic effects to reduced spending; or (b) approved government debts which would restart concerns about the US's sovereign debt status and the $US's role as the global reserve currency];
  • Reserve Banks through Quantitative Easing – to ensure against a lack of liquidity and a collapse in money supplies, and also perhaps to try to reduce financial imbalances (see Currency War? ).

While Western financial markets have been involved in the crisis, there seemed to be many other factors at play (eg see GFC Causes), and financial imbalances associated with the macro-economically unbalanced strategies pursued in Japan, Germany, and many emerging economies (notably China) have arguably been more significant. Moreover the G20 seems to have been totally at a loss in terms of trying to deal with this (eg see G20: AnnouncingPeace for our Time'?, 2009 and G20 in Washington: Waiting for Hell to Freeze Over?, 2011) because conventional macroeconomic measures cannot deal with the structural problem. For example, major cultural obstacles confront East Asian economies with an ancient Chinese cultural heritage if they are to avoid ongoing reliance on current account surpluses and on the willingness and ability of developed economies to incur ever increasing debt levels (eg see The Cultural Revolution needed in 'Asia' to Adapt to Western Financial Systems, 1998).

Various observers have recognised the role that financial imbalances have played (eg see G20: AnnouncingPeace for our Time'?,) and pointed to the need to increase demand (ie emphasize anti-austerity programs) in countries with current account surpluses, rather than hoping that the problem can be solved by ‘counter-cyclical’ spending in countries with current account deficits and large existing public and private debts. A recent article by Michael Pettis is instructive in this regard, though it did not mention the East Asia dimension of the problem (eg see All roads lead to Spanish pain, Business Spectator, 21/5/12).

The emerging debate about ‘austerity’ versus ‘growth’ (if the latter is expected to merely require counter-cyclical policies) seems likely to be futile. Some suggestions, with a US orientation, about the sort of changes that might force real attention to the structural problems are outlined in Getting out of the Economic Quicksand (2011).

I would be interested in your response to my speculations.

John Craig


Progress Towards Ending the Global Financial Crisis? [Working Draft]

In November 2011 an experienced economist (Professor Joseph Stiglitz) presented an assessment of the global financial crisis (GFC) in a web-cast that seemed a useful advance in the debate (as outlined below). However the web-cast also arguably showed that some critical gaps still need to be filled to gain the understanding required for a solution.

Outline of Stiglitz J, The global economic situation and sovereign debt crisis, UN Webcast, 24/11/12. The financial crisis started in the US, and was then exported to the world. Europe is now returning the favour. Much of the rest of world have been innocent victims. Because of the international linkages involved, this question needs to be addressed globally. Many countries are going in wrong directions. Before the crisis, the prevailing theory was that economic integration would reduce risk, by spreading financial risk around the world. However integration caused Europe to buy toxic mortgages from the US. An analogy with an integrated electricity system can be considered, as a breakdown in one part can bring down the whole system, and a system that is highly integrated can be unstable. After the crisis the IMF recognised the need for capital controls. As in the Great Depression there have been several (ie economic / monetary / financial problems) dimensions to the crisis, and capital market integration has spread these problems. During the Great Depression US monetary authorities were criticised for not increasing money supply fast enough. But this time money supply was increased very rapidly by Benanke (a student of the Great Depression). But the US economy has not recovered – despite labour market flexibility. Demand and supply are not working as they are supposed to. It is impossible now to go back to 2007. In 2008 it was recognised that there was a financial sector crisis, and it was assumed that repairing this would avoid an economic crisis. Money was given to banks without conditions – but was poorly used (ie for dividends not lending). Now the banking system has been repaired. The problem is that before the crisis, the economy was sick and sustained by a bubble that led to high rates of consumption. Several reasons for this were identified by UN Commission of Reform of Global System. One issue was structural transformation, as in Great Depression. In early 2oth century there had been massive increases in agricultural productivity, and agriculture was displaced by manufacturing as a major component of the economy. As manufacturing has become more productive, manufacturing jobs are down worldwide. There is now a need to move to move into services. However adjustment is a problem if incomes fall so low that people can’t move. In the US in the 1920s agriculture fell from 30% to 25% of workforce, but from 1929 to 1932 there was no movement out of agriculture as incomes went down. Incomes in agriculture fell 50%. There was no demand for manufacturing, and thus unemployment grew. Government’s role is important in stimulating the economy to help in the shift to a new sector (ie from manufacturing to services now). This is a hard task and high levels of unemployment trap people in the old sector. There are four other problems: (a) Globalization and changes in comparative advantage have led to a shift in manufacturing away from US / Europe, and this compounds the problem of increasing productivity; (b) growing inequality is a problem because those at the top consume less than those at bottom, just as before the Great Depression. This happens world-wide; (c) global aggregate demand is an issue, because the failure of the IMF and others to manage the East Asia crisis caused countries to build up reserves (as otherwise they risked losing their economic sovereignty). For each country this makes sense – but this involves not spending – and thus creates a lack of global aggregate demand. Countries that did best were those with the most reserves; and (d) income has been redistributed from oil consumer to producers, and this suppresses demand, as producers have high savings rates. Responses to the financial crisis have not dealt with these underlying problems. Thus even if the financial system is completely fixed, problems will remain. Where could the global demand previously provided by the bubble come from? Even after deleveraging the US can’t go back to expecting the bottom 80% of households to consume 110% of their income. On top of this there a crisis in Europe – even though debt GDP / ratio is less than in US (and Greece is small). The euro created a monetary system that leads to problems –as it has no fiscal framework (and frugality is not enough). Spain / Ireland had fiscal surpluses – and allowed a bubble to grow through market liberalization. The problem in Europe could be solved if there is cohesion, but otherwise there will be a serious global problem. Europe has effectively created a new equivalent of the gold standard that inhibits adjustment. The US also contemplates austerity. Reducing deficit would be easy if this was the only issue. Four things changed US fiscal position: (a) tax cuts for rich; (b) expensive wars – that don’t increase security; (c) deals with drug companies that leads to high prices; and (d) recession. Reversing these would solve the fiscal problems. Getting back to work is vital. Austerity will compound problems in US, and worldwide. The US has under-invested in infrastructure / technology / education for 20 years, so high returns could come from such investments. Yet the US talks about cutting this back. Direction of global economy is now exacerbating difficulties, as concerted austerity is a recipe from global economic suicide. After Lehman Brothers’ collapse, the world came together and recognised the need for stimulus. Stimulus worked – but was too small. If there had been no stimulus, US unemployment would be over 12%. The same applies globally. Many worldwide are using the crisis to pursue other agendas (eg downsizing government). But, given a balanced budget, increases in government spending increase GDP / jobs (ie if tax those at the top, and spend on areas with high multipliers). The balanced budget multiplier is over 2-3. Reducing tax system progressivity is dangerous, because growing inequality is already a problem. Before the crisis the economy was artificial (ie a bubble) – and the US can’t go back to this. Financial system is now partly repaired, and returns are near normal. But underlying problems remain. Too-big-to-fail banks continue. Non-transparency remains (eg involving derivatives), and is a problem as no one can tell if institutions are sound. Banks failed in Europe after stress tests. Thus ordinary investors can’t tell, and confidence can’t be recovered. Forecasts of recovery have low credibility. Thus there are still financial system problems. Bank concentration has increased. An agenda for reasonable economic health would involve: (a) countries with finance spending more; (b) addressing problems of inequality; (c) facilitating structural transformation; (d) reducing fossil fuels demand (as challenge of climate change needs a solution). But most likely prospect is long Japan-style malaise. This is a global crisis, because of interdependencies. Emerging markets have done well. Many grow despite turmoil in Europe / US. But if the latter did better this would enable world to do better. Thus need cooperation. Frameworks are inadequate to arrange this. There is a need for a coordinating council.

