The SECOND Failure of Globalization? (2003
and  2008+)

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Summary +




As a result of failures to deal with risks to international stability the basis of global order has been at risk - and political and economic disorder like that that followed the collapse of 19th century globalization is not impossible.

Democratic capitalism and communism were rival Western / European styles of political economy in the Cold War. This ended in 1989 when the communist Soviet Union collapsed in the face of the greater economic strength of the US and its allies. A new global order, based on democratic capitalism, seemed likely to emerge.

However there are many competing understandings of the nature of such an order. At the same time the UN, the main institution that could have provided the political framework for a unified world, has been proving ineffectual, while the economic institutions established at the Breton Woods Conference primarily reflected US assumptions.  Both have been subjected to criticism - though there appears to have been inadequate fundamental work on the causes of their problems to have allowed practical alternatives to be devised.

Moreover there are uncorrected defects in dominant democratic capitalist practices, theories and institutions. In recent decades these defects and a universal failure to consider how they interact in practice with non-Western cultural assumptions have been contributing to economic and political distress in rapidly developing East Asia, and to even worst problems in states on the global margins (eg failed, repressive or rogue states, leading in some cases to terrorism as an extremist reaction to political exclusion).

One symptom of this situation, was the launching of a terrorist attack apparently by Islamist extremists against core Western institutions in the US in September 2001. World leaders seemed unable to agree about how to manage the urgent security risk of 'terrorists with weapons of mass-destruction' and what model of political-economy could ease the political and economic malfunctions that give rise to such problems. The global response to this (which featured increasingly unilateral and militaristic action by the US) achieved very little (see Attachment on September 11: the First test).

Another major challenge to the global order arose in October 2008 when a credit crisis, which had first been recognised in the US in mid 2007, threatened to turn into a total failure of the global financial system.

Rescue operations were mounted by governments worldwide and calls emerged for the creation of a new world financial order. However success in creating this is anything but assured - for essentially the same reasons that the response to 911 attacks proved unsatisfactory.

John Craig
March 2003 - and updated from October 2003 and again from October 2008

Fragmentation of the Global Order

Fragmentation of the Global Order

Rather than creating a fair and workable global political and economic order based on liberal democratic capitalism, political disorder and economic collapse are a feasible alternative if political leaders do not cope adequately with diverse and related security and economic challenges. Those most likely to suffer would (as always) be the world's poorest [1].

International trade and investment have become more significant to the world economy over the past 30 years [1]. It has been credibly suggested that economic globalization and accelerated rates of economic growth were partly attributable to unilateral US action in 1971 to end the Gold Standard (part of the 1944 Bretton Woods agreement which had required convertibility of currencies into gold). The subsequent emergence a (US) Dollar Standard overcame previous constraints on the creation of credit [1], and complemented the effect of improved transport and communication in 'globalizing' economic activity. Not only was the $US the world's reserve currency, but US monetary policy played an informal, unpublicised but significant role in counter-cyclical management of the global business cycle (eg the US Federal Reserve maintained extremely loose monetary policies at times citing the need to counter the risk of 'deflation' - though this was a problem in Japan not in the US. Thus it is reasonable to conclude that Japan (and perhaps other countries) had behind the scenes influence on US monetary policy).

Moreover since communism was generally discredited as a system of political economy when the Cold War ended in 1989, large additional segments of humanity have been drawn into market economies and democratic capitalism in its various forms has been regarded as the global 'standard' - and likely to become the basis of a world order. 

However globalization has occurred before. At the close of the 19th century, in a global environment dominated by the British Empire international trade and investment were even more relatively significant in the world economy than they are now. Yet this collapsed in the frictions with Germany that led to World War I [1] - frictions that presumably arose from cultural differences in assumptions about the nature and role of power. 

Different styles: German (Teutonic) societies appear to favour general community reliance on the rationality of knowledgeable and experienced 'authorities' whereas Anglo-American (Saxonic) societies emphasize the rational initiative of individuals. Other characteristic styles might include arational / intuitive group consensus in Japanese society, and the rationalized social consensus favoured in French (Gaelic) society (eg see Galtung J. 'Structure, culture and intellectual style: An essay comparing saxonic, teutonic, galic and nipponic approaches', Social Science Information, V 20, No6, 1981).

Needless to say each of these preferred decision styles translates into preferences for different systems of political economy. For example:

  • much of the traditional friction (and centuries of conflicts) between France and England may have emerged from a lack of mutual understanding flowing from different ways of thinking. Frenchmen whose group rationality focused on 'the glory of France' as a whole - saw England, with its preference for individual rationality, as a 'nation of shopkeepers';
  • the first World War (whose origins no one seems able to explain) was the result of an intense contest for economic control between Germany and the UK. Again the core problem may have been the obscure difference between Anglo and Teutonic assumptions about the ground rules that should apply to a global order (whose origin in that case was likely to be in differences in assumptions about the influence of individuals versus experts / authorities).

Furthermore it may have been the tensions in the 1920s and 1930s associated with attempting to modernize to adapt to the globalization of Western-style society which led Japan to try to achieve independence through aggression in Asia prior to World War II in the hope of creating an 'Asian Co-prosperity Sphere' [1].

Moreover, while democratic capitalist models are widespread, they come in quite distinctly different styles [1].

The major styles are:

  • the Anglo-American varieties under British Law. The latter makes individuals equal to the state before the law, and expects that states will represent sectional interests. Economic outcomes are highly dependent on the initiative of individuals - which is advantageous because the power of rationality can be used in systems that are simple enough for it to be effective (see Competing Civilizations). This system also facilitates 'breakthrough' political initiatives;
  • those in some EU countries that are based in Roman Law - a system where the state is legally superior to individuals, and is expected to be concerned with the culture and functioning of society as a whole and not to reflect partisan interests. States have a significant influence on the framework for economic activities, which tends to ensure that the latter are more socially equitable, but less dynamic;

In the post Cold War environment differences due to such un-stated cultural parameters have become increasingly apparent - and contributed to a breakdown of multilateral institutions.

Europe and the US have been seen to have radically different perspectives on the nature and reliability of global institutions [1]. Similarly differences are perceived in basic values and beliefs in terms of: the value of institutional or military solutions to conflicts; focus on past or future; and the role of religion [1].

The European Union has been developed as a model for building economic and political collaboration amongst various nations based on a preference for collaboration and consensus. While national membership is expanding [1, 2] and an effective economic union has been created, the EU is not untroubled. For example:

  • institutional problems exist [1, 2, 3];
  • economies tend to be stagnant [1, 2, 3];
  • there is difficulty maintaining social [1] and political [1] cohesion. In particular where the state is expected to reflect to culture of society as a whole, the failure in assimilate large Muslim populations is a clear source of tension [1];
  • popular support of the EU is weaker than support from elites [1];

And East Asia, which now accounts for about half the world economy, incorporates elements of (neo-Confucian?) models that prefer government by elite bureaucracy (rather than by democracy and a rule of law) and which tend to favour mercantilist / communitarian economic goals, rather than being driven by the return on investors' capital available from meeting consumer demands.

East Asian models tend to be based on epistemologies (ie the frameworks within which people think) that are profoundly different to the rationalism that Western societies inherited from classical Greece - see outline in Competing Civilizations. These differences also appear to have been a significant factor in the Asian financial crisis.

Moreover structural incompatibilities between the mercantilist / communitarian economic goals of major East Asian economic and financial systems and those of the US / Western dominated global economic / financial systems could make global growth unsustainable.

Proposals have been made for the creation of an Asian Monetary Fund to operate on 'Asian values' in competition with the IMF which has operated on (an increasingly US dominated version of) Western traditions. 

Elsewhere the majority of the world's people live in states that have ineffective (or even despotic) regimes and tend to be economically disadvantaged to varying degrees. A substantial minority of this (still third) world involves states dominated by Islamic traditions - from whom also proposals have emerged for the creation of a new monetary system and economic union [1].

Furthermore there is no effective institutional basis for globalization.

Current global institutions were created at the end of the second world war, and involve primarily the United Nations (UN) and economic organizations established as a result of the 1944 Breton Woods agreement (WTO, IMF and World Bank).

However the core institution, the United Nations, is too often of little practical value being apparently:

  • inadequately staffed;
  • under-funded;
  • pursuing ineffectual 'political' formalities eg the Kyoto protocol that could never produce any real environmental gains [1];
  • irresponsibly influenced at times by tin-pot despots and single-issue NGOs) [1, 2] and;
  •  serviced by 'expert' bodies that can be democratically illegitimate [1].  

Of particular significance is that the UN could suffer the League of Nations' fate due to its inability to enforce its resolutions related to security breaches (eg by despotic regimes).

At the same time, global economic institutions have been heavily influenced by US interests to pursue its preferred liberal democratic capitalist model, and have attracted as much criticism as the UN system (eg see Bretton Woods project).   Worldwide reactions against global economic institutions (on environmental and social grounds) have also arisen, and been conspicuous for the fact that those involved seem to be only interested in 'protest' and have no practical alternatives to suggest.

In September 2003, the WTO's efforts to arrange a new round of multilateral trade liberalization was derailed by a dispute between developed and developing nations about whether improved access to the latter's markets is appropriate [1, 2, 3]. This breakdown in global multilateral trade arrangements may be as significant as the inability of the UN Security Council to resolve concerns about terrorists with WMD that led to unilateral US action in Iraq. It must impede trade, and thus reduce growth.

Furthermore it seemed likely that global economic growth may prove unsustainable because of the financial imbalances created by dependence of recent growth on US demand, and the structural incompatibilities between various economic models which may make it impossible to overcome those imbalances.

Causes of Economic and Political Failures

Causes of Economic and Political Failures

While many societies benefited from the global order that emerged after the Cold War, that era has been anything but problem free. For example:

  • political and economic failures escalated in the 1990s in many marginal states (especially in Africa, the Middle East and Latin America) perhaps because: (a) outside involvement / support declined following the end of the Cold War; and (b) increasingly intense global economic competition raised the standards required for economic success;
  • political failures in individual states have also compounded the difficulties facing the UN - as inept or despotic regimes have gained an increasingly influential 'legitimacy' in its councils;
  • financial and economic crises have emerged every few years - of which that affecting East Asia in 1997 was the most significant until 2008;
  • concerns have emerged about environmental sustainability.

In the context of the 911 attack in America Competing Civilizations suggested:

  • several difficulties that face non-Western societies that may contribute to economic and political failures in marginal states, namely:
    • the effect of historical events such as: European colonization which left an unsound basis for future progress in some states; and the Cold War;
    • un-evaluated side-effects of democratic capitalist systems of political economy and defects in the economic theories promoted by global economic institutions;
    • the unintended adverse consequences of foreign aid; 
    • the lack of attention to the practical implication of cultural assumptions that seem to be a critical determinant of a people's ability to be materially successful (eg the role which authorities play in defining and enforcing the moral basis for interpersonal relationships in societies which lack embedded 'put others first' ethical ideals derived from Christianity seems particularly significant given the important of individual liberty to Western economic and political models);
  • an hypothesis about how a 'clash' of civilizations might be defused which referred to:
    • expansion of democratic models;
    • ethical renewal, including a more serious metaphysics;
    • reform of the global order on a basis under which all may reasonably hope to succeed;
    • more effective mechanisms for development in disadvantaged regions;
    • specific attention to problems of cross-cultural communication; and
    • reviewing the economic role of money.

Economic and political failures have been associated with widespread misery, and have also contributed to the risk of terrorism. The latter seems to be an reaction to real or perceived social, economic or political concerns by extremists who feel otherwise powerless. It also has the potential to transmit failure to other states [1]. 

Those who had been economically and politically successful (especially the United States which was geared for Cold War conflicts) were for a long time not directly affected by the economic difficulties and political failures (and political extremism) - so they did not become serious about examining the political and economic development issues.

The attack by Islamist extremists in America in 2001 provided the opportunity to address those broader questions, but in the absence of global agreement about how to address this the US pursued almost unilateral actions with a militarist emphasis that, though enormously costly, did not materially improve the global situation (see September 11: The First Test).

However it is likely that the global financial crisis that emerged in 2008 will force a different approach.

In the context of the 911 attack, Competing Civilizations had also suggested that defusing a potential 'clash of civilizations' required reviewing the role which money plays because, though though there are advantages in its use as a means of exchange, store of value and measure of economic success:

  • the self-reinforcing effect which money flows can have on an economy's performance can lead to bubbles and busts; and
  • some societies have cultural difficulties in achieving economic success if this is assessed in terms of a strong balance sheet - a problem to which Western observers tend to be oblivious even though it seemed to be the basis of a 'clash of civilizations' related to differences in financial systems' which was more serious than that with Islamist extremists.

These issues have become critical since 2008 - though the latter continues to be put in the 'too hard' basket.

GFC: A Second Test of Globalization? +



Global Financial Crisis: The Second Test of Globalization?


A global financial crisis (GFC) had become well recognised in late 2008 when:

  • governments (especially but not only in the US, UK and Europe) found it necessary to provide financial support to prevent the failure of major banks;
  • share markets crashed; and
  • serious disruption of the global 'real' economy also seemed probable.

Financial Market Instability: A Many Sided Story (2003) presented an account of the emergence of this crisis as a result of financial arrangements that had become foundational to global economic growth and development. The crisis was revealed initially (in mid 2007) when, following falls in US housing prices in 2006, losses on US 'sub-prime' mortgages created large unexpected and non-transparent losses for banks. This then resulted in a 'credit crunch' (ie: it disrupted banks' ability to lend to one another; and made credit less available and more costly for their customers).

The problem quickly spread globally and subsequently escalated, even though traditional remedies were vigorously applied (ie the US Federal Reserve  responded with lower interest rates and made credit available to distressed institutions, while the US Government provided a fiscal stimulus to boost economic activity). 

GFC Causes

There appear to be many factor whose interactions contributed to the GFC including:  prior asset inflation; declining US housing prices; an oil price spike; loss of effective financial regulation due to globalization; inadequate aggregate global demand as a by-product of 2 decades of globalisation; failure of post-war international financial regime to recognise unsustainable macroeconomic consequences of demand-deficient Asian economic models, and the need which other emerging economies had to export-led development to guard against financial crises; emergence of an unregulated 'shadow' banking system in US;  alleged self-interest of bank executives; high levels of household debts which caused consumer spending to fall as financial losses emerged;  innovations in financing and monetary policy; statisticians' adjustments to economic data which perhaps gave a misleading impression; decisions by regulators and businesses; government social policies; complex financing arrangements that rendered consequences incomprehensible (Flash Crashes); possible intrinsic disequilibrium in financial markets that was not perceived by deregulators; community irresponsibility; a lack of top-level US government economic expertise because of the 'war on terror' focus; a 'savings glut' in East Asia that was vital to economic models adopted in the region; Japan's ambitions and 'carry trades'; the way Lehman Brothers failed; very high levels of corporate debt in Europe; risky investments in emerging market economies; and policy actions by governments in reacting to the emerging crisis.

More specifically:
  • the value attributed to property (and other) assets had increased rapidly to unprecedented levels in many developed countries notably, but not only, the US. Property values rose quickly perhaps because:
    • home loans were made more readily available to people with limited ability to repay [1];
    • tight land use regulations were imposed (eg in many urban areas tight limits were set on areas that could be developed) [1, 2];
    • the numbers of double-income families increased, and thus lifted their capacity to pay;
    • increasing land values forced home buyers to demand much larger houses (the 'McMansion' phenomenon) in order to avoid undercapitalizing their property;
    • the average size of families / households declined thus creating a demand for many more homes for a given population, in the face of limited supply;
    • the rate of inflation fell over a long period, thus allowing ever lower interest rates and encouraging home owners to borrow more [1];
    • improved financial technologies and the greater availability of credit provided a supply-side shock that induced much higher demand for credit [1];
    • "The US housing bubble was a 'quantity' bubble as well as a 'price' one - that is, there was a significant increase in the supply of housing in the US, as a result of widespread 'spec' building. .... this is why prices didn't rise as much and subsequently fell by more than in Australia. It would also appear that there were much greater swings in credit standards in the US than in Australia - initially adding to the purchasing power of buyers, and then greatly subtracting from it - see some of the work by Harvard's Joint Centre for Housing Studies which shows how 'innovations' in mortgage instruments substantially increased the amount which a borrower could afford to service, and hence pay for housing, up until about 2006, and then how subsequent tightening of lending standards dramatically reduced that maximum - this must have had an impact on the course of the housing price cycle" [personal communication SE Sept 2009].
    • a property bubble developed in Ireland partly because government encouraged development of this sector as Ireland's success in attracting export-focused foreign investment declined [1]
  • a fall in US property values [1] led to losses for banks and other financial institutions. This fall, which started in 2006, may have been the consequence of:
    • a boom-bust cycle in asset values like that which occurs periodically in all markets (eg due to poor affordability and oversupply [1]);
    • 4% increases in US official interest rates between 2003 and 2006 that deflated the boom created by the Fed's 5% cuts in rates between 2001 and 2003 [1];
    • the effect of high oil / fuel prices on people's willingness to drive - which particularly eroded property values in outer-suburban areas [1, 2, 3, 4]
  • a surge in oil prices disrupted economies dependent on oil imports in various ways. The most recent surge started in 2002 and led to a price spike in 2007 arguably because of an imbalance between rising demand and constrained supply for oil, due to (a) underinvestment in oil due to earlier periods of low oil prices; and (b) the start of global 'peak oil' event. Speculative purchases of oil may also have played a role. Some observers have argued that this new oil shock was the primary driver of the whole financial crisis, perhaps because:
    • significantly increased oil prices discouraged purchase of motor vehicle (which have large economic multipliers) and dampened consumer confidence [1];
    • a  rapid increase in oil prices  led to large transfer of income from countries where consumption is high to those with very high savings rates (ie a transfer of $200bn pa from 'main street' USA). As a result many economies (especially Japan / Europe) were in recession before the sub-prime crisis hit  [1].
    • by 2006 oil exporters current account surpluses roughly equalled Asia's [1] (and and thus were important in the global financial imbalances which required excess demand in countries such as US to counterbalance demand deficits elsewhere);
    • financial systems price assets on the assumption that oil (which is critical to transportation) is relatively cheap - an assumption that is proving invalid and rendering tradition methods of valuation invalid [1];
    • (a) recycled petrodollars accumulated as debt in US from 1970 - which can't continue beyond oil peak; (b) peak oil warnings were ignored, and unrealistic supply projections accepted; (c) the assumption that money economy can grow without limit while physical economy is constrained led to price inflation; (d) overconfidence about solving energy supply constraints set by thermodynamic laws controlling energy conversion; and (e) overdevelopment of oil-dependent infrastructure [1
  • there were defects in regulation of global financial / economic systems. For example:
    • former US Federal reserve chairman (Alan Greenspan) traced crisis to fall of Berlin Wall in 1989 - and subsequent shift in large parts of the world from central planning to market economies. The explosive growth of global economy (and rise of China) took power from central bankers. Especially since 2002, global bond / mortgage markets deprived governments of influence. Derivatives mushroomed to a $60tr market by 2007 - and underpinned huge volumes of risk. Critics suggest that the foundations for GFC was laid by Fed's response to dot-com bust in 2001 - keeping interest rates low til 2004 and thus fuelling a property boom and sub-prime lending. However Greenspan believes that the Fed's short-term rates had much less effect than global forces (eg huge amounts of money flooding in from China) which affected long term rates. Britain is seen to have suffered worse from GFC than US because its economy is more globalised. [1]
    • effective regulation of financial markets had become progressively less feasible as a result of globalization. For example, there was no recognition in regulatory regimes established in the immediate post WWII era of the need to consider the global macroeconomic consequences of, and thus challenge, the initially-Japanese monetary, financial and economic models that allowed rapid growth in East Asian economies. The latter involved large demand deficits (to provide the cash flow needed to protect financial institutions with bad balance sheets) and this required others (mainly the US) to cover the demand gap - which ultimately came to be financed on the basis of perceived wealth generated by rapidly increasing asset values (see Ungovernable Financial Markets). It can be noted that:
      • while the IMF argued that poor financial regulation rather than international financial imbalances were the main cause of the global financial crisis, those phenomena were simply two sides of the same coin in the opinion of the Economist  [1];
    • such unbalanced export-oriented industrialization strategies spread across Asia because of: (a) the impossibility of import replacement development; (b) encouragement by the US and World Bank; and (c) the Plaza Accord that re-valued Japan's currency and forced Japanese companies to establish suppliers across Asia - a technique that China subsequently copied [1];
    • similar strategies were adopted in other emerging economies in order to guard against the risk of currency crises (see below);
    • the collapse of the Bretton Woods systems under which currencies had been convertible to gold (which led to the $US's role as the global reserve currency) had led to various financial crises according to Chinese officials proposing that IMF SDR's should take the $US's place as the world's reserve currency [1] [See comment below];
    • the US Clinton administration was blamed (together with IMF) by a former Australian prime Minister (Paul Keating) because it did not reshape global economy after end of Cold War - but rather took world's savings as the spoils.  The IMF (acting on policies derived by Geithner - US Treasury Secretary under Obama administration) prescribed harsh medicine rather than bridging finance for distressed economies at time of Asian crisis. To prevent this recurring, Asia (especially China) built a war chest of foreign reserves with money that could have otherwise improved living standards. This increased the price of US government debt and reduced interest rates - which inflated the US housing bubble and poisoned global financial system. [1]
  • aggregate global demand was inadequate because 20 years of globalization had undermined the real incomes in most developed economies - which forced governments to promote leverage and asset price appreciation in order to fill an 'aggregate demand gap' [1]. [Note: It is suggested below that the demand deficit was primarily a product of the economic models adopted across East Asia in emulation of the techniques that had provided the basis for Japan's pre-1990 economic miracles ]
  • there were deficiencies in national regulation of financial / economic systems. For example:
    • 'big bang' financial deregulation in the UK in the 1980s under Thatcher administration was implemented to prevent UK falling behind in rapidly globalizing financial system. However it led to unintended consequences - especially the emergence of global banks that were beyond the influence of any one regulator. Breaking those entities up is now seen as needed by those who orchestrated the 'big bang' [1];
    • effective regulation of US financial institutions had also been ended in 1999 (eg when Clinton administration agreed to repeal of Glass-Segal Act) [1 - which cites OECD analysts]. That Act had been implemented in the 1930s to guard banks against investment risk by separating deposit-taking and investment functions. It was repealed as part of a general process of deregulation to speed economic adjustment in the face of international competition in traditional high productivity functions;
    • after the repeal of Glass-Segal Act the Wall Street model of investment banking came to involve banks taking large market positions not just facilitating investment by others [1];
    • a poorly regulated 'shadow' banking system had emerged in US (involving hedge funds, off-balance sheet SIVs etc) and property bubbles developed [1];
    • the concept of 'self-regulation' (the 'Anglo-Saxon model which is the basis of the Basel I and II regimes) may be inadequate - because it results in no regulation in the face of market euphoria [1];
    • strict new regulations introduced as a result of the Enron fiasco constrained the boards of banks and other businesses in the US, and reduced their ability to deal with strategy [1];
    • monetary policy, which seemed to be able to prevent financial crises spilling over to affect the 'real' economy for the previous 20 years, also became the major mechanism for macroeconomic management. Using monetary policy this way provided short term economic advantages - but also encouraged asset inflation which translated into asset inflation /  'bubbles';
    • credit was expanded very rapidly by US Fed after the 2001 terrorist attacks in NY in order to offset plummeting investor confidence [1];
    • US Fed chairman blamed the crisis on mismanagement by US (and others) of the big flows of foreign capital into their economies. They should have invested it more prudently and not created global imbalances. Capital adequacy and accounting rules had made banking sector pro-cyclical (ie to create credit in booms and contract in busts) [1];
    • the $US6.7 tr in reserves accumulated by China, Japan and the petro-powers contributed to driving bond yields too low for safety [1];
    • Keynesian economic intervention by by the US Federal Reserve was a significant cause of the crisis - an it should not be regarded as supporting neo-liberal policies (according to a Chinese economist) [1]
    • a (so called) 'savings glut' (revealed by global financial imbalances) added to the availability of cheap credit for which 'productive' uses needed to be invented. This 'glut' apparently emerged from (a) East Asia's export-driven / demand-deficient economic strategies; and (b) Japan's response to its 1990s financial crisis (ie becoming the world's major source of cheap credit which was exported through carry trades; and the earnings of some oil exporting economies). Investment of surplus savings in 'emerging markets' has periodically resulted in financial crises, and some analysts suggest that this time one of the 'emerging markets' involved less-credit-worthy areas in the US;
    • the GFC was only in one small way a failure of markets. Much more it was a necessary market correction to deal with imbalances that had built up during a decade of successful globalization [1]
    • Japan's ambitions to create a new regional (world?) order where 'Asian values' dominate may have played a role (eg by spreading its demand deficit / capital surplus economic model throughout East Asia; supporting the emergence of China as a 'super-power' that would be preferable to US; failing to reform its financial system after 1990 - so that recession and deflation constantly threatened and required creation of cheap capital that was exported through 'carry trades'; encouraging the Fed to adopt very easy monetary policies to guard against deflation (in Asia); and promoting the concept of an AMF - as an Asian-values alternative to the IMF) - see Don't Forget Japan
    • 'carry trades' involving the low cost credit created particularly in Japan and the US had stimulated high levels of investment and asset inflation in emerging market economies, and the latter suffered from a rapid withdrawal of capital as financial institutions adversely affected by the credit crisis were forced to de-leverage;
    • the way in which Lehman Brothers failed has been suggested to have transformed the crisis from one of orderly adjustment and routine transactions to one in which all organisations were simply concerned with precautions to protect themselves [1]
    • serious miscalculations in setting US monetary policy (ie keeping rates too low for too long after the 2000-2002 recession) may have encouraged an asset boom built on high debt levels [1] [CPDS Comment: keeping interest rates low seemed to reflect an attempt to use US monetary policy as the basis for global macroeconomic management - see above]
    • the European Monetary Union may have contributed to the emergence of an unsustainable property boom in Spain - as interest rates had been set below zero in real terms at one stage to help stimulate economic recovery in Germany [1];
    • the US Clinton administration apparently decided to use off-balance-sheet vehicles (eg Fannie Mae) to encourage mortgages for individuals who would not normally have adequate credit ratings [1]. Moreover legislation was enacted (Community Reinvestment Act) encouraging commercial banks and savings associations to meet the needs of borrowers in all segments of their communities to reduce discrimination against low-income neighbourhoods;
    • powerful pressure was placed on banks to lend to people least able to afford to repay loans. Banks who refused to do this were subjected to damaging sanction under the Community Reinvestment Act [1]
    • the loss of responsibility, restraint and remorse in US society (rather than any failure by capitalism) has been suggested to be the cause of the excesses that gave rise to the GFC. In turn it was suggested that this might reflect the US's retreat from its Christian values (as indicated by transforming 'Christmas' into the 'holiday season') [1];
    • regulators and business were apparently unable / unwilling to perceive the potential for massive losses to be transmitted through derivatives trade (which was designed to enable risk sharing) in the event of a major counter-party failure;
    • some entities had become 'too big to fail' (ie systemically important') and thus were not adequately disciplined by regulators and rating agencies [1];
    • government incentives to encourage home ownership led households to take on mortgage debts, they could not afford. Booms and busts are regular events. in the past these were dependent on business balance sheets - but they now depend on household balance sheets. Finance has been made available to households on an unprecedented scale, creating a new source of potential instability. Governments have experience in regulating corporations, but none in regulating households (Latham M. 'Building a house of cards', Financial Review, 30/10/08)
    • the US system for regulating and providing housing finance had become unstable as a result of 100 years of poor political decisions;
      • US financial system contains fundamental frailty which goes beyond role of GSE's - Fannie Mae and Freddie Mac. Most US home loans (70%) are funded by securitization rather than by deposit taking institutions. Elsewhere this has merely a marginal role.  US problem is not just the result of government support for home ownership, but of role of states in a fragmented federal system. This, and removal of debts of GSE from government balance sheet in about 1970, resulted in dis-intermediation of home financing. GSEs became surrogate for nationally-integrated banking system - and reduced pressure for reform. Securitization allows risks to be shared - however it also creates a risky separation between those who originate mortgages and those who own them. Quasi-private GCEs had a capital raising advantage - and in the early 2000s they were asked to facilitate lending in moderate / low income regions. By 2008 they held held $1.6tr of 'non-prime' mortgages. Where quasi-government entities don't dominate housing finance, banks take most responsibility and apply higher credit-assessment standards. The problem has arisen from (a) the lack of national banking system - because of state regulation and (b) extensive government intervention to cope with bank failures - which essentially suppress private market activity. US mortgages also tend to involve 30 year fixed rate arrangements, which impede ability of Fed to adjust interest rates. US control of banks by states makes risk sharing harder, leads to failures which require intervention and makes central banks task in guarding against failures harder. The prime cause of GFC was not sub-prime lending, but 100 years of flawed political decision making that created a fragile system. Since 1930s government-created yet nominally-private GSEs supplanted the role of deposit taking institutions - and entrenched securitization. They prevented a need for US banking industry to consolidate and insulate itself. As default rates rose, securitization transmitted the resulting losses and escalated global risk aversion. Many 'toxic' assets are only toxic because credit has frozen. Now private lending has almost disappeared with GSEs and FHA providing 95% of housing finance. US system of housing finance needs to be transformed to one based on bank balance-sheets, and nationally integrated private banking infrastructure.   [1] [Comment: Securitization only emerged in embryonic form in 1970s - and was realistically viewed as an advance over funding property through deposit taking institutions - because the latter involved borrowing short to lend long, which created risks of run on banks. GFC involved many current factors that are not part of US home financing system, but this account implies that GFC could have occurred much earlier]
  • the 'war against terror' had probably resulted in a US administration that was dominated by persons who had limited economic / financial expertise;
  • the US was one of the few countries in the world that had not allowed independent assessment of the effectiveness of its financial regulation by the World Bank and IMF. Such a review (based on self-assessment and external expert input) might have identified weaknesses [1]
  • financial institutions made mistakes or suffered failures:
    • collateralized / securitized debt instruments were developed as a major innovation in financing, as an alternative to traditional balance-sheet-based lending by banks which was seen to allow risk to be better managed and to allow much more effective use of available capital. Amongst other things, securitization appeared to allow risky mortgages to be bundled and sold as high yield investments with little risk;
    • banks and other entities provided credit and valued assets with little provision for risk, because risk was seen to have been virtually eliminated. This attitude probably emerged as a result of a long period of sustained growth - which seemed to be a product of the innovative use of monetary policy to prevent incipient financial crises from affecting the real economy, while the real economy prospered because high asset prices increased consumer demand;
    • credit rating agencies had suffered a failure of accountability and transparency - according to Australia's banks [1];
    • incentive structures encouraged sale of derivatives that turned out to be worthless (in the opinion of US President Obama) [1]
    • a quantitative model developed by David Li came to be universally applied for assessing the risks of correlated events (eg the simultaneous failure of many mortgages) in setting the prices of securities. Li developed a model which reduced the risk to a single number based not on historical data about defaults, but on the prices of credit default swaps. This ignored the instability of those relationships, the fact that the number could vary depending on market conditions and data more than a few years old (before CDSs were invented). It was widely applied as a 'black box' answer to complexity by people who did not understand the mathematics or its limitations. It meant that outcomes were safe 99% of the time, but ruinous the other 1% [1]
    • new securitization techniques for mobilizing funds for investment reduced risks under average conditions, but were exposed to huge risks if the whole market collapsed [1]
    • financial institutions saw guaranteeing mortgages through credit default swaps as a risk free way to earn fees, because it was presumed that home prices would rise faster than household incomes forever;
    • high levels of debts had been taken on by major European companies during the economic boom, and banks (forbidden by regulation from involvement in sub-prime mortgages had plenty of money to lend them). These debts are now falling due at a time when sales are weak, and bank lending has fallen 40%. Bonds have been issued at much higher prices, but many companies are struggling. Corporate debt totals, 95% of GDP, compared with 50% in US [1] [Note: European companies are traditionally financed much more by debt than are those in the US];
    • European banks had been involved in heavy investment in emerging market economies [whose fragile credit-worthiness depended on economic growth and] where values subsequently collapsed [eg see Europe on the brink of currency crisis meltdown];
    • European banks took a very large gamble on $US. Domestic savings was recycled into longer-term US assets. When short term funding dried up they could not fund their $US positions. An acute shortage of $USs emerged - and remains a barrier to restoring order in global financial system [1];
    • the technically complex financing innovations which were being developed perhaps caused financial institutions to lose the ability to understand their own best interests [1];
    • the short term focus of companies driven by the needs of shareholders - who had come to be dominated by funds with a 3 month time horizon led companies to take actions that were not in their long term interest [1];
    • the lack of firm principles about when profits and losses should be brought to account allowed manipulation which gave the impression of much higher than realistic profits for a decade [1]
  • executives in some banks allegedly adopted policies which maximized their personal remuneration through investment strategies that exposed their institutions to long term losses [1];
  • more generally, the complex financial systems that were established undermined the power of rationality. A core strength of Western societies has been the ability of individuals acting 'rationally' to produce social gain. However rationality (the use of abstract concepts to model reality) only works reliably in relation to simple fairly linear systems (ie where causes and effects are fairly obvious). A rule of law and the use of money as a medium for exchange helps create the necessary simplification (see Cultural Foundations of Western Dominance). However, when money is not simply an accounting tool but itself becomes the central component in a complex economic system, individual rationality can not be expected to be effective;

Flash Crashes - email sent 31/12/11

Gillian Tell
Financial Times

Re: Flash Crash Threatens to Return With a Vengeance, CNBC, 30/12/11

Your article pointed to the possible recurrence of an event like the ‘flash crash’ of May 6 2010, and to research (by Dave Cliff and Linda Northrop) which illustrates the dangers that arise when complex technological systems proliferate creating ‘systems of systems’ that nobody understands. In particular IT systems are seen to have proliferated to create ‘systems of systems’ that are unpredictable and uncontrollable, and it is now being suggested that more sophisticated computer modelling would allow such problems to be reduced.

I should like to suggest for your consideration that the problem of complex incomprehensible systems is more fundamental and not limited to the effects of technology / IT.

The global financial crisis that emerged in about 2008 was very much also a consequence of the complex interaction of different systems whose character and interactions were not understood (eg see outline of complex factors involved in generating that crisis in GFC Causes). For example, the role that the neo-Confucian systems of socio-political-economy that have been the basis of economic miracles in East Asia played in generating the international financial imbalances that required excessively easy monetary policy in the US, which gave rise to the asset bubbles that ultimately burst could only be comprehended by looking inside the ‘black box’ of cultural differences – which requires information that is well beyond the sphere of economics and computer science (eg see Understanding East Asia's Neo-Confucian Systems of Socio-political Economy, Impacting the Global Economy, G20 in Korea: Unreal Optimism? and 'Global Trends 2030' Report: Looking Inside the 'Black Box' of Cultural Differences).

Your article also suggested that markets normally work well, so people tend to ignore events that are uncomfortably bizarre. However there is a need to go back a stage and look at what is actually involved in financial markets – ie in the coordination of economic activities in terms of financial outcomes. This arrangement has strengths, but it also has weaknesses (see The Advantages and Limitations of Financial Criteria). The latter points to: (a) the role that rational / responsibles have played in the advancement of Western societies; (b) the fact that the use of financial criteria in coordinating economic activities has been one of the key ways of empowering rational / responsibles; (c) the fact that complex financial systems generally (not just those related to IT) have the effect of reducing (rather than enhancing) the ability of individuals to make rational decisions; and (d) other reasons to suspect that financial criteria are becoming unreliable on their own as a basis for decision making.

The broader problem of complex incomprehensible ‘systems of systems’ can’t be resolved merely by more sophisticated computer modelling, because the ultimate problem is to know what should be included in such a model. A possible solution to this broader problem is suggested in Restricting the Role of Financial Services?

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

John Craig

  • economics contributed to the crisis because:
    • the widespread emphasis on economic deregulation may have been unwise because financial markets may not necessarily tend towards equilibrium - because market trends can reinforce themselves and lead to boom / bust sequences [1];
    • neo-classical economics promoted faith in the innate stability of the market - and this tended to favour financial deregulation which added to market instability. This also distracted economists from signs of an impending crisis (eg asset bubbles) [1]
    • regulators believed in the 'efficient market hypothesis' (the view that financial markets could not consistently mis-price assets and thus needed little regulation). Also there was an acknowledged flaw in the principles of monetary management that the US Federal reserve relied on, and a moral failure implicit in building an economic system on the basis of debt [1];
    • the methods developed to respond to earlier economic problems contributed to the crisis. Moreover economists (who largely focus on mathematical models) were unable to identify the risks of a crisis, and have generally not had anything to contribute in terms of solutions [1]
    • economists failed to anticipate the risk [1]. Economists were unable to foresee the crisis because (a) the problem arose in financial systems - which economists tend not to understand (as this is only part of their training); (b) they assume that methods have been developed to contain financial system risks and focus simply on actual spending (by governments, consumers, business) [1]
    • the data used to measure economic performance (eg GDP and inflation) has become increasingly unreliable since the 1980s because of statisticians adjustments which have the effect of: (a) understating inflation relative to that assessed by pre-1980s methods (eg by assuming that when goods become more expensive households will use them less - which results in increasingly costly health care having a 6% weighting in US inflation index, though it constitutes 16% of GDP) and (b) overstating GDP by the inclusion of imputed income [1]. Such adjustments are based on valid logic (ie statistics would clearly be misleading if no adjustments were made), but making those changes also misleads authorities and the community in other ways which affects their decisions (eg disguising long term deterioration in a communities real economic position);
    • there was poor understanding of the risk of asset bubbles. people's unrestricted ability to borrow against assets causes their prices to increase. Reserve banks need to restrict the quantity of money that can be borrowed, not simply its price [1]
  • the financial crisis in turn triggered secondary economic repercussions:
    • initial financial dislocation adversely affected the real economy;
    • huge increases in unemployment were seen in June 2009 to be likely as a lagged effect of large falls in GDP in various countries - and this is likely to depress any recovery [1];
    • households (in US / Australia etc) had accumulated high debt levels after 2000 and responded to the emerging financial crisis by 'closing their wallets' which exacerbated the economic impact. This had not happened in earlier recessions in 1980s and 1990s because household's debt position was not so exposed [1];
  • policy actions by governments in response to the crisis have had, and potentially could have, unintended adverse consequences.

For example (and also note examples from Australia, which are mentioned in Defending Australia from the Financial Crisis):

  • the methods found necessary to stabilize the financial system (nationalization / government control over financial institutions) will constrain the ability of those institutions to make productive investments for at least the next few years, and this will inhibit ongoing economic activity. One observer has equated this with the political intervention which inhibited international trade after the 1929 financial crisis in terms of blocking post-crisis economic expansion (The Credit Crunch May Cause Another Great Depression);
  • the US government decision to allow Lehman Brothers to fail has been suggested to have transformed and intensified the crisis. Prior to this, slow writing off of debts with limited real-economy impact was the likely outcomes of the financial crisis. But when an institution that had been seen to be 'too big to be allowed to fail' collapsed, confidence in all such institutions was lost and they suffered a run. This shifted the the requirements for dealing with the crisis from restraining lending to all-out efforts by governments to stimulate growth - through monetary and fiscal policies [1]
    • [Comment: it may be that letting Lehman Brothers fail was not a matter of choice for US government. Huge losses were being incurred by banks and several were at risk. The resources available to recapitalize exposed banks may have been too limited - as it was only after the consequences of a major failure became obvious that the US Treasury gained legislative approval for a $700bn support package]
  • there seems to have been a lack of coherence and effectiveness in the US Treasury's use of funding approved to support the US financial system [1]. It is seen to be fumbling through a 'maze', and constantly being forced to do things it didn't want to do [2];
  • 'mark to market' accounting rules were seen to be misused by former US Treasury secretary Henry Paulson in dealing with Fannie Mae shareholders and bankrupting Lehman Bros, and to be the main cause of the global crisis which resulted. The crisis effectively ended the day those rules were dismantled by his successor [1]. Comment: However, while turning a blind eye to extreme losses may be reasonable because markets do recover, it can also result in ongoing problems in dealing with undisclosed bad debts (eg see)  
  • politically motivated intervention in the economy in the process of rescue operations (eg requiring banks to loan to favoured causes, and car makers to implement fuel efficiencies that their customers won't compensate them for) will have long term adverse effects [1];
  • the US could be caught in a situation where there is a need to allow banks to fail, yet the latter's political influence is so strong than this is impossible - so that no actual end to the crisis will emerge. This sort of problem often occurs in emerging economies - but the US's institutions are likely to be able to rise above it [1]
  • the radical measures being taken by governments to try to protect financial systems and prevent recessions could themselves generate further crises as:
    • (a) if they succeed they must lead to rapid inflation, and (b) if they fail economic and political collapse are likely [1];
    • government borrowing and monetary liberalization by reserve banks will inevitably stimulate some sort of recovery - but they will also risk rapid inflation and leave governments which huge debts, and these will require a rapid increase in interest rates and taxes [1]. However it was argued that so long as the increase in money supply by reserve banks is less than the contraction associated with reduced availability of credit from other sources, there should be little inflationary risk [1]
    • governments have been forced to borrow huge amounts in an effort to stabilize financial systems (eg by recapitalizing banks) and stimulate the economy (eg in US federal government costs of dealing with the crisis have been roughly double the inflation-adjusted cost of WW2 [1]). These borrowings and the deficit position of US government previously could lead to a collapse in it bond markets  - if / when those measures are successful in restoring business / household confidence and the 'flight to safety' of government bonds reverses;
    • the US Fed may have precipitated a major crisis for the car industry by misinterpreting the emerging financial crisis as a problem of liquidity (when it was more a problem of solvency related to counterparty risk) and slashing interest rates, thus triggering a collapse in value of $US, an escalation of the price of oil - and a collapse in car sales [1];
    • the harsh treatment of private investors in US government-influenced entities such as Fannie Mae and Freddie Mac (who had been encouraged to invest by official assurances that all was well, but received no consideration when government takeovers later occurred) has discouraged private investment (which government now needs) in recapitalizing other institutions. Thus recapitalization falls entirely to government [1]. [See similar concerns in 2, 3];
    • over-riding contracts which investors had entered into to give them preferred access to capital in the event of business failure (in case of Chrysler) will cause a loss of confidences in contracts and thus a demand by investors for higher interest rates [1]
    • US Treasury efforts to bail out banks have provided a 40% subsidy to speculators, and received little equity in return. Government is pretending that banks are still viable when they are insolvent. It has spent 29% of GDP on GFC compared with 8% in 1930s. The Fed's balance sheet has risen from $900bn to $2.7tr. The only way out is to debase currency which will lead to inflation in 3 years [1]
  • fiscal stimulus packages in the richer nations have compounded the problem of a lack of credit flows to emerging markets by diverting available funds [1];
  • it has been suggested that 'New Deal' policies during the Great Depression (which parallel some current initiatives) were counterproductive. For example, unemployment continued increasing and per-capita consumption continued falling from 1933 to 1939. The basis for a strong recovery by 1935 was set by stimulatory policies - but restraint on competition which allowed collusion in raising prices and wages. Wage rises resulted in job losses. The main lesson of the 'New Deal' was that government intervention will generate unintended consequences [1]
  • the effectiveness of fiscal stimulus has been questioned on the basis that the money used for this purpose would not have been sitting idle [1];
  • the real problem is not a failure of demand, but that there has been a crisis of confidence because of the withdrawal of credit from businesses that would otherwise be viable. Governments are resorting to fiscal stimulus because they don't know what else to do - and they lack the courage to force banks to flush out their bad debts [1];
  • fiscal stimulus measures will do nothing to solve the real problem which is concern about bank solvency that have arisen from large losses. [1]
  • there is concern that the explosive credit growth in the US since credit restraints were relaxed have merely fed a new asset bubble, rather than prompting job growth [1, 2]
  • cheap US interest rates are funding a 'carry trade' whereby investors borrowing $USs are boosting asset values worldwide - and a crash in global asset values is possible when $US strengthens [1];
  • government stimulus efforts face a 'capacity barrier' - ie that it takes a lot of time to to effectively spend large amounts of money - so that most stimulus spending tends to be wasted (according to Europe's experience) [1]


While the GFC might seem like merely a matter of fixing the financial system (a massive challenge in itself), it is in fact far more difficult because:

  • not enough has been done to enable credit markets to function effectively, and it may be impossible to to do enough. For example, in the US about 50% of credit had come to be provided by non-bank institutions selling structured financial assets through financial markets. While banks' capital base (which determines their capacity to lend) was eroded by their exposure to losses from such dealings, simply rescuing banks (which many governments have been attempting) can't allow credit markets to function as they did before the GFC. Pre-GFC levels of credit availability can't be sustained without: (a) development of safe methods of securitized funding; and / or (b) significantly increasing (not just restoring) the capital base of conventional banks to allow a large expansion of balance-sheet-based lending; and / or (c) radical innovations in financing practices. There are many indicators that not enough was done to prevent a continuing shortfall in credit from crippling global economic activity (eg even in terms of writing off banks bad debts, not enough was done).
It can also be noted that:
  • demand for credit is likely to decline in the face of severe recession. Households / firms may avoid uses which the credit crunch showed to be risky and seek to reduce their debts. This would moderate the perceived shortage of credit, but not reduce the economic effect of reduced provision of credit. It was suggested that there was (in February 2009) a global contraction in non-governmental borrowing of about $5tr [1];
  • reserve banks (especially the US Federal Reserve) have gone beyond reducing interest rates in boosting liquidity (eg through unprecedented 'quantitative' easing - by buying assets from banks or directly funding roll-over of corporate debts that banks are unable to fund). This should make credit more widely available, but whether this can be sufficient or whether this credit could be productively used is uncertain.  There may also be some risk, noting changes in household behaviour, of mainly facilitating speculative investments (which could create a new boom bust cycle);
  • US Fed chairman has argued that [1]:
    • credit markets are more dysfunctional than in the 1930s and Japan in the 1990s;
    • fiscal stimulus plans will achieve little unless financial systems are restored - which requires further efforts to socialize banks' losses;
    • concerns expressed about printing money (which risks Weimar Republic style hyperinflation) are valid but banks are not lending it merely leaving it on deposit with Fed;
    • the problems in September 2008 arose when a major money market reserve fund (which held $785m in Lehman commercial paper) became valueless and caused a run on all such funds ;
  • it has been suggested that the US did not fully remove bad debt problems in its banking system (because doing so would have been too economically damaging) and thus its future growth will be seriously impeded; [Comment: the debate about 'mark to market' accounting practices can be noted in this respect].
  • it has been argued that there are fundamental defects in mainstream economic assumptions about the ability of reserve banks to control money supply - ie that rather than credit creation by banks reflecting a multiplier of the base money created by authorities, than credit creation by financial systems is the primary driver. If this is so, then reserve banks are wasting their time trying to halt a contraction in credit, because this will be driven by a desire to deleverage resulting from a credit bubble. Banks will simply not use any liquidity provided to them under those circumstances [1]
  • Western banks have become so dependent on government guarantees (which supports short term borrowings) that it is hard to see them now operating independently. Lacking an adequate capital base they are are unable to to create credit on the foundation of deposits [1]
  • radical policy actions that governments and reserve banks took in an attempt to prevent severe recessions could themselves trigger further crises if they were unsuccessful (see above) - or perhaps even if they were party successful. There was some plausibility in the narrative that dominated in early 2009 - ie that a severe global recession in 2009 would be followed by slow recovery in 2010. But there was also a risk that the distortion of fiscal, monetary and economic affairs in stimulating recovery would cause 'the wheels to fall off'.
For example:
  • the virtual nationalization of many banks (especially in the US) that has been needed to prevent financial contagion must reduce their ability to support sustainable economic recovery, while government efforts to rescue other major companies to prevent the financial crisis spreading is likely to result in important economic sectors dominated by the 'living dead';
  • the strength that the $US has exhibited in the face of crisis (which has allowed its government to finance rescue operations) reflects a flight to safety, and when / if this is reversed by increased confidence in other investment options, the US (and world) economy could go into deeper recession [1]. It can be noted that:
    • a bond market crash starting in 1931 (after a post-1929 flight to safety) was apparently a significant factor in ongoing financial system problems during the Great Depression;
    • as bonds crashed the benchmark return on 'safe' investments was set to a higher level - thus putting downward pressure on other asset values;
    • there was a similar flight to safety of government bonds after 2007, and yields collapsed;
    • while the factors that caused the 1931 bond market crash were not present in 2009, there were different risks, ie (a) governments (especially the US) incurred huge deficits in an effort to recapitalize banks and stimulate growth; (b) funding its deficit had become difficult (ie by May 2009 it seemed that only the Federal Reserve bought US Treasury bonds - printing money to do so; forcing up yields [1]; and raising concerns (eg by China [1]) about durability of $US);
    • the capacity of the global financial system to provide cash and credit is much less than it was 2007 ; and
    • when investment prospects in equities seem attractive (ie when real economic recovery seems likely) the flight to quality would no longer be attractive - and 'everyone' could be expected to to dump low-yielding government bonds.
  • the US is facing very severe government budgetary problems because of the cost of stimulus measures and pending  retirement of the baby boomers will increase entitlements spending. Negotiating the fiscal stimulus in an environment in which tax rises and cuts to entitlements appear necessary will be difficult [1];
  • government debts in largest 10 rich countries will rise from 78% of GDP to 110% - and this will constrain spending but be difficult to reduce because it arises at just the time that pension and health care costs of an aging population will rise. This represents perhaps the greatest economic mess in history [1]
  • the US will be operating in an environment in which it is much harder to obtain the funds it needs for economic stimulus, because (a) much of this comes from offshore; (b) the role of states in economic affairs has increased; and (c) other governments will face domestic demand for funds and give higher priority to this [1];
  • Keynesian policies (ie a government economic stimulus) have been suggested to be ineffective. In the 1980s, when confidence in UK government finances had collapsed, the Thatcher government restored the situation by a sound money policy, cutting government spending, cutting taxes and allowing failing industries to fail. Throwing government money will simply increase debts while not reviving the economy [1]  ;

  • 'quantitative easing' by central banks and fiscal stimulus measures may be driving a re-run of the speculation that led to a market bust in 2007. Sharemarket rallies in 2009 appear unrelated to economic fundamentals - and there is fear that this could be driven by excess liquidity created by official responses to the crisis [1] ;

  • measures used to protect banks may have left US economy like Japan's in the 1990. Banks were 'rescued' (because failure to do so would have led to economic collapse) but were left with large bad debts (because government could not afford to absorb all toxic assets). Because the system was not really cleaned up there is no solid base for future growth (ie funure income will tend to be diverted to repayment of old debts), so a long period of economic stagnation is likely [1]

  • the US Fed has been seen to be pursuing a policy of promoting asset inflation with its easy money policies that are creating a dollar carry trade flooding money into everything [1]

  • government made huge efforts to save financial institutions (which they had to do) and this was ultimately successful, but (a) this was in some respects at the expense of the rest of economy and (b) the 'saved' institutions are not appropriate to future needs. Those institutions are now resisting regulatory reform; can't be expected to manage risk wisely (as they are too big to fail). There is a need for a credible threat of bankruptcy [1];

  • it takes a great deal of time to effectively spend large amounts of money. Europe's experience is that the huge short-term stimulus efforts by countries such as US and China is mainly likely to generate waste and corruption, and perhaps make the situation worse [1]

  • regulators plans to require an increase in bank capital risk creating another credit crunch [1]

  • efforts by governments and central banks to stimulate recovery seem likely to create nasty side effects (ie asset bubbles in equity markets across Asia, and property markets in China, Singapore and Vietnam) [1]

  • government attempts to reform US banking system have the effect of restricting banks' ability to create credit - and this has the potential to trigger a market crash [1]

  • emergency official efforts to cope with the crisis appeared to be trying to re-establish economic conditions that were as potentially unstable as those that preceded the GFC (ie by encouraging a resumption of high levels of household spending and borrowing in countries such as US / UK / Australia - which created a 'virtuous' feedback between (a) an asset bubble built on the foundation of unrealistically cheap credit and (b) global financial imbalances). That relationship was intrinsically unstable as the GFC demonstrated, and would have to be broken eventually and require further economic change.
In particular:
  • high levels of household spending and borrowing in countries which have had large current account deficits won't be sustainable. Moreover,  the US in particular needs to reinvent its economy and rebuild infrastructure which has tended to be neglected while reliance on financial engineering had been been an 'easy' way to generate profits [1];
  • the ending of extreme global financial imbalances will have significant repercussions in the long term (as noted below). Also, in the short term;
  • increasing debt had apparently been a major component of demand in recent decades (and had been essential to recovery from the previous two recessions), but this was now unlikely to continue. Most credit created by financial institutions, it needs to be noted, does not involve lending depositors funds but is rather created out of thin air (under prudential rules set by reserve banks).  Rather than further increasing debt a process of ongoing debt reduction (de-leveraging) may occur, and this had already been seen in both US and Australia. De-leveraging, from much lower debt levels, was a feature of both the 1890s and 1930s depressions. This effect (which would lead to future demand well below past income for many years) could swamp the stimulatory efforts of governments and reserve banks (and lead to deflationary depression) [1]. [Note: this doesn't / can't prove what is going to happen in the future - because, if confidence can be restored, the asset / debt bubble can continue to inflate. However it does suggest that: (a) if disaster is avoided for a time that another crisis will erupt in a few years an even bigger potential de-leveraging risk; and (b) there is thus a need to change the way in which asset values are determined so that ever-increasing debt is not a viable basis for investment strategies].  
  • 'East Asian' export-driven economic models (which do not yet incorporate well developed financial systems) are likely to impose an inbuilt deflationary demand deficit on the global economy - which may make recovery from the economic impact of the GFC very slow because necessary de-leveraging in other economies, which had previously compensated for those demand deficits, must overwhelm efforts by authorities to stimulate growth in the US, Europe (etc) if the conditions that created the GFC are not to be recreated.
It has been suggested that:
  • Japan's financial system is structured so that available capital is focussed on increasing production capacity, so efforts to 'stimulate' its economy have little effect on demand and increase its reliance on demand elsewhere [1];
  • China is constrained from relying on consumer spending by its huge imbalance of wealth. 0.4% of the population have been suggested to control 70% of the wealth, so 99% of the people are poor and can't afford to consume [1] [Comment: This wealth imbalance probably reflects China's focus on focusing all available resources on production capacity, which in China's case is controlled by elites with good connections to government];
  • most of China's economic stimulus package has been devoted to increasing its production capacity and hence their export over-capacity [1]
  • the GFC was followed by a dramatic collapse in global trade - though the reasons for this were unclear. Though a shortage of credit for trade did emerge, other possible factors included  declining demand or increasing protectionism [1];
  • resolving the GFC required that countries with large foreign exchange reserves (eg Germany and China) must facilitate adjustment in the global balance of payments - so that debtor countries could export their way out of the crisis. The alternative (which China asked the US to guarantee will not happen) would be that the value of their foreign exchange holdings must be lost [1];
  • signs emerged of a potential disruption of international trade because of an apparent inability to resolve concerns about financial imbalances (ie the accumulation of large foreign exchange reserves in some countries and huge debts in others) [1, 2]
  • major Western economies (eg US) were on the point of a demographic transition that would see a substantial decline in the household spending which had been a major source of global final demand.
    • Background: The huge baby boomers cohort was passing from their peak spending years into retirement. A US analyst (Harry Dent) developed an interesting theory about the correlation between the size of the cohort in their peak spending years and general conditions in the US economy (as revealed by stock market trends). That correlation went back to about 1900 (ie it 'predicted' the Great Depression) and in the early 1990s it 'predicted' a massive boom until 2010 - followed by a sustained economic slump. Clearly demographic factors are not the sole determinant of economic outcomes, but their implications should not be ignored either.
  • Europe's rapidly aging population contained the seeds of a new financial crisis, because pension arrangements were very generous and heavily indebted governments were likely to soon find it impossible to maintain these [1]. The GFC arguably exposed and compounded a fiscal crisis in developed economies related to the welfare costs of an aging population.
Greece is going bankrupt and the euro is on the point of disintegration [in 2010] because of early payment of age pensions with an aging populations. The baby boomers, it has been suggested, could not only dominate culture, fashions but also the accumulation of wealth, employment and housing - which reduced social mobility for the next generation.  Current controversies over public spending and taxes can't be separated from this. GFC merely exposed, rather than causing, the age-related fiscal crisis that is now emerging. The rational response is for governments to reduce spending on pensions, health and long term care - yet these entitlements tend to be unchallengeable. There will be a future political conflict between those wanting spending on aging boomers, and those preferring public spending oriented towards the future generations  [1]
  • political risks seemed likely to constrain financial / economic solutions.
For example:
  • geopolitical risks are increasing in 2009 everywhere except Iraq - yet these are not being considered by markets focused on GFC and so will provide negative surprises. [1].
  • politics will increasingly affect the economy because (a) there is been a shift everywhere towards economic reliance on governments because of weakness is financial systems and (b) governments have assumed control over financial institutions and other business entities in the course of rescue efforts. Economic progress is possible where the economic environment is stable and predictable - but this stability will now be less available [1]
  • political risk will be severe in US because of determination of Congress to exert independence from Executive [1];
  • authoritarian regimes that have depended on economic boom conditions for political stability could be in trouble, eg reduced oil prices may expose insolvency of the Russian state, while inability to provide jobs inflames China [1] - though it is also possible that Chinese people simply blame the West for their economic problems, and become increasingly nationalistic [1];
  • with growth collapsing, radical protest and social revolution can now be expected across East Asia  [1]
  • despite motions accepted by G20 about the need to maintain open markets, protectionist pressures are increasing in Europe [1]
  • China is planning to ban exports of rare earths that it alone produces which are vital to some leading edge technologies [1];
  • German finance minister threatened to force a substantial segment of the British finance industry to be shut down - based on perceptions (which were questioned) that: (a) that industry was responsible for the GFC; and (b) the British Government seemed reluctant to introduce tough controls  [1] [Comment: the alternative to blaming banks (and poor regulation in the Anglo-American world) for the GFC is to blame global financial imbalances linked to export-dependent economies (such as Japan, China, Germany). The implication of US pressure for more balanced growth is not only that radical changes are needed in Asia, but that Germany's preference for reliance on external demand spending would have to moderate].
  • the GFC affects and undermined the core of past economic globalization.
  • the decoupling of the $US from the gold standard in about 1970 was as important for economic globalization as improved transport and communication - because it overcame the limits on credit creation that had previously made it difficult to counter economic booms and busts. This made management of US monetary policy a critical element in sustaining the growth of the global economy as a whole (see above) - but now:
    • the status of the $US is less certain (and no alternatives are obvious);
    • the US monetary policy process has contributed to the emergence of the GFC (because it encouraged asset inflation) and needs to be re-invented;
  • US demand had provided a key economic driving force for the global economy. The US had acted as 'the consumer of last resort' and thus made export-driven growth a feasible method for economic development - and this in turn relied upon (a) asset inflation to support demand by US consumers and governments and (b) the ability of a strong US financial system to attract capital inflow. In future, the US appears most unlikely to be able to sustain this excess demand [1];
  • the development of financial services as an economic growth sector was an important part of the diversification of advanced economies into high wage knowledge intensive industries, as emerging economies with lower wages have tended since the 1970s to take the lead role in capital intensive manufacturing. The viability of complex financial services industries as a growth sector must now be in doubt because this may contribute to the failure of rationality in economic decision making (see above);
  • countries now dependent on capital inflow to finance growth need to reduce this in the face of the GFC - and this requires changing the balance of trade to increase exports [1]. Countries that in the past have been willing to provide the demand to counterbalance the export driven development strategies of Asian (and other) economies may no longer be able to do so. Also:
    • private borrowing in the US has fallen from about 15% of GDP to a net saving around 7% of GDP (and this seems likely to be maintained) [1]. The US government has very limited capacity to continue indefinitely borrowing to sustain US / global growth - though doing so in the short term is unavoidable (op cit);  Similarly,
    • it will be virtually impossible for the US government to stimulate economic recovery (as Japanese analysts have also noted) because (a) the US private sector is now going to be forced to save about 6% of GDP pa - which reduces its spending and thus increases the need for government spending to achieve growth; (b) there is a current account deficit of about 4% of GDP - which adds directly to the amount of spending in US needed to sustain growth; and (c) government (which is already running a large deficit) will face large increases in costs because of the recession. The incoming Obama administration hopes to run large budget deficits to stimulate recovery - but given these constraints recovery can't be achieved quickly. Also huge rates of spending can't be sustained very long. Structural changes in the US and global economies are required - which political leaders have not yet confronted (eg a massive write-off of bad debts to prevent ongoing impediments to economic activity; and ending of structural current account deficit) [1];
  • the export-driven development strategies, which have been the basis of East Asia's rapid economic advancement and also important components of past global economic growth, are now unlikely to be sustainable (see Are East Asia's Economic Models Sustainable?)
  • in the face of economic collapse, China's regime could be at risk - and respond by devaluing its currency, thus setting off a trade war that was a rerun of the Great Depression [1];
  • nationalization of many banks in US and Europe appears likely, and these would be inward looking and completely change the global financial environment [1];
  • emerging market economies generally have been damaged and clearly require that financing techniques be re-invented;
  • very low income developing economies could suffer a serious setback - which creates a humanitarian crisis [1]
  • current crisis is first modern threat to globalization. Even earlier there had been concern that globalization favoured wealthy more than poor. Drivers of globalization (open markets, global supply chains, global companies and private ownerships) are being undermined by protectionism. Companies return to national roots. Public participation has increased significantly. Global companies have been challenged by failure of global banking systems which had supported them. Existing regulatory arrangements had been inadequate for them. National responses to the crisis are leading to economic fragmentation. Companies in emerging counties depend heavily on foreign credit and are in particular trouble. Tariffs have been increased despite G20 resolutions. Once established protectionism takes a log time to dismantle. Also, as well as reforming financial systems, there is a need to ensure that international capital flows are maintained. [1];
  • China (which has benefited most in recent years from trade) imposed bans on the purchase of foreign equipment in investment projects - a more restrictive version of the US's 'Buy America' clause - which threatens to generate reactions elsewhere [1]
  • new techniques for macroeconomic management which were less likely to result in unrealistic asset inflation clearly needed to be developed - but what these might involve was anything but obvious;
    • there was a need for a new science of macroeconomics which started from a recognition that individuals have severe limitations on their ability to understand much about the complexity of the world they live in [1]
  • it may be that free market economies (such as the US) lacked the tools available to economies with strong 'command' features (such as China) to manage the crisis [1]
  • the nature of money and financial systems and their role in an economy is dependent on cultural assumptions - and these are viewed differently in various parts of the world (see Obstacles to Effective Regulation). This complication is likely to be well outside the knowledge base of those engaged in political and economic negotiations while specialists in the humanities, who might potentially make more useful progress, never seem to do so apparently because of their idealistic (post-modern) desire for cultural assumptions to have no practical consequences (see Competing Civilizations and Are East Asian Economic Models Sustainable?);
  • the methods for seeking to create a new global financial / economic regime would also be fundamentally different. While public debate with a goal of universal benefits is the accepted Western political model, behind-the-scenes doing without public debate would tend to be be the method preferred in East Asia (which is now around 50% of the global economy) and in each society goals would tend to be limited to benefiting a particular ethnic community - see East Asia and comments on the emergence of a virtual Asian Monetary Fund;
  • suggestions emerged about developing an alternative to the $US as the global reserve currency (eg a basket of currencies or IMF SDRs) [1, 2], and it was suggested that this might contribute to speedier resolution of the GFC by permitting stronger demand growth in emerging economies.
Creating a new reserve currency was advocated by China [1] on the basis that:
  • there has long been a search for a global reserve currency that: (a) can be issued in response to demand according to clear rules; (b) is flexible (c) and is disconnected from economic conditions in any country;
  • countries issuing a reserve currency are in the (Triffin) dilemma between meeting domestic monetary policy goals, and others' demand for reserve currencies. They may fail to meet liquidly demands of a growing global economy to restrain domestic inflation, or create excess global liquidity by overly-stimulating domestic demand;
  • countries issuing reserve currencies can't address economic imbalances by varying exchange rates, because of the demand for their currency;
  • Keynes proposed an international reserve currency in the 1940s. Bretton Woods system was implemented instead, and when this failed IMF's SDRs were created by not fully implemented;
  • a super-sovereign reserve currency would eliminate the risks inherent in a credit-based sovereign currency - and make it possible to manage global liquidity. This would also allow exchange rate policies to be used to adjust economic imbalances;
  • it would take time and political vision to establish such a system. SDRs should be considered as the basis for a new system - and this is being studied by IMF. SDRs' valuation should be based on a basket of currencies;
  • entrusting part of member countries' reserved to centralized management by the IMF would enhance international community's ability to manage crisis, Centralized management with a reasonable return will be more effective in deterring speculation and stabilizing financial markets. The IMF's universal membership, mandate to maintain monetary / financial stability, role as international 'supervisor on macroeconomic policies of member countries and expertise provides basis for managing members' reserves. This would in turn significantly strengthen the SDR's role.