The web-cast was useful progress because it recognised that:

  • the GFC is a global phenomenon that has many causes [see above for the present writer's version of these causes];
  • economic recovery has not occurred though policy actions suggested from experience of the Great Depression were implemented;
  • it is impossible to go back to the distorted economic conditions that existed prior to the GFC (eg when the US economy was sustained by asset bubbles that encouraged high rates of consumer spending);
  • recovery is constrained by a lack of global demand due to: (a) globalization and impediments to adjustment in developed economies; (b) growing inequality; and (c) high savings rates by oil exporters and by countries at risk of financial crises (eg in East Asia and emerging economies elsewhere);
  • There are serious problems in Europe, and these put the world economy at risk. Countries  that followed conventional economic wisdom (eg Ireland and Spain) were adversely affected, and the euro is a constraint on recovery equivalent to the gold standard in the 1930s. Austerity is not a solution;
  • the US (where austerity is also being considered) suffers fiscal problems with four main causes: ie: (a) tax cuts for rich; (b) expensive and futile wars; (c) high pharmaceutics costs; and (d) recession;
  • There could be high returns from public investment in infrastructure / technology / education - because these have been neglected for two decades;
  • Stimulus spending by countries that can afford this would be useful;
  • There remain underlying problems in the financial system (eg lack of transparency / confidence).

However in a number of respects there is a need to broaden the analysis presented in the web-cast (ie the GFC did not just start in the US; government fiscal problems can't be resolved without redressing international financial imbalances; productivity can be a constructive goal; and there are better options to facilitate economic adjustment than those linked to monetary and fiscal policies).

First, it was simplistic to suggest that the GFC originated in the US and was then exported to the world, because international financial imbalances were a prior and very significant factor.  In particular:

  • as the web-cast noted, high savings rates well in excess of investment (and consequent demand deficits) have characterised major oil exporters and countries at risk of financial crises since 2008, and these demand shortfalls are an obstacle to global growth. However this constraint had existed for decades prior to 2008 (especially as a result of excess savings / demand deficits by Japan, China, and major oil exporters) and this gave rise to international financial imbalances. Large demand deficits (which, as noted below, reflect structural features of East Asian economies) would have stifled global economic growth if they had not been counter-balanced by their trading partners' (mainly the US's) willingness and ability to absorb excess savings and provide excess demand. The US played the role of the 'consumer of last resort' while seeking to support the global spread of market economic models. Excess demand was sustained by domestic easy money policies and capital inflow that stimulated property inflation (which in turn encouraged very high levels of consumer spending as the web-cast noted) until the bubble burst and gave rise to the GFC, at which stage the major burden of borrowing to sustain domestic and international demand shifted to the US federal government (eg see Structural Incompatibility Puts Global Growth at Risk, 2003 and Impacting the Global Economy, 2009);
  • there are cultural factors which have encouraged major East Asian economies (eg Japan and China) to accumulate high levels of foreign exchange reserves (and thus run current account surpluses) in order to protect against financial crises. This is not easily understood from a Western perspective, but progress is possible by recognising that the traditional purpose of providing information in East Asia (which has no classical Greek heritage) is not to enable individuals to understand as the basis for independent rational decisions. Rather the purpose is to stimulate others to take actions that are likely to benefit the providers' ethnic community (see Why Understanding is Difficult). 'Information' can be likened to propaganda, rather than being expected to be 'truth'. This approach to 'information' is economically significant when applied to official statistics and to the financial performance of banks and businesses, and thus: 
    • the problem of non-transparent financial arrangements (which the web-cast described as serious in a Western context) is arguably more extreme in East Asia than anywhere else (see Evidence);
    • affected economies risk financial crises if investment is financed from borrowing in international profit-focused financial markets, rather than by suppressing demand and generating saving which exceed those needed for investment (see see Understanding East Asia's Neo-Confucian Systems of Socio-political Economy);
  • the resulting financial imbalances reflect not only a 'clash' of financial systems, but also a broader 'clash of civilizations', that has arguably affected recent history though it has been almost invisible to Asia-illiterate Western economists and defence analysts (see An unrecognised clash of financial systems, 2001+; Babes in the Asia Woods, 2009+; and Comments on Australia's Strategic Edge in 2030, 2011);
  • Europe was badly affected by the financial crisis, not only because of the effect of the euro and domestic problems in various countries, but also because 'safe' investment of foreign exchange reserves by many major oil exporters favoured Europe (due to political objections to investing in the US). European financial institutions then often had to redirect those funds to the US (which had the world's deepest financial markets) in order to prevent a significant appreciation of the euro, and a loss of export competitiveness (see also Sovereign Defaults: Stage 2 of the Global Financial Crisis). Because of this Europe's banking system appeared to be heavily exposed to financial products that turned 'toxic' when the GFC started and to incur losses that were at least as serious as those in the US. The losses incurred by European banks also seemed to be confronted and written off much more slowly.

Second, there can be no economic solution by increased government spending without dealing with international financial imbalances - as the latter produces demand deficiencies in many developed economies and are major factors in government fiscal constraints.

While it may make sense (as the web-cast suggested) for governments who can afford it to provide a stimulus when other demand is weak, the international financial imbalances that were mentioned above imply that almost no one can now do so - because the public and private debt levels of deficit economies are already high, while surplus economies can't move into deficit if their financial systems remain under-developed.

While it is possible to debate the effect of fiscal austerity in Europe, there is little prospect of government stimulus spending in many of the countries that are suffering the worst recessions.

The US's 'fiscal cliff' can also be considered - the 'cliff' being an economically-disruptive and mandatory set of severe tax rises and spending cuts that were put in place in 2010-11 to force serious action before 2013 to redress the US federal government's escalating debt levels. The fiscal problem might, for example, be temporarily 'resolved' by ignoring rising government debts (ie by continuing spending well in excess of revenues). This could be expected to lead to another downgrade of the US's credit rating [1] with disruptive effects on financial markets (as in 2011) and perhaps higher interest rates on US government debts, which could then compound the fiscal problem into a crisis in the new year or two.

Alternately the US's fiscal problem might be resolved, as far as government is concerned, by increasing taxes and / or reducing spending, so as to stabilize government debts. However, if the US is to maintain current account deficits (to accommodate excess savings elsewhere by continuing to act as the world's 'consumer of last resort'), it must maintain a capital account surplus (ie import capital / increase someone's debt levels). Any fall in government deficits will simply shift the need to borrow onto households and the private sector - if total demand is not to fall and cause a serious recession. If other sectors are unwilling / unable to significantly increase their borrowing, then resolving the US 'fiscal cliff' by balancing government budgets is likely to be recessive for the global economy. And it can be noted that: (a) households are in a de-leveraging mode because of historically high debt levels and stagnant asset values; and (b) business generally does not seem to have the confidence to invest.

Without rapidly rising asset values households and businesses in the North America, Europe, Australia etc can't provide the excess demand that is needed to sustain structural demand deficits in East Asia, emerging economies elsewhere and major oil exporters. And, if rising asset values were again to be stimulated by easy money policies so as to provide the basis for spending well in excess of income, this would recreate conditions like those prior to the GFC and presumably lead to another crisis. 

On the other side of the imbalance equation, major East Asian economies (ie Japan and China): (a) seem to be under immense pressure; (b) may have unsustainable financial and economic systems; and (c) could thus experience breakdowns that trigger Stage 3 of the GFC (eg consider Are East Asian Economic Models Sustainable? and China: Heading for a Crash or a Meltdown?).

Japan has been involved in stimulus spending for two decades and has government debts that exceed 200% of GDP. China has been engaged in massive stimulus spending (partly through easy credit for property development) since the GFC started. The more such stimulus is continued in the absence of strong demand elsewhere, the greater the risk of generating current account deficits and thus financial crises.

As suggested below, resolving the economic impasse is likely to require much more than debates about governments' fiscal constraints and options. Structural changes (rather than counter-cyclical fiscal and monetary policies) will be needed as (for example) the US relinquishes its role as the developing world's 'consumer of last resort'.