China's suggestion about a supranational reserve currency system (which would increase the number of countries responsible for protecting the value of foreign exchange reserves) might:

  • provide East Asia (and some others) with a means to protect the value of their reserves from the potential weaknesses of the $US that is now likely as a consequence of the global financial imbalances that have arisen from the demand-deficient export-driven development strategies that Japan spread throughout East Asia (see Structural Incompatibility Puts Economic Growth at Risk);
  • provide a possible means to provide desperately-needed credit to East Asian economies with limited regard to return on capital when their reserves have become depleted as would necessarily occur with domestically-driven growth (see below).

However from others' point of view it would be of uncertain merit because:

  • monetary policy has become the main basis of macroeconomic management. It is not obvious how global macroeconomic management through control of liquidity would be any easier (eg through the IMF's SDRs) than by the Federal Reserve using $USs. Certainly managing the relationship between domestic and international goals is a problem (as illustrated by the easy money policies the Fed was forced to adopt to maintain global growth in the face of a structural demand deficit in East Asia). However an even bigger constraint is the need for impossible levels of strategic insight into when asset values have become a 'bubble' by whoever the monetary regulators are. The suggestion by a Chinese economist [1] that Keynesian policies by the US Federal Reserve (ie attempts at macroeconomic management through monetary policy were part of the cause of the GFC may be noted);
  • problems seem to arise (as demonstrated by the European Monetary Union) where uniform monetary policies are applied (and attempts are made to encourage similar fiscal policies) across regions with vastly different economic characteristics (eg stimulus needed in the majority of regions may trigger bubbles elsewhere, while restraint needed in most regions can lead to severe downturns elsewhere).  Similar problems would apply to IMF SDRs;
  • unless the world economy's dependence on high levels of US demand to maintain growth can be quickly reversed, such a step in the midst of a financial / economic crisis would potentially trigger a much more serious global economic collapse (ie it would put at risk the ability of the US to mobilize the resources needed to recapitalize its banking system and stimulate economic growth with government spending - as these had come to depend on the ability of the US Fed to 'print money');
  • the use of SDRs would not eliminate the risk that financial imbalances would give rise to crises.  For the world as a whole, there can be no net current account surplus or deficit no matter whether this is valued in $US's or SDRs. So long as East Asian economic models depend on maintaining current account surpluses, someone else must be willing / able to run persistent deficits - a role which the US has been able to fulfil in the past only because of the strength of its financial system and the growth of an asset bubble;
  • it is not clear that SDR's would really be backed by much apart from $USs - as this is the main current form of the foreign reserves that would be made available to the IMF for centralized management. A basket of currencies has been suggested in valuing SDRs, but China (which has proposed this change and has (like Japan) had to accumulate large foreign exchange holdings because distortions in its financial / monetary systems could only be protected by running large current account surpluses) does not have any freely convertible currency of its own that could be provided to support SDRs;

As noted below (in comments on a A New World Order: Leadership by Emerging Economies?), suggestions that creating a global reserve currency might permit speedier resolution of the GFC by strengthening demand in emerging economies are neither necessarily valid nor optimal.

  • practical initiatives were taken in Asia to reduce dependence on the $US as the global reserve currency - without apparently creating any viable alternative
    • China has taken various initiatives to reduce its exposure to and dependence on $USs (see Doing China's Own Thing?)
    • in May 2009 Japan threatened to buy no more US bonds unless they are dominated in Yen - in parallel with frequent complaints from China that US is using quantitative easing to devalue $US. Because of their export dependence Asia' economies would be in serious difficulties if they 'crater' the US bond market [1]
    • the possibility of redirecting surplus savings (from East Asia and oil exporting nations) into investment in developing countries through international institutions created by the IMF has also been raised [1] [see comments];
    • in December 2011 Japan arranged direct currency swap deals with China and India without intermediate involvement of #US - a step that was seen as likely to boost the role of yuan as an international currency [1]
  • the possibility of a global swine virus pandemic raised fears of a further economic dislocation in April 2009 [1]
  • the financial difficulties facing developed countries in winding down, and recovering from, their stimulus measures was complicated by the costs of emissions trading schemes (which would make energy more expensive for their industries), while developing nations expect compensation for doing the same. Citizens want something done about climate change, but developing nations believed that this was their chance to get ahead - by making energy costs in the developed world much greater than in developing nations [1]

Economic growth and globalization had been dependent on complex and dynamic arrangements within the global economy which effectively disintegrated. Efforts to stimulate economic activity through government spending and loose monetary policies could not be sufficient - because the problem is, in effect, to 'put Humpty Dumpty back together again' (see also reference to our inability to 'restart the music' [1]).

Seeking a GFC Solution


Seeking a GFC Solution

Established machinery for international collaboration (eg G7, EU) made various attempts to promote a coordinated response to the GFC which would not only deal with the crisis but address its systemic causes. A forum of European and Asian leaders agreed in October 2008 on the need for such action, and arrangements were made for an international meeting in the US in November following the 2008 presidential election to find a way forward.

US Leadership? [<]

Much was apparently expected of the renewal of US leadership within global institutions under a new president in developing solutions to the financial and rapidly-escalating economic crises.  However given the complexities of the issues (which currently render them virtually incomprehensible) and dysfunctions in global institutions it is hard to see how 'hope' (for apparently-long-overdue reform of US government programs; 'liberal' values that some cultures believe to be socially damaging; and a vacillating approach to international relations) might translate into world leadership in practical reform of global financial / economic systems.

Why: In November 2008 there were worrying signs concerning the future Obama administration. While he was undoubtedly charismatic and politically skilled, he espoused a VERY conventional Democrat policy agenda (more and better government programs and liberal social policies) combined with a confused approach to international relations which promised both diplomatic collaboration and economic protectionism. While, of mixed race, he seemed to be a cultural Anglo-American (no less than then former US President Bush or former UK PM Blair) - which was presumably the reason that he was widely acceptable to the US electorate.

The international situation his administration faced was the same as faced leaders such as Bush and Blair in 2001 - eg involving dysfunctional global institutions, failing states on the global margins, security risks with potential massive costs (eg from WMD in the hands of extremists) - see September 11: The First Test.

The financial / economic situation his administration inherited was certain to absorb most of the energy that it wanted to apply to other other things - and probably quickly erode its public approval. There was little sign that his administration understood the problem - if it was anything like that outline above.

Parallels might be relevant with the 2007 election of the Rudd Government in Australia where populist rhetoric about solving presenting problems did not actually seem well founded (see Populism Trumps Electoral Victory).

Barack Obama as President also seemed potentially a 'Blair' - ie unsuccessfully seeking modified socialist ways to make the world a better place. Think-tanks in UK continued to develop ideas about Blair's 'third way' - and this would have influenced US Democrats. Feedback the present writer had from contacts in US who gave the impression that they were advising Democrats suggest interest in approaches to reform of government administration which come out of think-tanks that inspire ALP governments in UK and Australia. Those in Australia were be putting forward the argument that Australia's approach to financial system governance (for example) could provide a better model for the US. The latter conclusion arguably reflected a naïve assumption that Australia's system had been effective (rather than lucky that real risks had not yet caused a crisis) - and the Obama administration needed experienced advice to be able to see through such claims.

Whether the Obama administration mobilized or alienated those who could help it was critical to whether the 'hope' that it promised was likely to be realized.

G20: Avoiding Key Issues  [<]

A meeting of G20 nations (representing about 80% of the global economy) was arranged for mid-November 2008 to consider a coordinated response to the GFC. Resolutions were passed about (a) developing proposals for a coordinated response for consideration in 2009 and (b) restarting talks about liberalization of international trade under the WTO framework (which had previously failed because of disagreements about agricultural protection in developing countries).

Various published comments on the challenges facing the G20 included:

  • the G20 resolved that stiffer regulation of international financial markets is needed because they operate internationally, and consistency is required. Principles adopted were: (a) greater transparency and accountability; (b) strengthening existing regulatory regimes; (c) promotion of 'integrity; (d) more international regulatory consistency; and (e) reform of existing international financial institutions [1];
  • G20 resolved to conclude stalled Doha round of world trade talks [1]

There was however concern that: (a) the summit had not actually decided to take coordinated action; (b) the causes of the GFC were not raised in debating solutions; and the incoming US administration was not involved in the summit. There was also fairly clear differences of opinion between 'Europe' (which appeared to favour some sort of EU-style international regulatory regime) and the outgoing US administration's aversion to such arrangements.

An APEC meeting in late November again highlighted fundamental differences in approach - when China also strongly endorsed a 'new international financial order' as an alternative to the 'free markets' approach favoured by the US [1].

While the US administration of Barack Obama was more likely than its predecessor to favour an 'international' solution, this seemed unlikely to be enough. For example, as noted above the Obama administration's approach to international affairs has been internally inconsistent. Moreover the new president gained electoral support by promising to protect jobs in failing industries, though trade protectionism could seriously worsen the economic downturn associated with GFC - and the G20 resolved to pursue the further removal of trade barriers by revitalizing stalled WTO negotiations [1]

In the lead-up to the proposed G20 conference in April 2009 to discuss resolution of the crisis diverse and incompatible approaches to solutions were again very much in evidence.

For example:
  • G20 should focus on coordinated fiscal and monetary policies to boost growth and defer action to reform regulatory arrangements. Because the causes of the problem are not yet well understood, early changes could make things worse. Jittery investors need certainty not shifting rules. Moreover a unified regulatory system across the entire world is probably impossible and undesirable, given the quite different governance regimes that exist [1];
  • France and Germany want the IMF to act as a global supervisor of regulators as a means to substitute the European model of capitalism for the less heavily regulated US style, though even in the US, regulators' inability to adequately forecast future trends have resulted in significant problems [1];
  • the UK Prime Minister (Gordon Brown) issued calls for a global approach to wholesale restructuring of financial regulations in response to the GFC while stressing the dangers of protectionism [1]. [Comment: This seemed reminiscent of efforts by a former UK PM (Tony Blair) to garner support for a global approach to the war against terror - and likely to be unsuccessful for much the same reasons].
  • Australia's Prime Minister put forward a package of proposals based on cleaning up distressed financial institutions and better regulation  while a former Australian PM presented a radically different notion based on the view that global financial imbalances were the source of the problem and needed to be corrected. [Comment: The former was likely to be ineffectual for reasons like those applicable to UK proposal, while the latter seemed inadequate because the inability of East Asian economies to develop the type of financial systems this would require);
  • as well as proposals by Australia's PM and a former PM, the US government called for more public spending. Europe wanted more financial regulation. China wanted a bigger seat at the table. WTO was concerned about rising protectionism. World Bank warned that funding crisis threatens catastrophe in developing countries, unless developed world supplies capital. Reaching agreement at such conferences is hard - and becomes more so the larger the agenda grows [1];
  • China proposed  that IMF SDR's should take the $US's place as the global reserve currency - and others suggested that this would reduce the risks implicit in reliance on a currency that is only backed by one country and would make it possible to manage global liquidity [1] [See comment above, which suggests that such a shift might enable Asia to protect the value of foreign exchange holdings against the likely decline in their value that will result from global financial imbalances that result from 'Asian' economic models - but would be of limited benefit to most others]

Moreover unilateral action by various nations / regions acting independently seemed unlikely to lead to success.

For example:
  • neither the US nor the EU seemed likely to be able to provide sufficient funds to recapitalize their banking systems - a step which was widely seen to be vital to providing the ongoing credit facilities needed for economic recovery;
  • US Fed chairman suggested that US could emerge from recession in late 2009 if the banking sector stabilized. A reform agenda was suggested involving: supervision of banks that are too big to fail; improving resilience in system; reducing pro-cyclical risks; and creation of authority to identify systemic risks [1]. However:
    • while the Fed expected that resolution of problems in US banks would lead to recovery, the US government (which the Fed expected to restore the banks) appeared to be expecting that economic recovery would come first - and and that it would be economic recovery that would fix the banks [1]; and
    • the risk that the US might (because of a bond market crash) not be able to fund the budget deficits required for its stimulus and bank-rescue efforts appeared real [1]. Quantitative easing (ie printing money) has been started in order to provide funding for government deficit [1], but this poses huge risks [1];
  • the US Secretary of State had encouraged China to continue investing in US Government bonds (which would be vital for the US to fund its stimulus packages), while (a) China's premier expressed concerns about the safety of its investments and indicated an intention to diversify into strategic commodities, outbound investment and trade [1]; (b) China's current account surplus collapsed, because of its exports decline [1]  so that it had little new capital to invest; and (c) China sought to diversify perhaps 50% of its $2tr+ foreign exchange holdings away from $US - perhaps into commodities and other assets that are currently undervalued in order to protect against $US collapse [1]
  • the US will be unable to provide the high levels of demand required for export-driven growth in East Asia (see Unsustainable economic models?);
  • East Asia (China in particular) seemed likely  to be unable to sustain market-oriented economic growth because of structural obstacles to domestically-driven growth (see Are East Asian Economic Model's Sustainable?) - and thus to perhaps shift into nationalistically oriented growth which is likely to be both (a) non-viable in the long term and (b) potentially a threat to regional and global security (see After the Bubble).

In March 2009 a preliminary meeting of G20 finance ministers papered over pre-meeting differences between EU and US on fiscal stimulus and agreed on (a) a common framework for assessing impaired assets and bank recapitalization (b) boosting resources of the IMF and regional development banks to provide capital for emerging and developing economies (c) avoiding protectionism and (d) increase oversight of Credit Rating Agencies, transparency of exposures to off balance sheet vehicles; improvements in accounting standards, including provisioning and valuation uncertainty; greater standardization and resilience of credit derivatives markets [1] .

Despite hopes expressed by some, the prospects of reaching agreement that would be effective appeared dim.

Australia's PM, Kevin Rudd, (a) warned global leaders of the risk of 1930s style depression unless they collaborate to clean up banking sector and stimulate growth; and (b) suggested that the IMF needs more resources to meet a second-round financial-tsunami emerging from Eastern Europe. Other economic concerns are: (a) Japan's export collapse and likely 6% economic contraction; (b) uncertain funding for US / UK budget deficits and stimulus packages; and (c) nervousness about $US when US Treasury Secretary suggested that China's proposal regarding IMF's SDRs as new world currency might be considered. Mr Rudd will press for collaboration in finding solutions to avoid breakdown like that that followed failure of 1933 World Monetary and Economic Conference. Mr Rudd has argued for four part response involving: (a) macroeconomic stimulus; (b) restoring credit markets; (c) supporting developing nations; and (d) reforming international financial regulation. He will ask G20 to put aside self interest in favour of common good. There is concern that (a) US / European banks could withdraw from overseas markets; and (b) protectionism could emerge. [1]

The US delegation to the G20 believes that only an agreement between China and the US can create a sensible new world economic order [1]

[Comment: While no outcome that does not reduce global financial imbalances could result in sustainable growth (a) China is by no means to only East Asian country that would need to be involved and (b) the necessary adjustments to financial / monetary systems in Asia are arguably culturally impossible - see Financial Imbalances]

Though the situation is better than in 1933, there are also similarities. The US is trying to reflate its economy, while Europe hangs back worried about its currency. Prior to 1933 conference both Europe and US had tried to stick to gold standard - a position Roosevelt then abandoned. G20 summit is earlier in this depression, and fiscal and monetary responses are well advanced - except in Europe. Draft communiqué has been published, which is vague. It expresses hopes for growth, commitment to free trade and market (not capitalist) economies, commitment to reform of  financial regulation, concern about inflation and an exit strategy from fiscal expansion. Problem is more urgent than in 1933 because of speed of collapse in manufacturing. G20 needs to rescue globalization and trade as well as fixing financial system [1

In the 1930s any country that tried to reflate was punished by its creditors - so most stuck grimly to liquidation. Surplus countries refused to play their part in restoring demand - just as they do today either because they don't want to (Germany and Netherlands with combined $294bn surplus) or can't for structural reasons (China with a $401bn surplus)  [1]

Comment: In terms of resisting reflation, more attention should be paid to East Asia than to Europe. As noted, China has 'structural reasons' for doing so. However China's surplus may well be much less than the $401bn mentioned - as it had shrunk to almost nothing in February 2009 (see China: After the Bubble). Thus, unless there is strong recovery elsewhere, China's 'structural problems' may pose a threat if it seriously attempts to reflate its economy. Moreover, the 'structural reasons' for China's inability to reflate (which are the same as Japan's) requires explicit attention (eg see China: Victor of Victim?), as do apparent attempts to create defence mechanisms in the form of (a) proposals to increase the number of nations who would become responsible for protecting the value of Asia's foreign exchange holdings (see comments on China's proposals for using the IMF's SDRs as a global reserve currency) and (b) the creation of a 'A Virtual Asian Monetary Fund').

French president has threatened to walk out of G20 meeting if his tough globally-managed regulatory reforms to moralize capitalism are not adopted. He opposes stimulatory spending. US / UK argue that global regulator is impractical [1]

G20 seems unlikely to rise to challenge - because there is a need to both boost aggregate demand and shift its distribution away from chronic deficit countries to those with surpluses. No consensus exists on causes of crisis. UK / US argue that problem is not just deregulation - but excess supply in surplus countries (especially China - $379bn, Germany - $253bn, and Japan - $211bn in 2007). But China and Europe argue that problem is fault of deficit countries. German Chancellor points out that Germany is reliant on exports - and expects the rest of the world to adjust to be able to continue buying these sustainably.  But deficit countries have now run out of willing / credit-worthy private borrowers - and will now shift their fiscal balances massively towards surplus. In surplus countries (which relied on irresponsible borrowing by the private sector in deficit countries) the private sector will still run large surpluses, while governments are forced to very large deficits. Because of low fiscal deficit, China clearly expects strong external recovery. As there is no sign of adjustment of underlying structural imbalances, there is no chance of sustainable exit from crisis. [1]

The US wants the world to embark on macroeconomic stimulus programs - and believes that complicated task of reinventing financial supervision and regulation can wait. Many European countries can't afford a stimulus package because of over-stretched public finances - and so want to make progress on regulation of banking [1]  [Comment: It can be noted that under European Monetary Union rules government deficits are strictly controlled, and so even if individual countries wanted to increase spending to stimulate economic activity they may be unable to do so without breaking down the EMU]

Moreover it was what was not being discussed at all that seemed most likely to inhibit effective agreement.

For example:
  • there are major unmentioned differences in understanding about what an 'international' solution would involve (eg see Obstacles to Effective Global Regulation). To oversimplify:
    • when the current US administration refers to 'free markets' it means that capital should mainly be allocated to uses that produce the greatest financial return. The Obama administration would seriously undermine the US's economic potential if it took a different view;
    • when 'Europe' talks about a 'new international financial order' it means that capital should mainly be allocated by institutions which reflect prevailing 'democratic socialist' values as well as considering financial return;
    • when 'Asia / China' talks about a 'new international financial order' it means that capital should mainly be allocated by state institutions controlled by non-democratic social elites who tend to give preference to nationalists with good connections to the prevailing regime - and the lack of serious concern for profitability in such uses of capital should be concealed by constraining consumption to ensure a large current account surplus;
  • some of the world’s up-and-coming new powers neither embrace nor aspire to the Western model of liberal democracy and authoritarian regimes (eg Russia) are demanding a role in global governance on their own terms which makes the idea of an "alliance of democracies" hard to maintain (Karaganov S., 'Confrontation of cooperation', 14/11/08)

In the absence of commitment to addressing underlying problems, the predictable outcome of international negations related to the GFC could only be:

  • some sort of multilateral agreement on a very narrow series of global financial system 'reforms', or
  • the creation of several separate (incompatible?) regional regimes - which would retain the problems associated with incompatible national regimes. There seemed to be no mention of the creation of a virtual Asian Monetary fund as a regional alternative to an effective global solution.

Such 'solutions' would imply that another crisis would emerge in a few years.

G20: Announcing 'Peace for our Time'?  [<]

Following the G20 summit in London in early April 2009:
  • the UK Prime Minister (Gordon Brown) announced the creation of a "new world order". "This is the day that the world came together to fight back against the global recession," he said. "Not with words but with a plan for global recovery and reform." [1]
  • US President Obama, hailed the deal as a "turning point" that would put the global economy on the path to recovery; [1]
  • France's president also said that a "page has been turned" on the old Anglo-Saxon financial model [1];
  • Germany Chancellor Merkel spoke of a 'very, very good, almost historic, compromise' [1]
  • Australia's Prime Minister reportedly intended to produce a budget based on the assumption of economic recovery in 2010 [1]

Though Western leaders proclaimed the G20 meeting of April 2009 a success and there were some signs of progress, there is a real possibility that they were merely having a Neville Chamberlain moment because serious underlying problems were not being addressed.

Indicators of Success

Observers noted that:

  • the G20 summit: provided an additional $US1.1tr to IMF to support countries facing payments crises, finance trade flows or provide SDRs; agreed to publish a blacklist of tax havens; imposed oversight on large hedge funds and credit rating agencies;  created a supervisory body to flag problems in global financial system; did not accept US calls for new stimulus measures. Australia's PM suggested that this constituted crackdown on 'cowboys' who caused market problems. UK PM said governments had agreed to $5tr in stimulus measures before the summit - though others were unable to see where this figure came from. French president suggested that this reflected a shift away from 'Anglo-Saxon' finance model. Germany welcomed the lack of commitment to further stimulus measures [1];
  • at G20 summit, UK PM announced end of 'Washington consensus' because of $1tr injection for global economies. A six point agreement involved: new approach to tax havens; common approach to managing 'toxic assets'; radical banking system reforms; new regulatory arrangements including a 'financial stability body'. A new world order may emerge on the basis of international cooperation. Key pledges involve: publishing a list of tax haven; provision of additional IMF funding ($500bn general funds, $250bn SDRs and $250bn for trade assistance); and international colleges of supervisors for national financial regulation; agreement to promote growth domestically; revamping IMF / World Bank with more influence for China and developing countries; continuation of millennium development goals; $50bn for world's poorest regions  [1] ;
  • the G20 took a step towards the creation of a global currency, backed by a global central bank running monetary policy for all humanity - through $US250bn allocation to IMF for SDRs [1]
  • the G20 meeting had been a success in terms of boosting confidence [1]. Markets surged as world leaders agree sweeping package of measures to restore the world economy, including $250bn money supply increase [1]
  • G20 produced a more ambitious outcome than many thought possible. Rather than focusing on fiscal stimulus by large economies (which Europe's leaders were suspicious of) attention focused on the poorest developing economies and medium-income emerging markets [1]
  • the US and China agreed to ongoing dialogue on economic and political issues [1];
  • the Anglosphere went to the Summit seeking massive ongoing fiscal stimulus - but didn't get it because of European resistance. Europe wanted global financial regulator that would force US institutions to operate by European rules - but didn't get it because of US resistance. The outcome was 'coordinated unilateralism' (similar to APEC's free trade forums in 1990s) which was better than nothing. G20 also marked world's acceptance of US President as its leader [1]
  • all the suspects in the GFC (except the politicians and regulators who oversaw it) have been locked a new interlocking global / national system of regulation (ie hedge funds, institutions too large to fail, credit rating agencies, tax havens, derivatives, excess remuneration for short term risk) while a new Financial Stability Board will monitor the whole system [1]

Moreover there were 'real-economy' indicators that the effect of the GFC could be fading. Stock markets are viewed leading indicators of economic change - and will tend to bottom (say) 9 months before corresponding economic effects. There was a view in early April 2009 that stock-markets (having fallen about 50%) had fully discounted the real-economy downturn that were then unfolding and that there were signs of recovery which the market should thus anticipate. For example:

  • recent surveys of manufacturing and service industries show that conditions have stopped getting worse in US, Europe and Asia [1];
  • the main sign of progress is that rate of economic decline has slowed. China seems to be keeping its economy ticking over (though data is uncertain). Global contraction of manufacturing has slowed - and new orders are emerging. Low interest rates in US have triggered a wave of refinancing. Building approvals have strengthened in Australia [1]
  • new regulations will make global banking systems more healthy. There are also signs of bottoming of US housing market and improved consumer confidence. The US has recognised that it can't be the only consumer driving world growth. China / Japan and Europe will be forced to increase consumption  - which won't be easy and in China's case will require safety nets so savings can reduce. Australia will benefit from commodity prices during recovery, and from a reasonably sound (though not perfect) banking system [1];
  • mark to market accounting rules (which had made it hard for banks to sell toxic assets) were eased.[1] Assets could now be held on bank's books at estimated longer term values rather than current market values - so sales of distressed assets would not require that all similar assets on banks' balanced sheets be devalued.

It seemed that the economic dislocation triggered by the GFC could run much longer because: there was obvious confusion about the nature of the problem; nothing was done about the structural causes of the financial imbalances that make global growth unsustainable; correcting those imbalances is both essential and likely to make East Asian economic models unworkable; establishing global institutions to address the problem of economic management and financial regulation merely 'passed the buck'; and there are numerous market-level indicators of ongoing problems

Structural Indicators of Ongoing Recession / Depression

Confusion (ie unrealistically narrow perspectives) regarding the complex causes of the GFC seemed to be widespread.  The 'neo-liberalism-and-greedy-bankers-dun-it' view put forward by Australia's Prime Minister was only one example of this phenomenon. For example:

  • UK-French-German leaders and analysts discussed the problem in Eurocentric terms;
  • the US president noted that the US could no longer be the primary source of global demand, without suggesting any practical alternative;
  • even analysts who recognise the importance of financial imbalances find it too hard to examine the cultural foundations of such problems (eg that China's $2tr foreign exchange reserves and corresponding reserves in Japan are symptoms of systemic weaknesses, not signs of economic strength);
  • Asia's ethnic leaders engaged little in the Western artifice of political debate, because of the traditional preference for behind-the-scenes action to boost their communities' positions - just as their financial counterparts prefer 'real economy' outcomes to success in the Western artifice of financial profitability.

Nothing was  done to confront the structural causes of the financial imbalances that have made global economic growth unsustainable - and that were one factor in causing the GFC. The G20 established a Financial Stability Board to provide early warning of problems with systemically important financial institutions, instruments and markets. This totally missed the point that there was a need for early warning about the effect of destabilizing financial / economic / monetary systems.

Thus at best any recovery could only be a short term affair. Pre-GFC global growth depended on (a) excess demand from US consumers, which was maintained because asset inflation created the impression of high household incomes and (b) very high levels of government spending in Europe, which had left public finances over-stretched [1].

This can't continue, and the US (and like) governments can't continue borrowing indefinitely to stimulate economic activity (eg noting the potential for the US to encounter difficulties funding its budget deficits ), while countries like China  and Japan (and others with large demand deficits because of their export-based economic strategies) appear to assume that economic recovery will be driven by external demand.

Of even greater long term concern is that East Asian export-driven economic models (that have been major factors in both global economic growth and global financial imbalances) will almost certainly prove unsustainable in the post-GFC era but be incredibly hard to reform because of cultural constraints (see Are East Asian Economic Models Sustainable?).

Others argued similarly that:

  • G20 decided nothing of substance. More money was given to the IMF, but there was nothing new on fiscal stimulus - because German / US disagreement remained. Everyone knows indebted / deficit countries can't continue borrowing to prop up demand. Surplus countries have to provide the demand (especially Germany and China) , but they are waiting for the return of Anglo-Saxon demand in the near future. [1];
  • G20 involves contest between France-Germany and the rest of the world. Most others are backing various stimulus measures. While Germany is right that indebted countries can't keep adding more debt, global demand is contracting - and deficit countries should not carry burden. If surplus states don't do more, global demand will collapse. The mercantilist powers (eg Japan) are already being hit hard. Global system can't be rebuilt until countries like Germany and China accept that extreme imbalances are bad.  [1]
  • it has been argued by influential insiders that Germany can no longer continue to rely on an export-dependent economy [1];
  • the next collapse will only be a matter of time because key issues received no attention - namely the high levels of consumer spending in US (72% of GDP) and the low level in China (36% of GDP). G20 agreements dealt with regulation of financial institutions, but the main problem now is macroeconomic [1];
  • in Australia there had been a large element of unreality in government's approach to G20 in expectation that it might tackle the really big issues such as the rotten state of US / European banking, and the need to increase government spending. The G20 went nowhere near these issues [1]

While the G20's creation of a stronger global financial-monetary authority through the IMF reduces some risks to the global economy, this does not in itself solve the operating difficulties facing any such body. For example:

  • the step towards creation of a global reserve currency (ie IMF SDRs) and a global central bank to control monetary policy is of uncertain benefit;
  • macroeconomic management based on either fiscal or monetary policy now seems unreliable no matter who tries to do it. Working out how to do this effectively seems more important than just asking new institutions to do so;
  • IMF has frequently been criticised for its tough-love 'Washington-consensus' approaches (eg requiring fiscal tightening in the face of balance of payments difficulties), while the alternative approaches based on strong government control of the financial system and support from other countries with current account surpluses so domestic financial weaknesses can be ignored depended on the strength of the US as counter-party to such surpluses;
  • since the G20 summit the IMF has taken a much more pessimistic, and arguably more realistic, approach to assessing the prospects of the global economy and the challenges of reform (eg [1]) - but has also demonstrated significant deficiencies in the information that it relies on in attempting to do this [1]
At a market level there seem to be ongoing causes for concern that offset the optimistic signs outlined above. For example: 
  • the creation of a new regulatory regime for international finance in the absence of real understanding of the causes of the GFC seemed likely to be as destabilizing and vacillating as the US government's early efforts to respond to the credit crunch were widely seen to be. Moreover the proposals adopted seemed to give everyone a bit of what they wanted on the basis of radically different understandings of what was required (see Obstacles to Effective Global Regulation and also above). Coherent operation of this global regulatory machinery thus seems unlikely;
  • any stock-market recovery is likely to adversely affect the price of government bonds - which (especially US Treasuries) have had a high 'flight to safety' value in the absence of alternative investment options. Collapse in the value of such bonds: (a) will put the ability of governments to fund their budget deficits at risk and (b) set new (higher) standards for yields on corporate debt and equities;
  • US government rescue package for banks has been seen as unlikely to be successful - because of problems in setting prices for 'toxic' assets. If set too high, those enticed to buy them by government guarantees against loss would be unable to make a profit. If set too low, they would reveal the extent of banks' balance sheet problems - and thus banks would be unwilling to sell. Changes to mark-to-market accounting rules will ease this problem (and thus reduce their need for new capital)- but result in a loss of transparency regarding banks' balance sheets (and thus increase their difficulties in obtaining new capital);
  • recapitalizing US banks won't restore normalcy to credit markets - because about 50% of credit had been provided through securitization of assets which were then sold through financial markets;
  • government rescue operations for financial institutions has resulted in a high level of government control, and thus will reduce their ability to support innovative commercial activity that is vital for real-economy recovery and ongoing growth;
  • financial services had become a major growth sector of developed economies under pressure from competitive challenge from developing economies in traditional industries. This sector's future prospects (which were important in terms of both employment and tax revenues) will no longer be such a bright prospect;
  • major companies (eg US auto majors such as GM) are hovering on the brink of bankruptcy - and this will give rise to further rounds of derivatives losses via credit default swaps (CDSs);
  • it is not clear what has been done resolve the CDS problem. It was clear that (a) the total exposure to derivatives was many (eg 50) times the capital base of major banks - though their net exposure was only roughly equal to their capital base (b) any counter-party failure (such as Lehman Brothers) could amplify these net losses (c) it was thus unacceptable to allow major financial institutions to fail. There is a lack of transparency about what has been done to reduce the potential for losses on derivatives, and what still remains to be done;

And unfortunately indicators of an economic crisis which are recorded elsewhere continued to accumulate despite signs of improvement that were observed from mid 2009. Moreover, as the first phase of  the crisis abated, many analysts started raising concerns about ongoing risks.

The G20 summit was arguably a 'success' mainly in the sense that differences were papered over, no one walked out and a foundation was laid for ongoing negotiation. Many issues that needed attention were hinted at, which is at least a form of progress even though they were not addressed.

In September 2009 a meeting of the G20 decided that fiscal and monetary stimulus measures had been successful but needed to be continued (and great care taken in phasing them out) and the global financial system needed reform in terms of (a) better coordination of monetary and fiscal policies (b) higher capital requirements [1]

Some Observers See Why Imbalances Matter Though the G20 Officially Can't

However the issues that the the G20 avoided did not go away. Various observers noted the relationship between global financial imbalances and the GFC that was mentioned above. For example, Professor Martin Wolf (amongst others) produced useful accounts of the relationship between financial imbalances and the GFC (eg Challenges for the World's Divided Economy, 8/1/08 and How imbalances led to credit crunch and inflation, 17/6/08).  Moreover:

  • as noted below, imbalances were highlighted by an economist from an emerging economy as the major justification for a fundamental re-ordering of the global financial system in June 2009;
  • the US and Europe raised the need for systematic efforts to reduce imbalances in the context of a September 2009 G20 meeting - a proposal to which China objected [1];
  • in the face of increasing pressure to reduce trade surpluses, Japan and China are resisting. In China state-owned enterprises generate most savings. Better financial markets, social security reforms and a willingness to allow Yuan to appreciate a needed [1];
  • by October 2009 it was being suggested that the GFC was only in one small way a failure of markets, but was mainly a necessary market correction to deal with international financial imbalances that had built up during a decade of successful globalization [1];
  • by January 2010, the head of Bank of England was (a) suggesting the need for G20 to take control of IMF and (b) highlighting the need for balanced growth - on the grounds that unless imbalances are brought to an end by properly aligning exchange rates, countries might unilaterally impose self-defeating protectionism measures [1];
  • quite detailed prescriptions for global economic collaboration which took account of the problem of imbalances were being advanced by June 2010;
  • in late 2012, the constraints associated with financial imbalances were again being raised. For example it was suggested that "The world suffers from a persistent tendency towards deficient aggregate demand, because umpteen countries are chronic over-savers, with a tendency to run large current account surpluses" [1]. At the same time the complementary adverse effects of macroeconomic management through monetary policies (ie stimulating booms in deficit countries) were gaining attention (see Global Impact of Booms Stimulated by Easy Monetary Policies).

This issue was also reflected by G20 meeting in Pittsburgh which decided that (a) G20 would be forum for global economic management; (b) tougher bank rules would be in place by 2012. It was argued that responses by governments had stopped decline in global activity and stabilized financial markets - though (a) much more needed to be done to reform financial regulation and reshape global growth; and (b) stimulus measures will still be needed for some time. Other issues addressed included: IMF reform and world trade talks. In return for getting more say emerging economies would be expected to help rebalancing the world economy (by increased savings in deficit countries and more consumption in surplus countries). Some rebalancing was already occurring as US household consumption has shrunk. [1].

However while the G20 was able to get agreement on financial regulation (an issue on which there is wide agreement), it was seen to be likely to have difficulty getting agreement on trade, financial imbalances and reform of Bretton Woods institutions where there are significantly different views [1].

These difficulties had become increasingly apparent by the time of the G20s meeting in June 2010.

In July 2010 it was being argued that global economy, artificially boosted since 2008, was headed for sharp slowdown as stimulus wanes while excesses (ie too much debt in many advanced economies and excess savings in China, emerging Asia, Germany and Japan) have not been addressed. Global aggregate demand must therefore be weak because spending was not being increased in countries that saved too much as spending fell in countries that now needed to de-leverage. At best the world would experience a long U-shaped recovery, but there were many potential sources of a shock that could make the situation much worse [1]

In June 2012 a former head of the US Federal reserve expressed the view that financial imbalances had played significant role in the financial crisis, and argued for a more effective effective international financial system (see below).

In August 2012 the president of the European Commission argued that the primary goal of the quantitative easing in Europe was to create a framework in which financial imbalances could be corrected (see below)

Speculations about Moving Forward  [<]

Various observers have speculated about ways of moving forward, which do not yet appear to have resolved underlying difficulties.

For example: 
  • one observer argued that the GFC could be explained entirely in terms of commercial irresponsibility and defective regulation in the US, and suggested a way out of the crisis on the basis of that simplifying assumption. However, while doing one thing at a time (ie focusing on US institutions) is one possible approach, it would seem to merely make future global crisis unavoidable (see Avoiding Ongoing Global Crashes);
  • after the GFC the world will be different. In particular the level of globalization will have been reduced, and also that development strategies based on diversification into manufactured and other modern goods (which generated and relied upon large international financial imbalances) will no longer be viable. The potential difficulty facing developing countries could be overcome by ensuring that domestic demand for manufactured and modern goods could be increased (eg by allowing currencies to float; targeted infrastructure investment; industry policies other than those applied through exchange rates). [1]
  • it was suggested that "the age of a hegemonic model of the market economy is past. Countries will, as they have always done, adapt the market economy to their own traditions. .... A world with many capitalisms will be tricky, but fun." However The future is not necessarily one of many capitalisms - as the East Asian notions of a market economy seems to be based on Confucian social relationships rather than capitalistic search for profits (see Creating a New International 'Confucian Economic Order?).
  • the US presented a proposal for uniform regulatory reform of banking that could have global implications. The need for uniformity was stressed in order to prevent international banks exploiting inconsistent rules and the US losing its banking status through tighter government scrutiny [1];
  • there was uncertainty at a Davos meeting whether new model that will emerge will be a radically reformed version of Western democratic capitalism - or some variant of the authoritarian state-led capitalism favoured by China, Russia and some other emerging economies. Developing countries have lost interest in Washington consensus since crisis - and everyone talks about new Beijing consensus. The West needs to reinvent its systems or lose. It is not adequate to claim that Western and Chinese models of capitalism are not radically different. Also they can't peacefully co-exist. China's determination to run huge export surpluses through undervalued currency gives West cheap products, job losses and higher debts. China is growing more sure about its rejection of democracy. Minor banking reforms will not restore the Western system - as GFC reflected failure of whole market-fundamentalist model of capitalism of Thatcher / Reagan period. The challenge for West is to again create a new version of capitalism - eg with reserve banks and governments taking more responsibility for managing economic growth. Western political systems may also need reform to make them faster in consensual decision making. Does government need a heavy involvement in finance, energy, environmental and strategic infrastructure - but less involvement in health, education, pensions [1]

A New World Order: Leadership by Emerging Economies?  [<]

In June 2009 various observers noted that growth in emerging economies had remained relatively strong and that this was likely to: (a) drive future global growth; and (b) indicate the emergence of a 'new world order' [1]. For example:

Though there is gloom and doom in US, Europe and Japan, in some other countries growth powers ahead (eg China, India, Indonesia and Brazil). Government has little debt, and citizens are optimistic. It had been believed that emerging economies had grown because of exports to US / Europe. But not all economies and stock markets have gone down with US / Europe. In West / Japan banks are over-leveraged and dysfunctional, governments indebted and consumers rebuilding balance sheets. But in emerging markets banks are healthy / profitable, governments are in good fiscal shape, currencies are appreciating, bonds are rising. US remains powerful, but global powers have always found problems when they become overburdened with debt and stuck in a path of slow growth [1].

Professor Nouriel Roubini (who predicted the GFC) reportedly suggested that: the rise of emerging markets is a fundamental change; China's economy will eventually grow larger than that of the US; emerging economies are some of the US's strongest creditors, and will gradually lose their willingness to fund US budget / current account deficits;  and there will be a move away from international use of the $US - though this will take many years. [1]

In January 2010, it was noted that though emerging economies had been initially badly affected by GFC (because of dependence on trade and capital flows) they had subsequently achieved better growth and become attractive destinations for investment - though this could prove a bubble [1, 2].

And by September 2010, consumers in emerging economies (especially the BRICs) were being viewed as the saviours of the global economy in an environment in which weaknesses in developed economies (due to high debt levels) inhibited the growth of economic demand.

However the ability of such economies to continue growth may have been little more than a temporary consequence of the shift towards export-oriented growth and the accumulation of foreign exchange reserves (see Global Saving Glut). The latter apparently emerged from a desire to seek protection against possible financial crises which had been favoured as a reaction to the Asian crisis of 1997. The ability of major emerging economies (with the probable exception of India) to do this in the past depended on the willingness / ability of the US (mainly) to compensate for the resulting demand deficits.

Who's Got Superman - email sent 2/9/10

Karen Maley

Re: Saved by the BRICs, BusinessSpectator, September 2, 2010

My interpretation of your article: Stock markets have recovered because hope has emerged despite bleakness of US economic data. Jim O'Neill (Goldman Sachs) in a report entitled 'The world is down, but far from out' concedes the weakness of US position, but does not accept the 'double dip recession' case. Though the world has seen US-led global growth for the past 30 years, there is a new environment - as consumers in the BRIC economies are now important. Thus US financial system is now more important for global economy than US economy itself. Aggressive policies by US Federal Reserve mean that though US economy may be weak, financial conditions have not tightened (and indeed are likely to be further loosened). Robust global growth rates are anticipated despite US economic weakness, because 'decoupling' is becoming real.. China's economy appears likely to become stronger on the basis of consumer growth, and consumer spending is strong in many emerging economies. Though this is starting from a low point, rates of growth are very high. Thus, despite short term weaknesses because of concerns about the US, the outlook for markets is good.

Your article reminded me of a scene from the 1978 Superman movie in which Superman catches a falling Lois Lane in mid air and says "Easy, miss. I've got you", and she replies "You - you've got me? Who's got you?".

The same question unfortunately applies to the BRICs whose growing economic strength over the past decade (and ability to avoid financial crises triggered by under-developed financial systems) has apparently been critically dependent on maintaining export-based growth reliant on excess demand from major developed economies - especially the US (see A New World Order: Leadership by Emerging Economies?).

John Craig

Though most emerging economies had been protected by strong current account and fiscal balances, the IMF pointed out that many had been severely affected by the GFC because of their dependence on foreign capital inflows (mainly from Europe). [1].

While economic activity could be maintained for a time on the basis of accumulated reserves, long term growth in an environment in which such economies were expected to drive global growth (ie support export-led strategies by others and run current account deficits) would require the development of effective local financial systems. Creating financial systems that could operate without current account surpluses (which requires strong demand elsewhere) may be structurally impractical in emerging East Asian economies (eg China) that have adopted variations on the economic model that was the basis of Japan's pre-1990 economic miracles (see Are East Asian Economic Models Sustainable?). China position, for example, seems to be vulnerable, as it seems to involve a 'Ponzi-like' financial system, which would be in crisis if global growth has to depend on demand from emerging economies (see Heading for a Crash?). Expectations that 'Asian capital' could provide the basis for 'financing the world' in future are fanciful, because financial institutions whose capacity to provide finance depends on cash flows (rather than sound balance sheets) clearly could not do so if those cash flows dry up (see Future of the World: Again?).

China may in fact be making determined efforts to create a new international economic and (perhaps) political order because of concern about this constraint (see Creating a New 'Confucian' Economic World?) - though such an initiative  may not be durable.

A fundamental critique of the prevailing global economic and financial system was put forward in June 2009 by André Lara Resende (a Brazilian economist) leading him to conclude that establishing a new world reserve currency might allow emerging economies to increase demand and thus speed the resumption of global growth [1]. This proposal raised complex issues including: (a) the fear of currency crises that led to export-oriented growth in emerging economies; (b) the intractable stagnation probably facing the US economy; (c) the crisis this potentially creates for emerging economies; and (d) the possibility of enabling emerging economies to boost global growth..

Outline: In brief Resende suggested that:  
  • first world societies have assumed in recent decades that economic growth was sustainable (because of effective macroeconomic management) - but emerging economies tended to experience currency crises;
  • to protect against such crises, it became necessary to adopt export-led economic strategies - and accumulate large foreign exchange reserves;
  • world growth has been driven by consumption in leading countries - supported by growing debts. This is no longer sustainable;
  • the GFC reflects the complementary problems of regulatory failures and international financial imbalances. It can't be easily resolved because:
    • monetary policy can't provide a solution to the GFC, as the problem is insolvency not a lack of liquidity. Moreover using monetary policy to relieve bad debts of financial institutions won't restore growth when households / firms merely want to save. Similarly, use of fiscal policy must be ineffective because households just want to save any extra income - so multiplier effect of public spending that Keynes relied on will fail;
    • in the 1930s debts were written off and economies collapsed completely - but they were then able to grow from a much weaker base.  In the current crisis, the US is like Japan in the 1990s. Bad debts have not been written off (to prevent total economic collapse) - but now growth will be limited as new income will simply go to repaying old debts.
  • the US must thus face a long stagnation - though recovery could be accelerated by export-led growth with emerging economies providing the demand;
  • the features that led emerging economies to constrain demand need to be removed, ie their fear of financial crises which results from lack of confidence by those controlling reserve currencies;
  • the GFC reveals problems in the political and institutional framework that emerged from Bretton Woods;
  • China advocated a world reserve currency which might reverse past imbalances due to unrestricted expansion of spending / debts by central countries and conservative export-led stance of emerging countries.


The argument makes considerable sense in relation to the probably intractable nature of the economic trap that the US has fallen into. This, by implication, demonstrates that global economic recovery is likely to be slow and painful - because of the constraints on domestic demand which emerging economies face because of their reasonable fear about currency crises.

However Resende's proposed solution (ie the creation of a global currency) won't necessarily solve the problem (see above).  For example, whoever issues such a currency would be put in charge of global macroeconomic management - because of the role that monetary policy has come to play in this function. The question is how macroeconomic management should now be conducted - and creating a new currency / institutions does not (in itself) constitute an answer to that question. And, as noted below, manipulation of this for the benefit of particular political factions could have even worse adverse global effects than existing arrangements.

The high levels of consumption and build up of debts in the US in recent decades was not solely to serve US interests. Alan Greenspan, as Fed chairman, frequently referred to the need to prevent deflation as the reason for keeping US interest rates low. However deflation was Japan's problem - not one the US itself faced. This clearly demonstrates that US monetary policies were: (a) designed to promote global growth rather than merely meet US domestic needs (and this necessarily led to excesses in the face of demand deficits elsewhere); and (b) probably being formulated in consultation with Japanese officials.

Concern about currency crises undoubtedly constrained domestic demand  in emerging economies. However this arose as much from a lack of discipline in the operation of financial systems and institutions in emerging economies, as because they were remote from those who issued reserve currencies.

Unless those financial systems and institutions operate on a different basis in future, the only way that creating a global reserve currency would enable emerging economies to boost global growth through liberalizing domestic demand would be if the agency which managed the global currency system was prepared to issue SDRs to insiders without regard to return on capital - which is the way financial and monetary systems have tended to operate in East Asian economies.

Furthermore, the way in which East Asian financial systems operate (ie allocating capital to well-connected nationalistic elites rather than on the basis of concern for profitable use of savings) is not only wasteful, but provides no internal means to balance supply and demand and is thus no more likely to prosper than mercantilist economic practices in earlier eras (see A Fundamental Problem: Balancing Supply and Demand).

While it might seem to be socially desirable to allocate capital preferentially so that emerging economies (necessarily poorer) can increase consumption and environmentally desirable to allow 'informed' elites to direct resources to clean industries, neither social justice nor environmental goals can best be achieved through inefficient resource allocation.

Hidden Agendas?

Resende's analysis noted the long period of economic stagnation which the US faces as a result of the GFC, but did not mention the economic peril now facing emerging economies whose ability to avoid currency crises depends on export led development, and the ability to accumulate foreign exchange reserves (or at least not be forced to rely on foreign capital). Not only is US recovery likely to be weak and uncertain, but its government has indicated an expectation of domestically driven growth elsewhere.

A fundamental and un-stated agenda behind this proposal (which has perhaps been developed in consultation with advocates of Asian-style monetary systems) seems to be to overcome limits implicit in the economic model that Japan originated, used as the basis of pre-1990 economic miracles and spread throughout East Asia. That model, which is quite effective in organising economic production, is virtually incapable of doing so profitably (see Understanding East Asia's Economic Models and A Hidden Clash of Financial Systems in Competing Civilizations)..

Thus one real issue lies in the difference between Western-style democratic capitalism (under which market directions are set by enterprises pursuing the profitable use of savings) and neo-Confucian corporatism (which is based on the perception that market directions are best set by social elites in consultation with, and reliant upon the obligations of, their subordinates). Those issues are explored more broadly in East Asia, China as the Future of the World and Creating a New 'Confucian' Economic World?.

One practical difference would be between current global practices under which individuals with initiative can launch enterprises whose success is determined by meeting customers demand, and an alternative under which connections to nationalistic elites (rather than mere initiative) would be needed to do so.

A global financial system in which economic directions could theoretically be set by social elites, rather than by profit-seeking enterprises, would also seem to be compatible with the ideals underpinning Islamic banking practices. The latter also appear to be based on the assumption that morally-motivated elites can produce better economic judgments than profit sensitive enterprises.

Notes on Islamic banking practices:

  • profits and losses are to be shared - and interest is forbidden. Also investments must be acceptable in accordance with Islam. Lenders profit (while not charging interest) by, for example, purchasing an asset, and immediately on-selling it to the person who wants it at a higher price which is paid in instalments [1]  
  • as interest is forbidden, loans (eg 'sukuk' bonds) are presumed to involve partnership in a venture; the arrangement is governed by religious (ie sharia) law rather than by Western civil law (and these can be inconsistent); and securities tend to deliver a lower rate of interest and be illiquid (ie hard to sell) [1];
  • a focus on developmental and social goals (and a religious connotation) is a distinctive feature. As techniques to avoid appearing to pay interest seemed merely a sham, Islamic banking only made serious gains when financial deregulation made fees more important for banks than interest [1]

Straws in the Wind: It can be noted in passing that:

  • a (so called) 'clash of civilizations' has been of concern in relation to international affairs for some years (eg see Competing Civilizations);
  • those seeking to promote institutions based on traditional cultures as alternatives to Western-style democratic capitalism would have been aware of each other's interests;
  • Islamists also appear to advocate the adoption of alternatives to the $US (though this tends to involve a return to a gold standard);
  • Asia (by export-based development) and the Middle East (through oil exports) had the major role in the global financial imbalances whose growth contributed to the GFC (see Financial Imbalances) - though the Middle East tended to direct its surpluses to the Eurozone in the first instance;
  • in 2001 the present writer speculated that collaboration amongst extremists favouring traditional styles of socio-political-economy might have had a role in the 911 events (see Attacking the Global Financial System?).


There seem to be other options to improve the situation. For example, advanced economies (such as the US) might increase their productivity / incomes (and thus reduce their period of economic stagnation) by deploying methods for 'strategic market management' along the lines suggested (in relation to the Australian context) in A Case for Innovative Economic Leadership.

The prospects of emerging economies might be improved by recognition of defects that are built into prevailing business practices and economic 'wisdom' (see Problems with Conventional Wisdom which refers, for example to the distortion of local economic leadership by foreign resource investment and the adverse effects of traditional forms of foreign aid)

And rather than 'behind the scenes' manoeuvring designed to panic the world into a financial and economic 'solution' that would favour particular interests, a process might be put in place which explicitly takes account of differences in cultural traditions and capabilities in getting informed agreement about global machinery which might give all people a reasonable prospect of success (see the now somewhat dated proposal, A New 'Manhattan' Project for Global Peace, Prosperity and Security). The sorts of challenges that need to be overcome were speculated in Competing Civilizations). The latter referred, for example to: remaking effective democracy, ethical renewal, more effective development practices, and rethinking the role of money.

A BRIC forum in Russia in June 2009 sought means to ease the GFC while boosting the role of emerging economies. It called for a stronger voice in global forums; a diversified, stable and predictable currency system; and comprehensive reform of UN in dealing with global challenges [1]. 

There is little BRICs can do to change current global financial architecture. They have 15% of global GDP and 40% of foreign exchange reserves. They are united in concern that US's reserve currency status allows it to run budget deficits without fear of budgetary day of reckoning others would face. Excess $s must be reinvested to avoid damaging currency revaluation. There is little short term prospect of $US alternative - but Russia seeks system where particular motives and countries do not dominate. BRIC countries have little in common. China depends on manufactures' exports. Russia exports oil, gas and other resources. Brazil has agricultural exports, while India's growth is mainly domestically driven [1]

An exchange of views with an advocate of the superior prospects of emerging economies in May-June 2010 is recorded in Emerging Markets: What about the Longer term?.  It presents both that observer's reasons for believing that such economies have prospects that are stronger than those of developed economies, and the present writer's reservations.

In early 2012 concerns about currency appreciation were leading emerging economies in Latin America (notably Brazil) to express concerns about 'currency war'. At the same time it was noted that state-owned companies in other BRICs were sacrificing profits to maintain economic activity - just as China seemed to be doing [1]

A US Response to the GFC : Backing Away from Bretton Woods?  [<]

In March 2010, it appeared possible that the US might respond to the economic pressures that it was facing by backing away from the post-WWII Bretton Woods international order under which the US provided allies with access to its markets on condition that the US could exert a high level of control over security and foreign policy issues. Efforts seem to be focused on now boosting US exports.

US / China relations are strained because China's controlled currency allows it to boost exports - a tactic that is accepted in small developing economies, but becomes a problem in one of the world's largest economies. China has had strong growth since 1980s but like Japan and non-Chinese East Asia these dramatic growth rates can't be maintained. The driving force behind Japan's 1990 crisis and the 1997 East Asian crisis was that countries involved did not have free capital markets. These states kept costs artificially low - giving advantages over countries where capital was allocated rationally. China's economic system is unstable. China's impressive growth depended on government maintaining near-total capture of national savings, and directing this at low interest rates to state-run banks. Huge growth is possible using the savings of 1bn people, resulting in huge supply of 0% consequence-free loans. However this will also be unprofitable - and China (like Japan) works on market share not profitability. US system focuses on profitability - and is more able to cope with recessions. Chinese system results in social instability if hardship emerges. China's system generates other unintended consequences (eg  inefficient capital use; property bubbles; regional disparity; lack of domestic consumption; dependence on others to take exports). To cope with global recession, China's government recently had to triple the amount of cash made available to banks - and (given no-consequence lending practices which just aim to employ people) much was wasted. While China is trying to fix its system, these changes are only at the margins. China's growth has occurred while US administration was mainly focussed on other issues (eg 'Evil Empire' and war against terror). Also the post WWII Bretton Woods regime has changing. Under this US allowed allies free access to its markets, on condition that US could control security and foreign policy issues. But Obama administration has now  launched National Export Initiative with a goal of doubling US exports over 5 years. While details are sketchy, this type of policy has not been considered since WWII. If this is effective China is very exposed - and Japan (whose financial system China copied) shows how collapse can occur. China has limited options - as US can constrain market access. If China were to retaliate by limiting investment of its reserves in US, this would compound its problem (by further reducing US consumers' ability to buy China's exports). There is increasing fear in China about its outlook. (Stratfor 'China on a knife edge', 2/4/10)

In June 2010, US president suggested that currency flexibility that China adopted in lead up to a G20 summit would be expected to result in very significant (eg 20%) appreciation by yuan - not immediately but over several months [1]

US efforts to reduce / reverse its current account deficits seems likely to (a) be unavoidable due to constraints on other sources of demand to sustain US growth; and (b) likely to adversely affect countries (especially those in East Asia) that are highly dependent on current account surpluses (see China's Economic Performance) .

This effect will be amplified by the apparent need to reduce the rapidly expanding role which financial services have played in the growth of developed economies particularly since the 1990s.

Initiatives that are likely to contribute towards reducing / reversing US current account deficits include: (a) QE2 increase in liquidity that seems likely to trigger 'carry trades' to emerging economies (and thus asset inflation and increased spending) - see Currency War?; and (b) exploration of options for significant reduction in US budget deficits [1]

Restricting the Economic Role of Financial Services?  [<]

In April 2010 proposals emerged that could have the effect of significantly changing the role that financial services play in developed economies - because of concern about the instabilities that can result.

US president Obama has proposed tighter restrictions on the way big banks operate - and criticised them for resisting such changes [1]

The real contribution to GFC was not fraudulent behaviour within financial institutions, but rather the legal risks that gamblers could take within the system. The role of big institutions is an obvious problem - as they are the house / biggest players at gambling tables / agents for other players / and beneficiaries of limited liability and government guarantees when things go wrong. Possible solutions include: (a) restore tightly regulated financial system - which would be 'stodgy'; and (b) making current system safe. This might require (a) increased capital requirements (b) require institutions to have liabilities that can be converted into equity in bankruptcy; (c) make capital requirements more counter-cyclical; (d) require banks to hold assets that can be easily valued by lender of last resort; (e) change internal incentives to favour long-term rather than short-term gains (f) increase capital / collateral requirements against derivative trading; and (g) improve information availability. Even so system would have problems because of (a) inability to decide how much capital is enough (b) risks can be structured so that others face main consequences and (c) risk can be created via regulatory arbitrage.  Alternatives that have been suggested include (a) banning propriety trading by insured institutions (Paul Volker); (b) a 'narrow banking' system under which deposit taking institutions would be safe, but others would not be (John Kay). ; and (c) making deposit taking institutions into mutual funds so that all risk is taken by depositors (Laurence Kotlikoff).  Any change to make present system safer would be major. Any system in which financial intermediaries take risks on their own behalf will be inherently unstable [1]

There is an inherent boom-bust risk associated with the activities of financial institutions due to the feedback relationship between increases / decreases in the availability of credit, and increases / decreases in the level of 'real' economic activity and the perceived value of assets - a phenomenon which George Soros described in The Alchemy of Finance. What seem like virtuous feedbacks during a boom, can become vicious when a boom is perceived as a bubble and bursts. Authorities may be able, at considerable cost, to rescue too-big-to-fail financial institutions after a crisis emerges, but still apparently have no real way to judge when a burst-able economic bubble is emerging (see Booms and Busts: Unsatisfactory Tools for Macroeconomic Management).

Thus, while the risks associated with the behaviour of financial institutions may be reduced by tighter regulation, the potential for instability will remain serious unless that regulation constrains the ability of financial services to contribute to speculative bubbles (eg by limiting the 'paper' economy to a secondary role in support of the 'real' economy).

A close correlation was suggested in 2013 between escalating levels of debt over several decades to 1933 and 2007 and the growth of financial industries. This was followed after 1933 by a collapse in both overall debt levels and financial industries' share of GDP back to levels that had prevailed prior to the escalation.

Even more fundamentally, it can be noted that Western societies arguably gained strength by creating social environments in which individual rationality could be an effective means for problem solving - and thereby dramatically increased the effectiveness of individuals in all walks of life.  The use of money as a means of exchange and as a store of value facilitated rational decision making by individuals. However the development of complex financial systems resulted in the creation of feedback relationships that individuals have no means for recognising or taking into account - and this reduces scope for the effective use of individual rationality. These and other reasons for concern about reliance on financial criteria as the basis for thinking about economies are suggested in Fixing Australia: Do the Econocrats have the right answer?

Concerns have been expressed that regulation of financial institutions in the US will have the effect of damaging financial services industries (an outcome which is arguably necessary).

Reforms to US financial system include new consumer protection arrangements; more scrutiny for big banks and protection of taxpayers against future losses. Opponents argue that measures will over-regulate the industry (Hitt G etal 'Senate backs sweeping financial sector changes', Australian, 22-23/5/10)

In 2015 it was argued that the overall impact of financial innovation (eg derivatives, structured products, high frequency trading and improved communications) might be negative. For example. derivatives allow borrowing and lending with very low margin requirements - and no clarity about the real levels of leverage involved (and thus of the riskiness of the market).  Traditional arrangements have been replaced by more risky alternatives - which allows trading with less capital and less responsibility for the stability of firms or the market as a whole [1].

In early 2016 it was suggested that the fractional reserve system which allows private banks to create money mihjt be a significant problem - so that this role in future should be played by government institutions [1]. [CPDS Comment: Other observers would presumably point out that allowing governments that are influenced by interest group politics to 'print money' would be a formula for irresponsibility and hyper-inflation].

Clearly reforms that restricted the role that financial services play in developed economies would have consequences - because knowledge-intensive industries (especially financial services) have played a significant role in the diversification of developed economies since the 1990s as many traditional industries were increasingly challenged by emerging economies. Expected consequences would include:

  • an urgent need for developed economies to create new sources of competitive advantage in high productivity activities. Ways in which this these might be developed are speculated (in an Australian context) in A Case for Innovative Economic Leadership;
  • a further reduction in the potential for export-based growth in emerging economies - because: (a) the ability of the US (mainly) to sustain large current account deficits depended on its financial system's ability to productively deploy offsetting capital inflow; and (b) as noted above, fiscal constraints are already forcing the US to shift from its post-WWII role as 'consumer of last resort' towards a search for export-based growth;
  • increased risks of financial crises in emerging economies (especially those in East Asia) if their economic methods are not radically transformed for reasons suggested in Are East Asian Economic Models Sustainable? and Time May not be on China's Side .

Too Hard for the G20  [<]

The G20 Summit in June 2010 sought to find a path to sustainable global growth, at a time when the side effects of 'emergency room' treatments (ie the unprecedented fiscal and monetary stimulus measures) used to prevent the GFC turning into a depression were coming to be recognised (eg because, in the BIS's view [1, 2], they distorted economies and inhibited post-crisis adjustments).

Theoretical Uncertainty

All mainstream economic theories are in disarray because of GFC.  It is unclear what more governments can do to prevent a double dip recession. Would bigger government deficits stimulate the economy as Keynesians claim, or will government debts lead to financial crisis.  Government debt / GDP ratios are often high - those benefits of stimulus can be lost in: higher interest rates; falls in private spending; and through possible bank crisis if government bonds decline in value. UK and Germany's plans to cut deficits is seen as lunacy by leading economists. But others argue that US's spending, while initially helpful, raises the risk of a future debt crisis. Some analyses have found that budget cutbacks in developed economies have had an expansionary effect. Theories about the effect of monetary policy have also been challenged. The disconnect between economic theories and practice is ominous [1]

However the risk of serious economic instability in the medium term remained severe due to the G20's failure to address most of the complex changes needed for sustainable economic growth that the GFC had exposed (eg the need to: (a) do more than recapitalise banks to overcome constraints on the availability of credit; and (b) invent new techniques for macro-economic management - given that the use of both fiscal and monetary policies seemed to have been compromised).

In particular it failed to gain agreement on ways to reduce the financial imbalances that must make sustained growth impossible for reasons that the present writer first suggested in Structural Incompatibility Puts Global Growth at Risk (2003).

In fact the G20 seemed to turn a blind eye to the limits imposed by those imbalances - just as it had done in April 2009 (see Announcing 'Peace in our Time'), despite analysts' increasing recognition of the problem. The G20 seemed oblivious to (perhaps because of Western leaders' ignorance of) the role that neo-Confucian models of socio-political-economy in Asia played in those financial imbalances, and that the latter also had a non-trivial role in generating the GFC (because the demand deficits required by the neo-Confucian economic models had to be balanced by excess demand elsewhere if global growth was not to stall, and this was achieved by easy monetary policy mainly in the US which led to the accumulation of large debts).

Rather than dealing with such complexities the G20 appeared to focus on reaching a compromise between the incompatible opinions of US and German leaders (each of which had some validity) about the role of fiscal policy in macroeconomic management - even though the limits to which fiscal policy could be the basis of macroeconomic management had been widely recognised in the 1970s.

Observer's Views

Initial G20 summit was a success, but the world has since fractured into blocs with dangerously different interests. Pittsburgh summit resulted in agreement on G20 as principal forum on economic coordination, coordinated policies to support global recovery; and a process of mutual per review of action through IMF. However actions taken in US and Europe are making key problem of financial imbalances worse. Europe with current account surplus is tightening budgets, which will make imbalances worse. US had called for additional stimulus measures - and let it be known that it won't continue to be treated as consumer of last resort. Peripheral European states and UK with high budget deficits have a strong case for tightening - but Germany has also done so despite current account surpluses and weak domestic demand. Germany disagrees with US focus on short term effect of stimulus measures, and prefers to focus on longer term impact on confidence. US's budget problems are similar to UK's. China liberalised its exchange rates to avoid being a focus for the G20 in Toronto - but lobbying in US for protectionism against China on the grounds of currency manipulation is likely to be strong. China has its own vulnerabilities as domestic demand has been boosted by an unsustainable surge in lending. International economic tensions are rising in ways that G20's peer review process can't contain [1]

There is debate about whether global recovery requires fiscal stimulus (which will increase sovereign debts - in some cases seriously and thus raise interest rates) or fiscal consolidation (which could put struggling economies on a path to debt-deflation as in the 1930s) [1]

G20 meeting is to encourage countries to halve budget deficits by 2013 and have debts under control by 2016. Tensions between countries seeking austerity measures and the US who warned about withdrawing stimulus money were headed off by agreeing that one size does not suit all. There was no agreement on unified approach to fiscal policy or to imposing levies on banks (Mann S., 'G20 aims for fiscal balancing act amid debt fears', 28/6/10) 

G20 leaders endorsed targets to cut deficits and agreed to pursue higher capital requirements for banks once their economic recoveries take root ('G-20 near accord on growth, deficits ', 28/6/10)

G20 participants disagree- and simply try to put a good face on things. In 2008 and 2009 everyone wanted the same thing, so agreement was easy.  Now fiscal cooperation seems essential because of financial imbalances. Germany is rightly being criticised, but the UK also seems needlessly severe. US would be right to lecture others, except that: (a) it's poor policies and management led to the problem in the first place; and (b) its fiscal policies are a shambles (eg stimulus money was wasted). Failure to get agreement about financial regulation and trade are even more serious problems [1]

G20 governments have set an impossible goal of reducing government debts (because of financial markets' concerns) while encouraging economic growth. German finance minister ascribed current problems to massive budget deficits which could lead to higher inflation. US concerns about the risks with ending stimulus was also recognised - and G20 tried to accommodate both viewpoints by juggled wording. Efforts to cut deficits might succeed, but cutting debt / GDP ratios might be hard given aging populations. [1]

US and Germany are at loggerheads over spending - and the cooperative consensus that brought the G20 together has disappeared. US President (partly backed by France) wants economic stimulus to continue, while Germa Chancellor (aligned with UK's new leadership) favours austerity. US President is mainly worried about electoral impact of a double-dip recession - and wants to continue spending even though US's public debt situation is worse. German Chancell'r approach is equally political - preaching Teutonic virtues of fiscal discipline. German Finance Minister recently described these differences as having deep cultural origins - with Germans preferring a longer term approach and US focused on short term issues [1]

G20 highlighted contrasting approaches to financial recovery. US and Europe are moving in completely different directions. Europe sees austerity to ward off risks associated with government debts. US, facing similar budget issues, believes that it is too early to cut spending. US is approving financial reform package, much ahead of Europe. Politics party explains these differences. But there is a more serious issue related to trade and impoverishing one's neighbour. US expected export-led recovery due to devalued $US - though China's rigidity was a constraint, though it was believed that this would be overcome. China finally obliged with minor adjustment. But Europe's currency has sunk 20% - so US exporter's position has not improved. Behind apparent philosophical difference over economic policy, there is a more concrete concern about trade. Much of international problem during great depression resulted from competitive devaluations. There is a danger again of this, and liberalizing trade will be difficult. There is a need for separate and serious negotiations over trade [1]

The G20 seemed to agree that everyone would 'do their own thing' with some sort of general trend towards reducing fiscal deficits and government debts in a few years time.

This left unanswered the question of where the demand would come from to sustain global growth in a situation in which private demand seemed weak world-wide. The US was not in any position to (and said it wouldn't) remain as the 'consumer of last resort', while others made it clear that they wouldn't pick up the burden (and the associated increasing debts). This situation had clear parallels with conditions in the 1930s that led to 'beggar my neighbour' competitive devaluations, the US's Smoot-Hawley tariff and the collapse of international trade. Though in 2010 it seemed more likely that there would be a drift towards 'competitive austerity' (which the US ultimately would have no alternative to joining), the outcome would be similar.

The US President said that he expected China to significantly increase the value of its currency [1] apparently in the hope that this would alter international financial imbalances and in ignorance of the fact that: (a) changes in exchange rates have historically had little impact on trade imbalances (because of the importance of established production capabilities / distribution networks etc); and (b) if trade imbalances were altered to the extent necessary to make any material difference to the financial imbalances, China's economy would be wracked by severe financial crises - an outcome that China's authorities would not willingly allow.

Professor Nouriel Roubini (one of the small number of observers who anticipated the GFC on the basis of risky financial practices in the US) subsequently expanded his analysis to take account of the need for coordinated responses which would not only promote growth but also correct the financial imbalances that otherwise make growth unsustainable. And it is possible to see the influence of these ideas in the G20's deliberations.

Outline of Roubini N., 'How to avoid a double-dip global recession', Australian Financial Review, 17/6/10)

Failure to sustain demand could be fatal for global economy.  There is debate about how and when to exit from monetary and fiscal stimulus that prevented Great Recession of 2008-09 becoming a depression. Germany and the ECB push for fiscal austerity, while the US worries about early fiscal consolidation.  If stimulus is removed too soon, then there is a risk of recession / deflation (if private demand is weak). While fiscal austerity may be vital in countries with high deficits / debts, cutting government spending and raising taxes may make recession / deflation worse.  But the alternative could be sovereign debt crises - or monetisation of debts which forces up interest rates. For the last decade the US (and other deficit countries such as Australia, UK, Spain, Greece, Portugal, Ireland, Iceland and Dubai) have been consumers of first and last resort - and run current account deficits. meanwhile emerging economies especially China (and also Japan, Germany and a few others) have been producers of first and last resort. Over-spenders are now cutting back - to import less, reduce external deficits and de-leverage. But if surplus countries don't offset this with extra spending, there will be a lack of aggregate global demand - leading to another slump.

The way forward should involve:
  • countries which need fiscal austerity making monetary policy much easier to compensate:
  • countries where bond-market vigilantes have not yet awakened (US, UK, Japan) maintaining fiscal stimulus - while designing credible plans for fiscal consolidation in medium term;
  • reduced savings by over-saving countries (China, emerging Asia, Germany and Japan) -  specifically China and emerging Asia should implement reforms that eliminate the need for precautionary savings and let currencies appreciate; Germany should maintain fiscal stimulus into 2011; and Japan should reduce current account surplus and stimulate real incomes / consumption;
  • countries with current account surpluses letting currencies appreciate - while ECB should follow easier monetary policy to accommodate gradual further weakening of euro to restore euro-zone competitiveness;
  • countries with private sector de-leveraging maintaining fiscal stimulus as long as markets don't see this as unsustainable;
  • phasing in regulatory reforms that increase liquidity and capital ratios for financial institutions in to prevent a further credit crunch;
  • restructuring household debts in countries where housing booms have burst and the debts of governments that suffer insolvency - to prevent debt deflation and contraction of spending.  

In general de-leveraging (by households / governments) should be gradual and accompanied by currency weakening - to avoid a double dip recession. Countries that can afford fiscal stimulus and need to reduce savings should contribute to global current account adjustment (via currency adjustments and increased spending) to prevent shortage of aggregate global demand.

Failure to implement coordinated policy measures could lead to severe double-dip recession in advanced economies - with consequent risks in global financial markets, as well as a series of sovereign debt defaults and damage growth prospects of emerging economies 

However even such proposals contained limitations. For example:

Even if the G20's failure to deal with international financial imbalances did not result in another victory for protectionism in the US, global growth could not be sustainable.

The expectation that surfaced in (about) August 2010 that emerging economies could provide the demand to drive global growth reflected a failure to consider that such economies had been able to prosper on the basis of export-led growth because current account surpluses were needed (and adopted because they had proven successful in East Asia and been advocated by the IMF) to protect poorly developed financial systems from financial crises (see above).   Economies, whose financial stability depends on current account surpluses, can't provide the demand that now-heavily-indebted developed economies can no longer provide without simply setting themselves up for financial crises.

Moreover, in the absence of Asia-literate Western leaders, managing the resulting economic breakdown and international stresses would be beyond the G20 (just as a lack of real Asia-literacy had been leading to ill-informed domestic decisions by political leaders in Australia).

The global economic breakdown through 'competitive austerity' that the G20's failure implied would seriously damage (East) 'Asia', but there was little that that region's leaders (eg in Japan and China) could do to prevent this under the prevailing international order based on Western democratic traditions (ie those that incorporate features that are unnatural in (East) 'Asia' such as individual initiative, a rule of law and economic coordination through profit-seeking by independent enterprises) - see China may not have the solution, but it does have a problem.

In the face of 'competitive austerity', China's proposal for a new reserve currency system to replace the $US (through IMF-managed Special Drawing Rights) might be seen as a way to overcome the global demand deficit by providing credit to enable emerging economies (with notionally sound balance sheets because foreign exchange reserves had had to be accumulated because of their underdeveloped financial systems) to increase demand. However the latter proposal unfortunately contained severe defects (see above).

Alternatively, initiatives by Western societies (eg those the present writer suggested in China may not have the solution, but it does have a problem) seemed more likely to provide a constructive path to sustainable growth though they needed to be extended to helping 'Asia' to cope with the consequences.

In September 2010, it was argued that the G20 would be incapable of generating solutions to any global challenges - because it incorporates the range of countries who have significant influence but these have many different attitudes towards democracy, the economic role of government and the importance of transparency in investment - and that as a result the world was entering into an age of instability [1]

In October 2010 IMF and World Bank meetings were no longer seen to reflect the peacefulness of G20 meetings. Countries are retreating from cooperation.  Major developed economies are limping alone, and major emerging economies such as China are unwilling to do more [1] In the face of a possible 'currency war' the US sought to focus more directly on trade imbalances that were the source of these problems (eg by setting limits to trade imbalances) but this was opposed by major exporters - Germany and Japan [1]

'Currency War': A Counter-attack by the Federal Reserve?'

In late 2010, after considerable discussion, the US Federal Reserve launched a major new round of quantitative easing (QE2). This involved, in essence, printing money ($US600bn) to buy long dated US Treasury securities. 

This was nominally intended to stimulate a stagnant US economy (and seemed necessary because of the risk that banking system losses would have on the availability of credit). However for reasons outlined below the move seemed to the present writer to also:

  • be a virtual counter-offensive in relation to a generally-unrecognised 'Financial War' that had been being launched from East Asia for some decades; and
  • have broader goals than merely stimulating economic recovery, ie to create financial difficulties for countries reliant on the international financial imbalances that contributed to pre-GFC asset bubbles in the US, and thus to the GFC (see Impacting the Global Economy) and which now inhibited US economic recovery. 

This tactic could perhaps be likened to the 'pedal to the metal' methods used by the US to break the USSR in the Cold War (ie run an arms race flat out to see whose economy fails first). Putting pressure on financial systems by boosting liquidity is one way to find out whose financial system is most at risk - and the answer to this is by no means certain.

Threats to the World (Email sent 4/11/10

Philippe Legrain

Re: US economic policy is a threat to the world, 4/11/10

There is no doubt, as your article suggested, that aggressive US monetary policy is likely to be domestically ineffective and economically dangerous for the world. However the issue is more complex, because the world economy was already is desperate peril because of the macroeconomic distortions (ie structural demand deficits) that are embodied in East Asian financial systems (see Understanding East Asia's Economic Models and Impacting the Global Economy).

The fact that those financial systems constitute a novel form of protectionism, and are also probably reaching their ‘use by’ date, is explored in Proposed ASX Takeover: Lifting the Level of Debate.

It seems very likely to me (for reasons outlined in attached email, ‘Fed’s Version of Financial Warfare?”) that the current Fed tactic is not so much designed to stimulate US growth as it is a last-ditch effort to expose and demolish the macroeconomic distortions embodied in the financial systems of major East Asian economies (and in the emerging market economies who have also concealed their underdeveloped financial systems behind export-led growth strategies).

John Craig

Fed's Version of Financial Warfare? (Email sent 28/10/10)

Ambrose Evan’s Prichard

Re: Fed’s Impending Blunder, 27/101/10

The world is getting very interesting.

The primary consequence of QE, given de-leveraging in US, must be to feed into a $US carry trade boosting asset values and spending in emerging economies (as these currently seem the best prospects for profitable use of capital) – see some comments on Overlooked Issues Affecting Australia's Banking System.

It can also be noted that the asset inflation in the US whose bursting led to the GFC was largely associated with: (a) various forms of ‘carry trades’ of liquidity into the US from emerging economies (mainly those in East Asia); and (b) the necessity for the Fed to maintain very low interest rates if global growth was not to stagnate (given the demand deficits that characterised emerging economies) – see Impacting the Global Economy. Thus what is happening through QE can perhaps be seen as a counter-attack against economies whose under-developed financial systems require large and ongoing international financial imbalances.

Your article validly noted the likely inflationary effect of QE (given the emerging recovery in the velocity of money). However, when this happens the Fed will be forced to put QE into rapid reverse – and asset bubbles that have developed in emerging economies are likely then to lead to financial crises. What is happening may very well not be a simple-minded blunder. Of all analysts, Bernanke was the most vocal in raising issues related to ‘savings gluts’ (ie demand deficits) in Asia, and what could be happening could be intended to erode the viability of such tactics.

I note also that there seems now to be recognition in the US (see The Fed Debates: Is Unemployment Structural or Cyclical?, 20/10/10) that its’ economic problems may be structural rather than merely cyclical – and given such a recognition there are certainly many steps that could be taken improve its’ situation – and QE, with goals similar to those suggested above, would merely be one of these (see China may not have the solution but it seems to have a problem).

John Craig

Many of those countries (eg China, Brazil and Germany) expressed serious concern about the Fed's action - because of the likely adverse effects on their economies of large capital inflows (ie stimulating the same sort of asset inflation that the US had experienced in the past as a result of unwanted capital inflows) - and proposed measures to control capital flows. Brazil's finance minister (the first to warn of pending 'currency war') suggested that it was necessary for the US economy to recover, but that this had to be achieved by stimulating consumption in the US - eg with fiscal policy [1]. However, given that the US seemed no longer willing, nor able, to be the world's 'consumer of last resort' (see above), this clearly was not the Fed's goal.

In January 2011 a US observer suggested that China's exchange rate was a minor issue in terms of getting a better deal for US businesses in China, because revaluing the Yuan (which he saw as the goal of Federal Reserve's QE2 program), would not create US jobs [1]

China in particular is likely to be significantly affected because its currency is linked to the $US - while being undervalued just as $US is overvalued. QE2 liquidity will flow into undervalued segments of the dollar economy - and this will cause further overheating of China's economy [1]. China rejected US calls for measures to rebalance global trade (eg by limiting current account surpluses or deficits to 4% of GDP), and instead suggested that QE2 was the biggest threat to the global economy [1]. 

A Chinese rating agency (Dadong Global Credit Rating Co) criticises US central bank's money printing - which will cause $US to drop and lead to losses for investors. It warns US not to rely on loose monetary policy, and suggests this could put US solvency at risk. This suggests that China might reduce $US government bond purchases, and force up interest rates. Dadong suggests that credit crunch still exists in US. US credit crisis has morphed into monetary crisis. US has resorted to depreciating its currency and this shows the weakness in its economic model. Dadong argues that US has long relied on credit expansion to drive economic growth - and US can't repay this without massive increase in real value of domestic production. US government has amassed huge debts, but is exporting these through $US depreciation. This will reduce confidence in $US. US exports are mainly high tech products (some of which are restricted for security reasons) while its imports are energy and household items. Trade deficits can't be improved because US exports are not everyone's needs. Thus Dadong predicts long-term US current account deficit. However Dadon's main criticism is of quantitative easing - as this is likely to force up interest rates. The outcomes is suggested to be mainly damaging to US [1]

China, it may be noted, would be extremely vulnerable in the event that global economic growth were disrupted because its ability to avoid a medium term financial crisis associated with the poor balance sheets of its institutions seems to be critically dependent on strong ongoing cash flows (see Heading for a Crash?).

However the fact that countries concerned about the flood of new liquidity can't protect themselves by raising interest rates (as this would merely increase the 'carry trade' effect) means that capital controls are likely - and this could disrupt the global financial system [1]. Such a disruption (which now seems difficult to avoid) will be bad news for both emerging economies and for the US (because the lead role in making risky investments with the proceeds of the Fed's monetary easing is likely to be taken by US financial institutions).

In March 2011, another proposal emerged (from the G20 with conditional support from the US Federal Reserve) that could help to reduce international financial imbalances. This involved the G20 lending 'hard' currencies to emerging economies who are experiencing short term financial crises (in the expectation that this would reduce their need to hold large foreign reserves). It was apparently envisaged that the hard currencies that the IMF might provide would have to be drawn from the foreign reserves of countries such as Japan and China [1]. This was a variation on proposals for the IMF to issue SDRs under those circumstances (because SDRs would have had to be backed by hard currencies anyway). It was an interesting concept. The goal was presumably to reduce both the risk of financial crises in emerging economies, and the financial imbalances that arise when such economies seek to hold large foreign reserves. It would place responsibility for financing measures to counter international financial risk on countries such as Japan and China whose distorted domestic financial systems are primary causes of the financial imbalances (see Understanding East Asia's Neo-Confucian Systems of Socio-political Economy).

In early 2012, widespread concern was being expressed in Latin America about the effect that rapidly appreciating currencies were having on industrial competitiveness [1]. And Brazil again suggested that monetary policy expansion in the US and EU constituted a form of 'currency war' [1]

In August 2012, much stronger proposals for quantitative easing emerged in Europe in response to market aversion to sovereign debts in countries such as Spain [1]

In October 2012 concerns were being expressed about the effect in Asia of the US Federal Reserve's 'pedal to the metal' loose monetary policies. Stocks, currencies and real estate markets were sharply higher, and governments were struggling to contain the inflationary pressures. Indonesia, the Philippines, Thailand and Malaysia were seen to be likely to be more affected than China which restricts capital inflows (Law F., 'Investment flood hits Asia, The Australian, 24/10/12)

In December 2012 the adverse effects of 'pedal to the metal' monetary policies were being noted, though apparently without adequate understanding of the issues involved.

Monetary Madness - email sent 14/12/12

Stephen Grenville

Re: A Keynesian solution to monetary madness, Business Spectator, 13/12/12

Your article suggests that ‘flat to the floor’ monetary policy settings have been in place since the 2008 GFC – and are having adverse global consequences (such as the emergence of what can be seen as a ‘currency war’).

While this is undoubtedly correct, it is an over-simplification.

Excessively accommodative monetary policy had existed before 2008 and this in fact contributed to the GFC. However this was largely a way of maintaining growth in the face of the demand deficits / savings gluts that existed because of seriously distorted financial systems elsewhere, especially in Japan and China – as suggested in Progress Towards Ending the GFC?. And the Fed’s ‘currency war’ is now having an adverse effect on others (ie generating potentially de-stabilizing capital inflows) which is similar to that which other’s had long done to the US through their adoption of mercantilist economic tactics (see Currency War?).

John Craig

Follow-on email on 14/12/12 to Steven Grenville in reply to a response to the effect that:

Chinese imbalances had only a minor role in the GFC. Those within the EU were much more serious in their consequences. And current low interest rate policies of the advanced countries are analogous to China's exchange rate policies.

There is no doubt that imbalances within the EU have had serious effects. However this is due to the effect of a common currency on economies with radically different economic capacities.

The imbalances that have their origin in other factors (eg the savings surpluses by major oil exporters and in countries in East Asia and elsewhere with unreliable financial systems) were a major factor (though not the only factor) in giving rise to the GFC (see Structural Incompatibility Puts Global Growth at Risk, 2003; Financial Market Instability: A Many Sided Story, 2007; GFC Causes; and Leadership by Emerging Economies?).

In Asia it was Japan that seemed to do most of the damage (see Unrecognised Clash of Financial Systems). China became involved only as a relative latecomer (that soon became significant because of its size) after it adopted a variation on Japan’s neo-Confucian system.

I certainly agree the loose monetary policies by Federal Reserve and others (that amount to ‘currency war’) are likely to be equally damaging. However I suspect that the reserve banks can’t think of anything else to do to force financial system reforms in countries with large and persistent current account surpluses because of poorly developed financial systems. I suspect that they are wrong about this, as there are probably many other steps that could be taken (as outlined in China may not have the solution, but it seems to have a problem).

John Craig

In April 2012 a sudden collapse in the price of gold suggested the possibility of a further stage in the 'currency war' because of the role that gold had come to play in the foreign exchange reserves of countries such as China at the expense of $US.

Another view of gold - email sent 16/4/13

David Llewellan-Smith

Re: ‘Gold crash heralds return of King Dollar’, Business Day, 16/4/13

Your article suggests that the precipitous crash in the value of reflects the fact that we are now in a ‘risk off’ period because the monetary easing by reserve banks has created a sustainable path to global growth – so that there is no longer any need to hold gold as a hedge against a possible collapse in the value of the $US (eg because of US’s apparently-insoluble government debt problem and the Federal Reserve’s aggressive quantitative easing / money printing).

However it is possible (though not certain) that the explanation is quite the reverse of this, because:

  • It is quite implausible to suggest that gold is collapsing in value because investors are convinced that things are going well when the stock market is also undergoing declines (eg see 'Worst day of the year for US stocks, Business Day, 16/4/13)
  • The global financial system is headed for another crisis – as far as I can see (see Debt Denial: Stage 3 of the GFC?). Moreover:
    • One significant cause of this problem is that financial systems in major East Asian economies (eg China and Japan) don’t involve taking profitability seriously and thus require that (a) domestic demand be suppressed to avoid the need to borrow offshore; and (b) their trading partners be willing and able to perpetually increase their debt levels (see Impacting the Global Economy); and
    • there are simultaneously real risks of financial crises in China and Japan – because global economic instabilities would prevent the ‘world’ continuing to protect the poorly developed financial systems in East Asa;
  • There has been a ‘currency war’ underway for many years as a result of the incompatibility between global and East Asian financial systems (see Unrecognised Clash of Financial Systems ). For example Japan was the world’s major source of credit for many years prior to the GFC but had a financial system that did not allow credit to be made available for domestic consumption. This generated ‘carry trades’ which made cheap credit available elsewhere and contributed to the asset bubbles that burst as the GFC. Then the US responded in kind with aggressive monetary easing (ie to do unto others as they have done unto you) – see Currency War. And recently Japan has again launched aggressive monetary easing – at a time when it is headed towards current account deficits (and thus potentially having its bad national balance sheet exposed). I have recently had communications with former World Bank expert on China’s financial system. He concedes that China has a bad balance sheet, but that this doesn’t matter because China’s large foreign exchange reserves provide a protection against sovereign risk. Initially such countries held their reserves mainly in $US – but recently there has been a clear sign of a shift towards holding reserves in gold;
  • The fact that the $US has been the world’s reserve currency provides major advantages to US (because it allows it to create credit in its own currency) and also generates problems (such as those associated with manipulations by Japan and China). The shift to gold as a backing for foreign exchange reserves of major creditor countries threatens $US status – and also US’s economic, military and diplomatic strength.
  • In this environment it is possible (though not certain) that attempts to crash the value of gold could be a means to create problems for those who have been endeavouring to undermine the reserve currency status of $US;
  • This financial / economic environment is also characterised by other signs of potential geopolitical tension and instability (see 'Art of War' Speculations about North Korea's Threats – which incidentally had included speculations that terrorist attacks against US might be expected under one particularly nasty scenario).

Though there is no certainty, it seems to me that the crash in gold value combined with other symptoms of potential instabilities implies that the world could be in for significant political and economic turmoil.

John Craig

Later speculations about a variety of scenarios and the lack of transparency that makes understanding difficult are included below as Interpreting the Canary in the Gold Mine

Massive quantitative easing (ie roughly equal to that in a the US despite Japan's smaller economy)  was initiated by Japan in early 2013 (as part of the (so called) 'Abenomics' economic recovery program which also involved fiscal stimulus and regulatory reforms).

[CPDS Comment: This seemed likely to be an attempt to restore the outward 'carry trades' that in the 1990s and early 2000s had reduced reduce the risk of current account deficits that would potentially create financial crises in Japan given its 'non-capitalistic' financial system (ie where profitability is not taken seriously). Japan's position was becoming precarious because of very high government debt levels (200% of GDP), the emergence of current account deficits that would have required foreign borrowing and the potential official misrepresentation of the financial position of its banking system (see Japan's Predicament and Another 'sting' driving Japan's urgency?).]

In May 2013, it was noted that quantitative easing by the US Fed (ie the 'Currency War') had, in fact, generated large capital flows to to emerging economies with poor financial systems (because it had increased the availability of credit and reduced the scope for using it productively) and thus created very real prospects of financial crises in emerging economies when the Fed tightened and the $US thus strengthened.

In later 2013 it was noted that the prospective 'tapering' of QE in the US:

  •  was making Asia's economic miracle look increasingly vulnerable. Despite the region's thrift, low debt and high savings an ebbing tide of global credit is exposing  the region to rapid reversal of capital inflows like that which triggered the Asian financial crisis in 1997 and 1998 (to combat which huge currency reserves and policies to counter the risk were put in place) [1]
  • required many countries to sell foreign exchange reserves to defend their currencies, which threatened to inflict a credit shock on global economy. Rising economies in Asia, Latin America and the emerging world hold $9tr in reserves. Fed tightening and rising $US set off Latin America's crisis in early 1980s and Asian crisis in mid-1990s. Emerging markets now have more shock absorbers (ie borrowing in own currencies). But they are now over half global economy - and are significant enough to set off a crisis in the West. Fears of Fed tightening is forcing interest rates higher. Thus emerging markets are being forced into austerity and to seel foreign exchange reserves. China's reserve build-up compressed global bond yields - leading to property bubbles and equity booms in West. Reversing this could be painful. China sold $20 of foreign exchange reserves in June. Others are doing similar. US may be able to withstand higher rates - but Europe probably can't   [1]
  • suggested that the Fed's QE might have done more damage to emerging markets  rather than good by boosting US recovery. Most of the impact may have been outside the US. In the US the effect was to offset deleveraging. Elsewhere ready access to capital: permitted unwise budget deficits; slowed structural reforms; drove up currencies and encouraged over-consumption. Since the QE tapering debate started, external capital addicts (India, Brazil, Indonesia, Turkey and South Africa) have been hurt by reversal of that flow . The ultimate source of their problems are domestic opponent of economic reform - eg consider Japan's low consumer incomes and high corporate share of GDP. Likewise China's investment-led growth model seems to have reached the end of the road. China's government seems to favour reform - but faces domestic opposition to market liberalization. Emerging markets may be hurt less (as their position is stronger than it was) but should use the pain to force through needed reforms [1]
  • is generating market volatility especially (as usual) in emerging markets - though this time the adjustments taking place are the result of imbalances that emerged in the developed world. Since 201 unconventional monetary policies in advanced economies have fuelled unprecedented capital flows to emerging markets (up to $1tr pa) which generated unsustainable credit growth, raised asset prices and worsened several recipient countries vulnerability. The prospective end of QE requires more than temporary measures to defend currencies and stem capital outflows. Tapering is the start of re-normalization of interest rates. To be sufficient (to escape depression in developed economies), QE had to be excessive - and thus inevitably caused problems for emerging economies [1]
  • has relationships with both governments' addictions to debt and international financial imbalances (see references and comments on there issues in Fixing the Debt Problem below).

Fixing the Debt Problem - email sent 20/9/13

Gillian Tett
Financial Times

Re: West’s debt explosion is real story behind Fed QE dance, Financial Times, 19/9/13

Your article suggested that Western governments’ addiction to debt is the reason behind the FED’s QE program. I should like to suggest a broader dimension that needs to be considered, namely the impact of international financial imbalances associated with poorly developed financial systems – especially those in East Asia’s major mercantilist economies.

Martin Wolf recently argued (We still live in Lehman’s Shadow) that the growth of debt and asset bubbles (as well as the financial crisis that resulted from bursting of those bubbles) was a by-product of ‘savings gluts’ – especially in developing countries after the Asian financial crisis. Where demand is suppressed to maximize savings and thus achieve current account surpluses, trading partners necessarily have to be willing and able to run persistent deficits and accumulate ever-growing debts if the global economy is not to stagnate. He also argued that maintaining those imbalances (eg via QE) was the ‘least bad’ option where some countries maintain mercantilist economic strategies.

Stephen King then responded (Policy Makers have not tackled the causes of the crisis) by pointing to the need to address the savings gluts that are the root of the problem (and the reason for excessively loose monetary policy). He noted that:

  • previously-large current account surpluses by Japan and China have moderated, as has the US’s previously-large deficit;
  • savings gluts still exist because the Eurozone as a whole now has a large current account surplus;
  • much of cheap credit created through the Federal Reserve’s QE found its way to emerging economies – and created problems.

I should like to suggest for your consideration that:

  • savings gluts (which created a requirement for loose monetary policy elsewhere) have been an essential feature of the methods used to achieve ‘economic miracles’ in East Asia – starting in Japan, then copied by the ‘tigers’ and ultimately China – because they involve the use of national savings to maximize production by state-linked enterprises rather than encouraging profit seeking investments by independent enterprises (see Structural Incompatibility Puts Global Growth at Risk, 2003 and Are East Asian Economic Models Sustainable?, 2009);
  • the benefits of ‘savings gluts’ were perceived by many emerging economies following the Asian financial crisis because countries with poorly developed financial systems who maintained large current account surpluses (eg Japan and China) were able to avoid the distress experienced by countries with ‘crony capitalist’ systems that were reliant on foreign capital. This exacerbated the ‘savings glut’ problem affecting their trading partners – and thus played a role in generating the asset bubbles that gave rise to the global financial crisis;
  • QE by the US Federal Reserve is not simply intended to boost economic growth – as it necessarily would have the effect of reversing the flow of capital from ‘savings glut’ countries into the US, and thus creating risks for countries using East Asian mercantilist economic methods (or which have weak financial systems for other reasons) – see Currency War?

Some speculations about how these problems might be resolved are in China may not have the solution, but it seems to have a problem (2010). This involved (for example) highlighting the role that savings gluts play, seeking reform of financial systems as well as measures (such as those you suggested) to moderate Western government’s debt appetites.

I would be interested in your response to my speculations.

John Craig

  • could create risks for China (and spill-over damage for Western banks) similar to the 1998-style Asian financial crisis. The BIS notes that foreign loans to China's banks and companies have tripled to $900bn over the past 5 years. Loose monetary policies by Western central banks since Lehman crisis have cut cost of funding in East Asia, and encouraged heavy borrowing in $US. This process could go into reverse as US Federal reserve cuts this, and reduces liquidity across the region [1]

In December 2013 it was variously suggested that the Federal Reserve's quantitative easing (QE) program:

  • had been a resounding economic success [1];
  • needed to be phased out because it was not working as a stimulus but was creating severe problems; and would probably be followed by a significant recession [1]
  • was merely a means for enriching the cronies of those who ran the program - a cynical view that seemed a bit simplistic;

QE as a Counter-offensive in a 'Financial War' - email sent 20/12/13

David Williams
Punk Economics

Re: The Kidnapper Wears Prada, 18/12/13

Your video was drawn to my attention through a reference to it in Fed to America: ‘QE Scam Will Continue’ to Raise Inflation (Bonner B., Daily Reckoning, 20/12/13).

I should like to submit for your consideration that the issues involved in QE are rather more complex than your video suggested. QE arguably needs to be seen as a counter-offensive in an undeclared-and-virtually-invisible international financial ‘war’, rather than as something that merely seeks to enrich the rich. My reasons for suggesting this are outlined in Currency War. International financial imbalances that had their origin in the non-capitalistic financial systems that necessitated ‘savings gluts’ in major East Asian economies (eg Japan and China) played a major role in generating the global financial crisis because they required dangerously easy monetary policy in their trading partners (especially the US) if global growth was not to stagnate (see Structural Incompatibility Puts Global Growth at Risk, 2003 and Are East Asian Economic Models Sustainable?, 2009).

While the ‘currency war’ (through QE) has had, and will continue to have, casualties, resolving the ‘cultural clash’ between Western and East Asian societies (see Competing Civilizations, 2001+) through a publicly-unrecognised economic / financial contest will involve far fewer casualties than if it has to be achieved in more conventional military terms. And it does seem likely that the ‘financial war’ will soon be at an end (see The End of the 'Asian Century' Seems to be Coming into View).

I would be interested in your response to my speculations.

John Craig

It was also suggested that Turkey had become the first emerging economy to suffer problems as QE started to be phased out [1]

In April 2014 it was suggested that the US Treasury had developed tools of 'economic warfare' after 9/11 - tools which it was hoped would enable the US and its allies to constrict enemies' financial  lifeblood. It was also suggested that the use of these methods to constrain Russia in relation to disruptions in Ukraine could have unforeseen, adverse and global implications [1].

In September 2014 it seemed likely that the 'Currency War' (as a monetary counter-offensive in the undeclared  'financial war' that had apparently been started earlier by actions in East Asia) was coming to an end - and was likely to adversely affect countries that not strengthened their financial systems - see below.

In early 2015 the role that finance was coming to play in foreign and security policy was noted.

This Could Be The Year We Acknowledge The 'Weaponization Of Finance' - email sent 8/1/15

Ian Bremmer
Eurasia Group

Re: Holodny E., This Could Be The Year We Witness The 'Weaponization Of Finance', Business Insider, Jan 6, 2015

You were quoted as suggesting finance is now becoming an important tool of foreign and security policy.

However I should like suggest that finance has been an increasingly important geo-political tool for decades. The financial ‘weapon’ that has mainly been used in geo-political contests has involved financial systems themselves (eg related to ‘non-capitalist’ economic systems and ‘financial repression' in East Asia as suggested in A Generally Unrecognised 'Financial War'?, 2001+) and monetary policy (eg as suggested in 'Currency War': A Counter-move by the Federal Reserve?, 2010). And, as suggested in Reducing the Risk of Financial / Economic / Political Crises (2014), the financial system / monetary policy ‘war’ now seems likely to start having broader implications.

The ‘weaponization of finance’ by government agencies that your article referred to is very real, and much more obvious. Recognition of this in 2015 will presumably bring recognition to the 'weaponization' that has been associated with financial and monetary systems in recent decades.  

The Use of Finance as a Weapon (Note added later): Financial systems have been used in East Asia (eg by Japan and China) that direct savings from state-linked banks to state-linked businesses with little regard for return on or return of capital (see Understanding East Asia's Neo-Confucian Systems of Socio-political-economy and evidence). There arrangements constitute an invisible form of industrial protectionism (see Resist Protectionism: A Call That is Decades Too Late, 2010).

They also require 'financial repression' (ie suppressing domestic demand by selectively directing savings / credit to producers) so as to ensure a current account surplus and thus that domestic banks with unsound balance sheets do not have to borrow in international profit-focused financial markets (see Why Japan can't deregulate its financial system, 2000).

And the international financial imbalances that financial repression generates requires trading partners to be willing and able to sustain large current account deficits and ever rising debts (as (say) trade deficits are recycled back into foreign investment in the trading partner's economy) if global economic growth is to be sustained (see Structural Incompatibility Puts Global Growth at Risk, 2003 and Impacting the Global Economy, 2009). And those rising debts can only be sustained with easy money policies that: (a) create a wealth effect to boost household consumption; (b) make rising governments debts seem affordable; and (c) distort resource allocation and create the risk of financial market instabilities (such as the GFC -see GFC Causes).

That such methods have been used to achieve geo-political, rather than purely economic, ends is suggested by:

  • the massive cultural obstacles that exist in 'communitarian' East Asia to the adoption of 'liberal' Western-style systems of political economy (see Understanding the Cultural Revolution, 1998 and Competing Civilizations, 2001). Profitability is a useful basis for rational decision making in systems that facilitate independent (economic) initiative - but not where decision making is expected to occur within hierarchical social networks and independent initiative by individuals or enterprises is not facilitated and can be actively repressed;
  • the significant behind-the-scenes political and economic influence of ultra-nationalism  - a claim of racial / cultural superiority - in Japan (see The Dark Side of Japan, 2001+) and Japan's current prime minister's apparent ultranationalist stance (see A New Japan?, 2011+); 
  • the apparent deception about the nature of Japan's post-WWII industrial and financial bureaucracies (eg their likely imperial rather than democratic mandate, the significant role of ultranationalist gangsters in organizing Japan's post-war political and economic institutions and the claimed origin of their post-WWII economic methods in the Japanese military in the 1930s)  - see Implementation and The Dark Side of Japan;
  • the challenge that Japan has mounted for decades to Western-style international financial institutions (see A Generally Unrecognised Financial War, 2001+). The latter referred, for example, to;
    • Japan's encouragement of the use throughout East Asia of neo-Confucian systems of socio-political-economy which:
      • increased the international financial imbalances and demand deficits that destabilize international financial systems and put global growth at risk;
      • led to the adoption by China in the late 1970s of economic methods similar to those that Japan had used following WWII (though the social-elite catalytic role that Japan's bureaucracy had played was played in China by the so-called Communist Party). It can be noted that (in much the same way) after the Meiji Restoration, the ronin who orchestrated that event had taken key bureaucratic / economic roles, while there families / contacts were given control of Japan's business groups; 
      • can be seen as creating an equivalent of the 'Asian Co-prosperity Sphere' (ie a region whose system of socio-political-economy is based on East Asia's anti-individual-liberty cultural traditions) that: (a) Japan sought militarily in the 1930s; and (b) China is now apparently seeking to expand worldwide (see Creating a New International 'Confucian' / Bureaucratic Financial and Political Order which refers to the apparent intent to create something like the China-centered trade tribute system by which Asia was administered prior to Western expansion);
    • the 'dump the dollar' tactics that Japan adopted in 1987 (as its post-WWII economic tactics were failing) in an apparent attempt to use its accumulated reserves to damage the US's financial system. This significantly raised US interest rates and thus led to: (a) to a share-market crash; and (b) the use of easy money policies to prevent the 1987 market crash affecting the real economy. The continuance of those policies both provided a basis for two decades of sustained economic growth and ultimately left financial markets distorted and unstable;
    • Japan's role as the world's main source of credit in the 1990s - involving the creation of near zero-interest credit that was largely fed (via carry trades) into the stimulation of asset bubbles / consumer demand elsewhere - because of the lack of domestic demand for credit by Japan's over-indebted companies and 'repressed' households;
    • the US Federal Reserve's references in the 1990s to easy monetary policies being needed to guard against deflation (which was a problem that Japan faced but the US did not) which implied that the Fed was responding to behind-the-scenes Japanese influence;
    • the complementarity and possible (though not certain) connection between between Japanese ultranationalists and Islamist extremists (see also Islamist Extremists are not Alone in Favouring Pre-modern Social Systems).

I would be interested in your response to my speculations

John Craig p>

Monetary Policy is Not Just a Business / Economic Issue - email sent 1/5/15

Mark Gilbert

Re: The wrong professionals run global monetary policy, Business Day, 1/5/15 (being a reproduction of ‘Bankers Shouldn’t Run Central Banks’, BloombergView, 28/4/15).

Your article: (a) noted that the Japanese government recently appointed an industrialist to replace another industrialist in Japan’s central bank; and (b) suggested that other reserve banks should be dominated by people with industrial, rather than banking / economic, experience. There is no doubt about the breadth of issues that reserve banks have to deal with. However those issues are not simply related to banking, business and economic policy – as geo-political strategy is now also of central importance.

My reasons for suggesting this are outlined in The Could Be the Year We Acknowledge the 'Weaponization of Finance' (2015). The latter refers to the fact that: (a) the US government is now using finance as a geopolitical weapon; and (b) East Asian non-capitalistic / mercantilist economies (such as Japan’s) have apparently been doing so in a different way for decades – see also Understanding East Asia's Neo-Confucian Systems of Socio-political-economy, 2009+ and In East Asia Deals Always Involve Politics, 2012).

There certainly is a case for introducing a breadth of understanding into the work of central banks (eg by a serious effort to boost their Asia literacy for reasons suggested in Babes in the Asian Woods, 2009+).

I would be interested in your response to my speculations.

John Craig

G20 in Korea: Unreal Optimism [<]

In November 2010, another G20 summit (in Korea) failed to find a solution to the problems posed by international financial imbalances. The best that could be said was that everyone now recognised the problem, and that discussions about solutions (mainly between the US and China) were expected to continue.

Some Observers' assessments

At earlier G20 meetings, the emphasis in responding to GFC was (under IMF influence) on a Keynesian emphasis on fiscal expansion to counter potential recession. However this contributed to second (Europe centred) crisis, which was the result of past fiscal folly.  Major borrowers over the past decade have all had credit downgraded, or been at risk of this. IMF is now, once again, reverting to form and prescribing fiscal austerity. In the meantime governments used funds at the expense of private sector. Banks in Australia are blamed for lack of business investment funding - but governments are also to blame. Pre-GFC there were no calls for internationally coordinated fiscal action - yet crises were managed. Internationally coordinated monetary easing might have been more useful. G20 has great potential providing it pursues sound policy [G20'S Keynesian group think bungled GFC, 24/6/10]

World economy is getting stronger as financial crisis recedes. Challenge now is to work for common good in a world of differing economic conditions. Two very different transitions to stable growth are necessary. Major developed economies will recover slowly from financial crisis - as individuals save more and spend less. Emerging economies, but contrast, have had sharp recoveries and strong growth. After crisis, capital fled such countries, but now it has returned because of their sound prospects. These differences require new agenda for international cooperation. The problem is no longer to avoid economic depression, but to manage a two track recovery. Four objectives can be identified: (a) strengthen global growth. This requires more than growth in emerging economies (as this drives up commodity prices but is only 1/3 of global GDP). The main challenge is weak prospects of advanced economies; (b) there must be balance amongst growth across countries - so that growth can be sustainable. As major economies that previously ran large deficits deal with legacy of crisis, and increase savings, future growth in emerging / surplus economies will have to shift from exports. G20 finance ministers and Central Bank Governors agreed on the need to shift demand from deficit to surplus economies - and guard against the emergence of excessive external imbalances that could threaten future growth and stability; (c) a new framework to allow exchange rates to reflect economic fundamentals is needed. Current arrangements are adequate for Europe, North America and Japan - but must expand to include emerging economies whose currencies must appreciate to reflect their substantial growth. Previous G20 meeting agreed not to engage in competitive devaluation; and (d) markets need to be kept open and efforts made to boost trade. Emerging economy growth still depends on advanced economies, and advanced economies will benefit from increased demand in emerging economies. During GFC, G20 acted to prevent protectionist pressures.  (Geithner T., Shanmugaratnam T,\., and Swan W, 'A four point plan for the G20', The Australian, 11/11/10)

G20 meeting will endorse goal of mutual prosperity, but the uncomfortable fact is that globalization (the process that led to prosperity in countries such as Korea) is likely to be re-booted. There is an underlying quarrel about who gets to define how the world works. Capital controls will emerge as one element of this quarrel. These have acquired new respectability because of failures associated with financial crisis. Even the IMF's view has changed. Trade imbalances will be a key issue - and how a beggar-my-neighbour approach can be avoided to achieve rebalancing. It probably can't be avoided. [1]

Wayne Swan has signed up to US attack on China's currency management - suggesting (in a jointly signed article) that it risks suffocating recovery in major advanced economies. Emerging economies, by contrast, were enjoying a sustained period of rapid growth. PM also endorsed the idea that currency values should be determined in the market. G20 finance ministers agreed not to engage in competitive devaluation. US maintains that China is doing this - because history indicates that increasing productivity leads to appreciating currency. Article also supports the idea of countries minimizing current account surpluses / deficits. However many countries, including Australia, oppose that. Many countries also believe that US quantitative easing is manipulating currency values just as much as China does. [1]

G20 has shunned US plan to solve bitter divisions over trade imbalances and exchange rates. Agreement was limited to setting loose timetables during 2011 for agreement on 'indicative guidelines' on how to resolve problems of deficits / surpluses. US had sought to have countries restrict surpluses of deficits to agreed percentage of GDP. While G20 failed to make progress, IMF argued that forceful action on imbalances could be needed. The fact that meeting had not dissolved in acrimony was considered success. G20 agreed to give emerging economies more say in running IMF and Basel 111 standards. In relation to development, 'Seoul consensus on shared growth' was adopted to replace free market Washington consensus with growth related focus and heavy emphasis on mobilizing domestic savings to build infrastructure [1]

World leaders have tried to reduce trade imbalances many times since failed at 1944 Bretton Woods conference (eg at 2006 multilateral consultations run by IMF and at 2009 Pittsburgh summit). G20 meeting in Seoul only agreed on general statement of intent with no specific policies to produce results. All that there is agreement about is that there is a problem [1]

G20 leaders promised to avoid currency manipulation and trade protectionism - but differences between China and US have prevented progress in rebalancing skewed global economy. US president in concluding again criticised low value of Chinese yuan - which China spends a lot of money intervening in currency markets to ensure. China and other export-oriented economies launched a counter-attack against US Federal reserve QE2 program - arguing that this was intended to depress $US value. China's leader called on US to adopt 'responsible policies' and maintaining stable $US. He also sought global resistance to trade barriers. South Korea, which hosted meeting, suggested that world no longer faced the risk of a currency war [1]

World has been headed to another financial crisis - and deterioration has accelerated. G20 summit in Seoul merely covered up the problem. It acknowledged disagreements over currencies - but found no solutions, and did not even properly diagnose the problem. International monetary structures are shifting as in 1940s (with Bretton Woods) and move to floating exchange rates in 1970s. Such shifts happen infrequently and there are no road maps. Ideally there should be fixed exchange rates; free capital movement; and independent domestic monetary policy. But these goals conflict (ie only 2 are possible simultaneously). Currently emerging economies (especially China) have tied currencies to $US and thus generated savings gluts that contributed to recent crisis. The G20s' problem is not the level of specific currencies, but that the world's monetary system is being run in two incompatible ways. In the past such mercantilist policies could be said to be wrong, but why should not emerging economies protect their industries? Thus not only has international system broken down, but so has its intellectual grounding. This now matters more than in the past because of intrusion of democracy. US administration suffered recent electoral defeat, and Republicans have shifted (due to Tea Party) from supporters of Washington Consensus approach to globalization (ie free trade and deregulation), to strongest opponents. Proposal for gold standard by World Bank has advantages and disadvantages. It would imply end of banking as it has been known. Tow possible outcomes of G20 flop are (a) another crisis (sovereign debt / currency war) causes world leaders to confront the problem; or (b) change to global hegemony when China's economy becomes larger that that of US [1]

Australia's PM and Treasurer look to G20 to support US's war on China's undervalued currency as way of reviving US economy. But Australia risks getting caught in cross-fire as currency war destabilizes China boom (which affects Australia's biggest customer). G20 summit did not bring currency peace, but sought process to correct deeper imbalances (China's high savings and huge external surpluses vs US's under saving and budget deficits) that cause crisis in the first place. G20 is now spilt between booming emerging economies and rich-but-weak US / European economies and between China's resistance to appreciating yuan and US's torrent of debated $USs. Australia is exposed to repeat seizure of western capital markets, while becoming rich from exporting to Asia. Rather than 1930s style protectionism, competitive currency depreciation is inflating East Asian stock markets and property prices. Emerging economies are resisting flood of liquidity with capital controls. This, the IMF warned, could expose such economies to serious US trade sanctions. Central banks worldwide are becoming alarmed - with property prices soaring in Asia. This leads to Gillard and Swan view that global growth must lift overall, as well as being rebalanced, and this needs 'market based' exchange rates - so China needs to loosen currency control. China also needs to develop its financial markets and provide social safety net to encourage households to spend more. US treasury secretary recently proposed limiting external surpluses or deficits to 4% of GDP - but commodity exporters and China objected. Australia also sought to escape from requirements of global re-regulation of banks, as the problem was due to excesses of only a few US and European banks. Gillard and Swan also praised increased IMF role for emerging economies, and encouraged efforts to conclude Doha round of trade negotiations. PM suggested that rich countries struggling with high unemployment and pressure for big budget cuts need to see freer trade as the solution, not as the problem. [1]

Australia is exposed to global currency war, because of G20's failure to do more than paper over cracks between US and China. US Federal reserve will continue its quantitative easing. China will maintain yuan against depreciating $US. China and other emerging economies will seek to quarantine their economies against effect of capital flows. Australia is the only open, capital importing country with strong fundamentals, and so $A value must increase [1]

G20 summit in Korea ended as it started with row over gaps and surpluses - with China accused of keeping yuan artificially low. Obama argues that no country should see its path to prosperity paved with exports to US. China is furious with US over QE. UK PM suggested that adjustment was going to take time, and that at least progress was being achieved. [1]

G20's problem is that 'balanced global recovery' can't be engineered quickly.  US pressured China to shift from export-led growth, while China opposed Federal Reserve's quantitative easing. Renminbi is significantly undervalued. Stronger currency would reduce China's inflation and its current account surplus ($270bn pa compared with US's $470bn deficit). A huge exchange rate adjustment would be needed to make any difference - as well as changes in savings / investment patterns. US can't spend its way out of downturn. Thus China can't rely on export-led growth, and must generate domestic-led growth. US needs exports from weaker currency to get growth.  China's opposition harks back to Plaza accord where strengthening Yen did not affect Japan's trade surplus. Instead Japan cut interest rates to offset stronger Yen, and this inflated property and asset bubbles, that led to lost-decade of 1990s. Asian financial crisis of 1997 also causes China to be wary. IMF suggests that 5% real appreciation of renminbi requires complicated macroeconomic engineering.  It would also need to strengthen its financial markets. These deep structural / cultural changes will take time. This leaves big risks - that Asian asset price bubbles will get out of hand; Fed won't deliver a stronger US recovery by printing $USs; this will frustrate political efforts to clean up US budget ess; and that US will respond with trade war.  [1]

The G20's official optimism seemed unfounded given the intractable nature of the problem (see Too hard for the G20). More realistically, one observer noted that the international monetary system was now being run in two incompatible ways, and another argued that the issue now was who will have the ability to determine how the world works in future. Another observer argued that both the US and China were engaged in an 'economic war' (which paralleled the Cold War and pitted the US's reserve currency status and animal spirits against China's economic discipline, pegged currency and vast workforce). Both were suggested to be seeking to increase their GDPs through stimulus measures, though these must lead to long term problems (eg unsustainable government debts or inflation) [1]

A contest for control of the international financial system had apparently been developing for decades, though it had been invisible-in-plain-sight to Asia-illiterate Western observers (see An Unrecognised Clash if Financial Systems and Babes in the Asian Woods).