Third, suggestions in the web-cast about productivity as an obstacle to structural transformation (and thereby creating new economic / employment opportunities in developed economies) are suspect.

It was suggested that increasing productivity causes industries to decline.

This is certainly correct if 'productivity' is defined as ratio of output to inputs (eg inputs of labour). For example, if mechanisation (which has typically been mainly associated with significant increases in fossil fuel consumption) allows workers to each produce (say) 10 times as much food, and if demand for food is limited, then (by definition) 'productivity' will have reduced employment (and thus be associated perhaps with a decline in agricultural employment from 50% of a workforce to 5%).

However productivity is more usually defined in terms of increased economic value added relative to economic inputs (ie to over-simplify this means (sales – costs) / costs). The latter definition of productivity tends to be associated with rapidly growing economic activities. Though reducing input costs per unit of output implies reduced labour, significant reductions in prices can lead to large increases in demand, so that though the number of jobs / unit of output fall, the total number of jobs increases – until increased competition causes an over-supply relative to demand and a need thus arises for innovation and the development of new areas of opportunity.

While there are certainly constraints on the use of financial criteria as a basis for guiding economic activity, there are also significant advantages (see The Advantages and Limitations of Financial Criteria). And there are also disadvantages in alternative methods (eg neo-Confucian social networks in East Asia) as noted above.

Finally, there are better options to facilitate economic adjustment than those involving monetary and fiscal policies: Some suggestions about this are in 'China may not have the solution, but it seems to have a problem'. These include:

  • recognising the obstacle to global growth that structural international financial imbalances create;
  • constraining the availability of credit for consumption in deficit economies and the development of complex financial products and systems, while:
  • boosting productivity, incomes, equality and tax revenues through novel approaches to accelerating market-oriented economic adjustment;
  • reducing the need for defence spending (eg by increased emphasis on discrediting the ideology of groups seen to pose a security risk) and for some forms of welfare entitlements;
  • strengthening the ability of governments to act competently in the general community interest;
  • encouraging and supporting the development of reliable and transparent financial systems in countries (most notably Japan and China) that currently generate dangerous financial imbalances because of their risk of financial crises.

It can be noted that, while there may be large benefits from constructive public investments (eg in education, infrastructure and technology), this can only be put into effect if governments are more competent than many have been allowed to become over the last couple of decades. Possible means of improving government competence that were referenced above were written in an Australian context - and will thus not be of universal relevance, though there will presumably be parallels.

Sovereign Defaults: Stage 2 of the GFC?  [<]

Increased concern was also expressed from 2010 about the unsustainable debt levels facing peripheral governments within the Eurozone, especially the so-called PIIGS (Portugal, Ireland, Italy, Greece and Spain). This was seen as potentially leading to sovereign defaults that could trigger further international financial and economic instabilities.

However other governments faced (especially Japan) faced very high debt / GDP ratios, while the US's ability to maintain very high government deficits and high debt levels (see below) appeared to depend on the $US's status as the world's reserve currency. 

It was the the present writer's expectation in mid-late 2009 that further stages of financial and economic crisis were likely which had been overlooked in coordinated efforts by governments through the G20 to deal with the GFC (see Unresolved Problems and Coming Crises)

Factors in generating the problem in Europe apparently included:

  • the dislocation of previously successful economic strategies as a consequence of the first stage of the GFC. For example:
Ireland in 2010 faces 10% interest rates on government debt, and is expected to be unable to borrow from next May. Ireland, til recently, was the best place to live - with a high growth rate and an unmatched quality of life. Ireland adopted euro in 1999 giving it access to much bigger capital market, halved taxes, cut import duties and encouraged foreign investment. Many major companies adopted Ireland as their base in eurozone. By 2003 GDP / capita was 136% of European average, and unemployment was down from 17% to 4%. Emigration turned into net immigration. Government could increase spending dramatically, and still run surpluses. When inward investment / export-led growth slowed, government decided to boost property market with tax breaks, and encouraging banks to provide easy credit to house-hungry consumers. Ireland's construction industry boomed, Successful developers started acquiring property elsewhere. Bank lending for property increased 30% pa. When banks ran out of money to lend, they borrowed from Germany. At height of boom in UK, property industry accounted for less than 10% of economy, but in Ireland it was 25%. When Lehman Bros failed, asset values collapsed. Banks were bailed out, but Ireland went into recession. Supporting banks costs government 32% of GDP. More mortgages defaults are expected as unemployment rises and house prices fall.  (Arlidge J., 'Irishman walks into a bubble', The Australian, 17/11/10)
  • the failure after 2008 to clean up the balance sheets of European banks by writing off all GFC-related losses;
The core of global problem in 2012 is that European politicians and central bankers failed to recapitalise their broken banks. Europe's banking system is globally important. When a country undertakes austerity program its economy slows, asset values fall and this imposes losses on banks. This reduces banks' ability to obtain capital, and worsens the problem - as does risk of break-up of eurozone and ECB lending to troubled banks while encouraging them to gamble on bonds in countries that may be unable to repay debt. Stress tests on Europe's banks were selective and concealed problems. Thus attempts to rescue European banks have failed to address core problem [1]

Spain could be too hard for Germany and northern European countries to rescue. Its crisis did not result from government overspending (noting its budget surpluses and low debt to GDP ratio). Wealthy foreigners had rushed to buy second homes in Spain prior to GFC, and when the value of these collapsed, Spanish banks were left with large losses. This was like the situation in US, but because it was involved in EU Spain could not take measures to write off those losses, and ECB could not provide support (like US Fed did) because of its lack of regulatory control over Spanish banks [1]

  • features of the European Monetary Union (EMU), for example:
    • under the EMU 'Club Med' countries with relatively weak economies had the same currency as those in the centre / north of Europe. This arrangement improved the competitiveness of countries with well developed export capabilities (especially Germany), but it severely limited the competitiveness of the peripheral economies and required heavy government spending to maintain economic growth and employment;
    • automatic mechanisms to adjust for international currency flows resulted in Germany's central bank (the Bundesbank) being heavily exposed to potential losses elsewhere because it provides funds to the ECB to cover interbank transfers from (say) Greece to Germany [1].
  • democratic demands for welfare arrangements (exacerbated by aging populations) that those countries could not afford.

In 1984 the US was about to benefit from the ‘demographic dividend’ as baby boomers boosted labour supply and national productivity. But baby boom does not last forever – as baby bulge reaches retirement age, labour supply stops growing, older workers start spending their savings, national savings runs down. Strong growth is still possible, but requires increased productivity, longer hours. This is what is now affecting much of southern Europe. The first serious strains in European budgets are showing up in welfare – because pension schemes offer defined benefits paid out of future tax revenues. (McArdle M., ‘The boomer bust’, AFR, 25/5/12 - from Europe’s real Crisis)

Europe faces a civilization crisis - related to overspending governments and over-regulated economies. Normally this could be solved by slashing taxes and red tape, but Europeans are addicted to entitlements (eg welfare, early retirement) and so resist such reforms (Stephens B. 'Europeans addicted to what ails them', The Australian, 11/6/12)

[This issue does not seem to be confined to Europe as it is also reflected (for example) in: California's incompatible referenda to limit taxation and increase public spending, and in disputes concerning US federal budget deficits in 2011 that seemed likely to re-emerge in 2012 as the US approaches its so-called 'fiscal cliff', which could result on 4.5% of GDP in tightening [1]];

  • the apparent presumption by lenders that peripheral European economies could be provided with ready access to loans despite their increasing debts, because of the assumption that governments in the eurozone would not be allowed to default;
  • policies involving fiscal and monetary contractions affecting countries (eg Spain) suffering housing busts [1];
Spain's collapse is inevitable result of monetary and fiscal contraction on an economy struggling to deal with housing bust. ECB monetary tightening caused Spanish real M1 deposits to fall 8% in late 2011 (and also caused broader M3 for Europe as a whole to fall during 2011). This was incompetence [1]
  • international financial imbalances.

Financial Imbalances and the European sovereign debt crisis:

Though the situation is complicated, it is clear that the financial crisis threatening Europe from 2010 (as did the US-centred GFC in 2008) had its origins partly in the difficulties of finding safe / production domestic uses for the huge quantities of capital that accumulate as a result of  excess savings in countries with under-developed financial systems (eg see Understanding East Asia's Neo-Confucian Systems of Socio-political Economy and Leadership by Emerging Economies?).

The demand deficits associated with excess savings in East Asia (and in other surplus countries such as Germany and major oil exporters) had to be offset by excess demand elsewhere if global growth was to be maintained. Much of the excess demand was provided by US consumers on the basis of perceived wealth associated with a pre-2008 asset bubble and when this burst losses by financial institutions were partly shifted to US governments (see Getting out of the Economic Quicksand).

In relation to the role that international financial imbalances played in the financial crisis that emerged in Europe in 2010, it can be noted that:

  • financial imbalances did not only adversely affect the US. In many countries (including major European economies such as France, Germany and Italy) large fiscal deficits had been needed to achieve sufficient growth to keep unemployment under control (see Structural Incompatibility Puts Global Growth at Risk, 2003). In late 2011 one observer suggested (in relation to the European debt crisis that by then was seen as a major economic risk) that:

"Germany has kept the focus exclusively on fiscal deficits even though everybody must understand by now that this crisis was not caused by fiscal deficits (except in the case of Greece). Spain and Ireland were in surplus, and Italy had a primary surplus.

As Sir Mervyn King said last week, the disaster was caused by current account imbalances (Spain's deficit, and Germany's surplus), and by capital flows setting off private sector credit booms." [1]

  • current account surpluses associated with Germany's export-based economy and foreign investment in European financial institutions (eg by Middle Eastern oil exporters who objected for political reasons to investing in the US) created a requirement for large-scale external investment by European financial institutions (as otherwise economic competitiveness would have been severely eroded by increasing currency values). A great deal of that capital had been passed to US financial institutions (an economy well equipped to absorb it) - and thus became embroiled in the asset bubbles whose bursting led to the GFC. Thus European financial institutions appeared as badly or perhaps even worse affected by the GFC contagion, than those in the US in 2008. Other excess capital that accumulated in the European core was directed to Eastern and Southern Europe - and in turn generated large losses for European banks, and a need for governments to add to their existing high debt levels by protecting them from failure (eg by guarantees on sovereign debts of troubled EMU member countries such as Greece)   

In 2012 the link between financial imbalances and problems in southern Europe were being publicly discussed.

Peripheral European countries (such as Spain) which are uncompetitive, have high debt levels and savings rates that have been forced down to dangerous levels could leave the euro. Spain's position is stronger than many others, while France's position is marginal. Either (countries like) Spain must leave the euro or Germany must leave because of balance of payments problems and internal processes leading to financial crises. Spain has become uncompetitive due to excessively loose monetary policies driven by Germany's needs - and thus suffered current account deficits. Its savings rate collapsed, costs rose, debts soared and unproductive projects attracted investment. Spain must reverse its savings / consumption balance and get its current account into surplus - or else will continue struggling with growth and rising debts. There are three ways to do this: (a) core countries (eg Germany) could cut consumption / income taxes so as to reduce savings, increase domestic consumption, and reduce its trade surplus; (b) Spain can force austerity / high unemployment for years until wages are pushed down (a process that could be aided by other measures to facilitate business); and (c) Spain could leave the euro and devalue. The first option would be the best but is unlikely because Germany has potential huge debt problem on its balance sheet due to consumption-repressing policies over past decade which generated capital for offshore investment (mainly in Europe). A wave of defaults across Europe now would lead to a need for state bailout of Germany's banking system. Germany's anti-consumption policies are leading to the same sort of debt problem that the US did in the late 1920s. Germany's efforts to boost its credit-worthiness are likely to be counter-productive. Without a major reversal of Germany's current account position, net repayments from peripheral countries are impossible. Germany is presumably hoping that if crisis is prolonged it will be possible to recapitalise European banks sufficient to allow them to cope with losses (as US did with Latin American in the 1980s). However this won't work as: (a) the European banks losses are much more severe; and (b) Europe's political systems are less able than Latin America's to allow costs of adjustment to be forced onto communities. This is the reason that Spain can't follow the second path (ie carry the full cost of adjustment itself). Doing so would raise problems in: (a) reducing wages and prices; (b) coping with domestic debt burden (eg by confiscating middle class wealth). As other options are impossible, Spain is left with no choice but to abandon the euro [1]

It would be better for peripheral European economies facing debt constraints to stay in the eurozone and face up to reform because all parties will lose from a break-up of the eurozone. The eurozone's stronger economies had been financing the current account deficits of the weaker ones, which were losing competitiveness as their relative wage costs increased and as northern firms took advantage of the scale economies the move to a single currency allowed. Leaving with create severe problems for 'club med' economies - while also requiring recognition of substantial losses by banks in the European centre, and Germany's loss of its ability to achieve current account surpluses through exports to the periphery [1].


China and Japan Need to Do More Than Contribute to Europe's 'Begging Bowel' - email sent 20/6/12

Richard Gluyas,
The Australian

Re: Shifting power balance sees China, Japan dig deep to save the West, The Australia, 20/6/12

Your article suggested that the arrival of the Asian century is underscored by the funding committed by China and Japan to the IMF (which is now in effect ‘Europe’s begging bowel’) while the US did not do so.

However this is just a continuation of the practices that got the world economy into its current mess. Suppressing domestic consumption so as to generate savings which have to be exported and thus boost demand (and rising debt levels) in trading partners has been foundational to the systems of socio-political-economy that have been the basis of economic miracles in East Asia. Such countries have needed to protect their poorly developed financial systems, and this resulted in the international financial imbalances that played a major role in generating the global financial crisis (eg see Structural Incompatibility Puts Global Growth at Risk, 2003; Understanding East Asia's Neo-Confucian Systems of Socio-political-economy, The Asian Connection in the Public Debt Problems Facing Developed Economies; and GFC Causes).

The G20’s failure to understand / confront East Asia’s cultural problem, and the West’s futile hope that the financial crisis can be fixed by countercyclical fiscal and monetary stimulation of domestic demand in countries which already have large current account deficits and debts, is one reason that the crisis has continued to get worse (see G20 in Washington: Waiting for Hell to Freeze Over? and Sustainable World Growth Requires More than Counter-cyclical Policies).

While the financial problems facing some peripheral economies in Europe have many causes, in relation the availability of credit their problem has not been a lack of credit, but rather excessively easy credit (see Comment on the European Sovereign Debt Crisis). Heavily indebted economies need to be stimulated by external (rather than by artificially generated internal) demand.

Thus, if countries such as China and Japan really want to help, they would reform their financial systems so that they would not be at risk of crises if they allowed domestic demand to rise, and thus faced current account deficits. It is in Asia that financial system reform is most necessary (see Should Fixing the International Financial System Start in Asia?). If such countries do not want to help solve the global financial problem, then the rest of the world’s options might be something along the lines suggested in Getting out of the Economic Quicksand.

John Craig

PS: Some suggestions about the need to understand the other implications of a possible ‘Asian century’ are outlined in An Asia-literate Approach to 'Asia'.


Beyond Eurocentric Pessimism - email sent 2/7/12

Roger Bootle
Capital Economics

Re: Euro debt crisis: is complete pessimism justified?, The Telegraph, 2/7/12

Your article is spot on in suggesting that: (a) the real problem is a lack of demand; and (b) the solution must involve demand emerging from surplus economies (eg see China and Japan Need to Do More Than Contribute to Europe's 'Begging Bowel').