It still apparently remained invisible to the Treasuries of the US, Singapore and Australia - noting their idealised but impractical proposals to the G20 summit. They suggested that growth in future would need to be driven by domestic demand in emerging economies - and that achieving this primarily required revaluing currencies. However the real constraint for many such economies (just as for Japan) was that that financial systems were often insufficiently developed to tolerate current account deficits (eg see Who's got Superman?). For many emerging economies this problem could be overcome. But in the case of major East Asian economies (eg Japan and China), current account surpluses (and thus a mercantilist economic strategy) seemed to be vital to the systems of socio-political economy that had allowed them to enjoy economic 'miracles' (see Understanding East Asia's Economic Models) - even though those systems put global economic growth at risk.

Heading for the Grip of a Great Depression? - email sent 5/1/11

Martin Wolf,
Financial Times

Re: In the grip of a great convergence, Financial Times, 5/1/11

I must respectfully disagree with the hypothesis that you outlined in this article. You suggested that divergent growth (ie faster economic growth in emerging economies, especially China, relative to that in developed economies) implies a ‘great convergence’ in incomes in the medium-long term.

Rather I suggest that the most likely outcome is a ‘great dislocation’ of the economies of both developed and emerging economies – with all sorts of nasty social and political consequences. I have several reasons for suggesting that current economic trends are unsustainable.

Many of these concerns relate to problems in global financial systems. In particular:

  • The international financial imbalances, which are inseparable from the way the ‘great convergence’ is happening, are not being resolved (see Too hard for the G20?). Producers in East Asia and many emerging economies elsewhere are structurally dependent on strong demand from developed economies (especially the US). However the latter cannot provide this much longer because of the escalation of their debt levels (which is an inevitable consequence of those imbalances). Characteristics of the non-capitalistic systems of socio-political-economy that prevail in East Asia seem to be major factors (eg see Resist protectionism: Your call is decades too late? and Heading for a Crash?), as are weaknesses in financial systems in many other emerging economies that encouraged them also to adopt export-led economic strategies to guard against the risk of financial crises (see Leadership by Emerging Economies?);
  • Many governments (eg US, Europe, Japan) face high debt / deficit levels due to past bank ‘rescues’ and / or economic stimulus and / or public demands. This implies: (a) higher interest rates, given limited available credit and rising private credit demand if the ‘real economy’ recovers; and (b) a medium term need for austerity / higher taxes (unless real economy recovery is rapid and there is a not-yet-evident dramatic lift in productivity / competiveness that causes financial imbalances to reverse). Widespread austerity would hit growth, and the cash flows that conceal financial problems in ‘Asia’ and other emerging economies;
  • The global capacity to increase lending to meet borrowing needs is limited, noting (a) the ending of off-balance-sheet securitization (which in US, for example, had provided about 50% of credit before the GFC); (b) the higher capital adequacy ratios required under Basel rules to reduce risks of future failures; (c) the risk to currency values (or of inflation if the velocity of money normalizes) that quantitative easing by reserve banks poses, and (d) the exposure of many EU banks to near-insolvent peripheral governments. ‘Asia’ is seen as a reliable source of future capital, but its major banks (with poor balance sheets) rely on strong cash flows / high savings to provide credit, and economic weakness elsewhere (due to financial imbalances / debt levels) seem likely to disrupt those cash flows (and thus ‘Asia’s ability to provide capital) in the medium term (eg in 3-4 years).

There are numerous other reasons to suspect that the stability required for the ‘great convergence’ to unfold will not be sustained. For example:

  • There are structural obstacles to the rebalancing of demand that ending financial imbalances requires (eg see Ending the West's Global Predominance?);
  • The global peak oil’ event (ie the peaking of physically-feasible oil production) while demand continues rising is likely in the next few years – and can be expected to lead to: escalating oil / transport costs; inflation; and economic disruption;

  • Effective methods for macroeconomic management no longer seem to exist (see Booms and Busts: Unsatisfactory Tools for Macroeconomic Management);
  • Democratic governments have great difficulty in managing austerity. There are many examples in Europe and US where governments have seemed unable to resist public demands for benefits that cannot be provided without unsustainable deficits and debts. Australia seems to suffer similar problems – though they are currently concealed behind a resource boom driven by China’s rapid (but extremely uncertain) growth.

It is likely that none of these difficulties is insurmountable, but the fact that no serious efforts are being made to address them suggests that the next few years are likely to anything but the smooth transition to a more equitable world that your article speculated about.

John Craig

Scenarios that were more realistic, though less comfortable than the Treasuries' proposals, included:

  • global economic stagnation as deficit economies were forced to adopt austerity measures;
  • financial crises in emerging economies (and in East Asia generally) if serious attempts were made to drive global growth on the basis of their domestic demands;
  • efforts by East Asian economies to create an international order as a subset of the global economy that operates on neo-Confucian principles of socio-political-economy (eg see Creating a New International 'Confucian' Economic and Political Order'?); or
  • efforts by advanced economies (especially the US) to overcome the constraints on growth imposed by the macroeconomic distortions implicit in the economic strategies adopted in East Asia - perhaps by methods suggested in China may not have the solution, but it seems to have a problem.

Scenarios about how presenting problems might be resolved (eg by international collaboration) have also been suggested, though these have not inspired confidence.

China, though only partly developed, is the world's second biggest economy because of its size. Its leaders rightly focus on sustaining stability and achieving prosperity. To date, the world has accommodated China's rise successfully - which is remarkable given its different culture, history and political system. China's economy has been increasingly market drive. Contrast US protectionism in Great Depression with increasingly open Chinese economy and China's Keynesian's successful response to 'Great recession'. Consider also China's entry to WTO and its increasing trade. But there have been problems. China had large trade surplus and holds massive foreign reserves - which exposes it to US fiscal / monetary policies. US and others allowed cheap foreign savings to increase consumption, residential construction and financial sector leverage. Excess savings in emerging economies were part, though not all, of the cause. China's exchange rate must increase - to facilitate greater reliance on domestic consumption. China's challenge is also environmentally sustainable growth - a widespread problem. There is a need to recognise that (a) breakdown in China-West relationships would be catastrophic; and (b) it is vital to strengthen global institutions - even if China sees them as alien inventions. The key economic agenda for all must involve: maintaining open trade; external adjustment; reforming international monetary system; managing the global commons; and containing conflicts (eg over resources). East and West must cooperate or perish [1]

CPDS Comment: The need for cooperation has long been obvious, as have the reasons that it is unlikely – see Structural Incompatibility Puts Global Growth at Risk ( from 2003)

The world needs substantially more credit for future growth, while avoiding crises such as recently engulfed the world. Key challenges include: low levels of financial development in countries with rapid credit demand growth; problems in meeting demand for lending; revitalising securitisation markets; and maintaining cross-border financing. The challenge can be achieved if financial institutions / regulators / policy makers have better indicators of sustainable lending, contagion risk and credit shortages - and better mechanisms to ensure that credit drives development. Suggested steps include: including idea of sustainable credit into regulatory agenda; standardise government accounting practices - to increase transparency; encourage responsible borrowing through financial education; target credit at places where development is constrained by its absence; give a single agency responsibility of monitoring global credit levels and system-wide credit sustainability; align banks risk appetite with sustainable credit criteria; encourage innovations in financing to safely meet future credit needs; establish goals for efficient / deep capital markets in emerging economies by 2020 [1]

CPDS Comment: Some obstacles to meeting the demand for credit were suggested above. Fundamental problems are that:

  • standardisation of approaches to assessing credit seems unlikely in a world in which there is no common understanding of the nature and functions of financial systems (see Ungovernable financial markets and Obstacles to Effective Global Regulation);
  • strengthening Western financial institutions in the post GFC environment has been heavily dependent on transferring losses to governments, and on increases in liquidity by reserve banks. The latter ('printing money') has the potential to ignite inflation, and may need to be rapidly reversed (with adverse effects on the ability of financial institutions to provide credit) at some stage;
  • the development of complex financial systems is a formula for economic instability, because of feedbacks between credit creation and the 'real' economy - and seems economically counterproductive through reducing the ability of individuals to make rational decisions (see also Restricting the Economic Role of Financial Services?);
  • 'Asian' financial systems (especially those of Japan and China) are critically dependent on the continued strength of 'Western' financial systems (especially those of the US) because of the need for current account surpluses (and thus ever-increasing debt levels in the US and elsewhere) if financial crises are to be avoided in 'Asia' - see Understanding East Asian Economic Models.

IMF warns that imbalances threaten to derail global recovery, and may set off wars in deeply unequal countries. Many rich nations face slumps, while emerging economies such as China / India / Brazil face overheating. Global unemployment is at record highs, and inequality is rising. IMF suggests that global imbalances caused the GFC, and that China and Germany are the main sources of the problem - through reliance on export-driven growth. If these imbalances are not resolved, global clashes and trade protectionism are likely. China's effort to hold down the value its currency is seen as serious cause. This aligns IMF with US views. IMF also warned about risk of overheating, inflation and hard landing in Asia [1]

GFC accelerated arrival of the future. New mood is one of wary optimism. Global output is now increasing again. Crisis was neither the beginning of depression nor end of capitalism. Financial regulation has tightened, but within pre-existing intellectual / institutional framework. Private leverage in high income economies stopped increasing, and is now falling. Deleveraging is likely to continue. Crisis also marked reversal of global imbalances - which will not be of previous scale, though China continues accumulating foreign currency reserves (and this is perilous). Crisis also revealed eurozones' vulnerability to accumulation of public / private leverage (through directing savings into bad investments via undercapitalised banks). Deleveraging will be hard to manage. Aging populations will have serious fiscal impacts in high-income economies - and GFC brought this problem forward a decade - so managing public finances will be hard for forseeable future. Changes in global balance of economic power have been accelerated - with significant relative gains by Brazil, India and China. Advanced economies had 63% of global GDP at PPP in 2000, but will be less than 50% in 2013. This also puts pressure on natural resources. Attitude to West (and US in particular) has changed. Respect for West's competence has been lost (due to military and fiscal problems). Shift to G20 symbolised that transformation. Davos meeting illustrated uncertainty about the future (eg whether US can avoid Japan's fate). Effect of private de-leveraging is unclear, and there are risks of renewed economic weakness / financial shocks. Eurozone mood is more optimistic - as determination to survive exists, though ability to achieve this is uncertain. China apparently has no plans for global economic and political systems, yet its success requires it to develop ideas about this given the responsibility it must take. [1]

CPDS Comment: See Eurocentric Aspirations in a World of Rising 'Asian' Influence

An official US investigation into the GFC that reported in January 2011 simply dealt with domestic issues, and did not even mention the role that international financial imbalances had played in giving rise to the crisis (see FCIC: Eroding Confidence in the US?). And as illustrated by an interchange that arose following circulation of the latter comments, one informed US observer argued that domestic distortions in the US's political / public administration process are the main reason that such imbalances are not being officially addressed (ie the multinationals who, together with 'Wall Street', profit from the commercial dealings that result in imbalances have a dominant insider influence). The present writer's perception is that this is probably correct, but is only part of the problem.

Variations of earlier proposals for resolving the problem of international financial imbalances through issuances of Special Drawing Rights (SDR) by the IMF have been advanced. A US observer suggested that those SDRs should be backed by the hard currency reserves of countries with large reserves (such as Japan, Germany and China), while a 'Beijing Group' suggested that $US300bn in SDRs should be issued annually by the IMF on behalf of the G20 without specifying who might back this in the event that losses were incurred.

A Good Idea that Probably Won't Work (email sent 23/3/11)

Ben Jensen
Wall Street Journal

Re: IMF Plan Sees Role for Fund in Crises, WSJ, March 23, 2011

Your article outlined an interesting proposal for the IMF to draw on hard currency reserves held by countries such as China and Japan to provide support to emerging economies in times of financial crisis – and thereby reduce the need for emerging economies to hold large foreign exchange reserves. While this proposal has the potential to be a ‘game changer’ in reducing the risks that international financial imbalances pose to continued global economic growth, it probably won’t work because it seems incompatible with the likely aspirations of neo-Confucian states such as China and Japan. My reasons for suggesting this are outlined below.

I would be interested in your response to my speculations.

John Craig

Outline of Article and Detailed Argument

My interpretation of IMF Plan Sees Role for Fund in Crises: IMF is working on a proposal to become a significant lender of hard currencies in times of crisis – thus sharing ‘lender of last resort’ role with US Federal Reserve. US and other G20 members want IMF to provide support to emerging economies, and thus reduce their need to hold large foreign exchange reserves, while reducing the need for politically controversial and difficult support from reserve banks. France is backing the plan, with (conditional) support from US Federal reserve. US and Europe have been concerned that countries such as China can manipulate foreign reserves to keep currencies undervalued. But emerging economies don’t trust IMF enough not to hold substantial foreign reserves. In future US Fed may be unable / unwilling to provide swap lines to emerging countries in times of difficulty (as it had done extensively, but selectively, in 2008). Creating such a swap line for IMF would require changing its bylaws. IMF would need new sources of finance to undertake this – as it can’t just print money. Such funds might come from US Federal Reserve or increasing IMF membership dues, but these would be politically difficult. Another option would be for reserve-rich countries such as China or Japan lend the IMF money. If created the swap line could reduce emerging economies need to hold foreign exchange reserves, a trend which had been initiated by the Asia financial crisis.

This is an interesting concept. As this article noted, the trend towards emerging economies holding reserves to guard against financial crises started at the time of the Asian financial crisis. It emerged presumably because it was noted that countries with poorly developed (eg ‘crony-capitalist’) financial systems that held large reserves (such as Japan and China) did not suffer the adverse consequences that others who lacked that protection experienced (see A New World Order: Leadership by Emerging Economies?)

Reducing the need for emerging economies to accumulate foreign exchange reserves by providing emergency IMF support with hard currencies would not only benefit emerging economies. It would be a small step towards reducing the constraints on global growth that arise from international financial imbalances (ie from the requirement that trading partners of those who need to accumulate foreign exchange reserves be willing and able to indefinitely sustain current account deficits and thus increasing debts - see Financial Imbalances in Financial Market Instability: A Many Sided Story, 2007; and Unsustainable Economic Models?).

However if actually implemented the main benefit of the proposal, in terms of reducing the constraints on growth posed by international financial imbalances, would arise because the IMF’s efforts could in practice only be financed by reserve-rich countries such as Japan and China whose economies are primary causes of the international financial imbalances, because of their need to continually accumulate foreign exchange reserves to avoid crises in their domestic financial systems (see Understanding East Asia's Neo-Confucian Systems of Socio-political Economy). This would place those reserve-rich countries in a situation in which they would be exposed to losses as a consequence of IMF rescue efforts if the financial systems of emerging economies remained poorly developed.

This, of course, suggests why the current proposal is unlikely to be acceptable to the reserve-rich economies that would have to finance the IMF’s efforts to support emerging economies facing potential crises. It can be noted that: (a) it is unrealistic to expect neo-Confucian states that lack universalist values to be willing to take responsibility for ensuring strangers’ welfare as might be expected in states with a Western heritage (see Eurocentric Aspirations in a World of Rising ‘Asian’ Influence); and (b) a primary goal of efforts to create a new ‘Confucian’ international order seems likely to be to reduce the constraints on rule by traditional social elites that arise where financial considerations determine economic activities, as they do under Western traditions (see Creating a New ‘Confucian Economic World?).

Should Fixing the International Monetary System Start in 'Asia'? (email sent 6/4/11)

Professor Joseph Stiglitz,
Columbia University

Re: The best alternative to a new global currency, Financial Times, March 31. 2011

I should like to comment on the above article that you wrote on behalf of the ‘Beijing Group’ of economists (of which a brief summary appears below).

Reform of the international monetary system is undoubtedly needed. However, for reasons outlined in more detail below, such reforms can’t be effective without changes to the macroeconomically-unbalanced systems of socio-political-economy that prevail in major East Asian economies such as Japan and China, and that have been key factors in the imbalances that now put global growth at risk. Shifting responsibility for coping with structural demand-deficits from the US to the IMF will not solve the fundamental problem.

This point is elaborated further below, and I would value your reactions to my speculations.

John Craig

Outline of Article and Detailed Comments

My interpretation of your article: The international monetary system needs reform. It did not cause recent imbalances and current instability, but has been ineffective in addressing them. The G20 needs to take the lead in expanding IMF’s role in issuing special drawing rights (SDRs). Keynes proposed a global currency (Bancor) but system is now dominated by $US. This has disadvantages: (a) placing burden of adjusting to payment imbalances on countries running deficits; (b) creating tensions in relation to volatility associated with US current account deficits. Deficits are needed to create sufficient global liquidity – but generate excessive indebtedness (so if US deficit shrinks quickly, global reserve currency supply could be inadequate); and and (c) developing countries accumulate large reserves as insurance against balance of payments crises – but add to global imbalances. SDRs are a limited form of global currency issues by IMF that were created in 1960s and expanded in 2009 in response to collapse in global lending. SDR’s role should be increased – at times of large falls in private capital flows or commodity prices. G20 should encourage IMF to issue $US390bn of SDRs pa to (a) reduce problems of recessionary bias – by allowing reserve banks to exchange SDRs for hard currencies ($ or euros), and use this to increase imports; (b) partially reduce countries need to increase reserves; and (c) sustain / accelerate global recovery without inflationary pressure. SDRs need to be more effectively used – eg in financing short term difficulties for countries facing balance of payments constraints. When crises occur, SDRs could be issued in unlimited amounts, and then withdrawn as crisis is resolved. This would enhance global stability without altering existing monetary arrangements, while $US would remain main currency for private transactions. Can G20 show leadership the world needs?

As your article correctly pointed out, the international monetary system did not cause recent imbalances and current instability. Thus, in seeking a solution, it seems more logical to focus on the causes of those problems, rather than just seeking to change arrangements that were not to blame.

The G20 has paid a great deal of attention to the need to contain the financial excesses that arose in some Western economies (as a result of very easy monetary policy) but has, so far, paid no attention [1, 2] to the hard-to-understand financial distortions in major East Asian economies that require excessively easy monetary policy elsewhere if global economic growth is to be maintained (see Understanding East Asia's Neo-Confucian Systems of Socio-political Economy). Where a nations’ savings are mobilized by state-linked financial institutions to provide capital to state-associated companies in internationally-competing industries whose goal is to maximize market share / economic activity with limited concern for profitability, there is also a need to limit the availability of money for consumption to the point that a current account surplus results so that financial institutions with suspect balance sheets don’t need to borrow in international financial markets (eg see Mikuni’s Why Japan cannot deregulate its financial system, 2000; and Cultural and Financial System Considerations in China’s Development: Assessing the Implications). Economies that require large demand deficits (ie savings gluts) in order to avoid financial crises (because economic activity is coordinated in terms of ‘relationships’ (ultimately to the social elites who control national financial systems) rather by the calculation of financial profitability by independent enterprises) require trading partners who can continue to run trade deficits (and accumulate increasing debts) indefinitely (see Impacting the Global Economy).

The establishment of the system proposed by the Beijing Group (ie encouraging the IMF to issue large volumes of SDRs on behalf of the G20) would enable countries whose financial systems are rigged to (in effect) provide a novel form of subsidies to state-favoured activities [1] to continue doing this. There can be no solution to international imbalances until fundamental reforms are made to the distorted financial systems that make some countries dependent on export-led growth (and thus on financial imbalances). All that would happen is that the IMF would, in effect, take on the role that the US has played in recent decades as the world’s ‘consumer of last resort’. If the problem of imbalances is not be addressed at its source, the IMF in issuing SDRs on behalf of G20 nations collectively would have to run what amounted to a very easy monetary policy and see SDR (and hard currency) reserves continue to accumulate in countries with distorted economic systems.

Moreover this would not solve the monetary problems that your article suggested (ie that an increased role for SDRs would: enable to IMF to play the role of a global macroeconomic manager; and reduce the need for developing countries to hold large reserves). The problem would be [1] that: (a) macroeconomic management through monetary policy suffers fundamental constraints [1] (eg the need for unachievable levels of strategic insight would not be eliminated by shifting responsibility to the IMF); and (b) emerging economies require precautionary foreign exchange reserves mainly because their financial systems are poorly developed [1]. Unless the IMF was in future prepared to turn a blind eye to suspect balance sheets, the issuance of SDRs would not solve emerging economies’ problem. If the IMF were expected to ignore suspect balance sheets in issuing SDRs, the Beijing Group’s proposal would seem to simply amount to re-engineering the international financial system (which has been built on free market principles) on the market-authoritarian basis that characterises major East Asian economies.

In seeking solutions to international financial imbalances and current instabilities, there is a need to start with a close examination of how East Asian systems of socio-political economy actually work and what effect they have on international monetary systems.


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

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,

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]

  • the failure of banks which constituted a very large component of their host country's economies - such as in Iceland from 2008-2011 and in Cyprus in early 2013

The development of an internationally oriented banking system in Cyprus led to a crisis in 2013 when the EMU placed a condition on funding bailout for its tax-haven banks by placing an up-to-10% levy on the deposits in banks (after these had incurred large losses through investment in Greek government bonds as part of EU rescue arrangements for Greece [1]). This raised many complexities:

  • the proposed levy eroded public confidence that bank deposits are safe. Cyprus's banks held $90bn (5 times GDP) of which about $20bn was the property of Russian mafia. The proposed levy angered Russia's president. But the bigger problem was that eroded confidence in deposit insurance - which was introduced at the time of the Great Depression to prevent runs on banks. However it also allowed banks to increase their leverage ration on assets from 4-5 in the 1920s to about 30 in 2008. Now savers can not rely on  banks not to go bust, and can't rely on deposit insurance [1];
  • while Germany might protest that it had not forced Cyprus's banks to impose a levy on Russian (mafia) depositors, Russia could retaliate by restricting gas supplies to Europe [1]
  • After insisting that Europe's financial crisis was resolved, challenges emerged from the Italian election and from crisis over levy on Cyprus bank deposits - which has added further fuel to mood of insurrection in southern Europe. Germany is seen to be rigid in enforcing an austerity that is failing economically and leading to worsening social conditions [1]
  • banks have very little in reserve, and so always stand on the edge of disaster. Deposits always depend on a solvent state that is willing and able to step in. This is not possible in Cyprus because banking was so large relative to its economy [1]
  • the decision to impose levy on Cyprus banks was made in European core - because of bail-out fatigue at home. This has violated principle of deposit insurance, and thrown Portugal under a bus. The principle of EMU solidarity has been shredded [1]
  • events in Cyprus have called into question to status of tax havens everywhere [1]
  • the tax on bank deposits raises two serious issues - the risk of social / political instability because of tax on small depositors, and the risk that Europe's political system is seen to be failing [1]
  • what has been done in Cyprus could be a precedent-setting decision for future bail-outs in Europe [1]
  • Cyprus had become one of the biggest money-laundering centres in Europe. European politicians have been demanding a crackdown on Russian money laundering as a condition of any eurozone rescue package [1]
  • the deposit tax in Cyprus will remind depositors that they have a role to play in bank reconstructions [1]
  • parliament of Cyprus rejected EU / IMF bailout offer for its banks (which came at the cost of a once off levy) - and in doing so has left itself with no option for repairing budget / bank problems [1]
  • there has been a tension between financial stability and the question of who pays when financial institutions incur losses. Financial stability has been seen to require that depositors be protected - even though equity / bond holders could lose when banks failed. While it is argued that Cyprus is a special case, a precedent has now been set - ie depositors are no longer protected). In US authorities went to great lengths to rescue all depositors - except in the case of Lehman Brothers - and this has serious side effects. After Cyprus, whenever there is a problem in any peripheral European economy, there will be a flight of deposits from the peripheral country [1]
  • until recently Cyprus was prosperous with tourism / shipping / maritime activities as well as a significant international financial sector. Deposits attracted were too large for local use, and so were invested elsewhere. In 2012 Greek bailout engineered by EU imposed 50+% losses on foreign holders of Greek bonds - and this is a major factor in the problems in Cyprus's banks [1]
  • a last minute deal was done to resolve bank crisis with depositors under 100,000 euro protected, and larger depositors potentially losing 30% of holdings [1]
  • there are parallels between the 2008 failure of Lehman Brothers and official responses to bank problems in Cyprus. The initial solution proposed was viewed favourably across most of Europe as tax avoiders who had received high interest rates for decades would be punished. Cyprus was handled differently yo problems in Greece, because in the latter  allowing institutions to fail would have adversely affected German banks (but in the former only Russia would be significantly affected). Cyprus was like Lehman in that it was considered small enough, and not systemically significant enough, to be allowed to fail as an example to others. Chaos ensued after Lehman's failure. It is too soon to tell the consequences of Cyprus. The real test will come when a Spanish / Italian / Slovak / Hungarian bank needs assistance [1]
  • Cyprus's economy will suffer severely and for perhaps a decade from bank problems. Investors will be more nervous, and bond market sell-offs could result. Until now bank depositors in Europe had been protected. The change could aversely affect other countries with large foreign deposits. However it also provides clarity about new rules of the game. The crisis will also see a shift in the way banks are funded - with greater use of contingent convertible bonds [1]
  • parallels have been suggested between Cyprus crisis and the 1931 failure of a small Austrian bank (Creditanstalt) that precipitated a major financial panic. The transfer of losses to depositors was the first time this has occurred since the IMF started surveys in 1970. There is now likely to be flight of capital from weak banks in weak countries (eg from Greece, Portugal, Ireland, Italy and Spain). It will now also be harder for such banks to raise additional capital. The crisis also undermines the credibility of ECB and EU in managing the crisis while maintaining stability. It illustrates the increased reluctance of countries such as Germany to support the weaker Eurozone countries. The fundamental problem is that debt crises can't be dealt with except by financial repression [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].

 European share markets have improved since the sovereign debt crisis began - but severe problems remain. Europe's problems don't lie in 2008 credit crunch so much as in 1995 preparations for euro which led to interest convergence across what had been very different economies. This created a (private or public) credit bubble in peripheral economies. Wages and prices on periphery started diverging from the core - making periphery less competitive. This led to rising trade surplus in core, and deficit in periphery. Europe's problems are uncorrected balance of payments crisis - which hasn't been able to be corrected through exchange rate movements (which would otherwise restore price competitiveness and devalue debts). Under monetary union, creditor nations demand cash from debtors, which the latter have to endure self-defeating penury to provide. Debtors have to counter misalignment with cuts to nominal wages and asset prices. Some see progress from this as current account deficits are narrowing. Thus Germany seems to have transformed Europe into mini-Germanys. Likewise unit labour costs have converged with German core. However though some deficit nations are doing better on exports, most of the rebalancing reflects a collapse in internal demand on the periphery. And improved unit costs is being translated into rising unemployment. Reductions in labour costs have occurred mainly in the public sector - where this was easiest. Internal devaluation to boost competitiveness, reduces taxes and thus makes servicing existing debts harder. Raising taxes to plug the deficit reduces competitiveness. If Germany accepted higher inflation (eg by allowing ECB to buy asset backed securities in periphery) it would become less competitive, while helping peripheral economies. Germany also seems to be backtracking on creation of monetary union. To work, internal devaluation has to be accompanied by debt restructuring - ie by creditors accepting that their securities are worth less (eg as occurred in Greece and Cyprus) [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)

In October 2013 it was argued that Europe was sliding into a deflationary trap with debt ratios in several countries becoming unsustainable and making a mockery of the EMU's debt crisis strategy. Deflation may be benign in low debt countries, but is very serious in those with high debt levels. When total debt exceeds 300% of GDP it becomes lethal - and this is now the situation across most of Western Europe. Heavily indebted states are being forced to regain competitiveness by internal devaluations - which has the effect of increasing the risk of deflation. Countries such as Italy and Spain face rapidly rising debt / GDP rations despite draconian cuts. The alternative would be to allow higher inflation in Germany and thereby resolve problems of competitiveness differences within eurozone in a different way [1]

In late 2013 concerns about the risk of sovereign defaults also extended to the US federal government (see below)

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

In late 2013 concern about the apparent inability of the US political establishment to deal with the federal government's growing debt levels heightened further. Following a partial 'shutdown' of government as a result the refusal of the Republican dominated Congress to approve legislation providing necessary funding approvals (because of concerns about health reforms that had been labelled 'Obama-care'), there was further disputation about approving the federal government's 'debt limit' which was likely to be exceeded in mid October. If an increase was not approved, there was a risk that (as a worst case) the US government might default on some of its Treasury bonds - an outcome that would have severe implications for the global financial system / economy (because the credit rating of T-bonds might be down-graded, thereby requiring many institutions who use these as highly secure capital to sell - thereby driving up interest rates).  This was significant because:

  • high debt levels in the US (including those of its federal and state governments) have been partly a result of the financial imbalances that arose because emerging economies have relied upon the US as the world's 'consumer of last resort' to provide the demand to drive their growth (see Why China had to buy US debt). Many economies with poorly developed financial systems (especially Japan and China) had long suppressed demand to maintain current account surpluses (and thus avoid the need to borrow in international financial markets through unsound financial institutions).  Others most notably the US, thus had to provide demand in excess of income if global growth was to be maintained and be willing and able to continually increase their household / business / government debt levels. Prior to the GFC, households had assumed much of this burden (on the basis of rising property values supported by easy monetary policies). Subsequently governments tended to absorb significant costs (and rapidly rising debts to maintain confidence in financial institutions) 
  • US analysts (both those who agree that the US's federal debt position needs to be corrected, and those who do not, seem to under-estimate the risks involved - because they consider the issue purely from a domestic position (ie in terms of whether or not government spending is sustainable) rather than in terms of the potential 'shock' that might come from global financial instabilities;
US Federal Debt Position: Some Sources

US debt ceiling $US16.699 tr was reached in May. 2007 crisis created huge gaps between income and spending. Economy was in recession, revenues fell - as government tried to stabilize economy / financial sector. CBO says US debt is 73% of GDP - double that in 2007. Current Republican objections to raising limited are frame in terms of supposed electorate rejection of Democrats policies - and their concerns with Obamacare. Money could run out in October 2013 - creating problems and potential default. US can borrow at low interest rates in international markets - and this helps keep consumer rates low. Default could drive up cost of US borrowing - and create chaos in international markets. [1]

 At 30/9/12 federal debt managed by BPD totalled $16.039tr - mainly from borrowing fro operationsThis involved public holdings of $$11.27tr and $4.789tr of intra-government debts. External borrowings reflect cumulative cash deficits. Public debt includes holdings by individuals, local governments, Federal reserve and foreign governments. As of June 2012 48% of publicly held debt was held by foreign governments. Foreign holdings increased from $983bn in 2001 to $5311 bn in 2012. Intra-governmental debts mainly reflect debts owed to trust funds such as Social Security and Medicare that have an obligation to invest in Treasury securities. Intra-governmental debts have much less significant budget impact (eg they do not require cash payments) - though they do reflect a burden on taxpayers and future obligations. Federal deficit in fiscal 2012 was $1089bn down from $1297 in 2011. Public debt increased from 68% of GDP to 73%. Future debts are expected to grow relation to GDP because of structural imbalances driven by rising health care costs and demographics. Total interest expenses have been declining - because average interest rates have fallen. In 2009 and 2008 average interest rates paid were 0.3% and 1.3%. Total interest expenses in 2012 were $432bn ($245bn being public) - about 2.7%. Average interest rates on outstanding debts were about  9% in 1990, 6.5% on 1995, 5% in 20004% in 2005, 2.5% in  2010 and 2% in 2012 [1]

US debt position has been improved in short term, but little has been done about long term problems. Little has been done about drivers of debt - and economic recovery has not been strong. Current budget can't be sustained indefinitely. Higher interest rates / aging population / rising health costs / more health subsidies are the problem. Unchanged this implies that entitlement plus interest costs would double as share of econoy - while everything else falls. Total spending could be 26% of GDP by 2038 compared with historical 20.5% average. Public held debt could be 100% of GDP in 2038 9up from current 73%).  [1]

Between 2009 and 2012 federal budget deficits were highest relative to GDP since 1946. Public-held debt is 73% of GDP in 2013. If current laws remain in place debts held by public would decline slightly - but this is contrary to CBO expectation. Deficit has fallen to 4% of GDP in 2013 - due to gradual recovery and policy changes. Under current laws debts would fall to 68% of GDP by 2018 - then rise again due to effect of interest costs. How long growth in debt could be maintained is impossible to say. At some point investors would become concerned - making borrowing more expensive. Higher debt costs would also reduce private / productive investment; require tax rises; reduce government flexibility; and raise risks of fiscal crisis. [1]

When subprime crisis started in 2007 the US cash rate was 5.25%. By January 2009 it had fallen to near zero and remained at that level [1]

  • the effect of the threatened 'default' seems likely to provide a major impetus to reduce reliance by emerging economies on international financial imbalances - and thus can be considered complementary to the US Federal reserve's 'Currency War'. Whether this implies that the threatened default is a 'game' intended to change the practices of those who have maintained current account surpluses (and relied on US as 'consumer of last resort') is unknown.

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 help in identifying the most dangerous financial products [1] - without apparent recognition of the risks that large / persistent financial imbalances generate ;
  • proposals for a levy on bank deposits as part of a bailout for banks in Cyprus cast doubts on the security of bank deposits (especially in Europe) and thus of the extremely high leverage of assets that banks have relied upon;
  • removing the expectations of government support were suggested as a possible key to reducing the problems that high-risk strategies by banks can create [1];
  • efforts by the Basel Committee and the European Banking Authority to ensure that banks adopt uniform procedures for assessing risks were seen as likely to make the global financial system more pro-cyclical and unstable [1];
  • it was noted that reserve banks were being active in seeing to boost economies, while political systems seemed to be stalemated - and that there are risks with the reserve banks' efforts;
Meetings of BIS (which provides banking services to reserve banks and provides clearing house for policy) held a recent free-flowing discussion - about which nothing is reported. ECB looks like a hero for having come to rescue of Europe's banks last year - which contrasts with faltering approach of Europe's political leaders. US Fed's policy of buying government bonds has aided housing market (and thus general economic) recovery - as well as recovery in risk markets. US government is in gridlock, but Bernanke is getting things done. In Australia government is trying to rein in budget deficits, while RBA helped start house prices and retail sales rising. Japan's new government has installed fresh management at Bank of Japan to get inflation up. This will encourage spending and devalue government debts. It has also lowered yen value. Bank of Switzerland is targeting exchange rates. Central banks in Asia (eg in Hong Kong) are also engaged in direct regulatory intervention in the financial sector to control credit flows while rates are down. There is concern that: (a) US intervention could be merely creating an asset bubble; and (b) it will be hard to manage a recovery.     [1]
  • it was suggested that many of the problems that had plagued financial systems before 2007 remain in place - though there was no immediate risk of another crisis [1];
  • BRICS nations decided to establish a new development bank to finance infrastructure and to create a $US100bn Contingency Reserve Arrangement to tackle any financial crisis in the emerging economies [1]. However there was no agreement on how to give this practical effect [1]

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

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

  • firstly the global financial system shocks that were triggered by US sub-prime crisis - though they reflected far more profound structural weaknesses in the international financial and economic order (eg see GFC Causes);
  • secondly a potential for sovereign defaults that were increasingly obvious in 2010; and
  • thirdly 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 could no longer be papered over.

However in early 2013, the expected third stage had not happened and there was growing optimism about global economic recovery.


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).

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)

And reports started emerging of new technologies that had the potential to initiate new industries. Also 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. The creation of a North Atlantic free trade zone was suggested, and could provide a major impetus to economic recovery.

However this seemed 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. Europe most notably remained mired in recession and threats to the solvency of some governments and banks (eg in Cyprus) were proving hard to resolve.

Moreover many observers expressed concern that improved real-economy conditions might be more artificial than real, eg reference was being made to:

  • growing government debts and central bank balance sheets potentially not ensuring sustainable growth;
  • a lack of general agreement about the role of monetary policy;
  • the need to reverse 2 decades of trade, capital flow and debt imbalances for sustainable growth;
  • monetary policy's effect on underpinning asset values, and difficulties with extricating from quantitative easing;
  • the potential 'impossibility' of reversing monetisation of government debts;
  • a 'wall of money' resulting in flows to riskier assets - recreating pre-GFC risks;
  • official warnings of China's risks of a financial crisis unless debt levels are brought under control;
  • continuing developed-world debt crisis . Free money creates bubbles, capital misallocation and excess leverage;
  • peaking of real economic prospects. Emergency measures have become a dangerous addiction;
  • a possible rapid transition to higher interest rates trapping those whose position seems secure at low rates;
  • the financial sector becoming prosperous / bigger due to rising debts / asset values - though cracks are emerging;
  • reserve banks and sovereign wealth funds buying almost all of the AAA  rated bonds that are available;
  • a likely end to a 32 year bull market in bonds [thus interest rates would rise];
  • likely massive losses on bonds as interest rates rise - potentially putting financial system stability at risk;
  • inadequacy of proposed recapitalization of European banks relative to the scale of losses incurred;
  • inadequate demand in global economy - with almost all being debt driven;
  • extreme credit excesses worldwide exceeding levels prior to Lehman crisis;
  • world facing the most extreme levels of excess liquidity / money supply ever
  • global debt levels have risen 40% since the GFC, while global equity levels have fallen.

Pessimistic Observers

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)

Global 'currency war' could get worse if Europe becomes involved - according to Brazilian finance minister who first used the term to refer to describe currency devaluations by rich nations to bolster exports. Reinvigorating economies with more investments was needed he suggested, rather than seeking to weaken the euro to protect jobs. Brazil has actively sought to devalue its currency and discourage speculative capital imports - but argues that rich nations should not do this [1]

An attempt to defuse global tensions backfired, when it initially was believed that G7 statements implied acceptance of Japan's efforts to reinvigorate growth - even though the intent had been to warn Japan about the devaluation of the yen that was likely to follow from Japan's efforts to combat deflation [1]

While G20 tried to talk down the currency war risk, the risk remains because there is no longer any agreement about the role of monetary policy [1]

While the G20 agreed that there should be no currency war, the reality is that one is underway - to devalue currencies and thus boost demand via exports. This poses serious risks [1]

Trade, capital flow and debt imbalances that have built up over the past 2 decades need to be reversed before growth can become unsustainable - and the world needs to adjust. Key indicators to watch in China are: growth - which must decline if demand switches to domestic consumption;  slower rate of debt growth; financial scandals; off-balance sheet financing; inflation; and trade data. Other key indicators are in Europe [1]

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]

Global economic recovery from 2008 crisis has long seemed likely to be weak - because of rising debt / imbalances / inequality and policy incrementalism. Governments are trying to deal with this with hyperactive monetary policy and intermittent stimulus. In 2008 world faced a deflationary output gap, because of rising supply and falling demand (because of asset / credit bubbles). Governments attempted to bridge this gap - with fiscal spending, tax cuts and income transfers - financed by central banks at near zero interest. This worked for a while, but then the demand impulse faded. Global coordination was replaced by confusion / inaction. In 2013 US offers best recovery prospects - though growth will be slow. Housing recovery will help, but government debts will constrain. Japan is trying to boost growth - but may not succeed. The euro-zone will remain mired in problems.  Emerging markets can play a useful role, because balance sheets are flexible enough to support demand growth. But this can't be built on investment, production and exports - because developed market consumption is weak [1]

The amount of debt in the world is more than all bank accounts - and the current financial situation facing Cyprus must be next phase: confiscation. Central / bankers can no longer just repackage debt - as they have been doing since early 1980s. The result in 2007 was a huge debt mountain (eg $220tr debt (public / private / unfunded contingent liabilities) compared with $14tr US GDP. Deals in global derivatives now exceed $1 quadrillion - compared with global GDP of $60tr. Since 2007 world's taxpayers have been unable to pay interest / repay capital - so repackaging has been attempted in the hope that income would increase sufficiently. This didn't work - so Cyprus shows the next stage (confiscation). [1] [CPDS Comment: this writer appears to have a commercial interest in advocating holding wealth in the form of the form of gold / silver]

There is concern associated with rock-bottom interest rates that when rates recover there could be a repeat of conditions in 1994 which saw large numbers of significant bankruptcies [1]

There has been a massive increase in the sale of 'junk bonds' (ie high yielding securities) because monetary stimulus measures have forced safe yielding investments down to very low yields and thus encouraged even conservative investors to take on more risk. This lays the basis for another financial crisis [1]

Concerns about economic outlook arise from: (a) Fed's encouragement of risk - which has led to large take-up of junk bonds; (b)  US federal government is again encouraging banks to lend to riskier borrowers - which was a factor in the GFC; and (c) it may be that performance of US real economy is not up to that implied by stock market gains [1]

Monetisation of government debts (in US, Europe, Japan) can never e reversed. It must continue indefinitely as 'creditism' to encourage spending in an environment where nobody wants to borrow [1]

The wall of money generated by reserve banks and economic recovery will result in flows to the riskier assets seeking higher yields - thus creating risks like those prior to the GFC ('Get ready to ride a wave of money', Financial Review, 9/4/13)

One of China's top auditors has stopped approving local government requests to increase their debt levels, and warns that China faces a financial crisis bigger than that in the US and Europe unless debt levels are brought under control [1]

Economic problems in Europe (especially in peripheral economies) are as bad as in the Great depression. UK is on the point of recession - and has had the greatest fall in GDP in 100 years. The IMF sees Europe as facing potential stagnation like Japan's over past 2 decades. [1]

No one at a recent forum believed the world economy would rebound. 57% thought that West's twightlight conditions could not be escaped. 20% expect a full blown recession. Yet all are bullish on shares and property because of the effects of QE [1]

The developed world remains mired in the 2008 debt crisis. Growth is low, de-leveraging continues. Policy makers have responded with free money - creating bubbles, capital misallocation and excess leverage. A bubble in corporate bonds is inevitable. Companies are borrowing heavily, and investors are not being compensated for the likely risk of defaults. A new volatility cycle is likely in the US - because of the large rise in credit. [1]

There has been a massive flow of credit into emerging markets (BRICs) since the GFC - but the returns have been poor. When the US Federal Reserve changes gear there is likely to be a rally in the $US and a capital outflow from those countries that will generate a financial crisis. This is most obvious in South Africa - which risks becoming ungovernable. Brazil faces stagflation. The BRICs miracle is mainly about China - but a massive run-up in credit has been needed to sustain growth. China also is at the mercy of the Fed - as it has pegged its exchange rate to $US - its currency will rise against the rest of Asia when $US surges, compounding the effect of 30% yen devaluation. China's $3.4tr foreign reserves will provide no defence - as drawing on them would require conversion to yuan which would drive up currency value - and undermine competitiveness. This is happening just as China's trade surplus vanishes. The cycle of emerging market exuberance is as old as capitalism. [1]

HSBC index for global economy has peaked. Countries that have not yet locked in sustainable growth will be in trouble, and may experience deflation. Eurozone is still mired in recession. World's gloomy outlook seems disconnected from Fed's 'tapering' proposal. HSBC's leading indicator has taken a long time to buckle given commodities topped in September and trade topped in arch. The equity boom is built on quicksand. Markets are betting that central banks will come to the rescue again. Perhaps they will but only after demonstrating their distaste for asset bubbles. Insiders are concerned that the longer QE goes on the harder it will be to unwind. BIS has argued that emergency stimulus has become a dangerous addiction. Unwinding QE could be dangerous (and bring on events like 1937). But there are bubbles everywhere. Companies are still borrowing cheap to buy back their own stock - and some see this as responsible for half recent equity gains . If there is another round of QE there must be a better way found to inject the money - ie not just direct it to elites, but rather directly making productive investments. Interest rates are near zero across the developed world, and government debts are higher than in 2007. In 2007 BRICs were in the middle of a roaring boom, and China responded to crisis with unrepeatable loan spree. BRICS now have post-bubble hangovers, and China won't repeat what is now seen as a major mistake. Europe is not retreating from austerity. Monetary policy in Europe remains tight. Its M3 money supply has been flat. Core inflation is low - approaching deflation. Real personal income in US fell 5.8% in first quarter. After 5 years world is still struggling to contain depression - with world savings rate of 25% and a chronic shortage of demand. US has kept the world afloat by running savings down to 2.7%. But this is not sustainable   [1]

A rapid transition to higher interest rates could trap some whose position seemed secure at lower rates . The World Bank warns that countries with the greatest asset bubbles will be at the greatest risk. Interest rates in BRICS could rise 2.7% as West unwinds quantitative easing. Signs of problems are emerging in China - where private debt (at 160% of GDP) is now highest of all BRICS. Turkey, Brazil, Poland and India have all sought to block capital flight, while Indonesia had to raise interest rates. The BRICS need to tackle (for example) supply-side bottlenecks, poor regulation, corruption, inadequate supply of electricity and education to return to pre-crisis growth rates [1]  

Since early 1980s the financial sector has become very prosperous because of increased debt levels and rising share markets. In US total debt levels rose over 50+ year periods to pronounced peaks in 1933 and 2009 (ie up from about 100% of GDP in 1870 to about 300%, and then after a rapid fall from about 100% of GDP in 1950 to about 370% of GDP - from which level a rapid decline again seems to have started) - see diagram. These booms and busts corresponded with increases in Financial industry share of US economy from about 2% to a peak of 6% in the mid 1930s and 8% at present.  Rising debt levels permitted the growing role of financial industries. The difference now is that investment industry is more sophisticated. The financial industry had an easy time in years leading up to 2007. Since then massive amounts of central bank intervention underwrote market recovery - though cracks are now appearing [1]

Financial asset prices are manipulated by reserve banks and the sovereign wealth funds of a few emerging powers. They are buying $1.8tr of AAA bonds yearly out of $2tr that are available. This is unprecedented. Major reserve banks own $10tr in bonds - while China , the petro-powers and others own another $10tr - and the total is $25% of global GDP. That is why Fed talk of Tapering and policy action in China matters. Investors hope Fed will delay tapering - and he might for another three months. Yet there are an increasing number of reports which suggest that Fed now believes QE to be counterproductive (eg a former board member argues that it is becoming harder for Fed to extricate itself, as higher interest rates after QE could wipe out Fed's own capital base, and make it impossible to support US government budget with interest payments; Federal Advisory Council suggests QE may be having serious side effects but not boosting economy - eg pension funds are underwater on their liabilities; BIS has openly criticised QE; Fed doves have changed their minds). Thus a tough line by Fed is possible [1]

World may have seen the end of 32 year bull market in bonds. Changes affecting monetary policy have changed the game. Risk on, risk off trading is ending. The $US has strengthened on good news, rather than this encouraging 'risk on' moves into emerging markets. Resource currencies now reflect unwinding of resources boom. The markets are now more likely to differentiate sensibly between markets. But the eurozone still faces major problems. There are also uncertainties about whether the Fed will taper - and concern that it may not be able to taper. It is hard to see a happy ending [1]

BIS expressed concern about new bank crisis due to $trs in losses on bonds as interest rates rise. A 3% rise on US Treasuries alone would generate $1tr in losses. Financial system stability could be at risk. One effect of tightening has been withdrawal of capital from emerging markets. BIS argues that authorities must push ahead with monetary and fiscal tightening - because easy money policy was doing more harm than good and debt levels were becoming dangerous. However many others argue that such tightening could have serious economic consequences [1].

The Eurozone Stability Mechanism is to provide $60bn to recapitalize eurozone banks - but this seems irrelevant in relation to the $1-2.5tr in losses that they have probably suffered as a result of a series of crises. The preferred tactic has been to deny the problem and extend its effect [1]

Economic growth will now be difficult because there is low demand in the global economy - because most demand was debt driven [1]

Extreme credit excesses worldwide have reached / passed levels before Lehman crisis - according to BIS. Hunt for yield have lured investors into high risk instruments - just as Fed starts tapering. Previous imbalances are still present - total public / private debts in advanced economies are 30% higher than they were in 2007 - and there are new problems of bubbles in emerging markets. Subordinated debt (which leaves lenders exposed to bigger losses if things go wrong) has increased 3 times (to $52bn) in Europe over past year and 10 times (to $22bn) in US. Leveraged loans used by weakest borrowers in syndicated loans has risen to 45% (10% above the 2007-08 level). Investors are snapping up loans that offer little protection. Interbank credit to emerging markets is at highest level ever. The value of bonds issued offshore by companies in China, Brazil and other developing nations exceeds that in rich countries - illustrating scale of debt build-up in Asia, Latin America and middle East. The effect of Fed tapering is unknown. BIS argues that 5 years since Lehman failed have been wasted, as global system remains even more unbalanced - and is running out of lifelines. The ultimate driver for world will be US interest rates - and as this goes up there will be fall-outs for everyone. Abenomics could go awry in Japan, while Europe is vulnerable to outside shocks. The world is addicted to easy money. The is little ammunition left if things go wrong again [1]

In October 2013 the IMF estimated that phasing out QE (or partial US default as a result of failure to raise its debt ceiling) to lead to $2.3tr market losses on bond portfolios worldwide if this lead interest rates to rise 1%. Large elements of the world's financial system were seen to be vulnerable to stresses as the extraordinary post-crisis policies were wound back [1]

IMF's latest report suggests that World Economic Outlook is uncertain but not disastrous. Growth in developed world has strengthened, while china and emerging economies are weakening. The overall picture is of tricky rebalancing of global growth, Risks include: eurozone progress may not be sustained; disorderly tightening of US fiscal policy (or even debt default); rising interest rates as QE is unwound (or possible inflation). Excessively rapid fiscal austerity is creating problems in Europe, UK and recently in US. This has forced reliance on questionable monetary policies at a time when there is a private savings glut. US recovery is helped by property recovery, increased household wealth and easier credit. Japan is headed for fiscal tightening. In Europe fiscal tightening - at a time when weak demand constrains recovery. in longer term the pace of growth in developed world and the path of fiscal stabilization are key issues. The former is most important. Governments need coherent growth strategy. Failing to use low interst rate opportunity for expanding investment is a mistake. Emerging economies face a changed environment with higher interest rates, lower commodity prices, stronger growth in rich countries and weaker growth in China. The time of easy credit is over - and the risks associated with hot money flows are being revealed. India and China face structural slowdown. Both suffer important imbalances - yet a modest rebalancing will not serious dampen their longer term prospects. The position of emerging economies is more robust than in the past [1]

A recent report from JP Morgan has argued that the world faces the most extreme level of excess liquidity / money supply ever. The rise which started in May 2012 goes far beyond rises from 1993-95 / 2001-06 / 2008-10 all of which set off rapid asset price rises. Global money supply has risen $3tr (to $66tr) in first nine months of 2013 - with $2tr in emerging markets (probably China in particular). The surge in money supply has set off an asset boom which is likely to be vulnerable (because economies have not reached 'escape velocity' as indicated by declining global trade volumes in August 2013)  [1]

Credit boom in China has put the world in worse position than 2008. Credit crisis arose then because there was too much credit - and there is more now relative to economy than in 2008. IMF report shows that percentage relative to GDP of advanced economies is now 30% above 2008. In China credit has increased by 50% of GDP over past 4.5 years - the fastest increase in Asia. Many have suggested that rapid credit growth is China's biggest risk. Problems also exist with household debt in Asia. This has risen much faster than government debt. This raises risk that minor economic crisis will be followed by money printing - or of an inflationary spiral, Consumer and real estate prices have escalated in Singapore and Hong Kong [1]

2014 will be year of strong $US - as the world's safe-haven currency. US economy is also coming back to life - and may reach 'escape velocity'. QE overcame effect of drastic fiscal tightening. Yields on US 10 year bonds will exceed 3%. There are political uncertainties (eg China's Air Defence Identification Zone). Japan's leader visited Yasukuni Shrine - in a gesture aimed at China. China and Japan could be on a war footing already. Defence stocks are rising. US steps back from Middle East as the region is engulfed by Sunni-Shia conflicts - that are like Europe's 30 years war. Gulf oil matters less because of shale production. Ukraine's leaders have turned their backs on the EU. Global savings rates will reach 25%. There is a chronic lack of consumption. AS US Fed tightens a lot of the $4tr that has flowed to emerging markets since 2009 will come back. The 'taper tantrum' of May 2013 illustrates what is likely to happen - according to IMF. Shadow banking system of emerging economies is now the centre of global stress. Emerging markets have $7tr of external debt - of which $2tr is short term and must be rolled-over continuously. Europe will be hit by rising interest rates - and by the fact that US is becoming super-competitive (eg because of cheap energy) and so will be able to meet its own consumption and thus not provide a stimulus to others. Credit to firms is still contracting in peripheral Europe. Government debt continues to rise despite austerity programs. However youth unemployment rates around 50% will not be politically tolerated indefinitely. Europe's macro policy failure will be clear by the end of 2014.  China faces a massive bubble. Credit has grown from $9tr in 2008 to $24tr. The rate of loan growth (100% over the past 5 years) is without precedent. The central bank is struggling to deflate this. China may seek to prevent hard landing by driving down the yuan - which would lead to new Asian currency war. This would compound the deflationary shock the world is likely to experience [1]

The IMF has warned that governments in many developed countries will need to adopt 'financial repression' tactics like those that have been required in developing countries to deal with high levels of government debt - ie methods that divert citizens savings to the state [1]

The Bank of International Settlements warned that global debt levels had risen 40% to $100tr in the six years from mid-2007 to mid-2013 (and that most of the increase was government debt). However at the same time the value of global equities (a measure of unencumbered global wealth) had fallen $3.86tr to $53.8tr [1]

In recent years trade has played a major role in global economic growth. But 3 years into a very weak recovery, slack demand from consumers in Europe and US is depressing exports from developing world [1]

US economy contracted in first quarter of 2014 and bond yields have been falling (usually an indicator of economic slowdown) as a sign that Fed tapering is biting. US monetary supply also indicates likely slowdown [1]

Economic data in May 2014 has been driven by conflicting pressures. Major economies are not doing well. US was supposed to be recovering - but economy contracted (partly due to weather). Eurozone, China and Japan are also soft. Germany is stagnant and Japanese-style moderate deflation is a risk in in periphery . Japan's monetary stimulus threatens to turn into a problem as wages stagnate while costs rise - and fiscal structural aspects of 'Abenomics' are not in place. China's growth has slowed - but inflation is very low. Advanced economies need China (the world's largest creditor and trade surplus nation) to resolve the imbalances in wages, costs and capital flows that underpin the world's macroeconomic problems. Problems in China's real estate sector and general slowness will further complicate matters. And an economic reformist party has now won power in India - and this could enable India to become a sustainable export-driven economy . All of this indicates that the demand growth needed to reverse deflationary pressures in advanced economies may be absent. The persistent debt overhang in developed economies constrains consumer / government spending [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 only on conventional business / economic methods of analysis drawing upon 'real economy' variables.

For example, the sources outlined above (and others) indicate that:

  • 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;
  • interest rates were at very low levels because of monetization of (especially government) debt.  This created the risk of a crisis. In particular:

    • This allowed debt levels to rise well beyond what would be sustainable without monetisation.
    • government debts and those associated with losses by systemically significant banks were being monetised (by reserve banks) - and government debts were unsustainably high in many places (partly as a consequence of responding to the GFC and meeting unsustainable public expectations). There was no obvious way of reversing this process, because:
      •  Government spending could not be significantly reduced both because of the effect of this on reducing already inadequate demand, as well as adverse popular reactions to severe cuts. 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 was being resolved.
      • 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) was not impossible - and would be likely to be followed by a stock market crash when the yields on 'safe' investments reset a new higher benchmark for equities' yields;
    • increasing government debt can have a multiplier effect on the availability of credit - because in the hands of financial institutions it becomes part of their capital base which determines (via a multiplier) the total amount of credit they can create;
    • ultra-low interest rates allowed firms that would normally have failed in a severe recession to continue trading [1] - and this implied risk for some of these when more normal rates resume;
    • Encouraging investment may result in over-capacity if households' willingness to spend remains weak. The emergence of a 'wealth effect' to justify higher consumption is being relied up to reduce the need for government spending to sustain growth - but is not guaranteed. Serious industrial over-capacity plagues China;
    • ultra low rates on safe assets encouraged investors to seek yield through riskier investments, again creating conditions like those prior to 2008;
    • ultra-low rates on safe investments also appear to have encouraged a large flow of capital into riskier emerging market economies where the results have often been unsatisfactory and have created conditions like those prior to the Asian financial crisis (which was triggered by a large outflow of funds when financial performance was realised to not be up to expectations due to 'crony capitalist 'practices);
  • Corporate profits (to justify higher share market values) were being driven by rising asset values;
  • declining consumer demand; an increased need for savings; and dependence on exports were being accentuated by population aging. This phenomenon was apparent in Japan and peripheral European countries, but was expected to have an increasing impact elsewhere in future;
  • countries in East Asia with poor national balance sheets because governments have used 'financial repression' to steer savings into export-oriented production capacity / infrastructure and property 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;
  • some doubted the value of paper currencies - because of monetisation. Many countries seemed to be seeking to boost their gold reserves. Germany sought return of its gold reserves from external repositories (eg in US, France, UK) and was required to wait many years for this, presumably because that gold had been leased to financial institutions and used as the basis for a profitable 'paper gold' trade that accounted for something like 100 times the trade in physical gold. There has been a boom in the value of Bitcoins - an apparently-secure electronic currency with a theoretically limited / known supply that is independent of fiat currencies (ie those issued at the whim of reserve banks) ; 

However the problem was arguably more severe because it was hard to see how a serious global demand deficiency could be avoided - because:

To achieve economic growth in this environment 'everyone' needed to rely on either: (a) even more credit - which reserve banks had been seeking to provide; or (b) increasing net exports . It was clearly impractical for 'everyone' to increase net exports, and this raised the risk of 1930s-style 'competitive devaluations' to seek greater export competitiveness at others' expense.

In fact concern was widely expressed 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. Quantitative easing had been accepted as economically useful providing it was primarily aimed at stimulating the domestic economy (ie to head off deflation and drive down unemployment) [1]

In April 2013, an unexpected crash in the value of gold (which had been becoming increasingly strategically significant) suggested the possibility that a new dislocation of the global financial system could be imminent (see Interpreting the Canary in the Gold Mine).  This possibility was reinforced in April 2014 when the establishment of a physically-settled gold futures market in Asia was seen to indicate that the Western makers of paper-gold futures markets (whose physical gold holdings had disappeared) might be bankrupted [1] - though by that stage it was likely that significant institutions had eliminated their exposure to losses from failure of 'paper gold' markets.

Interpreting the Canary in the Gold Mine suggested that: (a) these events needed to be viewed in the context of a long term contest between Western-style 'capitalism' (ie profit focused investment) and (so-called) 'financial repression' by East Asian 'authoritarian family-states'; and (b) the gold price collapse might presage:

  • rising interest rates facing heavily indebted governments / institutions;

  • significant losses on 'paper gold' investments that might resurrect the credit freeze that unknown counterparty risk generated after 2008; and

  • no viable method for counter-cyclical macroeconomic management in the face of a severe financial crisis.

In mid 2013 there was increased speculation that quantitative easing was of uncertain benefit because of its apparent contribution to asset bubbles. However by that stage the build up of global debt levels (due to the combined effect over several decades of international financial imbalances and easy money policies) that there was a real risk of debt deflation and a major crash that would be far worse than anything in recent decades.

Credit Bust First: 'Sixth Revolution' Later - email sent 18/6/13

Kris Sayce
Revolutionary Technology Investor

There is no doubt about the potential for emerging technologies such as those suggested in your Sixth Revolution to drive the growth of new industries (and thus provide great investment opportunities).

However the credit bubble that has accompanied the Fifth (Information) Revolution probably has to be eliminated first.