However the obstacle to this is that the major surplus economies (ie those in East Asia that operate on the basis of neo-Confucian systems of socio-political-economy – such as Japan and China) would / will be in deep financial, economic and political trouble if / when their current account surpluses can no longer be maintained (see Understanding East Asia's Neo-Confucian Systems of Socio-political-economy and China can't fix the global currency crisis without economic disaster).

Some speculations about what might need to be done to resolve the global problem are in New Economics: Some Pragmatic Suggestions (which was written for an ‘Occupy Movement’ audience) and in detail in China may not have the solution, but it seems to have a problem. The latter referred, for example, to:

  • widely recognising the effect of poorly developed financial systems in East Asia;
  • constraining credit for consumption and boosting the supply side of deficit economies;
  • developing better methods for macro-economic management;
  • constraining the use of complex financial instruments;
  • reducing the need for public spending on welfare and defence in deficit countries; and
  • providing assistance in adjustment in countries with distorted financial systems (such as Japan and China).

I would be interested in your response to my speculations.

John Craig

In August 2012 the president of the European Commission suggested that Europe would seek to overcome problems associated with financial imbalances within a 'firewall' created by expansion of the European Stability mechanism

The eurozone is at a decisive juncture. Short term debt crisis has its roots in structural problems. Europe is undergoing a correction of macroeconomic imbalances that grew before financial shock of 2008. Europe's integrated financial market had channelled savings from countries with sluggish domestic demand to those with strong demand based on credit, and wages / prices were increasing. This occurred both in US and EU. Europe has made progress over past 2 years in correcting these imbalances - and the situation in Ireland, Portugal and Greece has improved. Talks continue regarding Greece and Spain. But correcting imbalances remains a major problem. Some countries need to reduce deficits, or increase surpluses - through boosting competitiveness. The European Stability Mechanism has created a firewall inside which this can happen. This will provide credit for countries that undertake lasting reforms. Europe will build a genuine economic union to strengthen the existing financial union (eg by creating a single supervisory mechanism for banks) (Rehn O. 'Delicate balancing act to end continental drift, The Australian, 16/8/12)

Further observations about political aspects of the situation are in Saving Democracy.

Limiting the 'Consumer of Last Resort [<]

In early August 2011, the US government finally accepted the need to constrain the growth of US government debt. Soon thereafter the US government lost its AAA credit rating because the adjustments to its budgetary position were seen to be inadequate and the US political process was not handling the challenge well.

This seemed likely to result in serious consequences for the global economy because poorly developed financial systems in major East Asian economies, and in emerging economies elsewhere, had been protected from financial crises by limiting domestic demand and reliance on current account surpluses largely at the expense of the US, the world's 'consumer of last resort'.

Will ending the magic credit card bring the world economy to its knees? (Email sent 2/8/11)

Peter Hartcher,
Sydney Morning Herald

Re: The magic credit card brings US to its knees, Brisbane Times, 2/8/11

Your article suggested that:

“The US debt crisis marks the end, at least for some years to come, of American exceptionalism - the idea that the normal rules of national conduct do not apply. And because exceptionalism tempted the country into grave misjudgments, this is a good thing.”

There is little doubt that apparent strategic misjudgements by the US (such as those your article outlined) may have been the result of overconfidence in its institutions and strength. However the issue is more complex, and it by no means obvious that there are any satisfactory alternatives.

For example the US’s now-officially-recognized inability to continue increasing debts indefinitely (which has been obvious for years) could prove to be a most ‘uncomfortable thing’ for the world economy. Global economic growth has long relied on the US’s role as ‘consumer of last resort’ and there are likely to be severe repercussions from its inability to continue this role (including the likely failure of the systems of socio-political-economy that have been the basis of ‘economic miracles’ in East Asia, and thus of Australia’s ‘China luck’).

Large segments of the world economy (especially the emerging economies whose growth is now seen to be critically important, because of weaknesses in developed economies, seem to depend on current account surpluses to avoid the financial crises that would otherwise afflict their poorly developed financial systems (eg see Leadership by Emerging Economies? and Are East Asian Economic Models Sustainable?). The latter notes in particular that neo-Confucian systems of socio-political-economy appear to involve state-linked banking systems mobilizing national savings and directing capital to state-linked enterprises with limited regard to profitability (an arrangement that constitutes a novel form of industrial protectionism), while domestic consumption is suppressed to the point that a current account surplus results, so there is no need to expose banking systems with poor balance sheets to a requirement to borrow in ‘capitalistic’ international financial markets.

These macroeconomically unbalanced economies have depended on the willingness and ability of trading partners (mainly the US) to compensate for their demand deficits by sustaining large current account deficits and continually increasing debt levels (see Structural Incompatibility Puts Global Growth at Risk, 2003). The associated financial imbalances clearly played a role in encouraging the risky monetary policies in the US that contributed to the global financial crisis (see Impacting the Global Economy ) and thus also in the large debt levels that governments in many countries incurred in rescuing their financial systems from the effects of that crisis (see The Asian Connection in the Public Debt Problems Facing Developed Economies). There are, of course, other factors in the public debt problems now afflicting many governments (eg limits to the democratic welfare state in the face of an aging population).

However, many will not find the end of US exceptionalism to be an unambiguously ‘good thing’ now that: (a) the limits to quantitative easing in stimulating economic activity seem to have been reached; (b) the world’s ‘consumer of last resort’ (finally) faces pressure for frugality not only from heavily indebted households but from governments; and (c) no country now seems to be in a position to provide the demand required to support the financial imbalances that emerging economies require.

Finally it is submitted that while problems have emerged partly from over-confidence in the US’s own institutions and strength, it is likely that problems have also been the product of a lack of understanding of others’ cultures and institutions – see Competing Civilizations and The Second Failure of Globalization, from 2001 – and in particular Fatal Flaws (in relation to cultural constraints on introducing democratic capitalism in the Middle East), An Unrecognised Clash of Financial Systems (in relation to an apparent pre-emptive challenge to democratic capitalism that seems to have been under way for decades) and Creating a New International 'Confucian' Social, Political and Economic Order (in relation to the prospective emergence of an alternative to democratic capitalism). The social science and humanities faculties of Western universities seem to have been ‘asleep at the wheel’ for decades (see A Case for Restoring Universities).

I would be interested in your response to the above speculations.

John Craig

In late 2012 there was a great deal of global debate about the so-called 'fiscal cliff' in the US which reflected the need to bring US government debt under control. However the international dimensions of this issue seemed to be entirely overlooked.

A Plan to Both Reduce US Debt Levels and Sustain Growth - email sent 3/1/13

Stephen Barthlomeusz,
Business Spectator

Re: Miles to go before markets can breathe, Business Spectator, 2/1/13 (also ‘No let-up in risk aversion until policymakers see path to stability’, The Australian)

Your article correctly points to the fact that the (so called) ‘fiscal cliff’ in the US is merely one component in problems affecting the global economy, and that sustained recovery is unlikely until policy-makers in the US and Europe have some clear path to achieving longer-term stability. I should like to make a suggestion about what that path might be.

My interpretation of your article: The US fiscal cliff is receiving a lot of attention, but this is only a distraction from larger problems affecting the global economy. Despite short term solutions being arranged to prevent immediate economic problems, US debt levels are unsustainable – and there is a need for a long term plan to reduce these while boosting growth. The US is still struggling with the consequences of the GFC, and Europe is in worse shape. All that central banks have done with unconventional monetary policies is to trigger a global currency war – in the hope that this might stimulate growth and lessen risk aversion. This has been good for equity markets, and ensured a flow of capital into $A assets. However long-term use of easy money policies creates a risk of unpleasant consequences. Without a real solution, institutions, companies and households will remain cautious. Risk aversion won’t disappear until it becomes clear that policy-makers in the US and Europe have pathways towards longer term stability.

As you are undoubtedly aware, the ‘fiscal cliff’ in the US was an artificial device that was created to force serious attention to be given to the US’s escalating public debts. And the latter is not simply a domestic issue because the real problem arguably lies in international financial imbalances (related to the developing world’s long dependence on the US as the ‘consumer of last resort’ and structural demand deficits in (mainly East Asian and emerging) economies that would face financial crisis if they incurred current account deficits because of their poorly developed financial systems). Prior to the global financial crisis, US households carried most of the burden of rapidly rising debt – on the basis of escalating asset values boosted by easy money policies – but since sub-prime crisis burst the asset bubble much of the burden in the US has shifted to the federal government. Imbalances have also been a significant factor in the fiscal problems in Europe (see Comment on the European Sovereign Debt Crisis).

As long as financial imbalances remain in the too-hard basket (eg see G20 in Washington: Waiting for Hell to Freeze Over?), it makes little difference to the global economy whether the US government (say) moderates its deficits, as (given the US’s large current account deficit) this would merely shift the need to be willing and able to increase debt onto already-heavily-indebted US households if total economic demand is not to stagnate. And, as your article noted, neither households nor companies are likely to be willing to carry this load until a clear path to long term stability is apparent.

This point is developed further in Progress Towards Ending the Global Financial Crisis? The latter also notes the inadequacy of counter-cyclical (fiscal and monetary) policies in dealing with structural economic problems and includes suggestions on: (a) options to overcome the constraints associated with international financial imbalances; and (b) novel methods to boost growth (and thus public revenues) in countries such as the US.

John Craig


Options to Resolve the Fiscal Cliff and Reduce Military Spending - email sent 7/1/13

Kevin Zeese,
Its Our Economy

Re: Fiscal Cliff Over, Now the Attack on the People Begins, Global Research, Jan 2, 2013,

Your article pointed to the failure of negotiations in relation to the so-called ‘fiscal cliff’ to make any serious inroads into US military spending (so that spending cuts are likely to adversely affect the general community).

I should like to suggest that this could be changed by demonstrating (to the US public / political system) that there are better soft-power alternatives to military spending to reduce the threats associated with groups who pose security risks. This is one of the options that could be part of a broad approach to the world’s financial and economic challenges (see Progress Towards Ending the Global Financial Crisis?).

The de-militarisation option (through a more serious effort to deploy soft power) can be illustrated in relation to the security threat posed by Islamist extremists. In particular:

  • There were major limitations in the stated logic of the US-led invasion of Iraq (see Fatal Flaws). The 2002 US National Security Strategy seemed to be based on the view that bringing ‘freedom’ to a country such as Iraq would result in major political and economic gains, and thus eliminate the case for Islamist revolutions in the Middle East (which indirectly led to attacks against Western societies because they were seen to be supporting autocratic regimes in the region). However this ‘logic’ overlooked the many cultural and institutional preconditions that would have to be in place before ‘freedom’ (eg by displacing Saddam Hussein’s autocratic regime) would be likely to bring those benefits. For example, ‘freedom’ from an autocratic state is not sufficient if family / communal constraints also seriously inhibit individual initiative, and democracy can’t be effective without well-developed civil institutions; and
  • There were soft-power options to greatly reduce the security risk from Islamist extremists (without visiting Baghdad in force) by giving potential supporters of Islamist extremists a chance to understand that the latter’s ideology would make the situation in the Middle East even worse (see Discouraging Pointless Extremism, 2002).

The military intervention option (which was advocated by the US neo-cons) was accepted in the apparent complete absence of any serious proposals in the US about alternative ways to dealing with what was a very real security threat. The absence of an alternative was not the fault of defence analysts (or their industrial / political connections) because their expertise is only in military / security options. Rather the absence of an alternative largely reflected the fact that students of the humanities and social sciences in Western universities had been ‘asleep at the wheel’ and had not considered the practical consequences of differences in cultural assumptions for a society’s ability to achieve political stability and economic progress (see Ignorance as a Source of Conflict).

Similarly there are soft-power options that, if successfully deployed by those outside the military system, could make it obvious that there is no need for high levels of US military spending in relation to the emerging security threat associated with China’s increasing militarisation. What this alternative might require is suggested in A Better Australian Response to US Defence Proposals? (2012).

It seems very likely that that what you described as ‘attacks on the people’ because of fiscal constraints can be avoided. But this requires that those with the necessary skills and motivations get off their backsides to show the public / political system that non-military / soft power options can be effective in reducing security threats.

I would be interested in your response to my speculations.

John Craig

US Focus on the Asia Pacific  [<]

In November 2011, the US President announced an intention to shift the US's national security focus to the Pacific, involving in particular:

  • standing "for an international order in which the rights and responsibilities of all nations and people are upheld. Where international law and norms are enforced. Where commerce and freedom of navigation are not impeded. Where emerging powers contribute to regional security, and where disagreements are resolved peacefully" and collaborating more (including militarily) with allies in the region [1]. In particular emphasis was placed on expectations that China would 'play by the international rules' [1]
  • strengthening efforts to free up trade in the Asia Pacific through a Trans-Pacific Partnership Program [1].

The incompatibility between such US expectations and East Asian practices clearly lays the foundation for ongoing international tensions.

From 2011 disputes grew between US and China about the apparently poor accounting practices of Chinese companies with US operations (and the suspect auditing of the Chinese operations of US companies) - and this (like the US Federal Reserve's so-called 'Currency War') seems likely to start getting at the root causes of those international financial imbalances that have their origin in East Asia.

Creating an Effective International Financial System?  [<]

In June 2012, a  former chairman of the US Federal Reserve, Paul Volcker, suggested that the global economy would be unable to rely indefinitely on high levels of consumption in the US, and on associated financial imbalances. He put forward some suggestions about how a more effective international financial / monetary system might be created in order to reduce the risk of financial crises. 

Financial systems can break down (eg Asia in the 1990s and US / Europe a decade later). Without international consensus reform will be difficult. Free markets can be constructive, but not with a deregulatory race to the bottom. There is a need for a consistent approach to the imminent failure of systemically-important institutions. The US has new approaches to bankruptcy - but this will fail without similar provisions elsewhere or where other jurisdictions undercut restrictions. There is also a need for reform of international monetary system - as at present there does not seem to be a system (ie there is no authority or official international currency). Such a system has been made harder as markets / capital flows have become larger and more capricious. The global economy and emerging markets have flourished with an organised system. But international monetary disorder lay at the heart of crises of 1990s and even more in 2008 - especially related to sustained / complementary imbalances in the US and Asia. From 2000-2007 US had cumulative current account deficit of $US5.5 tr, with offsetting increases in China and Japan. China ran large trade surpluses, based on high savings rate and inward foreign investment. By contrast the US had high consumption levels at the expense of savings, while a housing bubble eventually burst. Any individual country may prefer to prolong unsustainable imbalances - though this is likely to lead to financial crisis. Floating exchange rates were expected to solve this problem, but many countries find it impractical to let their currencies float. Thus there must be some sort of surrender of sovereignty if an open world economy is to work. Ways to achieve this include; (a) stronger surveillance by IMF; (b) direct recommendations by IMF / G20 or others following mandatory consultations; (c) potential disqualification from using IMF or other credit facilities; (d) interest or other financial penalties such as a being considered in Europe. There could also be agreement about appropriate 'equilibrium' exchange rates. An appropriate reserve currency and adequate international liquidity is also needed. $US (and other currencies) have play such a role, leading to complaints - but it is not in US interest to accentuate its payments deficits at the expense of internationally competitive economy with strong industry and restrained consumption. And the rest of the world wants flexibility afforded by the currency of the largest and most stable economy. A useful reserve currency must have limited supply, but be sufficiently elastic to satisfy large / unpredictable needs. (Volcker P., 'A roadmap for global financial reform', Business Spectator, 7/6/12)

However, while this recognised that not all countries could afford to have a market-based floating exchange rate (by implication countries such as Japan and China), there was no obvious reference to, or necessary recognition of:

In early 2013 a German member of the European Federal Parliament sought suggestions about what are the most dangerous financial products - without apparent recognition of the risks that large / persistent international financial imbalances generate [1]

Debt Denial: Stage 3 of the GFC... or Worse? [<]

In early 2013, there was growing optimism about global economic recovery.