That a credit wipe-out is likely is suggested by the diagram that appeared in Truth or Dare Time for the Investment Industry (Gowdie V., Daily Reckoning, 14/6/13). Though the escalation of debt / GDP ratios that this diagram shows applies to the US, it is probably a fair reflection of the global situation. It has, for example, recently been suggested that China’s credit bubble is unprecedented in modern world history

The Great Depression in the 1930s did not happen merely as a consequence of a sharemarket crash in 1929 (or as a result of insufficient government spending, or of a breakdown in international trade). Debt deflation was also significant. The collapse in the debt / GDP ratio after 1933 reflected the failure of large numbers of ‘secure’ financial institutions (arguably triggered by the 1931 failure of an Austrian bank, Creditanstalt) which took down the credit regime that had underpinned the global economy.

George Soros has plausibly argued (in The Alchemy of Finance) that the provision of credit escalates the value of the assets for which credit is provided (ie investing in something can have a self-fulfilling effect on the value of that investment – due to a ‘crowd’ effect). However a point is eventually reached, he argues, at which a credit-driven escalation in asset values proves to be a ‘bubble’ and bursts. This seemed to happen in Japan after 1990.

Another point that seems significant about the ‘Total Debt as % of GDP Graph’ is that it showed a rapid escalation in debt levels in the 1980s, then a bit of hesitation before the escalation continued. A severe recession was widely expected after a 1987 share-market crash had been brought on by a rapid rise in interest rates on government bonds. But the US Federal Reserve (under Alan Greenspan) then invented methods for preventing bond and share market losses from affecting the real economy (which would have compounded the financial market losses). The Fed achieved this by providing large quantities of additional credit to financial institutions.

However this tactic (which others copied) led later to an even stronger escalation of debt levels and asset values - because the expectation of effective reserve bank intervention lowered the perceived risk associated with investments, and thus increased the debts that were regarded as ‘safe’ for any given level of income.

Another significant contributor to the escalation of debts has arguably been long term international financial imbalances. Countries with sustained current account deficits (eg US and Australia) have had to borrow for decades to maintain growth, while others with current account surpluses (most notably in East Asia) have poor balance sheets despite their large foreign exchange reserves because of their poor financial systems.

The main source of these imbalances has been the non-capitalistic financial systems that have prevailed in East Asia (see Structural Incompatibility Puts Global Growth at Risk). Financial systems that don’t take profitability seriously for complex cultural reasons have had to maintain current account surpluses (by suppressing consumption) to avoid having to borrow in international financial markets. This required their trading partners (mainly the US) to continue increasing their household and government debt levels if global growth was not to stagnate. This has probably been a significant factor in the growth of the US’s debt / GDP ratio since the 1980s. Another source of international imbalances has been the effect of the euro as a common currency amongst countries with radically different economic capabilities. Germany developed surpluses, while peripheral Europe became heavily indebted (see Financial Imbalances and the European Sovereign Debt Crisis).

Now a credit peak seems to have been reached again, and debt-deflation threatens. Reserve banks probably have little more ammunition left to stop a credit collapse. Asset markets clearly respond mainly to expectations about the future of quantitative easing, thus: (a) supporting fears that QE is simply creating asset bubbles; and (b) leading to the perception that QE needs to be phased out, because it is doing more harm than good.

I somewhat doubt that the technological opportunities that now exist will now be able to drive sustained growth. If existing debt / GDP levels can’t be at least maintained there will be an ongoing decline in the total amount of credit (and thus in the availability of funds for consumption and investment). The increasing interest rates that are accompanying warnings about phasing out QE could well give rise to failures by a few supposedly ‘secure’ institutions (eg governments or major banks) which could trigger a self-reinforcing world-wide collapse like that which followed the failure of Creditanstalt in the 1930s. Presumably the reserve bank fraternity are trying to figure out a way to stop this happening. But given the high debt / GDP ratios that currently prevail they may well fail. Some sort of across the board wipe-out of debt obligations seems to be required. But how this could be achieved without crippling economies is hard to imagine. A debt wipe-out would simultaneously: (a) eliminate creditor’s assets; and (b) remove the underpinnings of bond, equity and real estate values.

A nasty recession would have occurred after 1987 if new monetary policy techniques had not been invented in the hope that this would bring an end to the centuries-old boom and bust business cycle. But the one that is now possible could be much worse (perhaps even worse than the depression in the 1930s) – and be accompanied by wars in various parts of the world (eg in the Middle East and East Asia).

Only then, I suspect, is the Sixth Revolution likely to come to fruition.

John Craig

In July 2013 the IMF warned of the consequences for the eurozone of the ending of quantitative easing by the US Federal reserve. The onset of a tightening cycle in US had already led to rising bond yields in the eurozone. The resulting increase in borrowing costs could damage demand and growth - unless European Central Bank takes countervailing action. There is a high risk of stagnation on the periphery, and this could lead to a debt-deflation spiral [1]

Stimulating demand through quantitative easing (ie boosting access to more credit) to overcome demand constraints due to high debt levels could lead to a severe financial crash followed by a prolonged and global 'balance sheet' recession and deflation. Quantitative easing is a method for counter-cyclical macroeconomic management that comes with risks, and those risks are compounded by by international financial imbalances.

There is no obvious way of averting such a financial crisis. However it is clear that financial system stresses can not be resolved without finally addressing the challenge of international financial imbalances which:

However, though some now understand that the financial imbalances that have grown in recent decades have to be reversed before growth can be sustainable [1, 2], most analysts (like the G20) continue to put this in the 'too hard basket'.

And in October 2013, it was suggested that there was no need to do anything in particular because imbalances were merely a transitory phenomenon which would disappear as China (for example) increased the role that domestic consumption played in its economy - a suggestion that seemed overly optimistic.

A case for economic gloom amongst the pundits' optimism - email sent 1/10/13

Stephen Grenville
Lowy Institute

Re: A case for economic optimism amongst the pundits’ gloom, Business Spectator, 1/10/13

Your article critiqued some observers’ economic gloom related to: (a) the possibility that technological progress may no longer create major new economic opportunities; and (b) oversupply associated with easy credit and heavy government spending to keep everyone employed – the latter being seen to be the result of a ‘global savings glut’ and ‘international imbalances’ (with China’s current account surplus seen as a major feature of this).

You then suggested that such concerns were overly pessimistic as: (a) many observers doubt claims about limits to technological progress; and (b) the ‘savings glut' is probably a transitional problem – noting that China has recognised the need for rebalancing (and raising consumption to more normal levels will automatically lower savings).

There seems to be no doubt that technology will create highly productive new opportunities. However the structural ‘savings gluts’ and consequent international financial imbalances that were essential components of the systems of socio-political-economy that allowed ‘economic miracles’ to be achieved in East Asia (initially Japan and ultimately China) have played a major role in generating global debt levels that make an economic crisis virtually unavoidable despite the new (technological) opportunities that would otherwise now permit sustainable recovery if the GFC had merely been a cyclical down-turn (see Credit Bust First: ‘Sixth Revolution’ Later).

When nationalistic financial institutions do not insist on profitability from the loans they make to nationalistic enterprises (see Evidence), it is essential that they avoid borrowing in international profit-focused financial markets. Thus suppressing consumption (and thereby generating domestic ‘savings gluts’ and international financial imbalances) has been necessary to avoid domestic financial crises. However the adverse effect that this has on the global economy (by requiring trading partners to massively increase their debt levels if the global economy is not to stagnate) is very serious – and has been going on for decades.

One observers noted many years ago that Japan could not repair its financial system in such a way as to avoid a need for favourable financial imbalances (see Why Japan can't deregulate its financial system) – and Japan’s position became extremely exposed as a result (see Japan's Predicament, 2009+).

China’s system is functionally similar to Japan’s (in that investment decisions are based on consensus rather than profitability calculations), and it seems extremely difficult to achieve the ‘rebalancing’ that China’s leaders have spoken about – because of the severe cultural obstacles involved (for reasons suggested in The Cultural Revolution needed in 'Asia' to Adapt to Western Financial Systems, 1998).

A Solution? - My suspicion is that China’s intent could be to try to bypass the problem by creating an internationally traded currency backed by the large gold reserves it seems to be accumulating. If China ran current account deficits, there would be a need to borrow in international financial markets – and China’s financial institutions (with poor balance sheets) would typically be unable to do this directly with safety. However China might be able to borrow against the value of its gold reserves – especially if the value of those reserves were increased dramatically by the transformation of the Yuan into an internationally-traded gold-based currency. Needless to say the effect of this could be to create another global financial crisis if the Western ‘bullion banks’ (ie those who create a market in ‘paper gold’) have indeed created an unsupported ‘fractional reserve banking’ arrangement for ‘paper gold’ as some observers have claimed (see Interpreting the Canary in the Gold Mine).

I suggest that there is a need to look much more closely at how East Asian systems of socio-political-economy actually work (and at the difference between the intellectual basis of those systems and that of Western political economy) – rather than assume that such differences are inconsequential.

John Craig

Resulting Interchange with Stephen Grenville - email sent 1/10/13

Response from Stephen Grenville - 1/10/13

Thanks for your comments. I'm not sure that high savings is a necessary part of the Confucian way. It certainly wasn't true of Singapore in its high-growth catch-up phase in the 1960s, when it ran very large current account deficits. I'm not even sure that it was true in Japan's high-growth phase in the 1960s and 1970s, but I couldn't immediately check the data (perhaps you can direct me to the evidence). Nor can I easily check Taiwan and Korea. But it certainly wasn't true for a number of other fast growth countries, such as Indonesia during the Soeharto era. Thus I'm less sure than you are that China is stuck in a high CAS state. Time will tell.

Reply to Stephen Grenville - 1/10/13

Thanks for your comments – which I would greatly appreciate your permission to reproduce on my website together with A case for economic gloom amongst the pundits' optimism.

As I understand it, Confucius advice was to become rich through savings and avoiding consumption. I can’t locate the original source that I had for this – though How the Wisdom of Confucius Can Lead You to Financial Success points in that direction. And if one looks at the intellectual basis of East Asian societies with an ancient Chinese cultural heritage, one finds that the use of abstract concepts as the basis for rational decision making that have been the basis of Western societies’ progress have had no role (see Epistemology the Core Issue and Competing Thought Cultures). Calculations of profitability by independent decision makers have been the method used for economic coordination under Western systems of political economy, but this has not been so in East Asia.

I am not certain what happened in Singapore in the 1960s, as I only got involved in trying to understand what was going on in the late 1980s (see background). My attempt to describe the consequences of differences in financial systems is in A Generally Unrecognised 'Financial War'? (which was not put together until 2001). The latter refers to: (a) evidence that profitability is not taken seriously in either Japan or China; (b) another observers very explicit comments on Japan’s financial system which corresponds precisely with my expectations; (c) suggestions by a well-known Japan-watcher that Japan’s system had been developed by its military in Manchuria in the 1930s and influenced China in the late 1970s; (d) observations about Japan’s chronic trade surplus with the US (and the US’s chronic trade deficit) which led to Plaza Accord in 1985 which was expected to correct those imbalances – but did not do so because Japan’s financial system directed capital to production but not to consumption; (e) the effect of the Asian financial crisis in 1997 on countries with poorly developed financial systems that did not maintain current account surpluses (such as Indonesia), and the consequent subsequent efforts by many emerging economies to arrange such surpluses.

I have not looked at the current account balance situation of East Asian economies other than Japan and China. I have no resources other than my own time, and I get involved in a large number of different issues. Singapore’s situation is a bit unusual as it (like Hong Kong) started with a strong basis of British institutions – though there is a clear neo-Confucian economic influence (see Competing and Collaborating Economically in South and East Asia). I don’t know about Taiwan – but Korea quite clearly did not emphasise current account surpluses before the Asian financial crisis – because it was badly affected at that time.

I offer no guarantees that China won’t find a way to operate with a current account deficit – merely that it would not do so by developing Western style financial institutions that rely on profitability. Some indications of this are in Financial and Educational Reform in China: Headed in Opposite Directions? . My earlier email suggested a possible way around this constraint that might be being sought that would have adverse effects on the global (ie Western style) economy.

However Japan does not seem to be moving towards acceptance of current account surpluses and (a) until quite recently Japan (ie in the 1990s and for a few years afterwards) was the world’s major source of credit – that was created at low interest rates and diverted to other countries through Yen carry trades which had the effect of boosting trading partners debt levels and demand for Japan’s exports; and (b) Abenomics appeared to be an attempt to recreate similar capital flows – though the actual consequences seem to have been quite different (perhaps because others are seeking to counteract Japan’s efforts).

Response from Stephen Grenville - 2/10/13

Thanks. Sure, you're welcome to post it. In the first sentence, my central point would be clearer if I had said 'high current account surplus' rather than 'high savings'. I agree that these countries had high saving during their fast-growth period but, sensibly, they also imported a lot of investment goods.

Reply to Stephen Grenville - 2/10/13

Importing investment goods does not preclude a current account deficit – if savings exceeded investment.

There is a need to look much more deeply at what is going on – especially at cultural features that influence what is, and what can be, done. The issue is whether there are cultural features involved in the methods that have been used for economic development that require surpluses – which translate into a significant macroeconomic obstacle to sustainable global growth (ie a structural demand deficit).

Suggesting that there is no problem without seriously considering the cultural dimension lacks credibility. Most analysts seem to assume that East Asia can be understood in terms of Western models and concepts – but this is grossly misleading for reasons suggested in Babes in the Asian Woods; Australia in the Claytons Century: The 'Asian' Century you have when you are not having an Asian Century; and Comments on Australia's Strategic Edge in 2030. The latter includes suggestions on why understanding is difficult – but that difficulty does not excuse failure to make an attempt to understand.

I have added your comments to my web-site.

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.

And the financial system reforms to create an environment for sustainable growth are complicated by the need to simultaneously resolve of other challenges facing the global community such as:

  • the emergence of new quasi 'world policemen' (eg France in North Africa), as the US no longer automatically assumes this role - partly due to fiscal constraints;
  • potentially explosive political stresses (eg China's social inequality and corruption; the conspiracy theories of the Occupy / Anonymous Movements and Islamist extremists; North Korea's nuclear-armed ratbag government; tensions between China and its neighbours);
  • potential environmental emergencies (eg those related to Arctic methane, biodiversity, food [ 1 ], water / soil, antibiotic resistant pathogens);
  • population aging - which cuts savings / constrains demand / dramatically increases government costs relative to revenues - and increases the dependence of economic growth on net exports in a world in which almost all countries need to rely on this. While developed Western counties have significant problems, Japan, China and the Islamic world appear to be even worse affected;
  • potential US push for trading links with Europe at the expense of Asia (as implied by President Obama's 2013 'state of the union' address)

Resurgent Protectionism? [<]

In September 2013 it was reported that over the previous year there had been a resurgence of protectionist measures which would impede global trade  - largely because of the credit difficulties that emerging markets face. This poses a threat to economic recovery. Emerging markets now account for 50% of global output - but seem to be turning their backs on free trade. Particular attention has been drawn to actions by Argentina, Brazil, India, Indonesia, Russia and South Africa - with less concern now about China  [1]

In June 2014 it was suggested that: "In the immediate aftermath of the 2008 global financial crisis, policymakers’ success in preventing the Great Recession from turning into Great Depression II held in check demands for protectionist and inward-looking measures. But now the backlash against globalization – and the freer movement of goods, services, capital, labor, and technology that came with it – has arrived. " [1]

An Approaching Crisis - From Late 2013?

Subsections under ....

Initial Economic Indicators of a Looming Crisis

Starting to Recognize the Limits of Monetary Policy - From Late 2014

Pressures for Rising Interest Rates

Do Low Rates Help?

Global Bond Market Crash?

Refusing to Face Up to East-West Structural Incompatibilities?

Economic Failure Looms - From Mid 2015

Geopolitical Indicators of a Potential Crisis

An Approaching Crisis - From Late 2013? [<]

Finding What You Might be Looking For: Diverse views on issues affecting the international financial system have been referenced below over several years.  Material on the same general topic can thus appear in different places. The following overviews the issues addressed here and identifies in time order the various places that related material appears.

In late 2013 there were increasing and accumulating signs of an approaching slow-motion crisis - one possible outcome of which was that the 'second failure of globalization' that this document has speculated about (ie a breakdown of international political and economic order - equivalent to that at the end of the 19th century that preceded and arguably caused WWI) might become a reality.

At the same time there were signs of constructive business and policy initiatives that could reduce these risks - though whether this could be sufficient to overcome the 'drag' from accumulated bad debts, resource constraints and geopolitical tensions was anything but certain.

Many cloud-based would-be industry disruptors have started business. This adds to the effect of acceleration of processing power and software development that provides the basis for 3D printing, driverless cars and sophisticated robots. Powerful forces of change have been unleashed that are disrupting traditional industries / jobs and bringing down prices / costs. This is a new age of deflation that might become the normal state of capitalism - freed from wars and cartels. The 20th century was characterized by inflationary wars and then oil shocks that led to 15% inflation - followed by 20% interest rates and recession. Now oil prices have fallen 40% due to massive increase in supply associated with fracking technologies (which eliminated 'peak oil' notions). A third industrial revolution is building. Some have predicted interest rate cuts in Australia. But world markets are pricing in lower inflation and interest rates than they were. Money printing is no longer seen as a risk. Inflation was seen as a monetary phenomenon - but this no longer seems to be so. Low interest rates are likely for a decade. A long period of steady / falling prices is likely - accompanied by low interest rates - as occurred in 19th century. This will be an era of rising asset values, huge volatility and huge transfers of wealth [1

Disruptive technological innovation (involving automation / robots in almost all fields) has shifted from linear to parabolic (according the Bank of America). This could eliminate 45% of manufacturing jobs and $9tr of all labour costs within a decade - leaving large numbers of global workers with a need to rapidly acquire new skills or be unemployable. In the US about half the workforce could be at risk. Others disagree, arguing that democratic changes will lead to labour shortages [1]

Disruptive technologies are making major changes. The rise of robots will eliminate not only industrial jobs but also 'good jobs' - such as those of paralegals, journalists, office workers, computer programmers.  This will further weaken middle class demand - which is already weak due to super-low interest rates on savings. Current major disruptions are resulting from: monetary policy (with zero interest rates and QE); exponential growth of computing power; cloud computing; ultra high speed data transmission; blockchain - as a decentralised way of verifying transactions; and direct interpersonal business dealings [1]

Enhanced energy technologies were seen as likely to make a major difference. For example:

  • new technologies for wind power were suggested to have made it cheaper (ie costing about 2.3 c/kwh in US) than coal and gas as a source of electricity [1];
  • major car manufacturers are investing heavily in improving electric vehicles and can be expected to start phasing out petrol vehicles at some stage [1];
  • according to a Barclays Bank analyst (Mark Lewis) the cost of solar power has been falling rapidly from about 40c/kwh in 2010 to around 6c/kwh. Significant improvements in energy storage are expected to make storage cheap in (about) 5 years and thus overcome the problem of intermittency [1]
  • despite the very low price of oil, investment in renewable energy technologies (solar power, batteries and electric vehicles) was accelerating as costs were declining rapidly. These technologies were expected to eventually eliminate economic dependence on oil [1]  [??? and coal??]
  •  an energy revolution is 5-10 years away because of rapid improvement in methods of storing electricity to overcome the intermittency problems associated with solar and wind power. In future coal fired and nuclear power are likely to be a thing of the past  [1]

On the other hand reasons were suggested to doubt that renewables could be as significant as political and public opinion clearly hoped they could be [1]

Massive changes (which would have the effect of eliminating up to 50% of jobs in US) are at hand as a consequence of machine learning / automation / robotics [1]

'Blockchain' is a method of using computer code to engender trust in digital-economy transactions. It first started to be used outside the mainstream financial system but its potential to dramatically reduce costs for mainstream financial institutions has now been recognized [1]

Economic change is likely to be driven by: virtual reality; wearables; big data and Internet of everything [1]

Disruptive innovations are changing the world at an accelerating pace. Passive investing is thus extremely risky because established firms in many areas are under challenge [1]

In February 2014 agreement was reached through the G20 that all members would seek (before the end of that year) to identify actions that could be taken to boost economic growth by 2%. However it was not at all clear that the financial / economic obstacles and geopolitical tensions which could disrupt such an outcome were being recognised. 

Initial Economic Indicators of a Looming Crisis  <<

Economic indicators of the possibility of a catastrophic but slow-motion crisis initially included:

  • constraints on global economic growth were indicated by the impossibility of continuing to increase the high debt levels that many (most?) governments had accumulated in an effort to stimulate economic recovery from the effects of the GFC - and the apparent dependence of economic growth on easy money policies (which had stimulated the economy by allowing government debts and household mortgages to rise to levels that were unsustainable at normal interest rates) - see Debt Denial (above).

In relation to this it is noted that:

  • the G20 (which was established to deal with the GFC) had proven unable to come to grips with the cultural incompatibilities that underpinned the international financial imbalances that made global growth unsustainable because financial repression / high levels of savings in countries with non-capitalistic economic systems translate into their trading partners' escalating public and private debts - but only so long as the latter are willing and able to put up with this (see Structural Incompatibility that Puts Global Growth at Risk and G20 in Washington: Waiting for Hell to Freeze Over);
  • counter-cyclical (fiscal and monetary) policies which had been deployed to respond to the GFC had (predictably) been unable to create a sustainable solution in the face of those structural financial imbalances (see Counter-cyclical policy can't solve structural problems, 2011). However, as noted below, there seemed to be a risk that they were contributing to the very real problem of inequality (which raised the risk of social and politic stresses) in many developed economies;
  • the private de-leveraging (ie reductions in total debt) that had started as a result of the GFC in countries such as US, UK and Australia has been reversed (ie private debt again started rising ) and this would thus boost (rather than suppress) demand and thus strengthen growth [1]. However it is noted that the total increase of private debt between 1992 and 2009 was something like 161% of GDP, and the reduction in this through subsequent de-leveraging before private debts again started rising was only about 6% of GDP . The potential for private debt to lead to a financial crisis remained much the same as it was prior to the GFC;
  • a disconnect was seen between financial markets (which had boomed) and real economies (which seemed to suffer many constraints);
Many assume that the GFC is history - but, while financial markets have improved, the real economy has been weak (with low growth, high and rising debt levels, slow investment, overcapacity, high unemployment, low income growth and negative real interest rates). GFC resulted from high debt levels, global imbalances, excessive financialization of economies and an entitlement society based on borrowing-driven consumption and unfunded social entitlement programs in developed countries. Despite talk of reform and recovery, the root problems remain largely unaddressed. Total debt levels in most countries have risen since 2007 - as high public borrowings have offset business / household deleveraging. If unfunded liabilities (eg for pensions, healthcare and aged care) are included indebtedness rises dramatically. Emerging markets (eg China) have increased debt levels substantially since crisis in an effort to boost growth. Global imbalances have decreased but only modestly - as a reflection of reduced economic activity in developed economies. Large exporters (eg Germany, Japan and China) remain committed to exports, large current account surpluses. Currencies are increasingly manipulated to maintain export competitiveness. The banking sector has increase significantly in developed economies. Too big to fail banks have become larger. Trading volumes are much greater than needed to support goods and services trade. Profits on financial trade still exceeds that in the real economy. Government / central bank policies of low interest rates and abundant liquidity have exacerbated this problem. Complex links within financial system that transmitted shocks in GFC remain - while new ones (such as CCP for derivatives have been added. Links between 'too big to fail banks' and nations have risen - as governments sought cheap funding from central banks. Reform of entitlements is politically difficult. The problem has been ignored, and made to appear to go away through low interest credit to fund government spending. Aggressive lending practices (equivalent to pre-GFC CDOs) have risen.  Policy settings have been like those prior to GFC.  It is proving difficult to end expansionary monetary policy. In future it seems likely that: growth will be slow; deflation will be a risk; sovereign debt problems will remain; emerging markets will experience greater problems; inadequacies of available policies will become more evident; economic problems will have social (eg social inequality / unemployment) and political (discontent, extremism) impacts. International distrust, 'beggar my neighbour' policies and rising nationalism are likely  [1]
  • the Bank of International Settlements (BIS - the reserve bank to reserve banks) warned in mid-2014 of the risks associated with ultra-low interest rates and the failure to deal with financial imbalances;

BIS warns that persistent 'easing bias' by reserve banks has lulled governments into a false sense of security. Ultra-low interest rates and a failure to lean against persistent financial imbalances could make global economy permanently unstable. Reducing interest rates during downturns while not later increasing them results in accumulation of excessive debt - which make it hard to then increase rates without damaging economy (ie creates a 'debt trap'). Another financial crisis could lead to retreat into protectionism and end current open global order.  [1]

 BIS warned of the need to end super-loose monetary policy in 2013. It has done so again in 2014 in stronger terms. In the meantime asset values have boomed. In 2013 BIS warned of dangerous imbalances in the financial system. In 2014 it suggested that the problems that led to GFC remain unresolved. Market buoyancy seems disconnected from underlying economic conditions. US Federal Reserve began tapering money printing 6 months ago - but has not increased interest rates. The slow pace of policy normalization after 2003 contributed to GFC. Keeping interest rates low for long periods lulls governments into false sense of security. It may be hard to arrange a smooth exist from low rates. Markets may move first if reserve banks are seen to be too slow. BIS sees a need to look at 15-20 year financial cycle - not just at business cycle of about 8 years. Apart from setting markets up for a big bust, persistent low interest rates are increasing income inequality. When asset prices rise, the rich get richer. But real wages are flat of declining, while governments cut back on welfare to reduce budget deficits [1]

The world economy is seen to be just as vulnerable in 2014 to a financial crisis as it was in 2007 according to BIS - because investors were ignoring the risk of increasing interest rates as they search for yield. The problem has been compounded by debt ratios that are now much higher and emerging markets are been drawn into the line of fire. Debt ratios in developed economies have risen 20% to 275% of GDP. 40% of loans are to sub-investment grade borrowers (higher than in 2004) while creditors have fewer protections. China, Brazil, Turkey (and other emerging markets) have had private credit booms - partly as a spill-over from QE in the west. Debt ratios there have risen to 175% of GDP - with average interest rates of 1% pa for 5 years - an extremely-low  rate that could suddenly reverse [1]

  • as a consequence of easy money policies many institutions and individuals had apparently incurred debt levels that they could be unable to service if / when interest rates return to more normal levels (eg see note below on governments). A crisis could be triggered if:
    • easy money policies were to stimulate a significant increase in real economic activity (rather than mainly just boosting asset values). An inflationary surge would seem very likely - as the 'velocity of money' would increase. To prevent an inflationary spiral, the ready availability of cheap credit would need to be rapidly ended and interest rates rapidly increased;
    • there were significant increases in wage rates. Signs of such a breakout (because of a decline in the available workforce, rather than because of any increase in economic activity) were being seen in the US in mid 2014 [1];
    • speculative excesses were seen to be to only effect of easy money policies - about which concerns were emerging in the US in mid 2014;.

In the US consumers and companies are reducing spending, technology leaders are not innovating and increasing regulation poses risks. Wall Street and the owners of capital are seen to be booming while Main Street and the workers struggle. Speculative excesses could cause the Fed to tighten. The stimulus from low interest rates has been unable to overcome de-leveraging, regulation and a lack of innovation. Despite this Wall Street booms. Though employment has grown, consumer confidence is weak. The 1% GDP fall in first quarter of 2014 is likely to be revised down even further. Nominal GDP has risen only 19% in five years - well below the 45% that arises in normal recoveries. Meanwhile the stock market booms. The longer this imbalance continues the greater the risk that it will be necessary to curb speculation before real recovery occurs. [1]

  • it was possible (though not certain) that government debt levels in various major economies may have become so high (as a result of counter-cyclical fiscal and monetary policies) that it may now be impossible to avoid a worse global financial crisis than that which started in 2008.
During GFC the world's money supply has increased rapidly as a result of QE by reserve banks.  A major effect of QE has been to allow governments to borrow cheaply and expand their debt levels while (except in a few cases) containing their debt service costs to within available revenue. Creating credit in this way has led to economically destructive inflation at many times in history. However this has not happened because the escalation of money supply has been counterbalanced by an offsetting decline in the velocity of money (ie the number of times that money supply turns over annually has fallen because business and households have been reluctant to spend the money that has been created).  In a recovery situation, the velocity of money could also recover and require a rapid reversal of QE if a high rate of inflation is to be avoided. However rapidly phasing out QE would have the effect of raising interest rates - and thus making government debt levels impossible to service in many major economies (as these currently depend on ultra-low interest rates). US national debt (for example) has been suggested to perhaps reach $20tr by 2020. If more normal (eg 5%) interest rates prevailed, debt service would consume 40% of US federal revenues. Thus in some sense government debts are giving rise to a 'too big to be allowed to fail' scenario which parallels that major banks created for policy-makers after 2008. However preventing government fiscal collapse by maintaining QE in a recovery environment would presumably lead to massive inflation [1]
  • financial exposure in countries with poorly developed financial systems had resulted from quantitative easing programs by the US Federal Reserve and others. Some had seen this as involving a Currency War;
  • simultaneous monetary tightening by the US and China raised the risk of a deflationary trap for many of the world's economies as liquidity drained away (according to the IMF) [1]
China appears to be serious about ending its credit bubble (rather than deferring this) - even though it has acted to bail out a number of failing trusts. This will have adverse implications for emerging economies and commodities' producers. It may be hard to achieve slow deflation - and a hard landing is possible. China's credit expansion had been unprecedented - and seeking to reverse this could lead to a crisis. China also has significant offshore credit exposure. Global coordination does not exist. Some exposed economies are tightening into economic downturns to protect their currencies. The US Fed is tapering out of concern for asset bubbles. The ECB has been paralysed by German constitutional court decision - which prevented Bundesbank participating in QE. [1]
  • there is concern that QE might leave a toxic legacy. High risk borrowers have been given automatic financing for car purchases and sub-prime auto 'asset backed securities' have been bundled and sold to investors seeking yield. The purpose of QE was to force investors to seek riskier investments. Securitization has packaged corporate loans, commercial mortgages and sub-prime auto-loans. Issuance of junk-rated corporate bonds is at a high level. QE may have unleashed demand in financial markets rather than in the real economy. Investors may be being encouraged into asset classes that do not compensate them for the actual risk they face  [1]
  • the creation of peer-to-peer 'virtual currencies' such as Bitcoin has been suggested to potentially make it impossible for reserve banks (and thus monetary policy) to operate effectively - a possibility that though anything but certain, seems to require closer examination because of its geo-political implications

Is Bitcoin a Threat? - email sent 18/3/14

Mike Ward
Money Map Press and

Michael Robinson
Money Morning

Re: Edison’s revenge on the dollar, 13/4/14

Your video-article suggested that Bitcoin (as a peer-to-peer virtual currency backed by a scarce electronic ‘commodity’) will undermine the ability of Reserve Banks to issue fiat currencies, and that this creates profit opportunities. I would like to suggest for your consideration that, if Bitcoin (and its imitators whose numbers are reportedly escalating) survives, the long-term effect could be to undermine, rather than promote, economic freedom. Thus the phenomenon needs much broader evaluation – and the following suggests some aspects that perhaps need attention.

There are undoubtedly problems with the way currencies are managed at present (eg as reflected in the apparent need for reserve banks to ‘print’ of paper money to provide credit to governments and liquidity to the banking system). However there is a need to consider why this practice has arisen – because this is central to the environment into which virtual ‘currencies’ such as Bitcoin would be introduced, and which they would potentially affect.

Firstly easy money policies by reserve banks reflect the breakdown of assumptions (that were popularised by Keynes in the 1930s) that economic booms and busts could be prevented by counter-cyclical government spending.

Explanation: Counter-cyclical public spending to balance business cycles was recognised to be inadequate in the 1970s. For example, governments could seldom get the timing right and their ‘counter-cyclical’ actions often proved pro-cyclical (ie attempts to increase spending to counter a ‘bust’ often resulted in large extra public spending during the next ‘boom’). When a potential ‘bust’ threatened the US as a result of the 1987 share market crash, the US Federal Reserve tried a new method for counter-cyclical economic management. Increasing the liquidity available to the banking system prevented the financial market ‘crash’ from affecting the real economy – and thus speeded recovery. The continued use of this method allowed an unprecedented two decades of global economic growth that was not interrupted by major reversals (ie the business cycle was stabilized to some extent and booms and busts in the real economy were minimized). However it also led ultimately to increasing risk of financial instabilities – because, for example, investors decided that they did not have to take as much account of risk as they had previously done, and this encouraged asset bubbles.

Secondly the bursting of particularly vulnerable asset bubbles in 2007-08 led to a major shortfall in ordinary financial institutions’ ability to provide the credit that the global economy required (because financial institutions’ balance sheets had been seriously damaged and it would be impossible in the long term to continue funding demand through large international financial deficits). The disciplined creation of credit through reserve banks provided a means to avoid a dramatic real-economy recession / depression. It also created the risk of future financial instabilities by allowing the risks associated with investment to continue to be discounted.

These and other concerns have arguably made it necessary to develop alternative methods for counter-cyclical economic management (see New Methods for Macroeconomic Management?, 2007).

Moreover there has perhaps been a ‘clash of civilizations’ dimension that needs to be considered in relation to the loose monetary policies by reserve banks that have prevailed in recent years (eg see Competing Civilizations).

Explanation: It appears that there has been a generally-unrecognised contest (a virtual ‘ war’ for control of the international financial system) between liberal Western-style institutions (ie economies based on profit-motivated independent initiative) and East Asia neo-Confucian alternatives (ie economies, initially Japan’s, where state-linked enterprises are funded by state-linked banks on the basis of consensus by authoritarian intellectual elites rather than calculations of investment profitability). Where (for cultural reasons) profitability is not taken seriously (see Evidence) economic growth can potentially be very rapid given elite guidance using neo-Confucian methods (see Understanding East Asia's Neo-Confucian Systems of Socio-political-economy, 2009). However such arrangements require financial repression / savings gluts to ensure that current account surpluses eliminate the need to borrow in international profit-seeking financial markets. Thus structural demand deficits exist that threaten global economic growth (see Structural Incompatibility Puts Global Growth at Risk, 2003). However the pre global-financial-crisis (GFC) era was characterised by loose monetary policy especially in Japan (to feed the so-call “Yen carry trade’) and in the US (where Federal Reserve officials often referred to the need to counter the risk of deflation – presumably in Japan). This permitted demand well in excess of supply - especially in the US - because asset values boomed. Thus global growth could be sustained despite the demand deficits that were needed by major East Asian economies and emerging economies with poorly-developed financial systems (see Impacting the Global Economy, 2009). In the post GFC era the situation has become even more complex because large international financial deficits could not indefinitely be relied upon to finance US domestic demand and the consequent need for quantitative easing by the Federal Reserve also led to the emergence of what have been seen as ‘currency wars’. For example, the Federal Reserve’s quantitative easing program can be viewed as a possible (also undeclared) counter-offensive – involving doing-unto-others as others had long done to the US – ie providing cheap credit encouraged carry-trades and incautious investment (which could create a risk of asset-bubbles) elsewhere (see Currency War?).

In this environment the creation of peer-to-peer virtual currencies could have geo-political implications – as (if they survive) they could threaten the ability of Reserve Banks to stabilize banking systems and provide a measure of macroeconomic management. Thus governments will (presumably) need to consider those issues – and other factors such as those mentioned below:

  • Without effective reserve banks there would be no back-up to banks. Such a back-up is vital, because banks typically borrow short but lend long, and are thus potentially exposed at times to runs because of short term financial-system instabilities even if their long term prospects may be sound;
  • The effect that independently-created / invisible virtual currencies would potentially have on allowing financial transactions to be hidden and taxes to be avoided is another reason that governments will have to consider the implications of Bitcoin and its imitators. Bitcoin has also reportedly been the subject of concern that it has been used for illegal activities;
  • Large numbers of virtual so-called ‘crypto-currencies’ are reportedly being developed to mimic Bitcoin (see Volkering S., ‘The Crypoconomy: Goodbye banks, Hello the future of money’, Money Morning, 17/3/14). If ‘crypto-currencies’ survive, this would not only dramatically increase their potential destabilizing financial / economic impact, but also put their survival at risk – because: (a) all such ‘crypto-currencies’ would presumably have the same potential value in the long term; and (b) as long as that value exceeded zero other individuals / groups would be motivated to make their fortune by creating a new ‘crypto-currency’ (as many now seem to be doing). Imitators' ability to create an infinite number of essentially identical and thus equally valuable crypto-currencies at low cost presumably implies that their price would trend towards zero; [In 2015 it was noted that Bitcoin could be facing an existential threat because two groups had emerged with different ideas about the nature of Bitcoin - at the same time that other groups were developing alternative crypo-currencies [1]]
  • Though it is unlikely it is possible that the mysteriously-sourced idea of ‘crypto-currencies’ could have been planted as a ‘currency war’ counter-counter-offensive. If Bitcoin and the like were to survive and make it impossible for reserve banks to stabilize financial institutions (and thus to stabilize the financial system and economies) liberal capitalistic Western-style systems of political economy would be disadvantaged relative to their East Asian competitors (as the latter rely on economic coordination largely through state-linked elite social relationships rather than through a search for profitability by independent enterprises). A reliable financial system is the ‘nervous system’ of Western economies, but is much less significant in East Asia. Making suggestions that enemies find appealing and act on without understanding possible negative consequences is a conventional ‘Art of War’ tactic. Also Western observers need to be aware of the need to Look at the Forest not Just at the Trees (ie at the big picture, not just at specific 'things') in order to adequately understand the implications of 'things' that might emerge from East Asia;
  • There have arguably been reasons for several years to constrain the ‘virtual’ economy (ie the possibility of making profits through transactions that have no ‘real economy’ benefits of which the Bitcoin is a recent example) - see Restricting the Role of Financial Services;

At the very least some sort of regulatory arrangement (presumably global in scope and perhaps under the Bank of International Settlements or the International Monetary Fund) would need to be created to govern virtual markets for ‘crypto-currencies’ like Bitcoin. Regulations would presumably need to include: (a) licencing the creation and operation of ‘crypto-currencies’; and (b) requirements for peer to peer ‘crypto-currency’ transactions to generate traceable records that would be accessible to authorities (to reduce the potential for of tax evasion and criminal activities).

I would be interested in your response to my speculations.

John Craig

  • the legacy of the GFC was a major constraint on global economy in the OECD's view. Growth was slow, unemployment high, inequalities were growing, public trust in institutions established over the past 100 years was low, investment and job growth were weak [1];
  • the IMF warned that the high debt levels that existed worldwide - and this constrains growth given aging populations. Public debts in rich economies fell from 129% of GDP after WWII to 29% in 1973 - but have since growth at 2% pa- to 105% of GDP after Lehman crash. The baby boom and surging growth after 1945 allowed growth out of debts - but without this a low-growth trap seems likely. This is not confined to West. China's workforce is shrinking 3m pa. There has been a persistent decline in growth since GFC - and this makes debt repayment harder. There is a risk that default will be seen as the way to deal with un-repayable debts [1]
  • Major European economies were seen to be headed for recession / potential depression in August 2014 - as a consequence of the austerity measures that were mandated by the European Commission to deal with high sovereign debt levels [1]. Inflation has declined over the past 3 years leaving the Eurozone perilously close to deflation - which is dangerous because a little bit of inflation is needed to encourage people to spend rather than save for later [1]. In July 2014 concerns about the viability of one of Portugal's major banks (and about the fact that Portugal's debt burden (eg private sector debts are 250% of GDP) will probably require defaults) cast doubt on Europe's leverage problems more generally [1] ;
  • questions have been asked about the future viability of pre-GFC economic growth rates in advanced economies such as the US - because of constraints related to: (a) demographic changes (which imply that a smaller population percentage is working); (b) the high cost of education; (c) high consumer / government debt levels; (d) costly environmental regulations; (e) the effect of globalization - which reduces incomes of those exposed to competition from low wage economies; and (f) inequality - the benefits of growth flowing much more to high income earners than to those on lower incomes who are also traditionally the main consumers [1] [CPDS Comment: Options to improve those prospects are suggested, in an Australian context, in A Case for Innovative Economic Leadership]
  • A great deal of attention was often paid to the level of (government / total) debt that particular countries had (eg by citing debt / GDP ratios) as an indicator of their risk of financial crises. For example there was concern that debts in relatively small peripheral European economies seemed unsustainable and serious US federal government debt problem seemed likely in several years if action to reduce deficits was not taken. However what was arguably really important was the quality of debt. Where borrowings have not been invested productively (as appears to be a structural feature of the non-capitalistic neo-Confucian systems in East Asia), they are much more likely to lead to a financial crisis than where disciplined financial practices are the norm;
  • Significant risks apparently faced various emerging economies, such as the so-call Fragile Five (India, Indonesia, South Africa, Turkey and Brazil).
 In relation to emerging economies it was suggested that:
  • A string of emerging market economies (Turkey, Argentina, Brazil) were forced to tighten monetary policy to halt capita flight - and this raised the risk of a viscous cycle as debt problems mount. Emerging markets make up half global economy. They had not undertaken necessary reforms over previous years - but instead relied on China's growth and ample global liquidity [1];
  • the IMF argued that banks and businesses in emerging economies undertook massive expansion of borrowing from international markets - and were faced with serious disruption as interest rates increase in the West. This implied that large foreign exchange reserves and borrowing in their own currencies had not insulated such countries from problems [1]; 
  • the possibility of a 'market rout' was perceived in emerging economies (and global contagion from this). Argentina's currency collapsed, and there was concern for Brazil. The IMF suggested that prospective tapering in US had caused global liquidity to dry up - causing problems for emerging economies. Countries that had benefited from the commodities super-cycle and the credit boom would need to implement structural reforms urgently [1];
  • OECD warns that deepening slowdown in emerging economies is holding back global economy and poses financial system risks to Spain, UK and other European countries with large bank exposure to emerging economies. The US's 'tapering' of QE has only just begun - and capital flight from emerging economies could intensify. Spain is particularly exposed (Spain's bank exposure to emerging economies is 35% of GDP) while US is not (3% of GDP). OECD wants phase out of QE to be slow and ECB / Bank of Japan to increase stimulus. Emerging markets' now account for 50% of global economy. Leading indicator for them peaked in 2011 and has declined since. Tightening monetary policy to defend currencies has recently made the situation worse. European banks are also increasingly constrained by ECB stress tests - at a time when private sector lending is contracting and small firms in southern Europe face a credit crunch [1]
  • major East Asian economies such as in Japan (see Japan's Predicament) and China (see China's Predicament) seemed to seemed to be at risk of financial crises because of the massive expansion of credit to sustain growth and their lax accounting standards (ie to the fact that return on, or even return of, national savings mobilized through state-linked financial institutions was not seen to be important - see evidence). In September 2014 it seemed possible that China was approach an economic crunch point. In November 2014, the possibility of a deflationary crisis affecting Asia (and spilling over to affect Europe) was suggested:

Deflation is affecting East Asia - much faster and more deeply than expected. This could soon affect Europe through currency warfare. Factory gate prices are falling in China, Korea, Thailand, Philippines, Taiwan and Singapore. 82% of items in China' producer price deflator are deflating. Entrenching deflation risks worsening debt problems for those countries that have let debt exposure rise. The region's debt level as a whole (ex Japan) have risen from 147% of GDP to 205%. They want to deleverage - but deflation makes this impossible (just as is the case in much of Europe). The PPI index for emerging Asia turned negative in September 2014, just before BoJ started a further deflationary impulse by driving down the Yen. The BoJ argues that China's weak yuan policy was the main cause of Japan's deflation crisis over its lost 2 decades. China is now close to a deflationary trap. Over-investment is massive. $5tr was ploughed into new plant and fixed capital last year - as much as in US and Europe combined. Consumer prices are starting to follow producer prices down. China has risked deflation before - but now its debt problems are vastly greater. China is sliding towards a European debt-compound trap - though the actual extent of the problem is unclear. PPI deflation increases the cost of leverage - and risks setting off a cycle of debt defaults with gets out of control. Asia is not yet in a full-scale currency war, but countries can't ignore deflationary effects from others. China's problems are compounded by yuan link to $US. China will have to lower interest rates and the yuan [1].

Starting to Recognize the Limits of Monetary Policy - From Late 2014   <<

  • in late 2014 there were clear signs of changes in the primarily monetary-policy methods being used to to try to stimulate sustainable economic growth, and debate / concerns about what was needed and its implications;
  • in mid 2014 there were increasing suggestions that easy money policies (eg quantitative easing) were not working and had significant negative side effects;
  • in August 2014 the world economy seemed to be headed for trouble despite being awash with huge quantities of cash as a result of quantitative easing by reserve banks. China's economy was slowing. Europe was flat-lining. Japan was declining. The UK suffered wage deflation. The US was just ticking over. Many policy-makers wanted to move away from QE - as their economies were not responding to it [1]
  • very serious problems with inequality had emerged in many developed economies over the past few decades. Though there were many factors involved reliance on easy money policies to sustain overall economic growth seemed to be a significant cause of those rising inequalities (see Who is Failing the Low and Middle Classes?);
  • unwinding the balance sheet that the US Federal Reserve has gained through quantitative easing has been suggested, by an early architect of that program, to be likely to be hazardous. The Fed has $4.5tr on its balance sheet - from ultra-low interest rate lending to major banks. This has benefited those banks, but: (a) a few institutions control most assets; (b) the top 1% of Americans have earned 90% of income gains since 2009; (c) US economy is 70% dependent on consumer credit - and household debt levels are maxed out. When Fed seeks to unwind its balance sheet, it will probably incur massive losses (as its low interest loans are devalued in a higher-interest rate environment) - and perhaps: (a) need to seek government bail-out; and (b) lose its political independence [1].
  • it has been suggested that quantitative easing (eg through reducing interest rates) may itself be causing deflation by (for example): reducing the collateral seen to be needed for lending; leading to excess liquidly flows into emerging economies that generate a financial mess and require increases in domestic savings ('savings gluts' that have a deflationary global impact) to guard against the risk of financial crises.  This implies that an alternative involving increasing the quantity of money may be better. However the issues are arguably more complex for reasons suggested below;
  • there is an increasing view that cheap money policies have been economically distorting - and many examples to support this. What has been done has been unprecedented in history. How it will end is uncertain - but it is almost certain to end badly [1];
  • concern was expressed by the US Federal Reserve of St Louis that easy monetary policies have restrained, rather than stimulating, growth - and that hyperinflation could accompany the ending of those policies. The quantity of money has been increased very rapidly, but this has been forced to the sidelines (ie is being hoarded) because interest rates are so low. When interest rates rise, there is concern that the increased incentive to buy interest bearing securities will release the hoarded cash into the market and trigger hyperinflation. As the quantity of money has escalated in recent years, its 'velocity' (ie the number of times per year money is used) has collapsed. A significant increase in the velocity of money could trigger substantial inflation [1];
  • an observer who had believed that permanent easy money policies might be needed to generate demand in US through stimulating asset bubbles has changed his mind. US faces an increasingly tight labour supply constraint on its economic production. Very significant structural changes may thus be needed to maintain growth while significant increases in interest rates will be needed to head off the risk of inflation [1];
  • in July 2014 it seemed that the US Fed was moving much more rapidly towards higher interest rates than previously expected - because unemployment had fallen to its 6% target and inflation was increasing - thus raising the risk of over-shooting on inflation unless easy money policies were wound back. This could cause problems for many countries that have 'gorged' on the $3.5tr that the Fed had provided to the world economy through its bond purchase program. Problems can be expected in the 'fragile five' (India, Indonesia, South Africa, Turkey and Brazil). Large amounts of hot money had gone into emerging markets - and will probably come out quickly. Monetary easing in West had forced emerging economies to choose between higher exchange rates and asset bubbles - and most had chosen the latter. Debt to GDP ratios have gone to 175% of GDP (and in China it is 220%). Many doubt that China can extricate itself. There are a lot of countries facing the middle-income trap - having exhaustion low-hanging fruit of catch-up growth yet have not put market reforms in place. Brazil South Africa and Russia have been headed for recession. All will now face secular rise in interest rates. The BRICS, mini-BRICS and much of global finance have taken out a short position against the $US. The Fed has now issued a margin call [1].
  • in September 2014 it was suggested that:
    •  global markets could face serious instability as the US Federal Reserve moves towards increasing interest rates as its economy is recovering, while the ECB and Japan have little choice but to continue monetary stimulus / quantitative easing. Other dollar-block countries (eg Canada, UK, Australia, New Zealand) will follow US lead. $US will strengthen significantly [1];
    • the world's financial system is at an inflection point - as both the US and China end monetary stimulus. This will have major effects on asset markets. The yield on US Treasuries is rising - perhaps to 3.75% in 2015. This will create a stress test for debt in Asia and developing world. Dropouts from US labour force are seen to be structural (due to population ageing and new technology) rather than cyclical - so economy could be near point where labour shortages raise inflation risks. Hopes that ECB might compensate for end of QE are unrealistic. Both China's and US central banks are turning hawkish. China's budget reforms will soon halt rampant borrowing by local governments. Large segments of China's shadow banking system have been shut down. This follows epic mal-investment over the past 5 years (as loans rose from $9tr to $25 tr). Whether China can extricate itself is an open question - as it followed script written by Japan 30 years ago. China's growth was more imbalanced, its reliance on external demand was greater, governments response to external demand shock was looser, debt growth was faster, overcapacity was worse and asset price appreciation has been just as rapid. While China may tough it out, adverse impacts will affect those who have lived by 'feeding the dragon'. Iron ore prices have collapsed and supply is in surplus. China's variation of QE (buying foreign assets such as US / EMU bonds) is coming to a halt - as foreign reserves are being seen as a burden - stoking inflation. The commodity bloc and Asia's rising powers have amassed $12tr in foreign reserves (gobbling up Treasuries, Gilts, Bunds, gold) as a form of world QE. If they start selling the global financial structure will be turned on its head. This wall of money was a key cause of pre-Lehman asset boom and continues to drive new bubbles everywhere (and thus what the BIS sees as disconnect between buoyant markets and underlying economic fundamentals). Asset markets are likely to snap. Emerging market economies (mainly in Asia) have borrowed $2tr in dollars since 2009 mainly at real rates of 1%. The emerging world imported the West's ultra-stimulus at the wrong time in their economic cycles driving debt-GDP ratios to 175% of GDP. Emerging markets have suffered minor problems as QE has been slowed, and must now face 'rates rage' as Fed actually tightens. Some (eg Mexico) have boost their defenses. Most have not. Fresh carry trades have washed over these countries - masking risks. Few have undertaken meaningful structural reforms. Most are vulnerable to a shock. Leaders of the BRICS and mini-BRICS insist that these countries have outgrown the problems they faced in the 1980s and 1990s. They will soon have a chance to prove it [1].
  • the next market correction was seen to be like that in 1987 - and be the result of changes in credit markets. Yields have been sought in global credit markets as central banks have held rates at near zero levels. In desperation at getting near zero yields from US Treasuries, funds have been buying anything with a better yield without concern fro credit quality. The issuance of corporate 'junk bonds' is at record levels. It is easy to get into such products but hard to get out - as if there is a problem (eg due to some high profile defaults) no one would be willing to buy. Thus fund managers who face redemptions could be forced to sell higher rated securities [1]
  • in October 2014:
    •  it was suggested that deep global problems were starting to affect stock markets. While the US is performing well, Japan and Europe face recessions, while China is slowing more than officially acknowledged. There are too many serious military threats around the world. QE flooded the world with liquidity - but this is now ending and so increasing problems in Europe and emerging economies. US investment bankers had used that liquidity to create financial risks like those preceding the GFC (according to International Organization of Security Commissions). High yield US bond issues will reach an historical high ($617bn); subordinated bond issues will be close to pre-crisis levels; covenant-lite issues will be $177bn; while use of debt to repay debt and contingent capital have returned to pre-crisis levels. High-leverage lending / margin debt / junk bonds are at record or pre-crisis levels. Those who have borrowed heavily to get stock market up will need to get out as the market falls and selling multiplies. If the high-risk games that have been being played turn sour, liquidity will be in very short supply [1];
    • complex securitized debt products that were the core of the 2008 financial products. The International Organization for Securities Commissions argues that they have made a comeback because of the hunt for yield [1]
    •  China announced liberal market reforms in relation to local government debt that were likely to: (a) precipitate substantial financial losses in China mainly by households and companies; (b) have uncertain but perhaps serious economic consequences; and (b) allow China's regime to blame the adoption of Western-style financial arrangements for triggering that outcome;
    • the President of the ECB (Draghi) announced unexpectedly that without significant economic reform in Europe future economic growth was uncertain - after having maintained for two years that the ECB would do whatever it takes to maintain growth. German exports, previously a source of strength for the region, fell 5.8% in August [1]
    • there could be a violent reversal on global markets (according to BIS) because investors take zero-interest rates for granted and thus presume that reserve banks can protect them. Fixed income investments could be particularly affected as liquidity dries up [1];
    • global liquidity was seen to be evaporating because central banks had reduced their net stimulus by about $US125bn per month. This has produced a shock to the financial system. The US Fed and the People's Bank of China have stopped their versions of QE - while others have reduced theirs' by half. The accumulation of reserves by the BRICS, emerging Asia and the Petro-states has collapsed. China has started selling its foreign reserves - as they were seen to be becoming a burden. Though reserve accumulation was not the same as QE, it had a similar effect (ie inflating asset values). This was what Bernanke had referred to as the 'global savings glut'. The flood of money into bonds reduced yields for everyone - and the US subprime crisis and Club Med debt bubble resulted. Over the latest quarters most countries have been choking back on reserve accumulation or becoming net sellers. QE by the west had set off roughly equal amount of bond purchases by reserve banks in emerging economies. In phasing down QE there has thus been a doubling effect from emerging economies. For over three years the liquidity bonanza had fuelled asset booms despite a weak global economy, a slowing China, a permanent slump in Europe and stagnation in Brazil and Russia. It was assumed that world economy would catch up with frothy stock-markets. it has not done so. Either more QE will be introduced or stock markets will deflate significantly. [1]
    • Robert Murdock argued to G20 finance ministers that quantitative easing has increased the gap between rich and poor. Where reserve banks attempt to stimulate the economy by buying assets with newly minted money, this could increase inequality by pushing up the price of assets and thereby disproportionately rewarding wealthier households [1];
    • the Chair of the US Federal Reserve expressed concern about the extent of social inequality in the US - a problem that some ascribe to the Fed keeping interest rates too low for too long [1]
    • it might be impossible to ever end QE because asset markets were now totally addicted to increasing central bank debt [1] ;
    • it was necessary to end QE even though this might have adverse effects on financial markets because QE had underpinned rises in all assets irrespective of their underlying quality - and it was now desirable to make proper analysis necessary. The fact that the real economy was doing well implied that difficulties in financial markets would not have effects that were too serious [1];
  • following the official end of quantitative easing (QE) by the US Federal Reserve in late October 2014, there was considerable debate about the potentially-disruptive implications of this transition.
  • there could be a significant monetary gap as the world's two superpowers (US FED and People's Bank of China) cease increasing liquidity simultaneously. The FED is closer to tightening interest rates. It no longer prints money to buy US Treasuries - which has contributed to $7tr in cross-border bank debt (including $2tr in emerging economies). The stock of QE remains, but the flow has ceased. This will have significant effect from classical monetary viewpoint . Some fear that even ending QE amounts to a significant monetary tightening. The world is caught in a 'liquidity trap' / 'secular stagnation' because China has been investing $5tr pa and overloading the world with excess capacity in everything, Europe has been starving the world of demand by tightening fiscal policy into a depression while running a $400bn pa current account surplus. The global savings rate has risen to $25% - which is the flip side of chronic under-consumption. US economic is growing briskly and can handle monetary tightening - but the rest of the world is weak. FED has ceased being the friend of global asset prices to being a threat. US Treasury market is pricing in near depression conditions. Inflation expectations have collapsed. It is strange that FED should withdraw stimulus under these circumstances. It must steer between risk of deflation and asset bubbles. Sliding commodity prices could indicate trouble. In 1928 commodity prices fell as Wall Street boomed and the credit bubble in Weimar Germany was rising. FED hawks ignored the deflation risk and raised rates to counter speculation - and this set off a global chain reaction. A broad measure of money growth has fallen from 6% in early 2013 to 2%. China's PBOC is also winding down stimulus to tame China's $25tr debt monster. Bad loans are rising fast in big state banks. China became a net seller of global bonds in the third quarter 2014 - after buying $35bn / month earlier in the year. The latter had been a different form of QE - and has now stopped. Brazil, Malaysia, Singapore and Thailand all cut foreign reserves. Russia is burning through its reserves to defend the rouble. Other oil states will have to do the same to cover their budgets. Net bond-buying stimulus by global central banks has fallen $1.5tr pa since the start of 2014. The $10.2tr of net reserve accumulation since 2000 (that has played a major role in the modern asset boom) has now been reversed. European central banks have not helped in terms of QE. [1]
  • the end of QE will cause great nervousness about bond markets, and thus is likely to trigger an equity market boom as safer destinations for investors funds are sought;
  • the QE program has been a success in that the US economy is now growing fairly strongly and will this should be sustainable without further QE [CPDS Comment: The effect of stronger growth on the 'velocity of money' needs consideration. Is there a potential for past QE to create inflationary pressures in the real economy (rather than mainly boosting asset values) and thus for past QE to need to be unwound very rapidly?]. The former Chair of the US Federal Reserve (Alan Greenspan) reportedly argued that 'the Fed's balance sheet is a pile of tinder, but it hasn't been lit .... inflation will eventually have to rise' [1];
  • a bull market in $US seems likely to follow the end of QE. This could threaten US shale-oil boom. It could also threaten emerging markets which have benefited from $US carry trades. In particular China could face a risk of economic collapse related to a currency crisis (see outline below). 

An Even Scarier Story for Emerging Markets - email sent 1/11/14

John Maudlin
Mauldin Economics

Re: A Scary Story for Emerging Markets, Maudlin Economics, 25/10/14 [see outline below]

I was very interested in your account of the nasty effect that a $US boom could now have on debt-dependent emerging economies. However I would like to suggest that the story does not have its origin in post-2008 ‘financial repression’ by the US.

‘Financial repression’ appears to have had its origin in the ‘bureaucratic non-capitalist’ systems of socio-political economy that have been the basis of economic ‘miracles’ in East Asia. This effect started decades ago (see A Generally Unrecognised 'Financial War'?, 2001+ and Structural Incompatibility Puts Global Growth at Risk, 2003) and played a major role in giving rise to the 2008 global financial crisis (see Impacting the Global Economy, 2009). Where little or no emphasis is placed on return on capital in making investments (see Evidence) ‘financial repression’ (ie diverting national savings from households / consumers to ever-rising production) is vital to ensure current account surpluses and thus that there is no need for financial institutions with suspect balance sheets to have to borrow in international profit-focused financial markets.

The expectation by emerging economies that the risk of financial crises (like the Asian Financial Crisis of 1997) could be avoided by maintaining current account surpluses compounded the problem. This seemed to be based on observing that countries with suspect financial systems who achieved current account surpluses (ie Japan and China) had not been affected by the Asian crisis (see Leadership by Emerging Economies?, 2009). Other emerging economies’ attempts to achieve similar protection magnified the international financial imbalances problem that: (a) made global economic growth unsustainable because it relied on their trading partners’ (especially the US’s) willingness and ability to be the world’s ‘consumer of last resort’ and sustain ever-rising debt levels; and (b) made reform of the international financial system increasingly necessary.

The easy-money policies that the US Federal Reserve adopted after 2008 can be seen as involving ‘financial repression’ (ie leading to large outward capital flows like the earlier Yen carry trade) only because financial repression in East Asia (and the methods the Fed had adopted to try to cope with it after 1987) and emerging economies’ reliance on current account surpluses to avoid financial crises had already led to unsustainable levels of debts in the US. What the US Fed then did (either intentionally or inadvertently) can perhaps be seen as A Counter-move – to put pressure for reform on those whose relied on current account surpluses (eg via financial repression in East Asia) to protect their poorly developed financial systems .

The risks that emerging markets currently face are probably very real – and much like your article suggested.

Some undoubtedly-improvable speculations about what might be required for a solution are outlined in Towards a New Economic Understanding.

I would be interested in your response to my speculations

John Craig

Outline of A Scary Story for Emerging Markets

A bull market in $US seems likely to follow the end of QE. This could threaten US shale-oil boom. It could also threaten emerging markets which have benefited from $US carry trades. In particular China could face a risk of economic collapse related to a currency crisis. The widening gap in economic activity amongst US, Europe is forcing a dangerous divergence in monetary policy. The US fed will taper QE3 asset purchases to zero. The Bank of Japan is likely to increase its asset purchases, and this will put pressure on the ECB to do likewise. This could lead to 1990s' style $US rally - with bad results for emerging markets and highly leveraged / integrated global financial system. Easy monetary policy since 2008 has led to increasing global debt / GDP ratio. This has led to some over-investment and capital misallocation in developed-world financial assets - but this phenomenon has been much greater in emerging markets where the flow of easy money has caused borrowing to explode on top of a massive $US funded carry trade. Financial assets in emerging markets have nearly doubled since 2002. The QE induced capital flows have kept sovereign borrowing costs low in emerging economies - and enabled sovereign debt issuance to be high for years despite the structural weakness in those markets. There is not only a direct effect from external capital inflow but also the effect on rising asset prices (especially real estate) that makes it seem that borrowers have more equity than they have. The problem for emerging economies is compounded by the fact that growth rates in global trade have become much less than pre-2008 levels. Emerging economies has to choose between a slowdown in parallel with developed economies (which risked social / political unrest) or gear up to attempt to stimulate domestically led growth. The consequence is illustrated by China - debt-fuelled / state directed / investment-led growth; massive debt bubbles, unmanageable non-performing loans and the prospect of a very hard landing. Many emerging economies have created a similar prospect of domestic financial crises because of the way  they kept growth growing in the wake of the GFC. The 'fragile eight' (Argentina, Brazil, Chile, India, Indonesia, Russia, South Africa, and Turkey) are in an 'addicted to capital' phase of their balance of payments cycle - and face risks of capital flight. Debt-fuelled over-investment may increase growth for a time but poor returns / selling lead to losses / defaults / banking panics. And where foreign capital drove the investment boom, capital flight and currency collapse is likely. This is the 'balance of payments' cycle. Central bankers can try to limit the effects by spending FX reserves or raising interest rates. A serious problem faces many emerging economies (especially the fragile eight) - and perhaps China in the event of a forceful unwind of the $US carry trade. Turkey, South Africa and Chile seem at great risk of capital flight. The ultra-low interest rate policies in developed economies have forced savers to seek risker returns for over 5 years. The effect on emerging markets has been collatoral damage. Raoul Pal estimates that resulting carry trade has grown to about $3tr into major emerging economies as well as $2tr into China. This is much greater than massive Japanese yen carry trade that had reached $1tr by 2007. All this could unwind very quickly in the event of a major $US rally. Major developed economies can adjust to these changes - but the need for reform in emerging economies makes this harder. China's situation is worse than it seems because state-sanctioned data under-states the world's most dangerous debt bubble. $US rallies have been associated with emerging-market crises in the past. The next round of policy divergence could be even more damaging. These are consequence of post-2008 financial repression - and are the reason that emerging-market central bankers (eg Raghuram Rajan) are calling for coordination of global monetary policy.  [1

  • The Bank of Japan has significant increased QE to drive down the Yen and avert a relapse into deflation. This threatens a trade shock across Asia and tightening deflationary risk in Europe. Asset purchases of $700bn pa will cover fiscal deficit and most of Japan's annual budget. This seems to be both to combat global deflationary risk - and to stimulate domestic growth of 5% pa which is the minimum needed to stop public debt of 245% of GDP getting out of control [1]

Putting Japan's New QE in Context - email sent 4/11/14

Rob Burgess
Business Spectator

Re: The Fed’s Doing an Italian Job on us all, Business Spectator, 4/11/14

Your article drew attention to the perilous situation that the global economy is in as a result of quantitative easing (QE) – and likened this to the predicament of those in a bus teetering on the edge of a cliff (in one eversion of The Italian Job) where any move was likely to lead to disaster. It also suggested that Japan’s new surge of QE could be sufficient to tip the balance towards disaster. I would like to suggest that this may be its objective.

My Interpretation of your article: When the US Federal Reserve announced the end of QE it seemed that the risk of debasing global currencies had been averted. This would stop narrow $US money supply increasing before borrowers / lenders realised that money was no longer worth anything. The Fed has trebled narrow money supply over the past 6 years but banks have been unable to leverage through the credit system to turn this into spending and investment. No one wanted to borrow for productive purposes – only to gamble. An sudden surge in confidence would risk generating too much broad money / demand and thus global hyperinflation and the end of fiat currencies. The Bank of Japan’s decision to start printing Yen just after the US shut down the presses was troubling. Central bankers are playing with the value of money as never before. If central banks are forced to resume QE – all that will result is more asset inflation accompanied by growing inequality in developed economies and entrenched poverty in less developed ones. In Australia there has been a growing disparity between average wages, living costs and the cost of assets (shares / property) people previously expected to own to fund retirement. Those who own assets have done well – others have not. This is mainly a difference between older and younger people. Australia also faces risks associated with changes in international capital flows much more than bigger economies. If there is no resumption of QE than asset prices should fall as interest rates rise. This would benefit allow younger people to benefit by getting access to previously unaffordable assets.

While your article raised many issues, it is worth noting that Japan has, for decades, been involved in efforts to change the nature of international financial systems (see A Generally Unrecognised 'Financial War'?, 2001+). This has presumably been done because there is a structural incompatibility between the methods of financial / economic organisation that were the basis of East Asian economic ‘miracles’ (initially in Japan) and global financial / economic institutions (eg see Structural Incompatibility Puts Global Growth at Risk, 2003+). That structural incompatibility (related to East Asia’s mercantilist / power-seeking, rather than capitalistic / profit-seeking goals) required international financial imbalances and the adoption of easy money policies by major trading partners if global growth was not to stagnate (see Impacting the Global Economy, 2009). QE by Japan from the early 1990s was the foundation of the Yen carry-trade that contributed to (though was not the only factor) in the asset inflation that gave rise to the GFC. There are reasons for Asian ultranationalists (who have been very influential in Japan) to believe that their economies would do relatively well if the global financial system were destroyed – because of their economies’ primarily reliance on coordination through social relationships rather than through financial results (see early speculations in Attacking the Global Financial System, 2001+).

A case can be made that one goal of post-2008 QE by the US Federal Reserve was ‘to do unto others as others had long done to’ the US – ie generate asset inflation in economies with non-capitalist or poorly developed financial systems and thus put them at risk if they did not develop Western-style capitalist financial systems (see 'Currency War': A Counter-move by the Federal Reserve?). In that respect the Fed’s QE seems to have been effective (see An Even Scarier Story for Emerging Markets, 2014).

It is possible that the goal of Japan’s new QE initiative is to ensure continuance of the dangerous asset inflation which US Fed now wants to ease off (ie by promoting a stronger Yen carry trade). It can be noted that, at the same time, China seems to be doing its best to promote the development of a new ‘bureaucratic non-capitalist’ international order as an alternative to the Western-style post-WWII international regime (see Creating a New International 'Confucian' Financial and Political Order, 2009+).

John Craig

  • Monetary policy in the UK was seen to be damaging - because money supply is growing faster than economic growth requires and is feeding bubbles and financial instability [1]
  • It has been argued by head of New York Federal Reserve that Fed should tighten rates quickly as it had done in 1994 rather than slowly as it did in 2004. This would send tremours through bond market. QE in Europe and Japan will cover only 35% of QE which US Fed had provided. Markets can no longer expect to be rescued every time there is a problem. The world has become addicted to central bank stimulus. 56% of global GDP is currently supported by zero interest rates - as are 83% of free-floating equities. Half of the world's government bonds yield less than 1%. 1.4 bn people have negative interest rates in one form or another. This suggests the existence of 1930s' style depression - though one that is still contained. No one knows what will happen as the Fed tries to break out of the 'stimulus trap' [1]
  • The OECD warned that investors seemed to be ignoring the risk of financial instability [1]

The Impacts of Falling Oil Prices - From Late 2014  <<

  • A rapid decline in oil prices in late 2014 was seen as posing risks

Declining oil prices would be:

  •  a potential trigger for another financial crisis - through putting junk bonds under stress (mainly involving US energy companies). 15% of 'junk' bonds are currently with energy companies - and a fall of oil prices from $74 to say $60 would put the whole US energy sector under stress. Such activities have relied on ultra-low lending rates in recent years - though improving technology is now improving their prospects [1]
  • likely to lead to a financial crisis like that associated with real estate in 2007-08 - because, as for real estate, it had been almost universally assumed that prices would not do anything but rise [see below] - so financial arrangements had been made that were now highly exposed [1]
  • likely to slow but not reverse the growth in US oil production through fracking technologies [1]
  • associated with many factors apart from just supply and demand changes (ie policies of US Federal Reserve, $US exchange rate and actions of market speculators) [1];
  • a product of a decade of rapid growth in demand for oil - which provoked an unprecedented increase in supply. As demand has receded the supply remains in place, raising the prospect of a hard landing [1].
  • if low oil prices were maintained they could result in reversal of capital flows from oil exporting countries - and this would have implications of liquidity, volatility and prices in global markets. Also low oil prices have implications for reserve banks that are concerned about countering the risk of deflation. Oil exporters have sovereign wealth funds around $5tr and have invested about $500bn pa into US financial markets. Reversing this could have significant effects. OPEC oil exporters earned about $700bn pa in il exports ($121bn less than in 2013) - when oil sold for $100 / barrel - compared with about $50 now. Oil exporters are now repatriating, rather than adding to, their reserves. The problems facing oil exporters are off-set by the gains available to oil importers. [1]

Heading for a Financial Cliff - 2015?  <<

  • A global recession was seen to be possible in 2015 because of: China's difficulties in ending its dependence on rapid growth in debt; potential debt crises in emerging economies; and severe problems in Europe [1];
  • it was however suggested that there need be no limit to the ability of reserve banks to stimulate inflation - as financial assets were not all that could be bought [1]
  • Emerging markets faced problems because the US FED had 'pulled the trigger' on higher interest rates.

Collectively they have borrowed $US5.7tr - which is comparable with biggest cross-border lending sprees of last two centuries. Much was borrowed at 1% real interest rates - on the assumption that Fed would flood the world with liquidity indefinitely. The borrowers are now 'short dollars' and face severe problems. The Fed has taken away the security blanket of a 'considerable time' before rates would rise. Developing countries are just as vulnerable to a dollar shock as they were in late 1990s. The difference is that they have now become half the world economy. Their aggregate debts are 175% of GDP (up from 145% in 2009). There was also an assumption that China would continue to drive a commodity super-cycle - even after its intention to wean itself it $US26tr credit leverage before it is too late.  These two false assumptions have exploded simultaneously. Stress is spreading. The Fed has cut bond purchases to zero - and needs to raise interest rates. The US economy has shaken off its long malaise. ages are rising. Consumers are confident. Rates might go up fast as in 1994 rather than slowly after 2004. Emerging markets' currencies could suffer. A crisis like 1997-98 is likely / possible in 2015. The problem now is not insolvent states - but rather with the high debt levels of their companies. Private debt becomes state debt when it affects systemically-important entities. These countries hold $$9bn in foreign exchange reserves (because they held down currency values to gain export market share). This is a buffer - but can't be used in a recessionary crisis because sales of foreign bonds lead to monetary tightening. The reserves are a mirage. Using them would choke one's own economy - unless the effects are sterilized. China could do this by current into reserve requirements from 20% - but others can't. The ECB can't compensate for ending of the Fed's QE. The combined effect of QE by Europe and Japan can only amount to 30% of theta by US Fed. The world is awash with excess capacity and can't stand a dollar tightening shock. This will eventually affect the US - and perhaps prevent Fed raising interest rates much. China probably will have to pay a large political price for purging the excesses of its investment bubble. Both the US and China may need to move to stimulus again - but this won't happen soon [1]

  • Russia's long-festering crisis was turning virulent.

Attempts to defend exchange rate failed - and this is likely to set of large numbers of corporate failures. Russia's reserves are not as great as presumed. Its currency has devalued 50% in a year. Its GDP is now only half of that of California. Russia's banks and companies have external debt of 70% of GDP. There is a domestic rush to buy imported goods - as currency devalues - and a defacto run on banks. A depression could result. Situation is worse than in 1998. Russian companies are shut out of global markets and IMF. Western sanctions are tightening. Putin is appealing to Russian patriotism. It is recognised that Russia is facing economic war. It was presumed that high and rising oil prices would protect Russia. For last decade, parts of US Treasury have been developing tools of economic warfare. This relies on hegemonic control of global financial system. It constricts enemies' financial lifeblood. There is concern that Russia could retaliate by military action in Europe that requires a NATO response. Russia was sliding into decline before this years problems. Recession was near even when oil was $110 / barrel. Commodities comprise 73% of exports (ie Russia suffers 'Dutch disease'0. The industrial core has hollowed. There are bottlenecks everywhere in its economy. Russia wasted its chance to build a modern, diversified economy after the Cold War. It has an aging population and a declining workforce.  Russia has $414 in foreign reserves, but these are below its $700bn external debt. Russia's companies need to roll over $120bn of hard-currency debt next year - and can't roll over those loans. Many companies are likely to default. Capital controls are likely to be needed. Russia faced similar problems in the mid 1980s when a seemly-stable superpower disintegrated - but did not seem to learn [1].

  • Large parts of the world were likely to experience problems because of strengthening $US and rising interest rates.

Fed tightening will have major effect on global financial system addicted to zero rates and dollar liquidity. $US will strengthen. BRICS need to deal with $5.7tr in $US debt, and fix obsolete growth models. US capacity use is 80%. Changes by Fed come as China tries to deflate its $25tr credit boom. It may be forced to devalue, to combat Japan's devaluation - and this would spread beggar-thy-neighbour policies across Asia. There is no longer reserve bank safety net for financial markets. Crashing oil prices will have various casualties. Russia will incapacitate Ukraine's economy, at the price of incapacitating its own. ECB can't solve the problem related to declining $US liquidity - as it can't print $US. Eurozone will be in deflation early in 2015. The North-South gap remains - with virtual depression in the south, Greece may blow this up. Equities can't defy monetary gravity. Half earning of US big cap companies come from offshore, and will be worth less in stronger $US terms. Profit share of US incomes is at record high - and can't be maintained as wages start to rise.

  • Global markets seemed to be gripped by fear.

Turmoil pervades world equity / currency markets. Oil and share prices are falling - though the situation is different to 2009 when this last occurred (because weakening of real economies implied lower oil demand). Now this reflects an energy surplus which has triggered a battle for market share. This should be good for many economies - so why have equities done badly. US market had already started to crack - because monetary policy was likely to change (towards higher interest rates).  Expectations of rate rises had caused capital flows to US - pushing bond yields down / raising $US. There was also substantial growth in US and stagnation in Europe - as QE was contemplated, China's slowdown cased problems for commodity exporters. Falls in oil prices turned into a rout. This is bad news for US sharle-oil; oil exporters (eg Russia, Brazil, Venezuela, Nigeria and Iran) and also for major energy exporters such as Canada and Australia. Russia was badly affected. OPEC producers often need much higher oil prices. However some have foreign exchange reserves - and will need to use them. Repatriating reserves from elsewhere (and there are $trs involved) could have repercussions. Greek elections are also causing concerns - though there is no current perception of a contagion effect across Europe. [1].

  • the global economy seemed to be at risk of deflation despite the efforts of reserve banks to prevent this happening by boosting liquidity. In assessing that risk it was arguably necessary to consider the effect of the structural demand deficits that were required to avoid financial crises in major East Asian economies (such as Japan and China) that had relied on 'bureaucratic non-capitalist' methods to achieve catch-up economic miracles (see Putting the Economic Risk of Deflation in Context);
  • in early 2015, the actions of reserve banks were viewed as likely to have significant implications - though there was no certainty that they would be beneficial.

The Swiss Reserve Bank disrupted financial markets, and put the credibility of reserve banks at risk, by ending its efforts to prevent the Swiss franc from appreciating against the Euro. It has sought for several years to prevent its currency appreciating, which would have eroded the competitiveness of Swiss exporters whose major markets in Europe) by buying large quantities of foreign exchange. However doing so had resulted in a rapid escalation of money supply in Switzerland and thus in escalating asset values. The expectation that the EMU was about to start a major program of quantitative easing implied that the Swiss Reserve Bank's efforts to prevent to franc appreciating would become even more costly (in terms of potential losses on the banks balance sheet) and domestically disruptive. The ending of the program: imposed large losses on the reserve bank; undermined the competitiveness f Swiss companies; was likely to exacerbate existing deflationary risks; and resulted in significant losses by traders. The possibility that this could be a 'Lehman Bros moment' was canvased [1] (after the occasion in 2008 when a major US bank was allowed to fail because the cost of preventing failures had become too great - and thereby triggered the loss of confidence that resulted in the GFC);

The ECB was expected to announce a major program of QE to boost inflation / growth in the eurozone. However there was concern that this would be ineffective because:

  •  the eurozone's real problem lay in the lack of political reform. Having the Euro as a common currency was incompatible with the absence of some sort of real political union [1]
  •  QE was expected to take the form of central bank buying of government bonds. This would keep interest rates very low and the yield curve flat - which would in turn make it very difficult for banks to profit from lending. This had the potential to turn Europe's recession into a depression [1]. It can be noted that in contrast to the US where most major businesses rely on financial markets for capital, in Europe they tend to rely on banks;
  • The EU is not a country - and the bond markets for individual countries are too fragmented for bond buying to help make banks more willing to advance business loans. QE works best when money goes into specific markets. Europe has no Fannie Mae to make it easy to inject capital into housing.  EU fiscal policy is headed in the opposite direction. The Euro as a common currency impeded economic adjustment. There is a lack of pan-European institutions [1]
  • unregulated lending (ie shadow banking) has escalated in the US and was again seen to pose a risk to the US financial system. This phenomenon (whose failures triggered the GFC) has risen to approach its pre-Lehman peak [1]
  • world economies debt levels have increased since 2007 - there has been no deleveraging as a consequence of quantitative easing. Global debt has increased 17% of global GDP since 2007 (ie from 269% to 286%). Inflation has not yet resulted from money printing because it accumulated in bank reserves. It did not flow to businesses and consumers. Now this is changing as business and consumer confidence rises.  An inflationary surge is likely. Government debts have risen 9.3% pa since 2007, but business and consumer debt only rose 5.8% pa and 2.8% pa. If a catch-up occurs inflation is inevitable [1]

Pressure for Rising US Interest Rates:

  • conditions seemed to be emerging which could force the US Federal Reserve to raise interest rates and perhaps even rapid unwinding of past QE. Maintaining easy money policies poses little risk of an inflationary surge if it is only feeding into asset prices, but could prove very dangerous if its starts to feed wage / price growth in the real economy. A shift to higher rates would have a highly disruptive impact on global financial markets by: accentuating yield-seeking capital movements towards US; and creating capital shortages elsewhere (thereby creating pressure for increased interest rates worldwide in an already almost-deflationary environment). The relatively self-contained US economy implies that, while a stronger $US would erode trade competitiveness, this would have a much smaller implication for US economy than for many others.

Indicators of pressure for rising rates included:

  • concerns (outline below) that ultra-low interest rates have limited real economic benefits and significant adverse side effects;
  • strong unmet demand for labour in US leading to rising wages [1];
  • rapidly increasing consumer confidence in US [1];
  • claim that rising employment and wages in US suggest that rising interest rates are possible in mid 2015 [1]
  • exceptionally strong growth in US jobs relative to the available workforce [1];
  • average hourly earnings of production workers in US are rising at an accelerating rate (ie up 2.2% yoy in January 2015 as contrasted with only 0.6% yoy in October 2014 and 1.2% yoy in December 2014) [1]. This implies that most recent wages' growth was achieving an annualized rate of increase of (about) 6%. Detailed data are available from Federal Reserve Board of St Louis.
  • Accelerating credit growth in US. Commercial and industrial loan portfolios of banks were up last month 12% yoy. Real estate / consumer loans are rising while cash holdings fall [1]
  • signs of CPI inflation emerged in US in February 2015 [1]
  • Monitoring Inflation Risk - email sent 3/3/15

    Don Stammer

    Re: Ignore the spectre of inflation at your peril , The Australian, 3/3/15

    I should like to try to add value to your article’s emphasis on the need to monitor the future risk of inflation and assess what effect this might have on monetary policy and financial markets. As I interpreted it, your article pointed to: (a) constraints on inflation (such as the oil price decline); (b) slight indications of an increasing inflationary risk that have (so far) caused wobbles in bond and equities markets; and (c) the risk of a bond market sell-off if inflation / interest rates rise (because bond values are high on the basis of expectations that low inflation and QE are (more-or-less) permanent).

    However (based on reported labour market and wage developments) there may be more than ‘slight’ indications of inflation risks in US. In fact domestic inflation in the US might be on the point of a breakout. If so, this would require higher interest rates in the fairly near future – and have repercussions that could be more significant that your article suggested. For example:

    • The whole edifice of QE might be at risk. QE in recent years has involved reserve banks expanding their balance sheets by buying financial assets sufficiently to keep interest rates at a desired low. This has had an inflationary effect on asset values (ie on bonds, equities and property) but has had very little ‘real economy’ impact – and thus little impact on CPI inflation. However if (in the relatively closed US economy) the low interest rates that QE has achieved start to feed into businesses’ willingness to expand / employ staff and thus into households’ willingness to borrow for consumption then CPI inflation could become a severe domestic problem. This could make it necessary for the US Federal Reserve to unwind QE and allow interest rates to rise quite rapidly. [Note added later: If QE is to be unwound, this would require reserve banks to sell financial assets (eg bonds) with a view to increasing interest rates and thus reducing the value of those assets. Given the low yields of those bonds (because of the high prices they have been bid up to) and the certainty of ongoing capital loses that the reserve banks were clearly intending to induce for owners of such assets as QE was unwound, there would presumably be few buyers except at greatly reduced prices - ie at much higher yields / interest rates];
    •  Though the US is no longer the only QE player, its activities in this area outweigh those of Japan and the EMU. Thus the effect of a forced QE reversal in the US on global asset markets (ie bonds, equities and property) would be severe because of: (a) the adverse effects on higher interest rates on the returns achievable from equity and property investment; and (b) the dependence of current asset values on the presumption of more-or-less permanently low interest rates (which provide the benchmark against which the PE ratio of assets are determined);
    • A significant reversal of asset values would result in: (a) financial losses to many institutions which could create another round of financial market instability perhaps similar to that in 2008; and (b) a flow of risk capital back to the presumably most secure financial assets (eg US Treasury bonds) at the expense of riskier investments in emerging economies with relatively poorly developed financial and regulatory systems;
    •  Australia’s dependence on foreign capital to cover current account deficits could again create risks to domestic property markets and banks. Current account deficits are balanced by banks' borrowing offshore and mainly loaning the proceeds for property investment. If such a flow were interrupted by an international financial crisis, property values and thus the assets of major banks would go into a self-amplifying freefall. The risk of this was presumably why the federal government used its world-beating credit rating to back the assets of Australia’s banks at the start of the GFC.

    Clearly the financially and economically disruptive impact of increasing interest rates in US (or any need to reverse QE) would compound existing deflationary pressures from elsewhere and thus reduce the need for anti-inflationary policy changes in the US. However the whole system seems unpredictable / unstable. Thus your article’s suggestion about monitoring inflationary risks seems highly desirable.

    I would be interested in your response to my speculations

    John Craig

  • There is a general expectation that Fed will take time to raise interest rates. But this could be wrong. US could be in full-blown boom by end of 2015 unless rates rise soon. US growth is 3.3% pa and unemployment is likely to fall below 5%. Inflation is a risk. However Fed may be unable to raise rates without setting off global chaos. There is a risk of same outcome as in 1937. But Fed may have no choice unless there is a global economic shock (eg associated with many companies' / countries' $9tr exposure to $US-denominated debts) [1];
  • Rising M3 money indicators point to a reflationary mini-boom in US and Europe by late 2015. Increase in US has been 8% pa over past 6 months. And Europe is catching up. EMU launched monetary easing just as cycle was turning [1]
  • the US economy contracted in the first quarter of 2015 (after allowing for rising inventories). 3-4% falls in interest rates are needed to cope with recession, yet there is no longer room for this. Business building investment fell 23%. Post-winter recovery has been disappointing. Consumer confidence fell. $US appreciation has adversely affected business- just as rinsing interest rates would. Exports fell. Europe and Japan are encouraging devaluation with QE. Energy investment contracted. However interest rate rise may not be delayed. US no longer has severe budget deficits. Money supply is rising quickly - as are commercial and industrial loans. House prices are rising. Job vacancies / applicants ration is now much higher than during 2007 boom. This does not seem like a country facing recession [1]
  • after a short reversal, inflation in US seems to be rising - thus supporting the Fed view that recent economic weakness in US could be transitory [1]
  • reasons to suspect that US economic recovery is underway include: (a) a 'current activity indicator' that seemed at odds with official statistics showing weak first quarter performance; (b) the adverse effects of severe weather; and (c) recent history where first quarter results have been weak, though annual performance has been reasonable [1]
  • CFOs of major global economies expect US economy to strengthen to allow rate increase by US Federal Reserve [1]
  • concern was expressed that easy money policies intended for emergency conditions in 2008 have lasted for 8 years, and that when signs of really strong recovery emerge the US Fed will find itself well behind the 'curve' in raising rates - and thus have to do so very quickly. Phasing in rate rises now makes sense to avoid this risk [1]
  • improvement in US economy was indicated by companies drawing more of their available credit to hire staff and expand their operations [1]
  • jobs' growth in US plus stronger consumer spending, housing activity and business construction is expected to push US growth over 3% pa in the second half of 2015 - and require higher interest rates soon [1]
  • there is potential for a construction boom in US given shift from housing over-supply to shortage and improved government financial position [1]
  • US labour market is seen to be tightest (ie with lowest numbers of jobless) since 1973 [1]
  • the only thing likely to stop Fed raising interest rates in September 2015 is concern about the adverse effect given global economic weakness and the severe difficulties that China is experiencing [1]
  • in the US jobs data, retail sales numbers and industrial production have all been strong enough to justify rises to US interest rates in September 2015 [1]
  • an increase in new housing construction in US boosts the case for an interest rate rise in September 2015 [1]
  • while there were economic negatives, the FOMC has implied that interest rates rises are seen as necessary because of concerns about financial stability that have emerged due to long periods of low interest rates [1]
  • US GDP growth for second quarter of 2015 was estimated at 3.7% yoy - higher than the expected 2.3% - while weekly jobless claims were down [1]
  • Economic over-heating is likely in Europe because of explosive growth in money supply [1]
  • everyone is telling Federal Reserve that US is suffering wage pressure [1];
  • decline in unemployment rate to 5.1% in August 2015 increases pressure for rate rise [1].
  • US is experiencing relatively strong growth during a period when others are suffering problems - and is able to do this because its economy is mainly dependent on demand within its own borders [1]
  • consumer credit is expanding fast in US - suggesting strong consumer confidence and support for growth [1]
  • it should be possible for Fed to begin raising interest rates without causing disruptions like those when it ceased large-scale buying of securities in 2013 [1]
  • there is a risk of deflation associated with increasing interest rates for the first time since 2006. However continuing low interest rates, which encourage a credit-fuelled economic bubble like that which have rise to the GFC, would be even worse than the deflation risk [1]
  • the US labour market has become very tight as the number of job vacancies now equals those looking for work. Inflation due to the emergence of a seller's market for labour is likely [1]
  • the US Federal Reserve now seems to be more concerned about the destabilizing effect of low interest rates on financial markets than it is about the effect of interest rates on the real economy [1]
  • pressure for increasing US interest rates is also likely to arise from China's reported [1, 2] shift from buying US Treasury bonds on a fairly large scale to selling (ie from buying $US30bn per month a year ago to selling $US10bn);
  •  net foreign selling of US Treasury bonds (especially by China, Russia, Brazil and Taiwan) had risen to $123bn by July 2015 - following years of net foreign purchases. This is being offset by domestic purchases by those concerned with global situation - thus keeping interest rates down. However this may not continue forever [1]
  • at the same time other observers suggested that rates were unlikely to rise [1].
  •  a strengthening labour market would not be sufficient to require Fed to raise interest rates;
  • Job market has improved briefly but this won't force Fed to raise rates. By historic standards jobs' growth is not strong. Wages have not picked up. Strong $ and Chinese imports block recovery in many areas. Service industries that add jobs do not pay well. Many unemployed have been seen to lack necessary skills - but as job markets tighten they will get a second chance. Jobs growth lags economic growth - so recent gains reflect past growth and growth has slowed more recently. The Fed may well not increase rates in June [1]

  • the US economy was struggling because of the effect of a deflationary international environment;
  • data on industrial production, retail sales and housing starts have caused economists to downgrade estimates of first quarter US growth in 2015 [1]
  • rapid jobs' growth will be hard to maintain if other indicators remain weak [1]
  • the deflation risk facing US was seen to be as great as that in Europe. Despite central bank easing, CPI growth worldwide has stagnated (and become negative in Eurozone). In US 12 month inflation was recorded as 0.8% - but would be lower if measured in the same way as in Europe [1]
  • the US Federal Reserve may be unable to force interest rates up because there is a demand for government debt that exceeds the available supply. In the mid 2000s long-term yield stayed low despite Fed tightening (a phenomenon that the Fed chairman labeled a puzzle) - and this helped fuel the housing bubble [1] [CPDS Comment: The situation in 2015 differs from that in the mid-2000s in that the US Federal Reserve has large quantities of Treasury bonds to sell if it wants to drive long-term interest rates up]
  • Fed may be unable to raise rates because global economy is so vulnerable [1]
  • The August US jobs report indicated weak employment growth. Unemployment is down at 5.1% because so many people have given up work. This could delay rises in interest rates - though low rates would do little to boost the economy [1]
  • a deflationary problem seems to be emerging in China as it struggles to overcome the legacy of its credit boom. This could potentially have a global deflationary impact [1];
  • some observers perceived the risk of another debt crisis because of: bond market volatility; adverse effects on many countries / indebted oil companies of oil price fall. Government bond rates in Europe are negative. US Treasury bonds are 40% higher than in 2014 - because of near zero interest rates from Fed. Small changes in yield expectations can lead to large changes in prices. Fixed income assets are now dangerous.  And ownership of risky assets has shifted from banks to other institutions [1]
  • Austria's Carunthia regions faces bankruptcy because Austrian government refuses to provide 'bail out' for the regions guarantee of a lender. The shift from a 'bail out' expectation to a 'bail in' policy (ie where those who have provided funds carry losses, rather than government) is now almost universal in Europe [1] [CPDS Comment: The adoption of 'bail in' practices will presumably result in significantly higher interest rates facing some government borrowers - as 'bail out' protection of lenders capital ceases to be available]
  • declining foreign currency reserves (eg in China) are already leading to 'quantitative tightening' - and thus reducing scope for raising interest rates (eg by US Federal Reserve) [1]

Do Low Interest Rates Help? >>

  • the effectiveness of low interest rates in stimulating the economy was increasingly disputed while their adverse consequences were highlighted;
  • as noted above there had been earlier concern that easy money policies (ie quantitative easing) was not working and was having negative side effects (eg generating social inequality, distorting economies, potentially causing deflation and creating potential instabilities / inflation as they were phased out). Likewise constraints on global economic growth were indicated by the impossibility of continuing to increase the high debt levels that many (most?) governments had accumulated in an effort to stimulate economic recovery from the effects of the GFC - and the apparent dependence of economic growth on easy money policies (which had stimulated the economy by allowing government debts and household mortgages to rise to levels that were unsustainable at normal interest rates);
  • low interest rates have been seen to be a significant cause of the world's deflationary problem because they tend to devalue currencies;
  • the quantitative easing efforts of reserve banks was seen as unable to spur either inflation or growth because the world had too much supply and too little demand. This generates deflation despite aggressive monetary easing. Monetary policy's effectiveness has been constrained by firms' lack of pricing power and too many workers chasing too few jobs. Rising inequality has exacerbated the demand shortfall. Policies that try to reduce the deflation risk via devaluation are a zero sum game. IMF proposals for public infrastructure investment are seen to be appropriate - but politically constrained. Slow growth, stagnation, and deflation are likely [1]
  • It was argued that low interest rates have ceased to be effective in stimulating economic growth - so that other means will need to be pursued.
  • Why Interest Rates Can't Stimulate the Economy - email sent 6/3/15

    David Uren

    Re: Rate cuts failing to bite: RBA, The Australian, 6/3/15

    Your article pointed to Dr Philip Lowe’s argument that interest rate cuts now have little ability to stimulate economic growth – primarily because high public / private debt levels had been built up prior to the GFC.

    My Interpretation of your article: Interest rate cuts are losing their ability to stimulate the economy and RBA warns that government needs to put measures in place to stimulate growth. Dr Philip Lowe (RBA) said that consumers, businesses and governments were not responding to low interest rates that would once have sparked an inflationary boom. Retirees and other savers cut spending as rates fall, while those with large debts simply repay more. Worldwide inflation / investment rates are falling despite years of low rates. Monetary policy works partly by bringing spending forward. Prior to GFC, reduced interest rates encouraged such responses – because people were willing to borrow. This is no longer so. The main reason that interest rates have little effect now is that large debts built up prior to the GFC. Neither households nor governments are now willing to use low rates to increase borrowing / spending. Lower rates have had some benefits (eg encouraging housing investment and devaluing $A – and thus increasing competitiveness). Monetary policy is not entirely ineffective. However the broader issue is that globally savings are favoured over spending. This can’t be solved by monetary policy.

    However in order to overcome this problem it cannot be sufficient to rely on domestic policy changes to make growth sustainable. The fundamental problem lies in international financial imbalances that long before the GFC made it necessary for some countries to be willing and able to sustain ever rising public / private debt levels (through cutting interest rates to make those debts seem sustainable). It is necessary to address those financial imbalance problems at their source despite the difficulty of doing so (eg see Putting the Economic Risk of Deflation in Context, 2015 and Structural Incompatibility Puts Global Growth at Risk, 2003+). The main problems seem to lie in:

    • the incompatibility of the ’ bureaucratic non-capitalist’ methods that have been used to achieve economic ‘miracles’ in East Asia and the ‘profit-focused’ international financial system – which required demand deficits / savings gluts in countries where profitability in the use of capital is not taken seriously because of cultural traditions that are radically different from those of Western societies (see also Background Note); and
    • the adoption of a common currency (ie the Euro) by countries with vastly different economic capabilities. This necessarily generated large surpluses in countries such as Germany and deficits / debts in ‘Club Med’.

    The problem has to be dealt in an international forum such as the G20 (eg see Making the G20 Useful at Last, 2013) though that body has so far been unwilling and unable to do so (see Will China's Presidency in 2016 End the G20's Chronic Failure? 2014).

    The need to do so is becoming urgent as the global economy seems to be headed for failure (see An Approaching Crisis). Moreover the fact that the ability of interest rates to stimulate economic growth (and thus cause rapid inflation) may be being restored domestically in the US could be the trigger that precipitates such a global crisis - because the US Federal Reserve will have to respond to domestic US inflationary conditions, and the impact of what it does will be global (see Monitoring Inflation Risk, 2015).

    John Craig

  • there was concern that the excess liquidity that has been made available globally has forced investors to over-value assets as they search for yield and that this could lead to another financial meltdown [1] ;
  • central banks have been cutting interest rates, but this has done nothing to stimulate growth. The US Fed is now starting to talk about raising them [1];
  • the head of the IMF warned that low interest loans were fuelling asset bubbles [1]
  • monetary policy seems to have become an obstacle to business capital investment. The BIS has noted that there is plenty of available capital. However there is great uncertainty about future economic outcomes - so there is no certainty about investment outcomes. This uncertainty has not disappeared as interest rates have fallen. Companies can't be confident when reserve banks show that they aren't. Also the way executives are rewarded discourages them from taking any risk - as with ultra-low rates they do well by doing nothing [1]
  • ANZ Bank's CEO has warned about risk of asset bubbles - as low interest rates oblige investors to chase returns by making riskier investments [1]
  • it has been suggested that QE does not boost liquidity (as it is intended to do) but rather has had the reverse effect - though others have noted other causes (eg stricter regulation) of declining liquidity [1]
  • low interest rates discourage banks from making long term loans that might boost the economy - because they recognize that when rates rise they will be left with long term losses. Their emphasis is thus on short term financing options that make short term profits but add little to real economy [1]
  •  despite historically low interest rates investment remains subdued in Australia as elsewhere. There is a clash between economic theory and reality. A lack of non-mining investment is blamed on inadequate demand, low business confidence and uncertainty. The question is why. Fiscal policy fell out of favour - then reliance was placed on monetary policy. This is working for household spending and property investment - but not for business (because low interest rates are not the main factor in their decisions). High 'hurdle' rates of return are required. And a lack of investment generates a vicious cycle. Businesses are paralysed by uncertainty - and this is quickly becoming self-fulfilling    [1]
  • in Australia a survey found that 90% of firms won't invest if expected returns are less than 10%. Firms are discouraged from investing by high costs / taxes and weak demand - and little influenced by low interest rates [1]
  •  Many believe that monetary policy has lost effectiveness (because long term QE has not set economies booming) - but this view has been disputed by Dr Christopher Kent. He argues that there have been many other factors which have prevented monetary policy being effective (ie that monetary policy is working the way it always did - but is facing strong 'headwinds'.  [1]
  • RBA governor recently argued that monetary policy alone can't deliver economic recover - thus implying the need for more fiscal stimulus. Ben Benanke has made similar suggestions. Monetary policy is more effective in choking off excessive growth than in stimulating upswing - because expected returns may fall as much as interest rates and households may be constrained by high debts. Also cheap credit may be merely channeled into boosting asset values with no economic stimulatory effect . However, while fiscal policy (spending by increasing debt) can have a stimulatory effect, there are limitations (eg the time lags involved).  Reform of the revenue base and tax system may be more important [1]
  • 7 years from GFC, central banks are re-thinking. The belief that ultra-low interest rates would stimulate recovery is fading. BIS argues now that rather than helping low rates have merely fueled booms and busts. Central banks have paid too little attention to effect of low rates on financial system - and should return rates to normal as soon as possible. Rate cuts from 2008 (while inflation was low) led to imbalances in financial systems. Household and corporate debts have risen substantially as rates fell to near zero. Central bank balance sheets ballooned. But this had little impact on economic output - or even inflation. Business investment / productivity / employment is weak / falling. International inflation and interest rates are increasingly synchronized. The current international financial system is sick. Central banks started life seeking to prevent bank collapses. This might be a useful role for them to return to - rather than inflation targeting as they have been attempting [1]
  • RBA governor speech and BIS annual report signal changes in central banker thinking - about limitations and risks associated with post GFC policies. Monetary policy has always sought both price and financial stability, But central banks focused on price stability / inflation targeting rather than on financial stability. Things got complicated after 2008 when large interventions were needed to prevent financial system breakdown. But these interventions have not restored growth. They have just encouraged leverage and risk. Low interest rates encourage lower rates, financial booms and busts, too much debt and too little growth. Investment is not encouraged. And risk-taking is exported to other countries, There is a need to rebalance policy away from illusory short-term macro-economic fine tuning - and for reliance on more than monetary policy. central banks now need to be as concerned with booms and busts as with near-term price stability. RBA points to G20 pro-growth agenda. While it is not clear how reserve banks can reduce dependence on low interest rates, the longer the present practices continue the greater the risk of another crisis. Central bankers now accept the need to return to pre-crisis settings and adopt more complex goals [1]
  • low US interest rates (ie just above zero for six years) have become the problem not the solution. Negative effects have included high bond prices and high PE ratios for stocks - while benefits have not trickled down to real economy. Low rates did not encourage new productive investment. Companies have borrowed cheaply - but merely used funds for stock buybacks (ie over $1tr pa in US). Poor quality companies have been able to survive / thrive. The BIS also points to the adverse effects of persistent low interest rates [1]
  • US Fed is beginning to recognise that zero % interest rates have increasing negative effects. They traditionally assumed that low rates stimulated not only asset prices but also real economy spending. But this is not so. Corporate investment has been weak. 3 month Libor rates have been 30 basis points for 6 years - and high yiled spreads have narrowed in search for higher investment returns. Many zombie companies continue to exist because of low rates, Creative destruction has been neutered. The old remains in place, the new is stifled. Companies borrow cheaply but don't invest - merely buy back stock.. BIS recently pointed out that: there are substantial medium term risks with ultra-low rates; banks interest margins are sapped; mispricing in financial markets is pervasive; ; the solvency of insurance funds / pension funds is threatened; and it is technically / economically / legally / politically hard to deal with these problems [1];
  • There is increasing focus on whether Fed should lift interest rates - though the possibility of resuming QE was also suggested. The market views a September 2015 rise as less likely because of China's problems. However Fed's focus is on US economy - which is becoming healthy and a return to more normal pricing for risk assets may be appropriate. It has been acknowledged that actions by Fed (and EMU and Japan) have international repercussions - especially large post-crisis capital flows that led to increases in risk assets in emerging economies.  Restoring normality will trigger volatility. original QE goal was to encourage more risk taking to stimulate economy. It is debatable whether this worked - but near-costless funding pushed an ever-intensifying search for return and increased risk exposure. Risk increased and was mis-priced. Recent market instabilities may reflect some unwinding of that risk - as is necessary if capital is eventually to be allocated more rationally. Such corrections could risk a full-blown financial crisis. The longer Fed leave rates near zero the longer risk mis-pricing will continue - and this creates risks of its own. The Fed's QE experiment has been underway for a long time (7 years) - and has generated many intended / unintended consequences [1]
  • QE has been seen to reduce potential growth through its impact on increasing inequality, reducing productivity and creating boom / bust risks - see diagram [1]
  • Society Generale is not certain that ECB can lift demand and stimulate spending in euro area. ECB started QE in March 2015 - and recently indicated that this would increase. However there is concern because of adverse effects of QE-driven excess valuations. QE and low interest rates have not increased lending to private sector. Fed's loose money policy under Greenspan inflated net household wealth and created an asset bubble. QE in fact caused a recession. The ECB is making the same mistake [1];
  •  Easy money policies by Fed are seen as responsible for weak business investment (according the Michael Spence and Kevin Marsh). RBA is also concerned about this. Financial risk taking has increased as investors seek steady income stream - but risk taking through business investment has become rarer. Investment by non-resource companies has dropped to very low levels in Australia. RBA sees a lack of business confidence as the problem. World's major central banks have sought to bring down long term (as well as short term interest rates they directly control). Business managers may worry about what happens when this unwinds, and prefer to invest in financial securities because these are easier to unwind.   Public policy is biasing investment towards paper assets over real-economy investment. Investors looking for income will not shift to growth stocks when yield fall - but rather seek higher yielding income stocks RBA agrees that borrowers use rate cuts to accelerate repayments - not increase spending. And savers (eg retirees) are cutting spending more than expected. The net effect is to limit consumption. However, even if low rates have have contributed to global stagnation, lifting them may not help. It is hoped that consumption spending will rise in 2016. However if it doesn't reducing interest rates won't help [1]
  • negative interest rates are being encouraged by ECB to stimulate the economy. However this may have unintended effect. It encourages depositors to take money out - and may also encourage banks to hoard cash (rather than lending) to avoid the risk of a major run [1]
  • In late 2015 about half of the world's major economies were expected to raise and half to lower interest rates - a situation that seemed likely to generate significant instability [1]
  •  Another financial crisis is likely because excess savings and declining interest rates are caught in a feedback loop. Natural real interest rate is near zero. But US Fed is likely to raise rates. There is a correlation between falling natural interest rate and financial crises with excess savings the main source of the problem. Destruction of wealth through crises encourage higher savings - which depresses growth and investment. Lower rates to boost spending can't work. Effectiveness of QE is now being questioned in Europe and Japan. Central banks may not be able to deal with next crisis. It is impossible to deal with risk of financial crises as long as desired savings exceeds desired investment. The only solution is for major economies to increase infrastructure spending [1]
  • one widely-read observer has suggested that the long period of ultra-low interest rates that followed the 2008 financial crisis has created asset bubbles that must soon result in another financial crisis - a view that others dispute [1]
  • when Japan adopted negative interest rates in early 2016, the effect was the opposite of what was intended - suggesting that monetary policy was no longer useful for economic management
  • There are indications that negative rates (NIRP) is not constructive. When rates have been cut, lending has fallen - the reverse of what was intended. ZIRP / NIRP are crushing banks - destroying their risk appetite. NIRP shows reserve banks are very worried about economy - so why should banks take risks [1]
  • Japan retreated from proposals to apply further emergency monetary stimulus measures - because of criticism that they do more harm than good [1]
  • low interest rates have done little to boost business investment - perhaps because they encourage firms to pay dividends or buy back stock instead. Since 2009 when US rates were slashed to near zero firms have increased stock buy-backs by 194%, dividends by 66% and investment by only 43%. Business investment might increase future earnings - but many investors (especially retirees) prefer to get income now [1]
  • US Fed is hoping to raise interest rates - assuming its economy is strong enough to sustain this. But higher rates in US while rates are low in Europe and Japan strengthens the $US. This puts pressume on China's competitiveness - and tightens global liquidity and thus leads to global slowdown - which in turn requires lower US rates again and increased global liquidity. High rates are a good idea - being the only way to escape the trap of speculation and wasteful investment. There will cause short term pain but are the only way to raise long term productivity [1]
  • US Fed won't increase interest rates because economy is getting weaker. The run-down in employment growth is like that before past recessions - yet this is not being discussed. Financial markets presume that the Fed will keep the casino going. And the US is doing better than Europe - where interest rates are going negative and encouraging hoarding of cash rather than investing it. Addiction to debt is chronic - yet reserve banks are continuing the practices that have created this problem over the past 7 years. Deflation is setting in - and will lead to share / property weaknesses; junk bond defaults; reduced consumer spending. Reducing interest rates from 18%, deregulating banks, removing gold standard, boomer consumers, backstopping Wall Street have accumulated into a major problem  [1]
  • Reserve Banks can't solve the problem, Interest rates are now low / negative. The problem is that supply is outstripping demand - so companies have little incentive to invest. Rather they use cheap credit to buy back shares - which has made equity investing popular. Consumers are cautious - because central bank policies have led to low wage growth, job insecurity and over-indebtedness - see here
  • BIS warns that world is suffering from effect of massive / unsustainable financial boom - rather than, as IMF believes, from lack of demand which would thus require further stimulus. If the IMF is right then further easing of monetary policy is required - but if not then structural economic reforms are what is needed. BIS argues that focusing on monetary policy has adversely affected banks' profitability / resilience and thus their ability to support economy [1];
  • Money-printing and negative interest rates are creating financial system vulnerabilities than need to be curbed according to BIS. As there are expectations of central banks loosening credit conditions in response to Brexit, BIS warns of urgent need to end reliance on debt-fuelled economic growth worldwide. [1]
  • There were large losses on financial markets after Brexit vote - followed by full recovery. However one cause of the 'bounce' (ie reserve bank efforts to counter Brexit negatives) indicates that the 'bounce' is the real threat. What reserve banks did was damagingly significant to UK. They are committed to keeping interest rates damagingly low and continue to create money in the belief that only they can head off what would otherwise lead to a global financial panic / recession / depression. This will keep two great investment dynamics of recent years running (ie money pouring into government bonds seeking yield and into shares / property seeking returns). The first has produced negative yields while the second has sent property prices soaring. It has also affected currency value - including putting a floor under $A value though this could change any time if the global mood alters. The main issue is the way central banks have pumped up share and property prices - which will eventually end brutally and unexpectedly with recovery being much harder than from the GFC because all fiscal and monetary policy options have been exhausted [1]
  • Central banks are approaching point of policy ineffectiveness - because of economic complexity and uncertainties [1]
  • Low and especially negative interest rates reduce bank earnings and can force them to reduce their balance sheets by cutting the amount they lend. This could be a significant constraint on economic recovery - especially in Europe [1]
  • low inflation is due to international factor which can't be addressed by the RBA. Inflation levels in Australia are low.  This has been an issue everywhere since 2012 - and it has often been shown that this is due to global factors. Inflation was expected to fall after GFC - but this did not happen immediately because massive stimulus programs were launched. Weak inflation has been due to slow global growth (associated with low levels of business investment, the absence of global trade growth, high levels of leverage and fragile banking systems. This has continued since GFC despite unprecedented levels of monetary policy support . The RBA's May rate cut boosted housing prices in Sydney and Melbourne (not the goal) but business investment remained weak. Preventing an appreciation of $A would seem to be strongest justification for a further rate cut - though reserve banks are not supposed to do that [1].
  • there is growing concern about problems that central banks have created. Deutsche Bank argued that ECB is causing misallocation in the real economy which is ever harder to reverse and more painful. The BOJ argues that a negative interest rate spread encourages firms to shrink, rather than expand, their balance sheets. It also reduces the financial system's resilience in times of stress. The BIS warns about a 'risky trinity'. The world economy looks better than it feels. Unprecedentedly accommodative policies have contributes to low productivity growth, historically high global debt levels and no room for policy maneuver. $10tr in bonds have negative interest rates - which harms savers, banks, insurance companies, pensions and investors. Reserve bank policies are setting up private and public finances to spiral out of control. There is a need to adopt other policy measures other than monetary policy to restore growth [1]
  • a substantial interest rate cut by the BOE in response to economic downturn that followed Brexit vote would be a mistake. The low interest rates and QE that was needed after GFC have continued - and had more impact on asset (eg property) prices than on the real economy. This boosted demand by wealthier people who own such assets - but others' incomes were squeezed eroding living standards. This goes a long way to explain why Brexit was supported. Low interest rates erode banks profits - and may cause a decline in lending. The big risk now is that UK faces an unnecessary recession brought on by Brexit. Looser fiscal policies are needed to compensate.  [1]
  • in September 2016 expectations about interest rates has change with a rise now expected - as economic conditions now seem stronger.  Increasing rates will make a big difference because markets have so long relied on low rates. Reasons for a policy change are: US 'full employment'; unsatisfactory effects of negative rates in Europe; reduced expectation about what global economy can achieve; and increased emphasis on government fiscal policies  [1]
  • the world (especially emerging market economies) is highly dependent on borrowings in $US and this will create problems as interest rates rise;

The world depends more on $US than ever before, and thus at the mercy of US Federal Reserve as rates rise. A recent BIS report ('Global dollar credit: links to US monetary policy and leverage') spells out the extent of global debt in $US and the effect of tightening liquidity. The Fed's zero interest rates flooded emerging markets with dollar liquidity. Asian and Latin American companies borrowed large amounts at 1% real rates - creating the basis for future problems. Foreign borrowing in $US is $9tr - up from $2tr in 2000. The emerging market share (mainly Asian) has doubled to $4.5tr (including camouflaged lending). Those outside US have no access to 'lender of last resort' arrangements. Markets are already pricing in the effect of increases in US interest rates. Emerging market currencies are devaluing. The dollar index has soared - even faster than in the mid 1990s when a US recovery set off East Asian crisis and Russia's default. Emerging market governments learned from this shock and no longer borrow in $US - but companies have more than made up for them. Emerging market stresses now are more serious than in 2013. Asian and Latin American companies are trying to hedge their $US debts on derivatives markets - and this drives $US higher and feeds a vicious circle. Major companies in emerging markets are in trouble. A Malaysian sovereign wealth fund came close to default. It had been a 'piggy bank' for political elites and now faces corruption inquiries - a common theme in the BRICS and mini-BRICS as the liquidity tide recedes. Chinese companies have $1.1tr in $US debts - probably more if disguised sources are included. They will be in big trouble if China seeks to devalue yuan to boost growth. Emerging markets could weather $US spike of 2014 as deflation scare held down cost of global funding - but this is now rising fast. Central banks in developing world have stopped buying foreign bonds after boosting reserve to $11tr (from $1tr in 2000).  The oil slump has been a factor, as has capital flight from China. Liquidation of reserves automatically tightens monetary policy in affected countries - unless offsetting action is taken. China can do this but Russia and Brazil can't. If they cut rates, their currencies will devalue. Some hope that the ECB's $60bn per month QE will keep asset boom going - but its main effect may be to further strengthen $US. The Fed may not proceed with monetary tightening because of adverse global effects - but reports from US suggest that it may not have any choice - eg because the flood of money coming into US constitutes loosening of monetary policy thus making Fed tightening even more urgent [1]

  • it was suggested that when the US Federal Reserve raises short term interest rates that will have little adverse effect on asset values because long term rates are more important, and when the Fed last raised short term rate (ie from 1% to 5%pa between 2005 and 2007) this had no significant impact on long term (eg 10 year Treasury bond) yields - which had stayed about 5%pa. [1] [CPDS Comment: This observation is interesting but likely to be misleading - because the interest rate rise from 2005 did not occur in a QE environment. When QE was put into practice from 2009 in order to simulate the economy by suppressing long term interest rates the latter fell to 2%. If, as appears likely, the US Federal Reserve will have to force long term interest rates up in 2015 to avoid the risk of an inflationary break-out in the US, this implies that merely increasing short term rates will be insufficient ie it will be necessary reverse QE by significant sales of Treasury and other bonds]
  • it was likewise argued that merely raising US banks' overnight borrowing rates would have very little global impact because: (a) doing so had had little impact between 2004 and 2006 (as noted above); and (b) many other reserve banks were actively intervening - so actions by the US Federal Reserve would not have as much impact as they used to do [1]
  • a mixture of high debt levels in oil sector and low oil prices could have far reaching effects on global economy according to BIS. Total debt in sector is now $US2.5tr 2.5 times what it was in 2006. With low oil prices, the value of assets has declined - and this could lead to a sell off of assets - and compound a wider sell-off of bonds [1]
  • IMF has suggested that fossil fuels enjoy a large subsidy. A tax on such fuels may well be introduced which would have the effect of devaluing those assets to almost nothing [1]
  • Europe has experienced a rapid and unexpected turn around in growth. Position is best in four years - though France remains weak.  [1]. In Europe retail sales are rising / consumer confidence is at 8 year high / private sector has best growth in 4 years / money is flowing to European funds. Credit flows to business are increasing, declining euro improves competitiveness. German wages are rising. Despite this Europe faces significant problems (eg some countries are not improving / recovery is weak) [1]
  • US intelligence agencies and others (eg CIA, FBI, Army, Navy) are suggested to be concerned that $US could lose its global reserve currency status. This could lead to global anarchy and 25 year depression.

In late 1990s financial market developments had national security implications - but CIA had no relevant expertise. 'Project Prophesy' was an attempt to overcome this gap.  Now the $US has become a threat. Fed has increased money supply $3.1tr. US has $17tr debt and $127tr unfunded liabilities. There is no way to pay this. Increasing debt no longer stimulates growth. A stock market collapse / depression are possible. There is a lot of social distress in US - but it is hidden. Real unemployment is 23%.  The velocity of money has reached zero (ie people save but don't spend). This is worse than in 1930s. The Federal reserve is at risk of failure. It has a $US56bn capital base - but $US4.3tr in unstable liabilities. The US banking system has $60tr debt. Banks / debt used to growth 2 times rate of economic growth - now it is 30 times. Stock market capitalization / GDP ratio shows a problem. 50% seems normal. Just before Great Depression it was 87%. Now it is over 200%. And global derivatives are now $700tr - 10 times global GDP. After 2007-08 market collapse, losses were $60tr. Now risk is even greater. Potential risks arise from: foreign ownership of US debt. Foreign ownership of US government debt has fallen from $700bn in 2011 to about $50bn now. Russia started dumping Treasuries before Crimea invasion. China has also been dumping Treasuries. US Treasury has set up a 'war room'. As China and Russia sell - 'Belgium' (ie the Fed secretly)  has bought large amounts. If Treasury yields go up, that will sink stock / property markets. The attack on US Treasury markets could ignite depression. An $US role depends on 'petrodollar' arrangement - which in turn depends on US keeping house of Saud in power. US military withdrawal is undermining this.  Russia is also moving from pricing oil in $US. Gold is emerging as an alternative to $USs. China bought 3000 tonnes in past 4 years to hedge against $US collapse. There are also global risks that arise in China (eg from shadow banking system). IMF is seeking to replace $US as global reserve currency. When next crisis comes IMF will be the world's only source of capital (ie SDRs).  [1]

  • when Fed raises interest rates, the world could face problems like 1937 when Fed also boosted rates after 8 years of ultra-low interest rates. Similarities include: (a) high debts creating bubble in 1929 and 2007; (b) interest rates hit zero in depression (1931 and 2008); (c) money printing started (1933 and 2009); (d) stock market and risky assets rally (1933-1936 and 2009-2014) - while economy experiences cyclical recovery; and (e) central banks tighten leading to self-reinforcing downturn [1]
  • US Fed will be forced to quantitative tightening (ie to sell bonds to reverse QE) by foreign central bank policies. Traditionally Fed raises interest rates by lifting the overnight bank rate. Longer rates are generally higher - and can be affected by bank rate if Fed acts soon enough. For several years rates have been ultra-low across all maturities and this has distorted asset markets and economies. When Fed allows rates to rise across all maturities asset values of all types will be affected. In 2004-2006 when bank rate was raised this had little effect on long rates - because foreign governments (especially China) were buying Treasuries to keep their exchange rates low. Now foreign reserve banks (in Europe and Japan) are printing money to force down interest rates and this encourages investors to buy US Treasuries - and thus keep long rates down as Fed raises bank rate. Thus to achieve higher long rates the Fed may need to start selling the some of the $2.3tr in US Treasuries that it holds [1].
  • tighter regulation after GFC has created a risk of another financial crisis by draining liquidity from bond and equity markets - according to Blackstone CEO. Mark to market rules will create losses - and thus require assets to be sold in a crisis - and this scares others from investing in them. There is thus only an illusion of liquidity in those markets [1]
  • while there is an expectation that FED will start raising interest rates later in 2015 rather than sooner, there are serious risks with doing so (eg encouraging investors to seek riskier investments in a search for yield). The Fed is 'behind the curve' in raising rates [1]
  • IMF anticipates that US Fed will raise interest rates faster and sooner than markets expect and that this will be disruptive. [1, 2]

Emerging markets face a $ shock as Fed raises rates more sharply than expected - according to IMF. The era of cheap credit over past 8 years is likely to end. Markets are pricing in slow end to easing. Global economy is becalmed - held back by problems in Russia and Latin America. Emerging markets have exhausted easy opportunities from catch-up growth. Potential growth in advanced economies is lower than before GFC - because of population aging and slowing that had been occurring. Legacies of GFC and euro crises remain. Market have been lulled into false sense of security by low bond rates. Emerging markets are heavily exposed - and could face capital outflows as US long-term rates rise. Countries that borrowed heavily in $US at low rates will have large problems. They account for half of $9tr debt outside US.  BRICS (apart from India) face problems. China's reforms have done little to help yet. Rebalancing towards domestic demand has been driven mainly by investment / credit - which is unsustainable. IMF sees changes in currency values as useful so long as not too violent.