However this is likely to be misplaced because nothing had been done to resolve fundamental problems in the global financial system (eg those that give rise to large financial imbalances) and 'recovery' was being expected in an environment characterised by 'Ponzi-like' financial systems. 

Elaboration - preliminary notes only

In early 2013 there was clear optimism about economic recovery being reflected in rising stock markets, in an environment in which quantitative easing by reserve banks (ie 'debt denial' by monetising the debts of governments and systemically-important corporations) was widespread (eg in US, Europe and Japan).

And a case could be made that monetisation of government debts could be a necessary / viable strategy.

Some are sure that Western economies suffer a surfeit of money; economic orthodoxy suggests that forcing private spending up is needed for recovery; and everyone agrees that monetary financing of government is lethal. All these views are wrong. It is only the quantity of money that matters - and these have stagnated since crisis started. Broad money in US in 2012 was 17% below trend. Deposits do not create loans, loans create deposits - and since the crisis started loans have stagnated. Banks don't expand lending in accord with their reserves - so hyperinflation is not unavoidable. Expanding bank reserves encourages low interest rates (and thus makes business investment more likely, while increasing asset values and thus making consumer spending more likely - though this might have unintended consequences (eg by threatening the health of financial institutions / financial markets / central banks and making government imprudent) that imply limits to what central banks can do. However there are alternatives - such as breaking the link between creation of money and growth of private debt (ie by offering state guarantees on all bank deposits). It is not necessary to go that far, but it makes the point that monetary easing can validly boost spending on public infrastructure. This has the twin advantage of fiscal stimulus and monetary expansion - without necessarily risking hyper-inflation. Japan could have solved its problem by going to outright monetary financing 20 years ago. a helicopter response to a financial crisis has to be recognised as a possible option (Wolf M., 'The Case for Deploying the Helicopter', Financial Times, 14/2/13)

Though Europe remained mired in recession, US housing prices (whose collapse had been a trigger for the GFC) were recovering, attracting investment and (potentially) boosting household wealth / consumption - and shale-gas developments raised the medium-term prospects of reversing the long term constraint of expensive oil imports on US domestic demand / economic growth. China resumed the infrastructure-investment-led methods that had maintained growth following the start of the GFC in 2008.

However many observers were concerned that these improved prospects might be artificial than real.

Global outlook is everywhere seen to be brighter. Leaders say their policies are now working - but central banks continue to grow their balance sheets - thus 'kicking the can down the road' while keeping hope alive. Australia's treasurer says things are fine. But what if the green shoots don't blossom, and central bankers tactics prove to be a giant Ponzi scheme. When governments / central banks in response to crises (eg that in Greece) there are consequences. There is now a very tight correlation between US stockmarket and FED's balance sheet (much tighter than in the past). Corporate earnings are not rising - rather stocks are rising because the ration between price and earnings is growing. This may be leading to misallocation of scarce capital. And governments spend without concern for fiscal prudence. Despite the fiscal cliff negotiations the US is heading into much deeper debt, and has a $US 7 tr deficit now (based on US Generally Accepted Accounting Principles) rather than its nominal $US 1.1 tr.  The West now has reached a situation in which total private and public debt plus unfunded liabilities can never be repaid by an aging demographic. One day even debt servicing will be impossible, and the great international Ponzi scheme will end. .  (Newman M., 'Lifting lid on a Ponzi scheme', The Australian, 23/1/13)

US Federal Reserve officials are worried about extricating US from quantitative easing. A paper pointed to the risk of Fed's capital base being wiped out as interest rates rise (and bond values collapse). The Fed has average bond maturity of 11 years - with implies much larger losses when interest rates rise than for shorter maturities. Sovereign risk for US is very real. qe in Europe also involves monetisation of the debts of weak governments. Fed may be trapped - because 'bond vigilantes' could devalue bonds - and force up interest rates. Gold would need to go to $10,000 per ounce to cover fed's obligations. The US economy has not reached escape velocity - and shrank in 4th quarter of 2012. QE recently (in US / Europe / Asia) have boosted asset markets - but not improved real economy - and arguably can't while East-West trade imbalances remain. Belt-tightening in countries with public debts over 80-90% of GDP is painful - unless offset by loose money. Tight money sets of down-ward spiral. US may start to experience this as gross public debt is approaching 107% of GDP. With domestic stimulus exhausted the only option may be to seek stimulus from foreigners - and this could result in trade conflicts  [1]

In 1931 Keynes suggested that bureaucratic tinkering (to attempt to deal with financial crisis) had created a huge muddle / problem because it involved tinkering with poorly understood systems. William White (formerly chief economist with BIS) suggested central banks efforts to boost economies were an unprecedented experiment which could be sowing the seeds of a greater financial crisis. Other economists express diverse views [1]

Stock market surge conceals problems in US economy, and regulators in trying to help are fuelling a bull market. Corporate earnings are up, and household income is down. Companies are using new technologies and outsourcing to boost profitability. But reserve bank efforts to boost credit by buying mortgages is boosting stockmarket - by forcing savers into equities. Congress is seeking to constrain government spending, which will increase unemployment. China faces the same income disparities as the US and fears revolution - and so is tied to uneconomic infrastructure investment [1]

Monetary policy in US and Europe are underpinning the value of assets. This process must either be continued indefinitely or will have a very poor outcome when the asset bubble bursts.  (Sender H., 'Feds free lunch will come to an untidy end', Financial Review, 4/3/13)

While there is a perception that money is flowing from bonds into equities as part of a 'great rotation', the reality seems to be that it is flowing from cash into both as savers prefer to get something rather than nothing in a QE environment (Shapiro J. 'Bond markets at tipping point', Financial Review, 6/3/13)

While share markets are surging, fundamental economic changes in US economy are disturbing. Corporate profits are at record level of GDP, at the expense of employees (because of the effect of new technologies and outsourcing). Also quantitative easing by Federal Reserve primarily just boost stock markets. Low interest rates (primarily a response to China) force savers into equities. In China income inequalities also increase, and raises fear of revolution. China ploughs money into unproductive investment to keep its economy going - but this has a ring of artificiality [1]

In Japan there is a massive divergence between stock market gains and real economy decline. China is experiencing difficulties. US is holding up. Europe remains a black hole. World Bank officials are concerned that global economy may not reach 'escape velocity' and be held back by debt overhang and chronic lack of demand [1]

In some respects the situation seemed like a return to 2007 in terms of the vulnerability of financial systems to potential crises - a vulnerability that was not necessarily obvious to those who focused on conventional business / economic methods of analysis drawing upon 'real economy' variables. For example:

  • interest rates were at very low levels because of monetization of debt. This allows debt levels to rise well beyond what would be sustainable without monetisation. It created the risk of a crisis - when interest rates normalize. In particular:

    •  government debts and those associated with losses by systemically significant banks were being monetised (by reserve banks) with no obvious way of reversing this process. Once concessional interest rates were restored to more normal levels, some government debts would no longer be able to be serviced by available revenues. A bond market crash (as in 1932) threatened;
    • ultra-low interest rates allowed firms that would normally have failed in a severe recession to continue trading [1] - and this implies risk for some of these when more normal rates resume;
  • countries in East Asia with poor national balance sheets because governments had used 'financial repression' to steer savings into export-oriented production capacity with little regard to profitability were reliant on accumulated-but-now-probably-eroding foreign exchange reserves to protect against 'sovereign risk' (see Interchange Regarding China's Financial Challenges and Japan's Predicament) - a phenomenon that seemed to be generally unrecognised;
  • There was a lack of demand for credit from consumers. Encouraging investment may result in over-capacity if households' willingness to spend remains weak. Serious industrial over-capacity plagues China;
  • Corporate profits (to justify higher share market values) were being driven by rising asset values;
  • There was a large build up of total credit . Credit was growing faster than economic production - and this was likely to be having a role in maintaining / boosting asset values;
  • some doubted the value of paper currencies - because of monetisation. Many countries seeking gold - China says that $US dominates to keep gold down??