  • 'Asia' borrowed heavily to avoid the worst of the GFC - and has continued doing so. Now debt levels are so high that economic growth is seriously constrained [1]
  • China and the Asian tigers are facing major growth constraints due to: decline in working age populations; high debts; and deflationary pressures [1]
  • Japan put a lot of emphasis on easy money policies as a means for stimulating economic growth in 2013 - but this was not successful. Japan's best prospect might lie in boosting exports - through market liberalization [1]
  • warnings were expressed in August 2016 about the risks of waiting too long before raising US interest rates - because it could then be necessary to raise them much higher and much faster [1]
  • concern was expressed that US will need to raise interest rates very quickly. There are indications that stagflation could be emerging (ie a high rate of inflation combined with poor economic performance [1]
  • there is concern in the US that low interest rates could make the provision of mortgages unprofitable and thus lead to a liquidity crisis (ie a lack of funding) in the property market [1]
  • Deutsche Bank argues that negative interest rates pose danger to the economy, savers and pension funds. ECB monetary policy is seen to impede strengthening of ecoomy and making banks safer. Negative rates were supposed to encourage riskers investments - but have actually increased savings and economic unease in community. [1]

Global Bond Market Crash?

  • there were emerging signs of a global bond market 'crash' (ie a decline in values and a rise in yield) from April 2015;
  • the value of European government debt declined significantly as investors sold bonds with negative yields as signs of inflation increased [1].
  •  A slow motion crash in sovereign bond values seemed to be occurring world-wide [1].
  • There are signs of panic in selling bonds. Everyone wants out. This is potentially dangerous because there is no strong macro-economic environment that could cope with higher interest rates [1].
  • There are risks in bond market rout - because low interest rates established by reserve banks have forced investors into increasingly risky investments. Once there are signs that bond have peaked, there is a need to get out of many different asset classes [1]
  • Bond yields are soaring because central banks have done enough to stop deflation. Broad money supply (M3) has been growing at 7-8% in US / Europe. Recovery in US expected. Those who drove European bond yields negative have had large losses. Europe is clawing its way out of depression. Rising interest rates will have adverse economic effects US companies are rushing to issue bonds before rates rise. This could force rates higher. Stock markets and emerging markets are at risk.  China is in trouble. Urban fixed investment has collapsed. Factory gate deflation is -4.6% - and this is transmitting globally through floods of cheap products. 2015 could be the end of 34 year bull market for global bonds - though it is also possible that another bout of low rates will be needed before hyper-inflation sets in. [1]
  • risk free government bonds in Europe have been collapsing. German 2046 Bunds fell 30% in value over a month. Austrian government 2062 bonds fell 60%. And anyone holding the latter to maturity faces a further guaranteed 60% loss [1]
  • Markets ignored warning signs of coming inflation due to rising money supply. Now bond markets which had presumed a deflationary outlook are crashing. This is matching the 'taper tantrum' of 2013 when US Fed first warned that QE would not last forever. Paper losses over past 3 months have exceeded $1.2tr. Yields have risen worldwide. Pimco is slashing its holdings of US government debt. Money supply aggregates have been rising in US and Europe - warning of bond crash for months. M1 was growing at 16% pa in Europe - while broader M3 was growing at 8.4% pa. $2tr in eurozone bonds were trading at negative yields. The bond bubble is evaporating rapidly because new regulations reduced liquidity - and bonds had offered risk with no yield. QE has a reflationary effect if assets are purchased outside the banking system (ie it increases money supply and thus lifts yields). The ECB overcame Europe's deflationary risk. What happens now depends on how fast US Fed raises rates. $US debts offshore have risen from $2tr to $9 tr over 15 years leaving the world vulnerable to Fed action. Total debt in developed world has risen by 30% of GDP (to 275%) and by 35% (to 180%) in emerging markets. China is still flooding the world with excess manufacturing capacity. Global savings rate remains 26% of GDP implying more of the same savings glut and debilitating lack of demand that lies behind the Long Slump. The world has used all its fiscal and monetary policy ammonition - and faces next downturn with nothing left.  The US may be strong enough to resist monetary tightening - but many others will not be. Interest rates might be 3.5% when inflation reaches 2%. The Fed might adopt a fast-tightening approach like that used in the 1990s  [1]
  • US Fed and its global counter-parts are now suffering unintended consequences of trillions of easing to allay fears of a market crisis. Liquidity is now the problem - which is ironic as this was what Fed sought to provide to boost asset values, generate a wealth effect that would spread throughout the economy. Asset prices have risen - and companies have issued 1/2 trillion in new bonds in the past year convinced that rates will stay low. But now Fed is looking at tightening and inflation concerns are rising. There could be a rush for the exists in bond markets. Low yields and surging equity prices have emerged since Fed went into ultra-easy mode in 2008. Low US growth allowed companies to believe that rates would remain low so debt costs would be low - while investors benefited from stock market rises.  Investors also bought 'junk' bonds - which is risky. Thus the Fed's 'solution' created the basis of a longer term problem. Now economic fundamentals are poor because investment has not been well focused. Bond yield are now rising. [1]
  • Bond funds are holding increasing amounts of cash because of fear of the consequences of rising interest rate [1]
  • The US 'junk' bond market is valued at $2tr (compared with $1.3tr subprime market in 2007) - and has fallen 8% in last month. 80% of these junk bonds could default in the next few years. Yields have averaged on 1.5% since 2002 misleading investors as to the risk. There will be no government support for losses on junk bonds [1]
  • In August 2015, high yield bonds that serve as a proxy for the stock market were selling off sharply [1]
  • there is a risk to global markets if reserve banks not only start to raise interest rates, but also shrink their balance sheets and take liquidity out of the system. The US Fed raised its balance sheet to $4.4tr up from $800bn at time of GFC. ECB has indicated an intent to raise its balance sheet by 1tr euro - but might need to change this if recovery / inflation is likely.   [1];
  • interest rates have been trending down in Australia since 1990 (and since 1980 in other developed economies). Since the GFC cuts to cash rates, falling inflation and excess savings have reduced interest rates to record lows. This has increased the price of many assets - and this benefited borrowers but hurt savers. The multi-decade decline in interest rates is likely to be at an end - but normalization of rates will be a slow (and bumpy) process. It will start earlier in the US than in Europe, Japan and Australia [1]

CPDS Comment: Will the Normalization of Interest Rates be Slow?

Ben Bernanke (a former US Federal Reserve chairman) indicated in 2015 that the era of ultra-low interest rates needed to be brought to an end because of associated problems (with exchange rates, asset prices and income distribution) and it had been impossible to use low interest rates to create a sustainable basis for global economic recovery (see Sharing the Blame for Global Economic Failure, 2015).

However it is not clear that lifting interest rates will be a slow process under the control of reserve banks (the US Federal reserve or any other).

 At present bond values are sky-high because of QE (ie reserve bank buying of bonds to get interest rates down in the vain hope that this would boost the ‘real’ economy). This could never have been successful in a global environment characterized by large / persistent financial imbalances - for reasons also suggested in Sharing the Blame for Global Economic Failure.

However the result is that developed-economy bond markets now provide essentially no yield to investors. In recent years bonds have been bought solely because QE has offered a steady capital gain. The moment easy money policies (and thus capital gains from bonds) cease to be available (and look like reversing), 'everyone' will need to have sold all their bonds ‘yesterday’ (because holding them guarantees a low initial yield and large ongoing capital losses). The only exception would be those who bought bonds years ago with an intent to hold them to maturity and are unconcerned about variations in the capital value of bonds.

And the risk of a rapid collapse in bond values has been exacerbated by:

  •  the widespread acceptance of the notion of 'bail ins' (ie that where major financial institutions suffer large losses, lenders and depositors will no longer be protected by government 'bail-outs' to protect the integrity of the financial system, but will be expected to carry a share of the institution's losses). This increases creditors' need to be alert to the implications of rising interest rates that could create losses for institutions to whom they have advanced money;
  • regulations designed to increase banks' protection against the effect of a financial crisis that have constrained their ability to buy bonds - thus eliminating that traditional source of demand when / if other investors seek to sell bonds [1];
  •  long-delayed inflationary risks may trigger a need for a rapid reversal of QE. QE by the US Federal Reserve involved expanding its balance sheet (ie creating credit) to buy bonds held by institutions (especially banks). This increased the price of bonds and reduced interest rates but did not directly increase money supply in the real economy (as doing so required - not just that banks had huge cash holdings and cheap credit was available - but that households and businesses wanted to borrow). Thus the inflation risk often associated with 'printing money' was avoided. However, presumably because of impending economic recovery in the US, money supply in the US is now starting to rise - thus creating the risk of inflation [1]. If a large increase in money supply in the real economy were to result, a reversal of QE to increase interest rates (perhaps including a rapid contraction of US Fed bond holdings) could be needed to prevent hyper-inflation;
  • one consequence of QE by the US Fed was to encourage ultra-low interest rate borrowings to invest for higher yield in riskier emerging economies. The prospect of rising US interest rates is making that tactic unattractive - and thus leading to a repatriation of capital, This creates 'capital flight' problems for emerging economies - and also increases cash holdings in the US for which no attractive investment options are immediately obvious. This must increase inflation risks unless the excess cash is withdrawn by reversing QE.

There may thus be the potential for another market-driven bond market crash like that in 1932 – and a rapid escalation in interest rates.  In the 1930s it was not the equity crash of 1929 that ushered in the worst of the Great Depression - but rather the combined equities and bond market crash of 1932 (see Stocks waiting on Bond Collapse, 2012) .

In late 2016 bond markets were already moving in that direction without waiting for reserve banks to act or equities to fall (eg see Bond yields are surging despite deflation, and that is dangerous, Telegraph UK, 14/9/16 and Government Bond Bubble Feels Closer to Bursting, The Australian, 16/9/16) . The only question was when / whether ‘almost everyone’ would realize that they needed to sell ‘yesterday’. 

Elaboration: Government / corporate bonds have been bought with negligible / negative yields in anticipation of ongoing capital gains as a result of ever-easier monetary policies. ‘Everyone’ will need to have sold yesterday (a formula for a crash) if it seems that interest rates might start rising. Markets have apparently realised that this might actually happen both because US Fed wants to do this and because negative rates in Europe and Japan are economically ineffectual and having serious side effects. The problem could be exacerbated by the preference for 'bail ins' that has emerged in recent years (ie requiring bond holders rather than governments to take the first losses in the case of bank failures) and the potential for this to happen in the case of Deutsche Bank.

As the above UK reference suggests the potential losses (to banks, insurance companies, pension funds etc) from very small changes in interest rates could be huge because official rates / bond yields have fallen so low and the amount invested in bonds is huge. Bond prices are inversely proportional to yields, so a rise in yield from (say) 0.6% to 0.8% could result in a (say) 33% capital loss (or a 0.15% rise from 1.5% produce a 10% loss) and damage the balance sheets of affected organisations. And when bond yields go up, the yields expected on other assets (eg shares) will also rise– thus causing a fall in prices which could also be large because yields have become so low due to ultra-low official interest rates.

It is possible, but by no means certain, that the effect on the prices of financial assets could be sufficient to trigger another GFC. After the 1929 sharemarket crash there was a period of market / economic recovery until 1932 when a second-round equities crash (which also triggered a bond-market crash) ushered in the worst social and economic impacts that were only ended by WWII. It is possible that a bond-market crash could now be the trigger for (rather than the consequence of) an equities crash because ultra-easy money policies by reserve banks have increased the risk and consequences of a bond-market crash. If a bond market crash causes a lot of damage to the balance sheets of financial institutions, reserve banks would probably not be able to compensate because they have already taken easy-money policies too far.

Note: A somewhat similar argument later appeared in How the Fed Screwed up the Bond Market (12/6/15)

  • global regulators have warned that the ultra-low interest rates associated with QE (by the US, EMU and Japan) have created asset classes in a search for yield that could be highly vulnerable as interest rates rise [1];
  • it was seen as unclear how money printing and low interest rates (which have driven equities and property values to high levels) can be reversed. Most business cycles end when monetary conditions tighten - especially in response to inflation (though GFC was due to unwise government policies - to encourage loans to people who could not afford them). Now inflation is low worldwide; wage growth is slow; commodity prices are subdued. Greece could be disruptive -as could shadow banking or problems in emerging markets. or perhaps there could be a spontaneous stock market / property collapse. In crash of 1987 there were viable alternatives for investors (ie bonds) which are not available now. Also not every boom is necessarily followed by a bust - and it is hard to see what could derail things  for next few years [1] [CPDS Comment: Irving Fisher, a now very influential neo-classical economist whose work led to the notion of monetarism, famously declared a few weeks before the crash of 1929 that the stock market had 'reached a permanently high plateau']
  • there is little that is legitimate about China's financial markets - and global stability is at risk unless China's ability to affect international financial markets is constrained

China's stock boom and recent collapse have had limited international impact. But China's companies are much more dependent on bank financing than selling shares. And Chinese people hold more savings with banks and less with equities than US citizens do. Chinese banks are mainly state-owned and fund projects reflecting State Council goals. A lot of China's savings are badly invested. To expand the pool of equity capital, China encouraged savers to buy stocks - including purchases with borrowed money (ie margin trading).  Shanghai market rose 60% in first half of 2015 - before government thought this had gone too far and tried to deflate the bubble. But the market collapsed. Now regulators have gone to extreme length to reflate the market. Little about China's financial system is legitimate. PBOC is not politically independent. State banks carry loans that can't be repaid by insolvent enterprises. The yuan does not trade freely. Yet yuan is accepted in international trade and may gain reserve currency status from IMF. This would allow China to plunder / destabilize markets globally. While the immediate effect of recent upheavals in Chinese stock market are limited, China could become a genuine threat to global financial stability if left unchecked [1

CPDS Comment: The concern expressed in the above article are valid - though the issues are more complex than were indicated:


Refusing to Face Up to East-West Structural Incompatabilities?   <<

In this context there seemed to be an urgent need for the G20 to finally face up to the problems associated with structural incompatibilities in the international financial system that had given rise to the need for easy money policies to sustain global growth in the first place (ie those related to international financial imbalances that the BIS had also highlighted - see above) - but perhaps little prospect that this would be achieved.

Making the G20 Useful at Last - email sent 26/11/13

Senator the Hon Arthur Sinodinos, AO
Assistant Treasurer

Re: G20 policy on private investment key for infrastructure, The Australian, 26/11/13

Your article started by suggesting that:

“Australia will take over the presidency of the G20 next week and, with it, the opportunity to advance an important policy agenda for the world's most economically powerful countries. Top of this agenda will be the promotion of investment, especially for infrastructure”.

I should like to suggest for your consideration that a focus on increasing (especially private) investment in infrastructure would be a waste of the opportunity that Australia has in having the presidency of the G20. My reason for suggesting this can be illustrated by the sub-heading that appeared with your article:

“Society is the poorer when capital is not allocated to maximize its value”

The biggest problem that the world’s financial systems face (which it is the G20’s role to address) has nothing to do with private investment in infrastructure, but rather involves the allocation of capital with little interest in maximizing its value by major East Asian states (eg Japan and China – see evidence). That problem:

  • Arises from the neo-Confucian ('bureaucratic non-capitalist') methods that have been used to achieve ‘economic miracles’ in East Asia (see Understanding East Asia's Neo-Confucian Systems of Socio-political-economy, 2009);
  • Played a major role in generating the international financial imbalances that required the loose monetary policies in the US that ultimately led to the GFC (eg see Impacting the Global Economy). Where capital is allocated by state-linked banks to state-linked enterprises with a goal of maximizing market share rather than economic value added, it is essential to suppress demand to maintain a current account surplus (and thus avoid having to borrow in international profit-seeking financial markets). Global economic activity can only be sustained if trading partners are willing and able to maintain large current account deficits and ever increasing debt levels;
  • Has been the main issue that the G20 should have dealt with from the start, but has been neglected because of the difficult cultural issues involved – see G20: Avoiding key Issues (2008); G20: Peace for our Time'? (2009); Too Hard for the G20? (2010); G20 in Korea: Unreal Optimism? (2010); and G20 in Washington: Waiting for Hell to Freeze Over? (2011); and
  • Seems now to be on the point of generating a crisis – because of: (a) the high debt levels in developed economies that constrains their ability to provide the excess demand that countries reliant on current account surpluses require; and (b) the huge levels of bad debts that apparently threaten economic and political meltdowns in countries such as Japan and China (see An Approaching Crisis?).

Thus the key reason for suggesting that a focus on private infrastructure investment would be the waste of an opportunity is that there is a much higher priority issue (and an imminent crisis) that arguably needs attention by the G20.

Another reason for not focusing on mobilizing funds for infrastructure investment is that Australia’s current machinery for the planning and development of infrastructure is dysfunctional (eg see Infrastructure Constraints on Australia's Economy, 2005 and Infrastructure Magic?, 2008). Fixing the institutional mess is much more likely to result in the ‘allocation of capital to maximize its value’ than encouraging private investors to direct funds into a dysfunctional system.

John Craig

Trade is not Enough for Economic Progress - email sent 20/1/14

Richard Goyder (Wesfarmers) and Harold McGraw (McGraw Hill)

Re: Davos offers rare opportunity to push for economic progress, The Australian, 20/1/14

Your article argued that trade liberalization should be the top priority agenda item for the coming G20 summit in Australia.

I would like to suggest for your consideration that dealing with financial system distortions should be an even higher priority – as they can make a liberal trading regime unsustainable.

This point is developed from one perspective in Making the G20 Useful at Last. Until serious attention is paid to the demand deficits / current account surpluses that some significant economies have had to have in order to avoid a financial crisis (eg those with non-capitalistic financial systems such as Japan and China, as well as emerging economies with poorly-developed financial systems), it will be impossible to sustain growth under a liberal trading order as: (a) the resulting international financial imbalances require their trading partners to be willing and able to tolerate ever-rising debt levels; and (b) financial crises will remain an ongoing risk almost everywhere. Moreover the non-capitalistic financial systems create what amounts to a novel form of protectionism that needs to be considered in relation to the rules of international trade (see Resist Protectionism: A Call That is Decades Too Late, 2010).

However problems have also developed in capitalistic (ie profit-oriented) financial systems as their complexity has escalated, and this also needs attention (perhaps as suggested in Restricting the Role of Financial Services?) before a future liberal trading regime can be sustainable.

John Craig

Structural Obstacles to Global Economic Recovery Need Attention - email sent 5/6/14

Ambrose Evan’s Prichard

Re: The nagging fear that QE itself may be causing deflation, The Telegraph, 4/6/14

Your article raised the possibility that low interest rate policies may not be able to prevent: (a) the global economy sliding towards deflation; and (b) economic globalization failing in the face of a new era of protectionism. It also suggested an alternative approach to monetary policy stimulus (ie boosting the quantity of money rather than restricting interest rates). However global economic recovery will arguably be impossible until attention is paid to the savings gluts and demand deficits that have been critical to the non-capitalistic financial systems that have been components of the ‘economic miracles’ achieved in recent decades in East Asia.

My interpretation of your article: The whole world is headed for zero interest rates - because of the risk of deflation in countries with burst credit bubbles and a global savings rate that has risen to 25% - starving the world of demand. ECB is headed for negative interest rates to lower the euro and pass the risk of deflation to someone else. China is proposing 'targeted monetary easing' and seeking ways to deflate its property boom - which is not easy because government revenues and economic activity depend heavily on this. Beijing's land value is about the same percentage of US GDP as Tokyo's was at the peak of its 1990 bubble. China is facing deflation in supply chain and a workforce that is now declining by 3m pa (similar to trends that started Japan's deflation). Difficulties in shaking off 'low-flation' malaise are partly the result of a glut of factories worldwide. However it is also suggested that low rates and QE may cause deflation - because buying government bonds lowers the 'liquidity premium' which in turn pulls down inflation. India's central bank suggests that QE is a 'beggar my neighbour' devaluation policy. Western QE causes a flood of money to emerging markets (seeking yield) which creates destructive booms - and post-bubble hangovers. Emerging economies thus need to tighten policy, restrict demand and build up foreign reserves as a safety buffer. This perpetuates the global savings glut that has starved the world of demand - and may be the main cause of the long slump. BIS argues that the world is suffering from addiction to stimulus. Refusing to let the business cycle run its course and purge debts is corrosive. The global economy can be in a deceptively stable disequilibrium. There are signs that globalization could be in retreat - and be followed by an era of financial and trade protectionism. Japan tried aggressive monetary policies in the 1990s - yet deflation ground on. In US / UK QE has had a potent effect - preventing double-dip recessions as austerity bites (in contrast to Europe). However recent US contraction is a warning sign of possible problems. The problem may be that Western central banks have focused only on interest rates - and not on quantity of money changes. Targeting quantity of money increases (with interest rates finding their own level) might have been better. The ECB could be making the same mistake - by only adjusting interest rates

Monetary policy is an unsatisfactory tool for counter-cyclical economic management because its effect, though potentially significant, is too complex to be properly understood or targeted. Monetary policy primarily affects asset values (rather than economic demand) and thus can contribute to asset bubbles and busts. And its effect can be transmitted internationally by carry trades, with potentially disruptive consequences (see Booms and Busts: Unsatisfactory Tools for Macroeconomic Management, 2007). It also (perhaps) contributes to the income inequality that is now causing international controversy (see Who Is Failing the Lower and Middle Classes?).

However finding an alternative method for macroeconomic management is not policy-makers’ biggest challenge.

Global economic growth can’t be sustained in the face of persistent and structural international financial imbalances. Increases in economic demand (whether due to market conditions or stimulus measures) are not limited in their effect to a particular country. They will also have spill-over effects on the global economy and, if trading partners persistently suppress demand so as to generate current account surpluses, then counties that do not deliberately restrict demand must increase their public and private debts to the point that demand eventually has to be stifled there as well. Financial and trade protectionism thus becomes unavoidable and economic globalization must collapse.

There is no possibility of overcoming the world’s current tendency towards a savings / supply glut and a demand deficit until attention is paid to cultural factors that have led to significant international financial imbalances for reasons suggested in Structural Incompatibility Puts Global Growth at Risk (2003) and Understanding East Asia's Neo-Confucian Systems of Socio-political-economy (2009). Globally unsustainable imbalances have been domestically vital to protect the non-capitalistic financial systems (ie those not seriously concerned with return on capital) that have been a central part of East Asian economic ‘miracles’.

The G20 was set up to address problems in the international financial system that gave rise to the post 2007-08 global financial crisis. However it has repeatedly failed to get to grips with the cultural incompatibilities that are arguably at the core of the problem it is supposed to be solving (eg see G20 in Washington: Waiting for Hell to Freeze Over?, 2011).

John Craig

Learning Nothing from the GFC: Cultural Incompatibilities Continue to be Put in the 'Too Hard' Basket - email sent 8/10/14

Callam Pickering,
Business Spectator

Re: Did we learn nothing from the GFC?, Business Spectator, 8/10/14

Your article noted that the world’s reliance on debt has increased since the GFC, and thus that the risk of another debt crisis remains (with Europe and emerging economies perhaps being the most exposed).

My Interpretation of your article: In the six years since Lehman Bros failed, households and business have scrambled to pay down / write off existing (often toxic) debts. But the world’s reliance on debt has not declined (according to 16th Geneva Report on Global Economy). Global debt / GDP ratios continue to increase rapidly. The GFC only temporarilly moderated this. Global debt (excluding financials) rose 180% of nominal GDP from 2008 to 2012% in 2013. In the developed world the ratio is 272% compared with 151% in emerging economies. Ireland (442%) and Japan (411%) are highest.In Ireland this is mainly corporate debt, while in Japan 243% of GDP is public debt. Australia’s debt / GDP ratio is 209% of GDP – and unusually concentrated in household sector (110% of GDP). Debt levels do not in themselves indicate where failures are likely. For example, Japan primarily borrows from its own citizens and can print money to cover debt. The US is similar because of $US’s status. The next global debt crisis seems most likely in Europe or emerging economies. Rising debt with slowing growth is the major risk – and this particularly affects Europe (partly because of the architecture of the euro-zone). Europe is also confronted by nasty demographics. Emerging economies face different threats – with China particularly exposed. Rising leverage allowed emerging economies to get through GFC. China’s debt-GDP ratio increased 70% since 2008 – much of which was directed to property and infrastructure. This helped Australia but was unsustainable. China now faces rising debt and moderating GDP growth. Its ability to service debt will be stretched – though low government debt will help. Little was learned from GFC. Countries with low debt were best placed. Countries that can deleverage (without compromising their economies) should now do so. Emerging economies’ debt is not especially high but it is increasing rapidly. They may find it harder the deal with debt burden than is the case in developed economies.

The need for economic growth to be driven by ever rising debt levels is likely to have been, and remain, a consequence of structural incompatibility between East Asia’s major non-capitalistic bureaucratically-orchestrated mercantilist economies (especially those of Japan and China) and the Western-style (ie capitalistic / profit-oriented) global financial system (see Structural Incompatibility Puts Global Growth at Risk, 2003 and Impacting the Global Economy, 2009). The non-capitalistic systems face certain financial crises unless they maintain domestic ‘savings gluts’ / financial repression to prevent any need for state-linked banks with poor / falsified balance sheets to borrow in international financial markets. Thus, to prevent global growth stagnating, their trading partners must be willing and able to incur large current account deficits and ever rising debt levels.

The G20 was set up to try to deal with the causes of the 2008 GFC – but the cultural core of this problem has been put in the ‘too hard’ basket (eg see G20 in Washington: Waiting for Hell to Freeze Over? 2011).

There is now a good chance (as your article implied) that the problem will lead to a second round of debt-driven failures (eg perhaps in Europe and / or emerging economies). Until the underlying cause of the world economy’s need for ever rising debt levels is eliminated, debt crises must continue to erupt from time to time. It is now also possible that the underlying problem might actually be ‘solved’ over the next year or two by financial failure in East Asia’s massively-over-indebted major economies in spite of the ability of their state banks and their governments themselves to borrow domestically (see Japan’s Predicament and China’s Predicament). Needless to say that path to a ‘solution’ would be anything but easy for the global economy and Australia.

An alternative would be for the G20 to actually confront the cultural incompatibilities involved (eg as suggested in and Making the G20 Useful at Last? 2013) but this still seems to be seen to be ‘too hard’.

John Craig

Sustainable Growth Requires More than an Infrastructure 'Trick' - email sent 9/11/14

David Uren and Dennis Shanahan
The Australian

Re: G20 growth ‘trick’ on target for summit, The Australian, 8/11/14

I should like to submit for your consideration that real reform of the international financial and economic system is needed for sustainable growth. Mobilizing funding for infrastructure from the world’s ‘vast pools of under-utilized private capital’ is most unlikely to do more than compound existing problems.

My Interpretation of your article: Australia is on track for a significant breakthrough at the G20 summit – as the IMF and OECD have confirmed that international reforms will realize the goal of raising global growth by 2%. OECD Secretary General (Angel Gurria) said that the proposed focus on infrastructure should do the trick. Finance ministers’ meetings continue to focus on investment – and the challenge has been to encourage this to happen particularly through long-term infrastructure. Kevin Rudd has endorsed this by arguing that infrastructure investment is now more important that free trade. He suggests connecting global public capital development with the vast pools of under-utilized private capital to bring about major project development. Mr Gurria argues for fostering investment because this can provide a short term boost to goods and services demand. A global strategy was seen to be needed rather than structural reform of economies.

Mobilizing private funding for infrastructure is likely to be an unsatisfactory ‘trick’ because:

  • the major constraints on global economic recovery are structural – and counter-cyclical measures such as large-scale investment in ‘infrastructure’ of uncertain priority can’t do anything about those structural obstacles;
  • shifting a lot of ‘under-utilized private capital’ that is a product of money printing to stimulate the real economy (rather than mainly simulating rising asset values as it has done to date) risks a disruptive inflationary surge; and
  • identifying and developing infrastructure that will produce net economic benefits requires institutional frameworks that don’t currently exist – and won’t be created by merely encouraging investment of ‘under-utilized private capital’.

My reasons for suggesting this are developed further on my website.

John Craig


One problem with reliance on large-scale infrastructure investment to stimulate economic recovery is that the global economy seems to primarily face structural rather than cyclical problems (for reasons suggested in Towards a New Economic Understanding). While appropriate infrastructure spending would undoubtedly be desirable, it would do nothing to resolve the structural obstacles to sustainable global economic growth (especially the international financial imbalances that have been a by-product of the methods of socio-political-economy that allowed post-WWII economic ‘miracles’ in East Asia). Towards a New Economic Understanding includes suggestions about possible structural solutions.

However stimulating growth by using ‘the vast pools of under-utilized private capital to bring about major project development’ could have nasty side-effects. Those ‘vast pools’ are a by-product of the easy money policies that have been needed to sustain global growth in the face of: (a) the above-mentioned international financial imbalances since the late 1980s; and (b) the global financial crisis that then resulted in 2008. Easy money policies have stimulated increasing asset values much more than they stimulated increased real economic activity – and this is likely to be the reason that they have not (yet) resulted in the inflationary surge that is conventionally associated with ‘printing money’. However if those ‘vast pools’ are diverted into stimulating real economic activity, the prospects of a low inflationary outcome could no longer be assured (ie if too much printed money is carelessly thrown at infrastructure, capacity under-utilization in the real economy would disappear and markets would start to bid prices up). The need to rapidly reverse quantitative easing in the face of an inflationary surge would then put a real dent in the said ‘vast pools of under-utilized private capital’.

Finally, there is no doubt that large scale spending on anything will generate demand and thus stimulate economic activity in the short term. However (as was demonstrated in Australia at the start of the GFC) large scale government handouts leave governments with debts that constrain their future activities without producing sustainable growth where structural constraints exist.

It is anything but certain that encouraging 'vast pools of underutilized private capital' to invest in infrastructure would be constructive. Under the best circumstances it is likely that projects will require government subsidies (often from constrained budgets) or guarantees. And investment that is not well-considered (which is anything but unlikely) can generate large public and / or private sector losses / debts that constrain ongoing growth. There have been many examples.

Examples: Japan has been labeled a ‘construction state’ (because of a perceived ‘iron triangle’ of companies / bureaucrats / politicians) and this has been seen to have resulted in the building of infrastructure which did not necessarily meet the needs of Japan’s people. After a financially-undisciplined investment boom in the 1980s had led to Japan’s financial crisis in about 1990, the post-WWII ‘construction state’ went into overdrive in the 1990s in an unsuccessful attempt to stimulate recovery. And China’s recent history has featured large scale apparently-financially-undisciplined investment to maintain economic growth – which now puts China’s future prospects at risk (eg see If China is Almost Broke How Can Chinese Investment Save Australia?). In Australia a politically-driven infrastructure development boom in Queensland (following the erosion of institutions that were capable of properly planning and implementing infrastructure) was associated with significant wastage and serious damage to public finances (see A Debt Binge?). And recent proposals by Australia’s federal government for a large-scale roads-focused program of infrastructure development appear to be driven more by considerations of what types of projects private investors would like to undertake than by what is appropriate for development of the regions in which they would be located (see The ‘Pink Batts’ Award for Public Goods and Services).  In the US: (a) concerns have been expressed about the distorted priorities which reduce the benefits of infrastructure spending as a result of interest group pressures [1]; and (b) federal administration proposals for large scale additional infrastructure investment as a means for stimulating the economy has been both criticized as merely imitating Japan’s ‘construction state’ tactics and defended as likely to be likely to be constructive (ie there is no consensus about the proposal). And China has now established an Asian Infrastructure Investment Bank whose governance and uncertain financial disciple have caused others concern (see The Future of the Asia Pacific).

While there is undoubtedly a great deal to be gained by appropriate infrastructure investment, creating institutions through which this can be reliably planned, financed and developed seems to be vital rather than simply encouraging those with access to a ‘vast pool of under-utilized private capital’ to try to guess what is needed and manipulate governments into supporting those projects that can most readily be privately financed and developed (irrespective of whether they are those that are most needed). Central 'strategic planning' can not work for infrastructure any more than for any economic function - because 'planners' always work with an overly simplified perception of the situation (see Infrastructure: A Big Picture View and Uncertainty about Traveston Dam's Viability). Moreover private ownership and control of public goods and services that are subjected to real market failures (as much infrastructure is) must always create the risk of conflicts-of-interest and distortion of real priorities (see Distorting / Corrupting Government in relation to Public private Partnerships generally).

In Australia’s case it is clear that the creation of effective machinery to plan, finance and develop infrastructure is vital to reduce the risk of waste and other problems from merely encouraging private investment in projects of uncertain priority (see Sorting Out Australia's Infrastructure Mess Needs 'Government' not Micro-management). There have, however, been no proposals for such reform.

A 'Developing Nation' Perspective: Australia's G20 infrastructure agenda seeks to raise quality investment in global projects - using the private sector to boost growth and job creation. These initiatives need to ensure that developing countries are not marginalised. The WEF argues that public infrastructure investment can have macroeconomic benefits (ie by raising output through boosting demand) - and long-term benefits by boosting economic productive capacity. However for many developing countries meaningful benefits from infrastructure depend on sound legal frameworks and credible policy tools - which many African countries lack. Few have financial institutions with healthy balance sheets that could undertake massive investment in energy / transport / water. Thus PPPs are seen as solution - as this allows both finance and technical competence to be mobilized. Through G20 Australia has advocated the establishment of a knowledge sharing platform for infrastructure - to assist development of PPPs and address information gaps on opportunities and investors. Infrastructure development was advocated through G20 in 2010 - but until now had not gained traction. Australia is drawing upon its own Infrastructure Australia initiative - a body responsible for the central planning of infrastructure across the whole country. PPPs and tax incentives are its main mechanisms. Australia's PM wants to internationalize this mechanism even though PPPs are seen to: socialize private sector risks; focus on value-for money objectives (rather than others). Private sector-led efforts would be encouraged over government-led efforts. Obstacles to the G20's agenda are: (a) the G20's institutional weakness - eg its agenda changes annually when presidency changes; (b) many countries affected by infrastructure constraints are not represented in G20; and (c) there are too many competing infrastructure-oriented initiatives. These competing initiatives could result in the opposite of the global cooperation needed - and result in significant resource misallocation [1]

Deciding about Infrastructure? The G20 infrastructure agenda cites an OECD prediction of a global infrastructure shortfall of $70tr by 2030. It is hard to assess this claim or to know what types of projects would be involved. Projects should be included only where benefits exceed opportunity cost - yet debate about infrastructure needs is opaque. Deciding what investments are warranted requires cost-benefit analysis, and consideration of alternatives. For example, cost effective transport requires considering: road prices / congestion changes; public / private transport options; upgrading roads or building new ones; and relationships with other (eg water / electricity) infrastructure. Sometimes decisions about infrastructure can be made by private investments - but at other times governments need to make the decision [1]

Creeping Threat to Global Economy - email sent 15/11/14

Dennis Shanahan
The Australian

Re: ‘Creeping threat’ to democratic values , The Australian, 15/11/14

Your article recorded criticism by Britain’s Prime Minister (David Cameron) of the ‘authoritarian capitalism’ of countries (presumably an indirect reference to China) that seek to enrich their people but bypass democracy and freedom.

My Interpretation of your article: David Cameron (Britain's Prime Minister) criticised ‘authoritarian capitalism’ – whereby countries seek to enrich their citizens but bypass democracy and freedoms – just before China’s president is due to address Australia’s Parliament. He criticized seeking shortcuts which bypass democracy and the rule of law. He praised the common values of Australia and Britain (including democratic elections, the rule of law, independent judges and a free press) but said that there was a threat to those values – from countries that believe there can be an ‘authoritarian capitalist’ shortcut without such values and restrictions. He emphasis that companies want to invest where there is a rule of law, no corruption, protected property rights and no risks of companies premises being taken. Western corporations have faced such problems in China. A democracy-free shortcut to economic success should be rejected. Democracies makes countries strong – public debates are painful but also empowering. They can drive out the corruption that some countries suffer. Companies prefer to invest where courts are independent so their property rights can be protected. The word’s most successful countries are those with an absence of conflicts and corruption and strong property rights and institutions.

While the points Mr Cameron made seem valid, it is wrong to imply that countries such as China have ‘authoritarian capitalist’ economies. ‘Capitalism’ involves independent profit-focused investment, whereas economic ‘miracles’ in East Asia have been founded on authoritarian ‘non-capitalist’ systems. Investment of national savings by state-linked banks through state-linked enterprises has had mercantilist (ie power seeking) rather than ‘capitalist’ (profit seeing) goals (see Evidence). The absence of a serious commitment to democracy and a rule of law derives from ancient Chinese cultural traditions that place little reliance on the use of abstract concepts as a basis for decision making by individuals (see East Asia: The Realm of the Autocratic, Hierarchical and Intuitive Ethnic Group?. The notion of ‘profit’ is foreign under such systems – and for the same reason that the notion of universal values or law is foreign.

An attempt to outline: how such systems have operated; the risks the financial imbalances they required have posed to global financial and economic systems; and what might be required to remedy the problem are in Towards a New Economic Understanding. Dealing with this obstacle to global economic growth (and the associated challenge to Western notions of freedom and a rule of law) has long needed attention by the G20 (eg see Making the G20 Useful at Last, 2013).

John Craig

Background to The Case for 'Selling Almost Everything' - email sent 14/1/16

Andrew Roberts,
Royal Bank of Scotland

Re: European Rates Weekly, 8/1/16

I should like to draw your attention to some suggestions about a significant causative factor in the reasonable conclusion that your latest Weekly reached about accumulated debt now acting as a constraint on economic growth.

That causative factor relates to fundamental differences between ways of thinking in Western societies (whose traditions are the basis of the international financial system) and East Asian societies with an ancient Chinese cultural heritage. Those differences are outlined in Competing Civilizations (2001+). Western traditions involve the use of abstract concepts (eg profitability) as the basis for rational decision making by independent organisations / individuals. East Asian traditions regard abstract concepts (truth, law, profitability) as overly simplistic, and emphasise action based on consensus within ethnic social hierarchies.

These differences have major impacts on financial systems. The lack of emphasis on return on / return of capital under East Asian (mercantilist rather than capitalist) traditions has arguably been a factor behind a great deal of what has happened in the international arena in recent decades and which has led to the current global predicament. Reasons for this are suggested in The Cultural Background to East Asian Savings Gluts and Escalating International Financial Crises.

I submit that the effect of these profound cultural differences needs to be taken into account in RBS’s useful efforts to anticipate future financial / economic trends.

I would be interested in your response to my speculations

John Craig

However progress may be eventually be achieved because China was nominated to lead the G20 in 2016

Will China's Presidency in 2016 End the G20's Chronic Failure? - email sent 6/12/14

Stephen Grenville
Lowy Institute

Re: Did the G20 go far enough on financial stability?, Business Spectator, 1/12/14

Your article pointed to the fact that financial stability (the issue that the G20 was set up to address) gained very limited attention at the recent G20 leaders’ meeting in Brisbane. It also noted that the ‘solution’ to that problem that is being considered involved boosting the capital reserve requirements of major banks to make them less susceptible to failure in the event of a financial crisis – and thus less likely to impose costs on governments to avoid systemic contagion.

The G20 has failed. The main threat to global financial stability has been and remains the unreliability of the balance sheets of ‘non-capitalist’ banks and companies in major East Asian economies such as Japan and China. The latter’s cultural obstacles to reliable financial accountability have long been overdue for attention (see Making the G20 Useful at Last, 2013). Macroeconomic threats to global growth (ie structural demand deficits) have existed because those cultural obstacles have required domestic ‘financial repression’ / ‘savings gluts’, which induced international financial imbalances and thus made economic growth dependent on easy monetary policies. The latter have proven hazardous by: distorting investment and financial markets; increasing financial market instabilities; encouraging probably-unsustainable public and private debt levels; increasing social inequality with consequent risks of political instability; and potentially leading to an outbreak of inflation if QE stimulates the real economy rather than asset prices and / or a loss of confidence in affected currencies.

There has not yet been any serious effort by the G20 to address these structural obstacles to global financial stability.

However a solution may now emerge by accident. Australia, which has had the G20 presidency, has nominated China to preside over the G20 in 2016. This will place China’s leaders in a very interesting position because:

  • Most G20 members will presumably expect China’s presidency to continue exploring options that are compatible with the liberal ideals that have been the foundation of international financial and economic institutions since WWII – such as: (a) democracy to ensure that a state is accountable to citizens; and (b) capitalism to ensure that a society’s resources are mainly directed towards meeting independent enterprises’ expectations of profit by satisfying citizens’ demands;
  • China faces increasingly severe risks (eg unsustainable debt-driven growth and a popular desire for social equality that is incompatible with the ‘neo-Confucian’ hierarchy through which East Asian economic ‘miracles’ have been orchestrated);
  • Because a liberal international order exacerbates those risks, China has clearly been attempting to stimulate the emergence of a more compatible international trade / tribute regime, ie a regime like that by which Asia was administered by China’s Confucian bureaucracy prior to Western expansion (see Creating a New International 'Confucian' Financial and Political Order, 2009+). Under that new international order the princelings and others at the top of China’s social hierarchy presumably hope to exert domestic and international political and economic power without the constraints that that democratic capitalist practices impose on would-be aristocrats.

With luck China’s presidency of the G20 will result in recognition of the cultural origins of these differences / difficulties – and thus of the financial instabilities that the world has increasingly suffered. Understanding would then allow solutions to be found.

John Craig

Reducing the Risk of Financial / Economic / Political Crises - email sent 30/12/14

Professor Ashoka Mody,
Princeton University

Re: G20 leaders clueless about how to avoid the next economic crisis ,The Australian, 29/12/14

Your article was very useful in highlighting the lack of any serious plan by the G20 leaders to deal with the risk of a new financial and economic crisis. You mentioned: problems in the Eurozone; the limits to the US’s ability to run large trade deficits so as to act as the ‘locomotive’ of global growth; and development challenges in emerging economies. I should like to suggest another way of looking at the problem – ie at the dependence of countries with poorly developed financial systems on current account surpluses and thus on the now-almost-exhausted ability of the US (and a few others) to act as global economic ‘locomotives’ by sustaining large trade / current account deficits (and thus accumulating ever-rising public and private debts).

My Interpretation of your article: In 2007 Reinhart and Rogoff compared the gathering US sub-prime crisis with previous financial crises, and forecast severe consequences and that recovery would not start for three years. There was however no prediction of the global effect. In 2007 the global economy looked healthy – so it was presumed that the US scare would have limited effect. But 6 years on the world economy is still in bad shape. Thus the G20 meeting in Brisbane should have had some urgency. But the G20 only promised ‘structural reform’ and other unspecified changes. The world economy won’t restart because of: bad policy; fading of the US as an economic locomotive; and deep development challenges in emerging economies. Geopolitical tensions and oil market turmoil add to the problems. The main policy failure has been the eurozone – a poorly conceived monetary union with a paralytic governance structure. Eurozone growth is very weak. ECB recently promised more action but only ‘if needed’. Fiscal policy is contractionary. Japan’s PM announced action in December 2012 – but Japan’s economy is so fragile that it is back in recession and could do worse than in its ‘lost decade’. The world now has no global locomotive. From 2004 to 2007 US imports grew 6% pa – now this is just 3%. Without vigorous US demand for imports, other nations can’t sustain momentum. China played the US’s traditional role in 2010 – but is now slowing rapidly. Add in the eurozone’s stupor and the reason for the collapse in global trade is clear. Trade grew 9% pa in the boom years to 2007 – but now only grows 3% pa. Emerging market growth was puffed up by transmission of US bubble through world trade. Now the costs of those wasted years are evident. Brazil and some others can’t now catch up with advanced economies. Deflationary tendencies are emerging. Extended widespread weaknesses are breeding new crises risks. There is a real possibility of a shift in market confidence, a reversal of capital flows from emerging economies and a debt-deflationary spiral in eurozone. World leaders in Brisbane were clearly out of ideas. They have no grasp of global growth dynamics – and no plan to deal with the next crisis.

International financial imbalances are a serious structural constraint on global growth because, as you noted, the US’s ability to sustain the large trade / current account deficits needed to continue to act as the world’s economic ‘locomotive’ (ie maintain its Cold War role as the world’s ‘consumer of last resort’) is almost exhausted. Despite this the problem has been persistently ignored. A case for dealing with this by the G20 in Brisbane was outlined in Making the G20 Useful at Last (2013). However, as at all previous G20 meetings, this did not happen - presumably because complex (and hard to understand) cultural factors are involved.

Though many emerging economies have been dependent on current account surpluses (which generate international financial imbalances) to protect their under-developed financial systems from crises (and thus on the ability of advanced economies, especially the US, to perpetually tolerate current account deficits and rising debts), the most significant problem arises from the methods that have been the basis of rapid economic growth in major East Asian economies (especially Japan and China). East Asian societies with an ancient Chinese cultural heritage lack the classical Greek heritage that has been the basis of the use of abstract concepts for ‘rational’ problem solving in Western societies (see Epistemology: The Core Issue in Competing Civilizations, 2001+). The ‘bureaucratic non-capitalist’ methods that have been used to achieve rapid economic growth in East Asia have placed little emphasis on the abstract capitalist notion of ‘profitability’ as the basis for investment decisions by independent enterprises (see Evidence). ‘Financial repression’ to direct credit to producers but not to consumers has thus been needed to protect banks and companies with bad balance sheets from the need to borrow in international financial markets. This has, in turn, resulted in massive financial international imbalances and has arguably: (a) posed a serious structural obstacle to global economic growth; and (b) been a major contributing cause of financial market instabilities (see Impacting the Global Economy, 2009).

A senior official in Japan’s Ministry of Finance (Eisuke Sakakibara – once called ‘Mr Yen’ because of his role in manipulating exchange rates) argued that Japan has a ‘non-capitalist market economy’ which is dramatically different to that of Western economies. Yet the consequence of Japan’s ‘non capitalism’ (a variation of which seems to have been adopted by China in the late 1970s) has not been seriously explored. In fact a review of the implications of Japan’s post-1990 financial crisis sought to reach conclusions by presuming that Japan’s economy involved profit-seeking companies that operated in the same way as Western companies (see Comments on 'The Holy Grail of Macroeconomics: Lessons from Japan's Great Recession'). This seemed to be quite the reverse of Sakakibara’s claim. Similar mistakes are frequently made by the Asia-illiterate in seeking to understand China’s economy (eg see Beyond State Capitalism in China, 2014).

The consequences of the G20’s failure to address the causes of financial imbalances have been serious. Easy money policies have been needed to sustain global growth (ie by making high and rising public and private debt levels seem affordable) despite the adverse side effects of ultra-cheap credit (eg resource misallocation; increased financial instability; and growing social inequality). China’s ‘bureaucratic non-capitalist’ economy (which is now globally significant) seems to be on the point of a crisis like that Japan’s ‘bureaucratic non-capitalist’ economy experienced from 1990 (see Or maybe there IS a Real Problem). In desperation China has been forced to threaten global political stability by seeking to establish an ‘Asian sphere’ in which its ‘bureaucratic non-capitalist’ methods might be able to avoid the crisis that its exploding debt levels threaten within a framework of established liberal international institutions (see Creating a New International 'Confucian' Financial and Political Order, 2009+).

A long-overdue opportunity to explore the implications of international financial imbalances – and the role that ‘bureaucratic non-capitalist’ social, political, financial and economic systems in East Asia have played in generating them and thereby putting global economic growth and political stability at risk – will presumable be available as China takes responsibility for arranging the G20 leaders’ meeting in 2016 (see Will China's Presidency in 2016 End the G20's Chronic Failure?).

I would be interested in your response to my speculations

John Craig

In mid 2016 a suggestion by the Reserve Bank of Australia (involving international regulation of the quality of lending and of the total amount of credit in an economy) seemed to offer prospects of significantly increasing financial stability in future (see International Regulation of Lending Standards).

Economic Failure Looms - From Mid 2015   <<  > >>

In May 2015, the former chairman of the US Federal Reserve who had initiated its QE response to the GFC (Dr Ben Bernanke) indicated that he believed that a lack of complementary stimulus measures was the reason that easy money policies had failed to create a basis for sustainable global growth - a suggestion that indicated a lack of understanding of the risks created by international financial imbalances.

Sharing the Blame for Global Economic Failure - email sent 30/5/15

Adam Creighton
The Australian,

Re: Ben Bernanke: ‘Lack of stimulus to blame for rates’ , The Australian, 29/5/15

I should like to suggest that Dr Bernanke is wrong in claiming that a lack of ‘stimulus’ is to blame for the problems (ie with exchange rates, asset prices and incomes) that have arisen as Reserve Banks’ have tried to achieve sustainable economic growth with ultra-low interest rates. There is no doubt that low interest rates on their own can’t provide a path to sustainable growth, and that ultra-low rates can create severe problems. However to explain the inadequacy of low interest rates there is a need to look elsewhere – especially towards Asia with some understanding of how economies such as those of Japan and China actually work.

My Interpretation of your article: Ben Bernanke (the most influential central banker in a generation, who guided the global economy through the GFC) blames governments for the ultra-low interest rates that are playing havoc with exchange rates, asset prices and incomes world wide. He argued that reserve banks had had to slash interest rates to unprecedently low levels because governments had not provided essential stimulus measures. Everyone complains about low interest rates, but no one does anything. There has been a need for a more balanced monetary and fiscal mix to support recovery. IMF data shows that largest economies have cut their combined deficits from 10.3% of GDP in 2009 to 3.8%. The Abbott government has controversially distanced itself from austerity policies by seeking to stimulate small business and delay balanced budgets to the 2020s. Dr Bernanke urged countries not to engage in ‘beggar my neighbour’ currency wars – and to use their interest rate policy merely to maximize their economic growth. The RBA recently cut interest rates to low levels that have sparked fears of high household debts and unsustainable house price growth in Sydney and Melbourne. Bernanke endorsed controls on excessive house price growth. Globally ‘money printing’ has quadrupled the balance sheets of US / Japanese / European central banks since 2007. There had been a fear that this could lead to inflation. However that risk was not real, because the reserve banks merely created reserves that never became cash. A decline in financial liquidity (particularly in global bond markets) is a cause of concern – but even a stockmarket crash of 15% would not be too serious, because the financial system is now more stable. Bernanke suggested that China’s growth would continue – as its economy adjusted to reliance on domestic demand. The biggest risks Bernanke saw were geopolitical – especially in the Middle East.

A huge obstacle to creating a basis for sustainable global growth involves international financial imbalances (ie where countries have persistent current account deficits or surpluses) as this implies a steady build-up of debts by those with persistent deficits that must eventually stifle global economic growth. Given persistent imbalances, growth (whether or not it is accelerated by fiscal or monetary stimuli) is inevitably limited for reasons suggested in Structural Incompatibility Puts Global Growth at Risk (2003), Putting the Economic Risk of Deflation in Context (2015) and Why Interest Rates Can't Stimulate the Economy (2015).

One source of such imbalances has been the adoption of the euro as a common currency by countries with radically different levels of industrial productivity and competitiveness. Having the euro as a common currency in the EMU leads to constant surpluses by countries with strong economies (especially Germany) and constant deficits by those with weaker economies (ie the so-called ‘Club Med’ countries).

However the biggest source of financial imbalances has arguably been the distorted financial systems that have been used in major East Asian economies. The reasons for this are rather complex because they relate to fundamental differences between Western and East Asian cultures . However in brief it seems that the rapid growth and development that has been achieved in East Asia in recent decades has been based on neo-Confucian (‘bureaucratic non-capitalist’) methods that are quite different to those used in democratic capitalist Western-style economies. Those methods have involved:

  • maximizing savings (ie creating a ‘savings glut’) by constraining consumption by the ‘national family’;
  • directing the ‘national families’ savings into state-linked banks and then to state-linked enterprises to maximize production with limited regard for return on capital – a practice that generates both strong cash flow and poor balance sheets;
  • accelerating economic ‘learning’ / competitiveness within enterprises and industry clusters as a whole by the use industry policy tactics that have been a variation of the methods that Confucian bureaucracies traditionally used to govern on behalf of East Asia’s emperors - and which (one Japan-watcher suggested) were developed by Japan's military in Manchuria in the 1930s;
  • achieving large current account surpluses (because of the structural domestic ‘savings glut’) and thereby protecting financial institutions with poor balance sheets from the need to borrow in international financial markets; and
  • requiring trading partners (especially the US) to be willing and able to sustain large current account deficit and rising debts.

Their trading partners could sustain rising debts for a couple of decades (though not permanently) by adopting easy money policies, because ever cheaper credit:

  • stimulated a constant rise in asset values and thus created a ‘wealth effect’ that enabled consumer demand to exceed household incomes; and
  • made it possible for governments to ‘stimulate’ their economies by spending well in excess of revenues – because the debts they thereby accumulated seemed sustainable.

A lack of ‘stimulus’ is anything but the source of the fact that easy money policies could not create a sustainable path to growth. The problem needs to be addressed at its primary source – namely in the financial distortions that require macroeconomic imbalances (ie economic supply well in excess of demand) that have been part of the ‘bureaucratic / non-capitalist’ methods used to achieve economic ‘miracles’ in East Asia. Until that and other sources of international imbalances are eliminated large scale spending programs (eg on infrastructure) will merely lead to a rapid escalation of government debts in countries that don’t deliberately suppress demand. And those debts will become completely unaffordable when interest rates return to something like normal levels. And, if interest rates do not soon return to ‘business as usual’ conditions, then the side effects that Dr Bernanke mentioned will become even more dangerous than they already are.

Addressing the major financial imbalances that arise from East Asia’s distorted financial systems requires attention to:

  • the cultural obstacles that exist in East Asia to working within the framework of Western-style financial practices (see The Cultural Revolution needed in 'Asia' to Adapt to Western Financial Systems, 1998);
  • the risk of financial, economic and political crises that face countries with poorly developed financial systems as they struggle to create a viable economy that does not depend on suppressing domestic demand to provide a protection against a financial crisis. Japan failed to cross that hurdle in the 1980s – and China’s ability to do so now is anything but assured (see China: Heading for a Crash or a Meltdown);
  • China’s apparent current attempt to bypass that problem by creating a new China-centred international order (ie a trade-tribute system like that by which Asia was administered from China centuries ago) in which the constraints on the rule by social elites (ie a rule of law, democracy and capitalism) that apply in Western societies could be avoided ( ie Creating a New International 'Confucian' Financial and Political Order).

Real Asia-literacy is needed to understand what is going as argued in Babes in the Asian Woods (2009+). Dr Bernanke’s belief that the constraints on the creation of sustainable global growth reflects an imbalance in the sources of stimulus applied within Western economies is misleading and cannot be the basis of a viable solution. Both monetary and fiscal stimulus measures have been used as much as is reasonably possible. Solutions now depend mainly (but not only) on long overdue real reforms in East Asia. The G20 meeting that China is to host in 2016 may be the best opportunity to explore those issues (see Will China's Presidency in 2016 End the G20's Chronic Failure?, 2014).

John Craig

The possibility that a bond market crash might trigger a new financial crisis was suggested. Bond yields in Europe had surged in April. In US both labour market and consumer spending signalled sustainable recovery. Markets anticipated a rate rise in September 2015 - though it could occur at any time. If rising yields spur corporate bond market sell-off, those who want to sell may be unable to. Tight post-GFC regulations have reduced dealers ability to hold corporate debt. This lack of liquidity could trigger a future financial crisis [1]

In June 2015 the IMF warned of danger to emerging economies from expected tightening by the US Federal Reserve - and this probably had particularly severe implications for China.

Global growth is constrained by high debts / unemployment and weak investment. Emerging markets could be vulnerable to Fed tightening because many banks / companies sharply increased borrowing in $US. China would be vulnerable through adverse impacts on its export markets. However China is also vulnerable through effect on debts. Federal Reserve has been flirting with tightening since May 2013 - and this led to 'taper tantrum' (ie dumping of stocks and currencies in emerging markets with high $US denominated debts). Those who had borrowed in $US for carry trades faced higher US rates - and started unwinding their $US debts. However emerging market borrowers did not reduce their $US denominated debts. Emerging market borrowers are now 'short' $US9tr. When Fed raises rates there will be enormous financial distress and capital flight from emerging markets. This will hurt some countries' ability to buy Chinese exports. However China will also be hit as an emerging market which has the largest amount of $US-denominated debt. China's private debt /GDP is 200% (up from 120% in 2008) and with government debt the total is 245%. China has massive external $US debt and local currency debt. This includes real estate loans / infrastructure bonds / Ponzi-like 'wealth management products' offered by banks and shadow finance. The debt bubble is much larger than in US in 2007. US Fed has not shown awareness of these risks - as they focused on US economy. Many regard China as an emerging capitalist economy - but this is incorrect. China is subject to tight centralized rule. China has $4tr in foreign exchange reserves (mostly US Treasuries). These could be used to ease any credit crisis. But if it does so this would drive $US interest rates higher - making crisis worse. History shows that when a run starts no amount of foreign reserves can stop it. China will seek to prevent its debt crisis (eg with capital controls, selective defaults, asset freezes and currency wars). But China faces problems because a strong currency is needed to repay $US-denominated debts - yet this will damage industrial competitiveness. China will probably seek to maintain a strong yuan to improve its prospects of gaining global reserve currency status [1]

This highlighted the geo-political implications of any new international financial crisis.

Background: The former head of US Federal Reserve had suggested at a conference in Sydney that he believed that the QE (quantitative easing, ie massive money printing) program he started in 2008 in response to the GFC did not work (ie did not create a basis for strong economic recovery) because there was inadequate stimulatory spending by governments. This was overly simplistic for reasons outlined in Sharing the Blame for Global Economic Failure.

A ‘financial war’ (initiated by Japan) has been under-way for decades related to the different ways in which money is used in Western and East Asian cultures. Bernanke’s QE efforts have compensated for the post-GFC decline in the availability of credit in the US. However it also had international effects.   The Fed's QE was perceived externally as a ‘currency war’ (ie it was seen to be about devaluing currencies to boost export competitiveness). However, given the high debt levels in the US, a major effect of what was done was to encourage low-interest $US carry-trades and thus asset inflation and high levels of $US-denominated debts elsewhere. This reversed what had previously been done to US. Credit had been made very cheap in US (and this contributed to the asset bubble that burst in 2008) partly because of large scale recycling of ‘Asia’s’ current account surpluses into purchases of US Treasury bonds; by large-scale Yen carry trades; and by a post Asian-Financial-Crisis shift to current-account surpluses by other emerging economies with poorly-developed financial systems.

One consequence of the ending of the ultra-cheap credit era would be that China and many other emerging economies would face potential financial crises (as indicated in The New Big Short above).

Indicators emerged in mid 2015 that the risks facing emerging economies were real.