Moreover government debts were now unsustainably high in many places (partly as a consequence of responding to the GFC).

There is likely to be a global deficiency in demand - because almost everyone suffers from significant debt problems - a corollary of the high levels of credit. Outcome could be global balance sheet recession / deflation. Can't keep increasing government debts indefinitely - cost of credit rises, then assets (bonds / equities) fall

Austerity programs in Europe were: (a) generating social stresses that may make them unsustainable; and (b) contributing to ongoing recession. It was not clear that Europe's debt crisis is being resolved.

There was concern about monetary easing - namely that it might constitute a form of 'currency war' to drive down exchange rates so as to boost trade competitiveness. In particular there was concern that Japan might seek to directly interfere in currency markets by buying foreign bonds to weaken the yen. This would go beyond quantitative easing that is accepted providing it is aimed at stimulating the domestic economy (ie to head off deflation and drive down unemployment) [1]

None of these financial system stresses can be resolved without dealing with the challenge of international financial imbalances which:

 In 2009 the present writer had speculated that the GFC was likely to be a three stage process.

The first seemed to be the global financial system shocks that was triggered by US sub-prime crisis - though it reflected far more profound structural weaknesses in the international financial and economic order (eg see GFC Causes). The second involved the potential for sovereign defaults that was increasingly obvious in 2010. The third could involve either the breakdown of the global financial system altogether or the failure of East Asian economic models - related: (a) their internal weaknesses; and (b) the stresses that they impose on the global financial system creating an environment in which their internal weaknesses can no longer be papered over.

To create an environment in which economic growth can be sustainable there is arguably a need to:

In the unstable environment that will exist in the meantime countries would arguably reduce their risks by seeking: political stability; a future oriented economy; and sound balance sheets for households, businesses and governments.

Financial system reforms to be achieved in an environment in which there are numerous other challenges facing the global community such as:

  • the emergence of new 'world policemen' (eg France in North Africa), as US no longer assumes this role - partly due to fiscal constraints;
  • potentially explosive political stress (China's social inequality and corruption; Occupy Movement; Islamist extremists; North Korea; tensions between China and its neighbours);
  • potential environmental emergency (eg methane, biodiversity, food [ 1 ], water / soil, pathogens);
  • population aging - which cuts savings / constrains demand / dramatically increases government costs relative to revenues. While developed Western counties have significant problems, Japan, China and Islamic world appear to be even worse affected;
  • potential US push for trading links with Europe at the expense of Asia (as implied by Obama's 'state of the union' address)

The Future [<]

A process to build agreement and facilitate complementary domestic initiatives that the present writer suggested in the context of the need for effective global responses to the underlying problems related to the 'war against terror' might (with modifications) be relevant if there were to be a serious international commitment to addressing the true complexity of the GFC (see Proposal for A New 'Manhattan' Project for Global Peace, Prosperity and Security, 2001).

Moreover in parallel with the narrow financial-system reforms initially arranged through, and the macroeconomic policies subsequently discussed by, the G20, it might be desirable to assemble some sort of 'coalition of the willing' to address the more fundamental problems.

However, as experience suggests that such initiatives are unlikely, the GFC probably marks the end of an era in many respects. For example:

  • the role that the US has sought to play in world affairs since WWII (ie in promoting and defending Western-style democratic capitalism as the dominant system of political economy) will be even less financially feasible than it had been becoming because of large past budget deficits and spending backlogs - and (as noted above ) the US seems to be moving away from its former willingness to allow its markets to be used to accelerate development elsewhere;
  • efforts to develop effective global institutions appear likely to end in failure. Existing weakness in the UN , will probably be compounded by an inability to reach agreement about any international system for economic and financial regulation , because of the lack of agreement on (or even acknowledgement of) the radical culturally-based differences in perceptions about the nature of such a system; 
  • virtual nationalization of (or at least extensive government influence over) many banks in the US and Europe appears likely, and this would tend to result in an inward looking, and rather than international, global financial system [ 1 ];
  • countries such as US and Australia will need a concerted effort to boost the supply side of their economies in order to shift from high consuming capital importers to being high savings capital exporters. Methods to overcome their declining productivity performance have long been available (eg see Defects in Economic Tactics, Strategy and Outcomes , and A Case for Innovative Economic Leadership ). The long delays in starting to consider these requirements (while priority is given to trying to restore economic growth on a pre-GFC basis) will clearly make this challenge more difficult;
  • export-dependent economic strategies will be much less viable, and it will be difficult to unwind these without a retreat into protectionism;
  • past strategies that led to the rise of Asia thus won't be sustainable, because export-oriented industrialization has been foundational. Development based on domestic demand, which would require financial institutions that took profitability seriously, would encounter severe political and cultural obstacles (eg see Are East Asian Economic Models Sustainable? ). Whether socially-coordinated economic systems (eg Japan's 'non-capitalist market economy' or China's 'crony capitalism') can be successful as the basis for an entirely different kind of economic regime in which the role of capital / money played a minor role is currently unclear - though it does appear that such an arrangement is being attempted (see Creating a New International 'Confucian' Economic Order? );
  • 'Europe' also appears likely to suffer setbacks because of both demographic and economic decline which are long entrenched [ 1]
  • democratic governments may also be under pressure because of difficulties in meeting community expectations. Broadly representative democracy emerged following the industrial revolution in the UK arguably as a means for better sharing the wealth generate from the use of capital in mass production . This has progressively ceased to be available since the 1960s in the face of NIC competition in mature technology capital intensive industries - but was replaced by high value-added knowledge industries - especially those linked to financial services which are likely to be much less productive in future.  
  • there appear to be no obvious techniques for future macroeconomic management, as counter-cyclical public spending proved defective in the 1970s (ie it was difficult to get the timing right so initiatives tended to amplify, rather than smooth, business cycles) and monetary policy was effective in the short term because it generated asset bubbles that were dangerous in the longer term.

The future may be one in which political and economic power will be available for the taking, and there will be many contenders perhaps using methods of which Western societies have little  experience or understanding (eg see China as the Future of the World?, Creating a New 'Confucian' Economic World? and Don't Forget Japan).

One observer appears to see such a world as like a return to the Middle Ages.

Imagine a world with expanded Chinese and India power; expanded Islamic influence; a European crisis of legitimacy; sovereign city states; and private mercenary armies / religious radicals / humanitarian bodies playing by their own rules. This seems increasingly likely, and was also true at height of Middle Ages. 21st century might resemble 12th century, not just with many nations but with many other forms of power. World was genuinely western and eastern simultaneously 1000 years ago. In medieval times there was a global trading system - like today, and transcontinental ventures were arranged. Globalization is now doing the same - diffusing power away from the west (and also away from states to cities / companies / religious groups / NGOs / super-empowered individuals). Diplomacy now is amongst those with power, rather than legitimacy. Some see contrary trend (ie return of state power) in post GFC world. But the crumbling of most of post-colonial world into failed states is more revealing. Many states are shifting to hybrid public-private systems of governance. States have simply become filters trying to manage flows of people / money / goods. In medieval world, loyalty was to whoever delivered the goods - not to states. World now looks to companies rather than states to deliver. Middle Ages had no America. But if Europe now plays the part of declining Holy Roman Empire, America could play the role of Byzantium which faced both east and west, and survived for many centuries while slowly declining. (Khanna P. Future shock? Welcome to the new middle ages' , 28/12/10