Emerging Problems in Emerging Economies - see also earlier indications above related to the so-called 'Fragile Five'

Turkey could be the first of the debt-laden emerging market economies to experience major problems - as a result of political changes that left it without clear government. The currency has fallen to all time low (down 60% since 2008) and foreign debt problem (the result of unchecked credit boom) escalates, External debt is $495bn and $95bn must be rolled over in 12 months - just as US Fed starts raising rates. Turkey has long had large current account deficits. It can't devalue its way out of this as this would make it harder to repay debts. Foreign liabilities / reserves ration is double that of Brazil, Indonesia and South Africa who are also in trouble. There had been a great catch-up growth spurt in recent years - but this has ended as productivity declined. It is common in Latin America, Asia and near East for populist regimes to rely on credit growth to mask a lack of reform and poor growth models. The effect of zero interest rates and US QE allowed this to continue for years - but underlying deformities are now clear in Brazil, Russia and China. Emerging markets borrowed $2tr in $US after Lehman crisis - bringing total to $4.5tr - much at 1% interest. Those who did so indiscriminately could now face serious problems [1]

An emerging boom in US brings forward the likelihood of Fed tightening and this leads to withdrawal of capital from emerging markets at fastest rate since GFC - and a risk that future flows may stop. Equity funds in emerging markets faced $9bn withdrawals in the week to June 10, while onshore-listed funds in China lost $7bn. Signs of incipient wage inflation bring forward the likelihood of Fed raising rates for the first time in 8 years. Data from US indicates much stronger growth in second quarter than expected. Major funds, not just small investors, are now starting to withdraw investments from emerging markets [1]

Currency decline is supposed to boost exports - but in major emerging markets this is not happening. Currencies have fallen 30% while export growth has fallen to lowest levels in over half a decade. Exports fell 14.3% yoy in the three months to May 2015. Weak growth in US, Europe and China combined with low commodity prices to wipe out hoped-for improvement. Funds are being withdrawn from emerging markets because of concern about the effect of higher US interest rates on them. Interest rates in those countries are at highest level in 15 years [1]

PNG has ben badly damaged by fall in commodities' prices and faces something like a Greek crisis [1]

Russia's economy has contracted 4.6% yoy in second quarter - and oil sell off threatens deeper recession [1]

Puerto Rico is broke because (unlike US mainland) its employment base is continuing to shrink through out-migration. Government has financed social spending with borrowed money and is now approaching bankruptcy [1]

Economic activity in Brazil has fallen 5% yoy. Service sector is weakest since depth of GFC. Political system is scandal ridden. Interest rates are high. Fiscal policy is tightening. Inflation and unemployment are high. The major source of problems was political and declining commodity prices [1]

Turkey once enjoyed China's like growth rates about 9% pa - but this has weakened to 2.9%pa which is low for emerging economy. Reforms are needed if investment is to continue to be attracted [1]

China's devaluation in August 2015 is likely to damage some of the world's weakest economies - by worsening the position of commodity exporters. A 1% decline in yuan is estimated to create 05.-0.6% fall in commodity prices. Brazil, South Korea, Australia and Chile will be worst hit [1]

Brazil will be hurt most by China's currency devaluation because it compounds its other problems [1]

South Africa is in crisis as economy contracts and currency collapses as part of global rout of vulnerable emerging economies. 25% of workforce (and 50% under 25) are unemployed. Rising inequality has driven increased crime and violence [1]

Asia's emerging economies are facing problems because of declining trade. Growth in emerging Asia has been extraordinary (ie from 10% of global GDP in 1985 to 30%). It became the heart of world manufacturing. But this won't necessarily continue. Exports were critical - rising 12% pa. But since GFC world trade has slowed - and is now likely to decline. Asia can't participate in the new growth industries. Rapid growth in Asian trade largely involved Asian nations trading with one another. But now China is reversing outsourcing to bring manufacturing in-house. Import volumes in Asia are contracting rapidly. There is concern about the problems facing export industries - because they have been funded by debt whose repayment required never-ending growth. Property development was another growth driver - and this was also debt financed and often involved poor lending practices (eg related to cronyism and corruption). This was not critical when times were going well. Many rely on the expectation the expectation that China's leaders can deliver unlimited growth - despite their recent ham-fisted economic management  [1]

A contractionary monetary cycle is seen to be starting in August 2015 like that in July 1997 and 2007. The world economy involves nations with capital deficits (the WEst) and capital surpluses (East ASia and emerging markets). However those with surpluses tie their currencies to US - the major deficit economy. The result is that both deficit and surplus economies have similar monetary policies even though their needs are quite different. This link led to a burst of credit expansion in emerging economies that is now unwinding - and forcing monetary tightening. When credit pours from deficit economies to those with surpluses, foreign exchange reserves rise. China's reserves peaked at $US4tr and have since fallen to $US3.6tr. Capital has been draining from emerging economies since 'temper tantrum' of May 2013. This process is just beginning. [1]

Brazil's economy is contracting at 5%pa - while growth in Mexico is slowing and concentrated in regions with links to US [1]

Brazil's currency has fallen to all-time low and its debt has been downgraded to junk (which had already happened to Russia another of the BRICS). Brazil's government had been unable avoid continued over-spending. It will not however suffer a complete melt-down because it had not used foreign exchange reserves to defend its currency [1]

Emerging markets have $7.5tr of external debt and are vulnerable to rapid rise in US interest rates. Financial markets are assuming that rises in interest rates will be much slower than Federal Reserve seems to be assuming. External debt in emerging economies rose $2,8tr since Lehman crisis - with biggest rie (118%) in Latin America. Fed ignored evidence of stress in Russia and Asia when rising rates to suit US needs in 1998. It was then forced to slash rates when a crisis unfolded. But the Fed may have limited options as US loans / money supply is rising rapidly. Also QE by BoJ and ECB may be considered enough to maintain global liquidity. At latest G20 meeting, Mexico and India called on Fed to lance the boil quickly. Emerging market borrowing has been mainly by companies this time - rather than by governments in 1970s and 1990s. However the sheer quantity of external debts could cause problems if Fed raises rates and $US appreciates. It is possible to use foreign exchange reserves to stop currencies falling - but this automatically results in monetary tightening that makes any credit crunch worse. AS China is finding huge reserves can't be easily used in recessionary conditions [1]

Emerging markets are seen as biggest risk to global economy as a consequence of China's slowdown because of: (a) plunging currencies; (b) reliance on commodities; (c) declining business activity; (d) high debt levels; (e) a lack of capital inflows (f) instabilities emerging from China; and (g) a lack of alternative growth drivers in post-GFC world [1]

IMF warns that ultra-low interest rates have fuelled a borrowing binge in emerging markets that risks another round of financial turmoil as rates start to rise [1]

Also it seemed likely that a resolution of Greece's debt crisis would involve both increases in taxes and reduced spending in Greece and a (say) 30% haircut for its creditors (achieved without any obvious write-off by extending loan terms and reducing interest rates). Recognition that Greece could never recover without debt relief had forced Germany to change its opposition to this [1].

[CPDS Comment: If Greece is to get relief from crippling debts would seem likely to encourage other heavily indebted regimes to also seek relief (eg in Europe Portugal, Italy, Spain and even France). This will inevitably alter the terms on which lenders will offer credit in future - eg reduce the availability of credit to marginal borrowers and raise expected interest rates. Given that very high debt levels have been created in many part of the world on the basis of ultra-low interest rates, this adjustment process could have a significant adverse effect on global economic growth]

It was also noted that the euro had been designed as a political project to promote unity in Europe. But the debts of member countries were not consolidated. Banks were required to lend to all member countries. This worked as long as Europe was growing - but not during recent stagnation. Greece was bankrupt - and this must wipe out someone's assets and potentially have a contagion effect elsewhere [1]

In July 2015 it was being suggested simultaneously that:

  •  China's liberalization of its financial markets would dramatically affect the international financial system - because this would allow Chinese people with very high levels of savings to invest offshore [1]; and
  • China seemed to be headed for a financial crisis that would render vain its efforts to promote international China-centered economic projects and arrangements.

[CPDS Comment: China (like Japan) had encouraged a very high domestic savings rate (eg by suppressing the flow of income or credit to households) and directed those savings through state-linked financial institution to state-linked enterprises with nationalistic (economic power-seeking) rather than capitalistic (ie profit-focused) motives.

Ultimately this translated into unproductive over-investment in industrial capacity / property / infrastructure which left China's financial institutions with bad balance sheets so that the 'savings' that China's people had accumulated and wanted to invest off-shore would no longer exist if those institutions were subject to external scrutiny of their balance sheets - see also If China is almost broke, How can Chinese investment save Australia, 2014.

Later in July 2015 China experienced a sudden and potentially damaging crash in its embryonic stockmarket whose implications are speculated in Context to China's Sharemarket Boom and Bust

In August 2015 the world was seen to suffer a 'glut' of money, savings and oil (according to a PIMCO analyst) - and of these a high savings rate was seen as a serious limitation on future growth.

Cheap money and energy should boost economic recovery while an abundance of savings would keep interest rates in check - and promote low growth, low inflation and low interest rates. A desire to save rather than to invest was described by former FED chairman as a 'savings glut' and this imbalance has continued increasing to force interest rates even lower - and weaken demand, reduce investment and increase unemployment. If governments could not lift demand, central banks were forced to 'blow bubbles in financial markets' to avoid worse outcomes. However the oil glut should be helpful by shifting income to consumers from savings by oil producers. [1]

Currency depreciations had been underway in most Asian countries for years (which would raise the cost of servicing external debts). This could be seen to parallel the problems that gave rise to the Asian Financial Crisis of 1997-98. However the risks seemed much less than they were at that time (eg because of slower devaluation and greater foreign exchange reserves) [1]

In late 2015 there was increased speculation that a global recession could be looming.

The current situation in US was seen to be worse than during 'Great Recession' because productivity growth (and thus potential economic growth overall) has been extremely low since start of GFC. The result was job creation with little rise in wages. Unemployment rates were low enough to justify higher interest rates by FED - but living standards were poor. The recovery was the worst since Great Depression [1]

For decades there has been a global recession every eight years - so one is now due. Given China's panicky response to it currency and stockmarket devaluation it could well be that the next recession will be 'made in China' (which has become a contributor to global growth that rivals the US).  The problem is that China's recent rise has been dependent on huge stimulus measures - and its resulting rapid rise can be expected to lead to economic slowdown and financial crisis China's foreign exchange reserves fell by $350bn over 5 quarters (down from $US4tr) mainly due to capital flight. This put downward pressure on economy and forced China's devaluation. China's policy-makers are unwilling to accept downturns - and this leads to rising debts that can't result in sustained upturn. Global economy is thus close to recession. Developing countries are badly hit by China's slowdown. US is one of the least affected because of its limited trade / investment links with China. There is a need for other sources of global growth. US can't provide some - but not enough. The world is just a small decline in China's growth rate away from recession [1] [see also CPDS speculations about this in Debt Denial: Stage 3 of the GFC... or Worse? 2009)

World shipping has fallen into a deep slump. Asia to Europe freight rates fell 20% in August 2015. A US manufacturing index has had steep drop. Commodity index is at 13 year lows. Emerging market currencies have fallen for 8 weeks. China's devaluation indicates that it is in more trouble than admitted. Emerging markets may struggle to service $4.5tr in $US debts. Monetary expansion cycle is reversing.  Russia's recession caused a 36% fall in exports from Europe. Dutch World Trade Index fell in both April and May. There have been significant declines in container trade - at a time of year where this is usually strong. China's reliance on imported components for its export industries has fallen significantly (ie from 75% in 1992 to 35%). Manufacturing has been moving from China to Europe / US as Chinese labour costs rise. Thus trade intensity of global economy is falling. Measures of money supply (which are improving) may be more critical than trade levels in predicting future economic performance [1]

Significant increases in inventories were a feature of US growth in the first half of 2015 - and unwinding this could slow growth going forward [1]

In August 2015, rapid declines in share markets prompted discussion of whether this presaged major economic problems. 

After a long boom, the world is facing a Great Credit Contraction that must crush global growth. A debt super-cycle (ie a massive credit expansion) has underwritten life for three decades - and there are now signs it is coming to an end. This is causing problems in markets / China / oil / likely changes in interest rates. Defaults are likely on $trs in debts. Interest rates are new zero - so this weapon is not available. Budgets are over-extended. China has four times more debt than in 2008. Even if central banks increase QE - it is losing its potency [1]

China's meltdown is seen as the cause of the mess in financial markets. But this is only an excuse, as the US has created its own problems. China is 16% of global economy and has many problems (slowing growth; papered-over loan defaults; problems in shadow banking; massaged economic data; massive government interventions). However China's economy has little impact on US. What is happening in US is the product of actions by US corporations. Stocks became more expensive than growth justified. Companies did not reinvest to generate long term growth, but sought quick payouts (eg via share-buybacks). PE ratios have become very high - and the Fed indicated that rates would start rising. The harsh reality of a future without endless QE is sinking in. China seems to be the cause of the problem - but US markets have been deeply flawed [1]

China's meltdown is an obvious trigger for market correction - but the 'Fed Put' (ie the willingness of central banks to bail out investors by printing money) may be losing its power - especially in context of crowed global bond trade. There has recently been concern about a 'rush for the exists' of retail bond funds when Fed starts raising interest rates.  'Risk parity' funds control $1.4tr in investments and invest in both bonds and equities - while increasing bond risk through leverage (and this has made markets more fragile).  Concerns about China have led to a flight to bonds, but if a flight out of bonds also emerges then all hell could break loose. The Fed would need to put off raising interest rates and launch QE4 instead. The market is now like a drug addict hooked on QE - so the latter is losing its potency. At the same time there has been a rush out of emerging markets bond and equity funds because of yuan devaluation and equities generally are unusually expensive [1]

China's recent economic troubles make it seem a threat to (rather than a rescuer of) the global economy.

Instability on global sharemarkets has been partly driven by concerns about China's economy. There is also concern about the ability of monetary policy to generate growth in real economy. Ultra-low interest rates have generated equity and property asset bubbles - but little real investment. China announced proposals last year to shift from state-led / debt funded investment to a a more market-led / consumer oriented growth model.. But implementation is not going well. Establishing stock market to allow state-owned / controlled enterprises to raise capital to reduce the need for state funding. Ordinary citizens were urged to invest and market surged 150%. The subsequent collapse undermined not only government credibility but an essential component in shifting to free market economy. There is a need to explain why China spent so much money defending a market that is currently marginal to China's real economy. Measures to stimulate China's economy have been put in place. But exports have fallen 8% yoy - and steel exports have escalated driving down global prices. China's debts were $282% of GDP a year ago. The overall effect on emerging markets, the developed world and Australia (which is most tightly bound to China) does not look good - despite the denials of Australia's Treasurer.  China's decline is at the worst possible time for Australia given the falls in domestic capital spending / investment and wage stagnation. [1]

What Could 'Cause' a GFC Resurgence? - preliminary CPDS speculation only

Numerous risks could be identified in August 2015 which underpinned a stock market sell-off and warnings of global economic risks. While these factors were very real, it seemed likely that combined impact of those risks and / or contagion (ie the spread of those risks to create others) would be required for really serious adverse economic outcomes to emerge. As was noted above, the GFC in 2008 was the product of a large number of contributing factors while the US sub-prime lending crisis (the widely-perceived 'cause' of the GFC) did this by generating spill-over effects.

In August 2015, identifiable risk factors included:

  • emerging economies - weakening currencies / weakened by China's imports slowdown; exposed to $US denominated debts when interest rates likely to rise;
  • emerging financial losses - many states' bonds / junk bond / oil
  • oil price war
  • Greece - probably debt position is unsustainable without write-offs - which would impose losses on major European financial institutions / contagion elsewhere if debts are written off;
  • Euro - monetary union amongst countries with radically different economic competencies is unsustainable
  • refugee crisis is having destabilizing effect in Europe
  • easy money policies
    • used to prevent financial crises affecting real economies since 1987 - but probably no longer viable;
    • escalated after GFC
    • distorts investment - high asset values
    • increased social inequality
    • FED wants to end
  • US economy - recovery but not strong - creates jobs but limited income
  • Japan - continuing stagnation - potential financial risk
  • China
    • credit dependence - suspect balance sheets - protected by foreign reserves
    • political stresses
    • economy slowing - progress and problems in adjustment (ie in developing high value sectors / services)
    • unreliable data
    • keeping exchange rate down - stimulatory (keeping it up - opposite)
    • economic 'miracle' depends on social hierarchy - so also does China's ability to orchestrate rapid transition to economy based on domestic consumption. If the authority of the hierarchy is disrupted, economic adjustment simply can't occur

Global inflation levels were seen to be below levels that reserve banks believe to be desirable [1]

China's economic slowdown was seen to have adverse effects on other Asia Pacific economies [1]

IMF warned G20 of risks to global economy (eg China's slowdown, market volatility, strengthening $US, weakening emerging market currencies, falling commodity prices, weaker capital flows) [1]

China was one of the biggest risks to global economy in IMF view given to G20. IMF advocated doing more to lift productivity and demand. While emerging economies (eg China, Russia, Brazil) had helped pull the world out of GFC, their easy money policies and budget stimulus measures were threatening global economy [1]

And problems in financial / monetary systems were seen as a major factor in the risk the global economy faced - for quite complex reasons.

China's quantitative tightening was seen as a major threat to global economy. People have looked in the wrong place to understand China's impact - eg at whether its economic growth slows. Its biggest threat emerges from intent to change its economy from one driven by debt to finance industrial / housing growth to one driven by consumers and stock market investment. Achieving this by reducing foreign debt purchases could have a serious impact - because of the effect that this has on global liquidity. China began massive reserve accumulation in 2003 - and built up to $US4tr (including $US1.27 US Treasuries). This kept US yields low - with flat yield curve. Now China is devaluing currency - triggering capital outflows of $200bn in August 2015. This requires selling foreign reserves - and amounts to quantitative tightening. Fixing this requires either aggressive easing by PBOC, action by other central banks, or more confidence in China's overall economy. However other observers believe that maintaining growth is China's main problem [1]

China's central bank was not the only one selling its currency reserves. Saudi Arabia also had to do so because of declining oil prices. The Saudis hold one of the world's largest foreign exchange reserves (about $650 bn - of which 10% has been sold over past 10 months) and selling strengthen $US and increases interest rates [1]

The world's global savings glut (that was responsible for: low interest rates; the global demand deficiency; and asset bubbles) was seen as likely to continue / increase because of population aging in advanced economies and the current account surpluses of emerging economies [1]

The global slowdown in 2015 was seen as primarily a consequence of the ending of quantitative easing by the US Federal Reserve in late 2014 [1]

BIS has expressed concern that extreme debt levels everywhere leave the world vulnerable to US monetary tightening. Market instability and capital outflows from China indicate that massive credit build up is serious. policy-makers are struggling to cope. Total debt ratios are now much higher than before peak of last cycle in 2007 - and this time emerging markets are involved [1]

$4tr of corporate US debt is maturing over the next 4 years. Companies that sought cheap debt from Federal Reserve easy money policies will face problems. Companies used cheap credit to finance takeovers, share buybacks (which allowed earnings on remaining shares to increase) and dividends. Companies are likely to default in increasing numbers as rates rise - especially in the energy sector (because commodities prices have languished). [1]

China's real problem was seen to be in its banks - not its stock-market. Banks were likely to experience losses that affect the whole country - because of problems with their loans. Bank asset rose 400% from 2007 to about $31tr - compared with $10tr GDP. Rapid growth implies losses - and even if these were only 10% (ie $3tr) China's entire foreign exchange reserves might be needed for a bail-out. Similar problems exist in many emerging markets (especially in Asia) and these could affect global economy. Countries like South Africa could be severely affected. As emerging markets see steep losses, the next two years will be tough for global economy.[1]

Global debts are $US223tr (government 55tr, financial sector 75tr, household / corporate 92tr) - which is 300% of global GDP and unsustainable. Derivatives also add $700tr. Rate rises would increase this - and also sent $US higher. External debt in emerging markets has risen $2.8tr since GFS to $7.7tr. The rise in Latin America was greatest- 118%. $US has already revalued 10-30% against emerging market currencies [1]

The Fed could not raise interest rates in September 2015 because of concerns about global economy. The world is highly leveraged and thus sensitive to rising rates. And the strong $ and market rout in August already have the same effect as 75 points rise in rates. Asia is spreading deflationary shock to West - and it is not clear that this is over. However by not raising rates the risk of a different crisis next year rises. Capital flows from China may (or may not) be out of control - but are likely to be blocked by authorities. China is not collapsing. It had a recession in early 2015 as a result of policy errors - and market crashes later also showed that China's authorities don't know what they are doing. But now credit and fiscal spending are rising rapidly which will both stimulate economy and create future problems. Also Europe's money supply is rising rapidly - and US is not approaching recession. The risk the Fed faces is that it could find itself behind the ball in a few months and need to raise rates very quickly [1]

Huge losses are likely from investment in fracking technologies for oil production. About $5.5tr was invested over the past 5 years - and the collapse in oil prices from $100 / barrel to a probably sustainable $60 (which is brought on by Saudi Arabia's exploitation of its extremely low marginal production costs) could see 20-50% of this lost. The effect of this will be greater than the sub-prime losses that brought on the GFC [1]

See further below regarding instabilities in 2016

Changing demographics (which result in a decline in working age populations) could invalidate past economic trends and assumptions about ongoing deflation.

The global economy has been flooded with cheap workers for the past 4 decades - but this process is now at an end and must also end the deflationary super-cycle and the era of zero interest rates [1]

The owners of capital are likely to get less of world's wealth because of the end of the era of rapidly rising workforces. Deflation and low interest rates will end. This is ominous for global bond markets. Increasing worker power due to labour scarcity will reducing inequality. Falling birth rates and longer life spans created temporary distortion of labour economics which was compounded by collapse of Soviet union and China's entry to global economy. The global workforce doubled over a short period - and led to 25 years of wage stagnation. Multinationals either used cheap labour in emerging economies, or suppressed wages in developed economies by threatening to relocate. Low consumer price inflation resulted in low real interest rates being set by reserve banks - which fed asset bubbles.. Labour in China is no longer cheap - as wages rose 16% pa for a decade. Fertility rates have fallen worldwide - especially in East Asia. The working age population rose relative to children - and for a time faster than elderly. But now labour will be in short supply. China has been particularly badly hit by its one-child policy. An inflationary world could re-emerge. China won't flood the world with excess savings. the elderly will need to draw down savings. Companies will need to invest heavily in labour saving technologies.   The excess savings that have fed asset bubbles with disappear. Interest rates will normalize. The very rapid rise in dependency ratios will shatter past economic assumptions [1]

It was suggested that it would no longer be possible in future to drive global economic growth by increasing spending in excess of incomes through continually reducing interest rates

In August 2015 markets were acting as if the end of the world was at hand (in terms of credit / stocks / central bank reputations). Markets have no concluded that this is not so - but they are probably wrong. Since WWII credit has expanded in US. This was healthy at first. Then credit cards emerged in late 1950s - allowing large increases in consumer credit. There were no problems til 1970s as wages were also rising. Since then real US incomes have tapered, as has real GDP growth. This was seen at first to be a consequence of 1873 oil crisis - but has continued for decades. The average US worker now earns less (in real terms) than 50 years ago. People with good jobs earn more - but there are now few of these. And labour participation rate has fallen from 67% in late 1990s to 62.5%. But though incomes slipped debt continued growing - beyond capacity of economy to repay it. This was possible because in 1971 the gold backing for national currencies under Bretton Woods Agreement (which stopped nations getting too far into debt) was abandoned. The US was spending on 'guns and butter' in late 1960s. When gold was demanded for US debt, the US defaulted and left holders of US debt on their own. With a fiat money system inflation accelerated 9to 15% by 1980). Gold rose to $800 / oz. US Fed then increased interest rates (to 19%) to squeeze inflation out of the system. Bond should have rallied (ie to lock in 10% return from US Treasury) but they fell until 1982 - when markets realized that inflation would be contained. Bond yields and inflation have been coming down ever since. However falling interest rates and paper $ allowed people to impoverish themselves by spending money they didn't have. This drove global economy at a furious pace. But now that stage is over [1]

Low interest rates may be 'gifts' that keeps on taking - email sent 9/11/15

Noel Whittaker
Sunday Mail,

Re: Low rates are gift that keeps on giving’, Sunday Mail, 8/11/15

Your article suggested that, while the RBA kept interest rates on hold recently, a future reduction is inevitable – and that, while the US Fed talks about a rate rise in December, a small increase will have negligible impact and may not be justified anyway. Thus you recommended that investors rely on continued low interest rates. However your conclusion may be wrong.

There seems to be increasing agreement that ultra-easy monetary policies can help in the immediate aftermath of a financial crisis, but that their long term effects can be harmful (see Do Low Rates Help?). Problems that have been identified seem to include: suppressing global economic demand (by encouraging ‘savings gluts’ in emerging economies that are the destination of those seeking high-yields in a low rate environment but face risks of financial crises unless they accumulate foreign exchange reserves); encouraging very high levels of government and household debts; stimulating asset inflation, but not real economy activity, in developed economies; and thus boosting politically-destabilizing social inequality and the risk of financial instability.

Moreover statements from the US Federal Reserve seem increasingly to express concerns about the adverse systemic risks associated with ultra-low rates – and to now show little interest in their potential real-economic stimulatory effects (eg see Cox J., This is the real reason the Fed might hike rates’, CNBC, 4/11/15).

If, as seems likely, the US Federal Reserve raises rates and makes a solid case for doing so largely based on reducing financial-system risks, then markets could quickly drive rises in interest rates up a lot more than 0.25% - for the same reason that a bond market crash was starting when rate rises were expected earlier this year (see Will the Normalization of Interest Rates be Slow?).

I would suggest caution about predicting ongoing ultra-easy monetary policies.

John Craig

Increasing economic nationalism was seen to be choking trade and threaten global growth. After 30 years rapid growth, trade was declining fast as a share of global GDP. In the past it had only been this weak in periods of global recession. The rise of globalization after 1990 was a source of world peace - as economic integration and political cooperation made conflicts less likely. This lifted hundreds of millions out of poverty. [1]

On the other hand concerns about a global recession were suggested in late 2015 to be becoming inappropriate because of stronger monetary and fiscal stimulus measures [1]. 

Fiscal stimuli were strong in US, China and Europe - while money growth (8% pa) was at a 25 year high. Fiscal austerity was over. Thus despite record debt levels, economic recovery is likely. Broad money supplies hade risen 19% pa over past 3 months. Despite the end of deflationary risks in Europe, ECB still seems to want to increase QE.  At the same time governments have launched an investment blitz.  [1]

Analysts suggested that the world economy will be affected by the fastest rate of increase in global money supply in 30 years (which would overwhelm any effect of December 2015 interest rates rises by US Federal reserve) and by accelerating recovery in China.  Global equities have risen 15% in the 6 months following past interest rates rises - and analysts suggest that their starting values are now lower . Global M1 money supply has been rising 11% pa in real terms - led by China and eurozone. This is higher than before dotcom boom. China will have the biggest impact. Money supply has ignited. Floor space sold is increasing at 20% pa. China's real M1 growth is faster than at any time since post-Lehman credit blitz. China's fiscal spending has risen 36% yoy. This could lead to a soft landing in 2016 [1

It was also predicted that the era of low inflation could be over because of: (a) large increases in money supply were a likely consequence of declining foreign exchange reserves in China and elsewhere; and (b) changing demographics.

Government bonds were seen to be over-priced. Large increases in global money supply were emerging and likely to cause inflation - and make government bonds likely to produce large losses. Bonds are being sold by traders to buy real estate. There has been concern for years that QE-fuelled monetary expansion could lead to Weimar or Zimbabwe inflationary situations. But this did not recognise the effect of liquidity traps [presumably that purchasing financial asset adds to liquidity - but noes not put money into the hands of those likely to spend it]. Yet that inflationary risk could be coming to fruition. China, the petro-powers and Asian central banks had a large increase in foreign reserves to $12tr from 2000 to mid 2014 and this stoked asset bubbles everywhere [presumably because buying financial assets caused cheap credit to be available to investors]. This process is now reversing. Reserves dropped by $550bn in year to June 2015 - as capital flight resulted from commodity bust. This amounts to a fiscal stimulus for the rest of the world. Money hoarded as capital will go to real economies to increase spending / demand. At the same time China is trying to shift consumption from 30% of GDP in 2010 to 46% by 2020. Bernanke's 'savings glut' is ending. Global savings peaked at 25% of GDP and was now declining. Also China's / eastern Europe's entry to world economy after 1990 led to doubling of global workforce and 25 years of wage compression. The rich got richer and deflation became entrenched. Now labour will be scarce. Wages will rise - and real interest rates will need to rise. An end of the deflationary super-cycle will end the 35-year bull market in government bonds. Central banks could find one day that they are facing an inflationary situation. This will cause problems where there are high public and private debt levels (265% of GDP in OECD and 185% in emerging markets). Equities will not do well when this happens - perhaps in late 2016 [1]

Savings gluts were seen (see article outlined below) to be a major cause of the world's increasingly severe asset bubbles and financial crises - and as likely to make it impossible for reserve banks to play an adequate role in dealing with the world's next major financial crisis.

The Cultural Background to East Asian Savings Gluts and Escalating International Financial Crises - email sent 31/12/15

Joachim Fels

Re: The Cause of Our Next Financial Crisis, Business Spectator, 30/12/15

I should like to suggest that there is a need to consider East Asian cultural traditions as a major driver of the global savings glut – which, as your article validly argues, is a major factor in the development of the asset bubbles and financial crises that have had increasingly serious regional and global consequences since the late 1980s.

My Interpretation of your article: While the 2011-12 euro sovereign debt crisis and the 2008 GFC have receded in memory, financial crises remain an important issue. The last few decades have been characterised by asset bubbles and financial crises which have become ever more severe. At a recent conference, John Williams (San Francisco Fed) focused on the natural interest rate. This has been declining over time, and became negative after 2008 financial crisis. There has been a correlation between declining natural interest rate and bubbles / financial crises – and these are due to global savings glut. Concern about excess of savings over investment has been expressed by Ben Bernanke and Larry Summers for many years (and was recently mentioned by John Williams (Berkley) and Janet Yellen). High savings can arise from demographics, inequality and voluntary / forced savings in emerging markets. Also technology and progression of services economy have reduced desired investment and thus demand for savings. As supply of savings rose to exceed investment, the natural interest rate had to decline. The global savings glut helps explain the emergence of financial bubbles and subsequent crises. There were no significant financial crises in 1970s and much of the 1980s. This changed in late 1980s and especially in 1990s. Most of the latter crises were contained – yet over the past 15 years crises have had global impacts. Excess savings not only drove down interest rates, it also drives up asset values and causes serial asset bubbles – and when bubbles burst they caused financial crises. And then financial crises prompted deleveraging – and thus exacerbated the savings glut. Also central banks had to lower interest rates more and more to prevent a tightening of monetary conditions – and this drove rates to the lower bound of interest rates thus making it ever harder to respond to future economic downturn. Thus it is likely that central banks won’t be able to deal with the next crisis. With a global savings glut it is almost impossible to make financial system safe. And it will be hard to change savings glut because drivers (demographics / inequality / demand for safe assets in emerging markets) can’t be easily influenced. Major countries need to overcome this problem by increased spending on infrastructure / education / etc – but this faces political obstacles. Thus it is necessary to expect another bubble and crisis.

There are, as your article indicated, several causes of the global savings glut – but given the increased significance of Asia in the global economy, the impact of the mercantilist (ie power rather than profit seeking) economic systems in major East Asian economies now requires serious and long overdue consideration.

State-linked financial systems in major East Asian economies have provided capital for investment with limited regard for return of or return on capital – because of cultural features in societies with an ancient Chinese heritage (eg see Notes on the emphasis on maximizing ‘real’ production rather than ‘financial’ returns on capital - and Understanding East Asia's Neo-Confucian System of Socio-political-economy for suggestions about how these systems work in practice).

These non-capitalist financial practices require savings gluts (ie suppression of demand below national income) to generate current account surpluses so as to avoid the financial crises that would inevitably result if state-linked banks with poor balance sheets had to borrow in international profit-focused financial markets.

And those domestic savings gluts result in a global demand deficit that has in turn required ultra-easy monetary policy action elsewhere to avoid economic stagnation in the short term despite its adverse effects in the long term.

Some suggestions about the global consequences of state-corporatist financial practices are in A Generally Unrecognised 'Financial War'? (2001); Structural Incompatibility Puts Global Growth at Risk (2003); Financial Market Instability: A Many Sided Story (2007); Impacting the Global Economy (2009); and World facing 'Crisis of non-Capitalism': Non-economist (2011).

The global implications of those financial practices are also explored in The Second Failure of Globalization (2003+) which refers, in the context of other current challenges to the prevailing international order, to: (a) the 2008 global financial crisis; (b) the failure of international institutions to get to grips with the cultural factors that are a non-trivial factor in the world’s systemic financial problems; and (c) the potential emergence fairly soon of a crisis that will be very hard to control.

I would be interested in your response to my speculations

John Craig

Note added later: The suggestion in the subject article that a future economic downturn could be combated by high rates of public spending is suspect. This can’t be done by countries that have experienced large current account deficits to maintain global growth in the face of savings gluts – because their governments will already tend to have high debt levels. Such stimulatory spending would only be feasible for countries with large foreign exchange reserves. This basically means that, to counter the next financial crisis, Germany, Japan and China (in particular) would need to provide high levels of domestic public spending to stimulate demand elsewhere – which would be the reverse of the high levels of spending elsewhere that has allowed those countries (with large savings gluts) to achieve both strong growth and current account surpluses. And, of those three, Japan and China seem to not only have significant ongoing savings gluts / demand deficits but also to be facing financial crises when the 'economic music stops' (eg when something disrupts the global financial system and there is thus no longer a constant flow of new activities to obscure the underlying financial position) because their national balance sheets tend to be poor despite their foreign exchange reserves (eg see Japan's Predicament, 2009+ and China: Ongoing Uncertainty). And there is no way that (say) Germany could carry the global burden alone.

Fundamental changes in global economy were seen as likely because: (a) recycling China's large current account surpluses into foreign assets will shift from China's central bank (which has preferred US Treasuries) to private businesses; (b) volatility in China's markets will affect the world; (c) globalization has been completed (ie value chains are now fully in place)  - and world trade peaked in 2008; and (d) services will be the new driver of global growth [1]

Problems in economic management in China were seen to be both a cause and a consequence of problems in the broader global economy.

China's leaders may not know where they are going - but seem determined to get there quickly. This could do a lot of damage to global economy. But China is not the only source of problems. There are few other sources of growth that could offset China's weakening. Longstanding global structural problems have been left unresolved for years. China's slowdown would be expected to adversely affect commodities - but its effect has been much greater than this - and global growth was already weak. Though US has been recovering - its growth remains weak. Eurozone was weaker. Japan has fallen into recession despite Abenomics. Emerging economies (mainly China) had been expected to drive global growth. Situation of Brazil and Russia is much worse than China. South Africa is in recession - due to steep mining / agriculture falls. A new debt crisis also threatens - as emerging economies debts rose to 200% of combined emerging economies' GDP - much of it in foreign currencies because developed economy lenders were desperate for yield. Repayment is harder because of devaluation, stronger $US and higher US interest rates. Falling oil prices have not contributed much to consumers spending, while they have reduced producers revenues. Oilfield investment has fallen. Oil changes have also had geopolitical impacts. Monetary policy which bore the brunt of GFC has reached the limits of its effectiveness. And different monetary policy approaches around the world create problems. Governments are reverting to stimulatory spending (eg in Japan, US, Eurozone, China) - despite their huge debts. Structural constraints on growth has not been addressed. Multifactor productivity growth in emerging economies is about zero - and this is hard to fix without growth. Confidence in governments has been lost almost everywhere. It is easy to blame China with uncertain / bumbling / heavy handed leaders trapped between necessary market-oriented reforms and authoritarians' need to maintain power. But there are no Western leaders doing any better [1]

Financial market instabilities in 2016  (>) were seen by many observers as possible indicators of a financial crisis like that that has seemed likely since 2013 and imminent since mid 2015

Freezing of US credit funds could point to start of next financial crisis - though both funds had specialized in riskiest junk debt. For 6 years reserve banks have maintained zero interest rates - and thus forced investors up the risk curve to gain yield. In the US this has led to record levels of corporate debt - and a junk-bond market that doubled. And IMF warns that developing countries have 'over-borrowed' $US3tr - much in US dollars - thus raising currency risks.  Some observers believe that credit markets contain potential for crisis - with US Fed decision to raise interest rates likely to trigger this. Collapse in oil prices has raised risks because US shale oil and gas boom was financed by junk bonds - and some are now at risk of default. And the role of asset managers has escalated relative to banks - and they face problems of illiquidity (ie funds are supposed to be available immediately - but underlying assets are illiquid).  While regulated financial institutions have been made safer - new sources of risk have emerged.  The big question is whether the normalization of interest rates can be done without inducing a financial crisis [1]

Things are likely to get worse for BRIC countries because their currencies are depreciating - though not as severely in China as in the others. However China may break $US peg and shift to a basket of currencies to allow yuan to depreciate without direct action [1]

While there are serious economic risks emerging from China, the biggest obstacle to global growth is recognition that reserve banks can no longer repress financial volatility [1]

RBS has warned of a deflationary crisis in 2016 which make it wise to focus on return of capital rather than return on capital. There are risks like those prior to Lehman crisis in 2008. Global trades and loans are contracting - which is serious because of high global debt ratios. Oil prices are down and falling. German Bund and US Treasury yields will fall to near zero in flight to safety. US growth is weak - and raising interest rates is risky. China's debt-driven expansion is unsustainable. UBS is not alone in expecting trouble. However while there are risks there are also real-economy indicators of improvement [1]

Sliding inflation in Asia is a major concern - because it makes high debt levels harder to service and reduces the impact of future reductions in interest rates. Optimists believe that this is merely a consequence of falling commodity prices. But the problem is bigger than this because there is no end in sight to falling commodity prices (probably because of the influence of hedge funds) and growth has not stabilized yet. Construction in China has not increased as home prices rose, and exports are weak. And deflation creates problems for borrowers who have splurged recently. Increasing problems with debt service reduced economic demand. The more leverage an economy has the worse the effect of deflation. The problem in Asia is not confined to China. Though inflation is above zero it should have been much higher given currency devaluation. Easing interst rates could be a response, but there is not much room to do so - and with the Fed raising rates the effect will be to encourage capital outflows which would tighten (not ease) overall financial conditions. There is some scope in some Asian countries to boost government spending - eg on infrastructure [1].

The quality of financial / economic data available (especially from countries such as China and India) has been seen to make it impossible to reliably trade financial markets  [1]

Financial markets could prove increasingly unstable because of the dominance now of machine trading [1]

Despite the financial market instability at the start of 2016 many do not wish to believe that there is a major problem for US.  But there has been a recession in the US every 5 years - and the last (which saw a 37% market drop) started 7 years ago. The one that is due will be worse. A major source of this will be effect of China's faltering economy - because its government has increased debt to 300% of GDP very quickly to build an unproductive fixed asset bubble. As this unwinds China's growth is stalling - perhaps declining rather than growing at claimed 7%. This is a problem because China has accounted for 34% of global growth (50% when account is taken of multiplier effects on emerging economies). . Thus corporate earnings of multilateral companies will fall as global growth falls. But the biggest problem is that: (a) equity / real estate prices can no longer be supported by incomes and GDP; and (b) Federal Reserve's QE and low interest rates policies have ended - thus exposing asset prices to 'gravitational' effect of deflation. The median house-price / income ratio is 4:1 whereas the historical average in 2.5:1. Despite very low interest rates, first home buyers can't get into market - and existing home owners thus have problems moving up. US stock market value / GDP ration is 110 compared with long term average of 75. Business, the federal government and the federal reserve are now more indebted than in 2007 (up 20%, 100% and 400% respectively).  Banks may be better placed than at start of Great Recession by government and Federal Reserve are insolvent because they tried to borrow and print money to produce recovery. Thus in coming recession: the Federal Reserve won't be able to lower interest rates or provide debt-service relief for economy; and any significant increase in government spending would cause spike in interest rates and turn recession into depression.  To deal with this the Federal Reserve may try to launch another round of bond purchases - but confidence in it may disappear. Thus the ability of government and Fed to save markets and the economy will be limited this time - and market chaos should be expected [1]

A financial crisis is likely because global growth is no longer sufficient to service global debts. Thus banks who lent the most with least reserves may go bust. Emerging markets (which became highly dependent on China's commodities' demand) will be worst hit as they escalated debts after 2008. Commodity prices have fallen as China's economy shifts from manufactures.   But the problem of excessive debts is not confined to emerging economies. As global manufacturing has declined , services can be expected to follow. Even well performing economies will be hit. One problem is that reserve banks created a credit bubble with low rates - and this should have been ended long ago. US is importing deflation (and thus low corporate profits) because $US is strengthening. US corporate debts are spiking because spending has exceeded cash flow and share buy-backs have been used to maintain profit ratios. Chinese companies are rushing to pay off $US debt - before it becomes more expensive. Emerging market currencies are falling - and investors in emerging market debt are in trouble. Losses could be huge [1]

China is facing risks of economic / financial contraction and instability - and this could destabilize global economy - especially emerging markets. Issues of concern are: (a) imploding stock markets; (b) weakening currency and capital flight; (c) slowing real economy - with growth perhaps only 3% pa; and (d) excessive debt both in China and globally. The next global financial crisis will emerge in emerging economies - as a spin-off from developments in China [1]

Global financial system has become dangerously unstable - and faces avalanche of bankruptcies that will test social / political stability - according to leading OECD monetary theorist. Situation is worse than 2007 - yet macroeconomic ammunition to counter this has all been used. Debts have been built up over the past 8 years that can never be serviced. The key issue now is how debt write-offs are handled [1]

The world was seen (by ASX CEO) to be drowning in $200tr debt that could not all be repaid and would ultimately destroy emerging market economies and global growth [1, 2]

What could central bankers do if recession hits while interest rates are low - as seems likely. Intervantion rates now are very low - and negative in some cases. A significant UK / US / eurozone / Japan recession is likely before 2025. Imbalances in China are severe and emerging economies have problems. High income economies are likely to hit recession with little scope for conventional monetary policies. One option would be to do nothing - to have a cleansing (but very damaging) recession. Another would be to reduce growth targets. Third option is to change instruments or use exist ones more powerfully. One option would be forced deleveraging - converting debt to equity. QE targets could be raised from 30% of GDP (as in fed, ECB and BoE) to Japan's 70%. This would be provocative and unnecessary. Negative interest rates are another option - yet it is unclear that they would be effective. A final option would be 'helicopter money' - permanent emission of money from reserve banks to stimulate government / household spending. QE seems to have become permanent in Japan.  [1

A hedge fund has decided to cease trading because it perceives that there is insufficient liquidity available to cope with any significant withdrawal of funds [1]

A problem that is being overlooked is the extent that US investment banking industry may have duplicated errors like those what led to GFC by involvement in packaging loans for shale oil and emerging markets. The main problem is that no one knows the extent of the problem [1]

There has been uncertainty about global share rout in early 2016 - with explanations possibly linked to China slowdown, possible US recession, oil price collapse. But the biggest issue involves link between commodities slump and decline in bank shares. However losses associated with bank loans to (say) energy companies that are now experiencing problems can't explain what has been happening. The banks problem may relate not to direct loans to commodities sector but to exposure to derivatives linked to that sector. The amounts involved are much larger - and if any player in the derivatives market defaults than losses will transmit in unpredictable ways through the whole market [1

 A cycle of collapsing commodities, corporate defaults and currency wars loom. A global recession is always on the way - all that is unknown is when and how deep it will be. Commodity prices have fallen 2/3 since 2014 (oil especially). Interacting factors (oil / China / emerging markets and financial markets) are coming together as a perfect storm. BRICS growth is poor and probably worse than reported. A 20% stock market fall that lasts 6 months could have feedback effect by cutting consumption 0.5-1%. Spreads on high-yield US energy companies are higher than for Lehman Bros. Over 1/3 of high-yield US index is vulnerable to oil. First wave of bankruptcies of oil corporates is likely in 2016 - and this could trigger a tidal wave of corporate bankruptcies in US. This problem is not limited to US. What is unknown is the extent that this could spread beyond oil sector - as banks cut credit access, loans turn bad and financial institutions enter tightening phase. Every time US high yield spread has risen above average there has been a recession / financial crisis (except 2011 when Fed's QE made a difference). Sharemarkets are down. Weakness in US manufacturing has extended to services. $US strength has adversely affected US economy - while also forcing China to burn through foreign exchange reserves to defend yuan. China could lose control of its currency - because it is impossible to have a fixed exchange rate, and independent monetary policy and an open capital account. This would have significant impact on emerging economies. Fed's decision to ease off on monetary tightening may not be enough to ease jittery markets. If things got really bad it could expand QE. Oil prices are likely to recover by late 2016 - as vulnerable shale oil producers fail. However postponment of next global recession won't solve the fundamental problem. Monetary policy may need to be used to put money directly into economies.   [1

Borrowers have been blinded by illusion of sustainability - but BIS says that liquidity is now drying up. Global oil industry is caught in downward spiral as falling prices induce increased production by debt-strapped producers. The strategy being adopted by Saudi Arabia and OPEC members is thus suspect. Oil exporters are practicising fiscal austerity which is slowing global economy. Oil industry carries huge quantities of debt. This is just part of overstretched financial system which is exposed to dangers of changing financial cycle. There are huge $US debts outside US - some of which was used to play foreign property markets. $US carry trades led to credit bubbles in emerging economies.  Private credit in emerging economies has increased significantly - and corporate leverage is higher than in US and Europe . This was very profitable in era of ultra-low interest rates. But now liquidity is drying up. The stock of debt must be reduced [1].

The flood of easy money from reserve banks has laid the foundations of a severe credit crisis. There are now $21tr in debts globally compared with $2tr 20 years ago. Reserve banks can now do nothing and the correction will come quickly over next year [1]

For the past 7 years there has been a disconnect between financial markets and the underlying economy. Markets have benefited from stimulus by central bankers - but the economy has been constrained by deflationary forces (eg population aging, debt fatigue, automation, excess supply and weak demand. Now stimulus measures by reserve banks are no longer working to benefit financial markets [1]

World economy will benefit from cheaper oil and from eroding assets of sovereign wealth funds that have resulted from financial imbalances. For the last 8 years wealthy asset owners have benefited while real economy has been weak. This is now changing. Paper wealth is being lost while real economy is OK. It can even be argued that what is happening is good because it reflects erosion of global savings glut - the ultimate cause of long economic slump. Oil prices have crashed. This acts as real-economy stimulus - while oil exporters have not reduced budgets to reflect declining revenues. Sovereign wealth funds are being run down instead. Distressed sellers are liquidating financial assets - which is exact reversal of what happened during commodity boom which deprived global economy of demand. Money is coming out of markets into consumers' pockets.  Capital flight from China remains the wild card. China is close to safe level of foreign exchange reserves. There is no problem if this merely reflects repayment of $US loans  but serious if it is real capital flight (ie a reflection of loss of confidence in China's regime). China spent $5tr on fixed capital investment last year (the same as North America and Europe combined). There is massive overcapacity in Chinese industry. A 15% yuan devaluation would have shock effect globally perhaps leading to depression. However China is now recovering from hitting a brick wall in early 2015. Authorities are back to bad old ways of stimulus as usual. The effect of bond tapering and first rate rise by US Fed has been equivalent to 3.25% rate rise - and had massive effect because world economy is 'dollarised' as never before. The contractionary effect has been compared with adoption of gold standard in 1930s. However that dollar squeeze is now declining. $US has weakened. Combined with cheap oil this should lead to strong future global growth [1

Japanese yen has become indicator of stresses in global financial system. Japan risks deep deflation and failure of 'Abenomics'. Interest rates were cut below zero -and yen fell 9% the opposite of what was intended. Safe-haven inflows increased because of Japan's large foreign exchange holdings. The Nikkei has fallen 22% since early December. This perverse outcome shows that monetary policy is no longer of any benefit [1]

The notion of loss-absorbing capital (ie bond that became equity when an enterprise faced financial difficulties) was introduced as a means to reduce the need for government bail-outs of too-big-to-fail institutions. But its effect as financial uncertainty has increased is to amplify financial instability as everyone seeks to avoid the risk of losses from loss-absorbing bonds [1]

The methods that major banks have used to make money are disappearing (ie exploiting net interest margins doesn't work in a low interest rate environment) and investors are pulling out. Other methods (eg selling structured derivatives, making bond markets, trading currencies / commodities and selling payment-protection insurance) are also declining [1]

There may be an economic fallout from current stockmarket collapse. Crises are similar in that abrupt asset repricing leads governments to pump in money that causes next crisis.  This has been done to a massive extent since 2008. The answer is not more regulation - as this merely leads to games to beat the rules. There is a need to shift back to original purpose of financial systems (ie directing savings to investment). This is only a tiny fraction of what now happens in financial systems. Also many firms now have limited capital needs.  [1

There is a sense that a financial crisis could be brewing (eg because of falls in commodity prices, China slowdown, worsening economic outlook, and US Fed raising rates). There is also concern about the possibility of a major liquidity event that chokes credit - and brings the long debt-fuelled boom to an end [1].

There are signs that major European banks could be facing problems. If so they should be allowed to fail - as public finances could not stand another round of bail-outs [1]

Credit stress has returned to European banking systems (and begun spreading to Italian, Spanish and Portuguese governments) as it did 4 years ago. Liquidity is drained. It is hard to find buyers to exit trades. Yields are being forced up in former crisis states of southern Europe. This is happening at a time when sovreign wealth funds from commodity exporters and emerging markets are being forced to sell to defend currencies or cover domestic spending crises. The BOJ's failure to achieve anything by cutting rates has amplified crisis - as belief in central banks' ability to do anything was lost. A significant factor in latest credit squeeze is the adoption of 'bail-in' regimes for eurozone bank bonds. there is also a belief that the ECB could be running low on ammunition. It can't cut rates without hurting banks profitability.  [1]

Concerns about financial risks facing emerging markets have been seen to be being exaggerated [1]

There has been concerns about global banks because: (a) profitability in Europe has been eroded by ultra-low interest rates; (b)  many have exposure to oil-industry losses; (c) liquidity in financial markets has been drying up; and (d) sovereign wealth funds have been forced to sell [1]

Germany's proposal for a 'bail in' arrangement for government bonds - similar to that which has applied to European banks that came into force in January 2016 as part of a general 'no bail out' policy.  This raises the risk of speculative attacks on Italy, Spain and Portugal - which would encourage them to re-establish their own currencies (ie to break up the eurozone) [1]

At the peak of the GFC in 2008 there were 761 distressed bond issuers worldwide. The number is now 576 - after having been 100-200 during the intervening years [1]

Banks worldwide have provided large loans to resource companies without other security - in complete contrast with what they do for SMEs. As problems have emerged, banks' only way to avoid acknowledging large losses is to keep resource plants running - thus maintaining commodity over-supply that keeps prices low. Huge losses are likely at some point [1]

Satyajit Das sees post-war promise of endless growth at risk because of the excessive debt binge of past two decades. He expects either a long period of stagnation (70%) or a major crisis leading to social breakdown (30%). Only 15-20% of borrowed money since the late 1980s has gone into productive investment - while the remained financed takeovers / real estate / life-cycle consumption / gadgets. Assets are overvalued. Capital flight has emerged in China. Deflation starts. Emerging markets are having problems. Then cross-contamination starts. The policy response to GFC (low interest rates) did nothing to encourage debts to be repaid. Ultimately everyone needs to continue borrowing ever more just to repay existing borrowings and finance growth. The negative interest rates practiced in Europe and Japan punish savers / investors and discourage stimuli to growth. Shrinking the economy 30% is the only solution Das can see [1]

Negative interest rates have been a major economic failure. They lead to the slow ruin of banking industries. It undermines the effects of QE - as it causes banks to shrink their loan books rather than expand them as intended. Markets have crashed in both Japan and Europe since negative rates were adopted - as this is seen as a move of desperation. Current market instability is probably a false alarm - because recessions normally start when growth is too fast and interest rates are raised to prevent overheating, But the world is not near that yet. What is happening now is foretaste of what is likely in 2017 - with end of China bubble and world debts 36% above those during the Lehman boom. The ECB and Japan seem determined to push ahead with negative rates despite the damage they are doing.  [1]

A cash crunch is affecting the online-lending industry - as cost of borrowing grows / funds look scarce / ratings agencies are cautious. Start-ups that have originated $bns in loans are being forced to reduce lending - of put more of their own funds into loans [1] 

Westpac has joined NAB and ANZ in raising interest rates for business customers - because of higher funding costs [1

The cost of insuring Australian bank debt has been rising [1]

Emerging markets accounted for 60% of global growth during 2010-14 and for 34% of global GDP in 2014. Their growth rate has halved since 2010 - and this will have significant external impacts [1]

The G20 in China is expected to discuss stimulus measures to help global economy and also increased policy coordination [1]

23 countries that produce 1/4 of global economic output now have negative interest rates - and this has driven US ten year bond rate down from 2.3% to 1.75% in recent months. Negative rates might reduce bank profits - though some banks have passed this on to investors (eg with bank accounts that produce negative returns). The Swiss Government issued a 2 year bond with negative interest rate. Negative rates will change the way business is done. Companies will seek slow payment of bills, and customers will want to pay in advance. It will be possible to buy assets with essentially no cost. Lenders won't push to get their money back from borrowers who are seen to be credit worthy. The overall effect will be to boost asset prices - as negative rates do not seem to be a short term aberration. Moving back to positive rates will be extremely difficult. [1]

In a final act of desperation central banks are abdicating control of their economies. First they adopted zero interest rates, then QE and now negative interest rates - which will be as futile as the other methods. This also will merely set the stage for the next crisis. Negative rates were tried in Europe in 2014 and have now been embraced by Japan. Previously emphasis in seeking to stimulate economy had been placed on lowering borrowing costs and creating a wealth effect. Now penalties are being placed on deposits with central banks. This could have stimulatory effect through supply side of credit system. Banks will be encouraged to make new loans irrespective of the demand for funds. This misses the key problem that has existed in post crisis world. Focus is needed on the demand side of crisis battered economies where growth is limited by a debt rejection syndrome as a result of balance-sheet recessions. This problem is global (ie it exists in US and Europe as well as Japan). In US consumer demand remains stuck in the eight year quagmire that has driven the great recession. Central banks can't restart demand in balance-sheet constrained economies that have fallen into a 1930s style liquidity trap. Japan was the first to show this 20 years ago - when banks and non-bank corporates imploded under the weight of excess debt. In both US and Europe now, balance sheet problems prevent the re-emergence of demand. Bernanke tried QE. There was an assumption that there is no difference between such methods and conventional monetary policies. But conventional policy has its effect through stimulating the real economy. Now transmission is through creating a wealth effect. Both increased the risk of financial instability. Governments ignored the need for fiscal stimulus because of the effects being generated by frothy asset markets. The shift to negative rates increases penalties on banks for not making new loans. This is equivalent to 'zombie lending' to insolvent Japanese companies in the 1990s [1]

Mark Carney (BoE) has warned central banks against getting involved in currency war - as weaker exchange rates cause problems. Nations can't simply export their problems through currency depreciation. Monetary policy can't work at global level merely by shifting demand from one country to another. For the world as a whole, exporting excess savings and transfer of demand weakness elsewhere is a zero-sum game. Weak growth / inflation have led some reserve banks to negative rates. Concerns about the inability of monetary policy to boost demand has led to market turmoil recently. G20 leaders need to emphasise supply-side initiatives. Risk sentiment in financial markets has deteriorated - due to weak medium term global growth prospects and downside risks. Global economy risks being trapped in low growth, low inflation, low interest-rate equilibrium. Japan recently adopted negative interest rates - and ECB further reduced its negative rates. Stimulus measures need to boost domestic demand - particularly from sectors with sound balance sheets.  Targeting weaker exchange rates pushes increased savings onto global markets - and this causes short-term equilibrium rates to fall and pulls global economy closer to a liquidity trap [1]

Politicians in Japan have expressed concern about Japan's adoption of negative interest rates - on the grounds that it indicates desperation and will reduce confidence in the economy [1]

Global economy will remain leaderless as G20 countries are unlikely to produce more than a rhetorical statement - according to Citigroup. There was seen to be a need for an agreement on exchange rates through intervention like the 1985 Plaza Accord [1] [CPDS Comment: The Plaza Accord failed to deal with the economic imbalances that it was intended to address because of the radically different way Japan's financial system was organised - see Focusing on Japan in the Global Financial Crisis. Until serious attention is paid to the cultural issues involved, no agreement now would be more effective in dealing with problems in the global financial system - see Will China's Presidency in 2016 End the G20's Chronic Failure?)

A global currency accord can't be agreed because the US Fed argues that countries best contribute through managing monetary policy in accordance with their domestic economic needs [1]

Global markets have swung from pessimism to renewed optimism - but the big sources of instability remain. US Fed is likely to use this weeks meeting to flag its intent to press ahead with rate increases - despite massive monetary stimulus from ECB. Japan is also pressing ahead with QE. China's central bank has the biggest problems because it is simultaneously trying to keep currency stable, stem capital outflow and use monetary policy to stimulate growth. [1]

Morgan Stanly believed that there was an imminent 30% risk of a global recession because of the effect of low oil prices and interest rates [1]

Europe's banks were seen to be a bigger financial risk than China, a US recession or oil - because parts of region are focused on cutting debt levels (leading to balance sheet recession). Lending growth is low despite efforts to encourage borrowing. Low interest rates are also hurting banks profitability [1]

There are many adverse consequences of negative interest rates - and it is hard to see positives [1]

There are now gluts of everything because of China's attempt to keep its economy going by building vast amounts of infrastructure. 6 central banks now have negative interest rates. They are trying to overcome the low prices that are due to supply gluts by boosting demand. However demand is weak because of excess debt - and central banks see more debt as the solution. Low rates have a devastating effect on savers. Much higher levels of savings are needed to meet retirees' spending needs when interest rates are low. Thus low rates reduce demand by forcing savers to save more. At the same time bank's profits have been squeezed - because they don't want to follow reserve banks into negative rates for depositors. This problem is exacerbated by increased life expectancy - and thus a requirement for ever higher household savings. [1

China's opening of its huge bond markets to foreign investors was seen as: (a) a way to spread the risk associated with the huge debt levels that have been incurred to drive growth; and (b) dangerous to the international financial system. China does not have financial markets as others know them as these are just a political tool.

Japan and Europe have failed in their efforts to weaken their currencies against the $US with negative interest rates. They can't go further without seriously damaging banks - or requiring depositors to pay to put money into banks.  They have been unable to restore inflation to their minimum 2% target. There is nothing more they are able to do [1]

 Very large investments are being made in emerging economies - and this has the potential to support global boom. And credit is being loosened for real estate in the US - probably indicating another boom  [1

Morgan Stanley views rally in emerging markets as a bear market rally. Weak fundamentals and structural imbalance continue.

A significant reduction in the US's public spending / GDP has resulted in a decline in the availability of Treasury bonds - and thus (given a global savings glut) investors keep pushing bond prices higher (and yields lower) to buy them. However this decline in bond issuance can't be maintained without deep reform of pensions and health care [1]

There are signs of rising inflation (driven by commodity prices) that will justify increases in US interest rates [1]

Data about government debts has long been available - but not about private debt. BIS has now rectified this. This makes it possible to identify the seven countries that in order of risk are most likely to experience a financial crisis (China, Australian, Sweden, Hong Kong, Korea, Canada and Norway). Crises occur when private debt / GDP ratios are high and growing rapidly. This is what led to GFC - ie when rate of growth in credit started to fall. China's private debt / GDP rat is 290% while Australia's is 190%. The rate of growth of this ratio for China is 20% and for Australia is 15% [1]

OECD warned governments of the need for coordinated policy responses to prevent persistent slow growth and another downturn. A low growth trap exists because of lo investment, inadequate demand, unemployment, low global trade and slow structural reforms [1]

Despite the perception that emerging markets are facing severe problems when the $US strengthens because of rising interest rates, in many cases the long delay in raising rates has allowed their positions to improve [1]

A tidal wave of defaults may affect bond markets. At present risk is seen to be limited to commodity sector and high risk bonds - but other firms may have trouble repaying debt because of: falling profits; tightening lending standards; and the increasing cost of credit [1]

In June 2016 there was extensive and highly-contested debate about the the economic and geopolitical implications of the BRexit (ie Britain's referendum which resulted in a decision to leave the European Union) - see here

Reserve banks worldwide are collaborating to ensure that liquidity is provided to banks to prevent any short term problems from generating a major financial crisis [1

(CPDS Comment: Counter-acting short term problems in banks' access to liquidity is undoubtedly possible (and would prevent such problems generating a broader financial crisis). This was first demonstrated by the US Federal Reserve in the 1987 stock market crash. However the easing of monetary policy was subsequently seen as the core of counter cyclical economic management - even though doing so had long term adverse side effects (eg distorting investment, limiting real economy performance, boosting inequality, increasing political instability, encouraging a massive increase in public and private debts). The sort of crisis that could thus emerge now could be multi-dimensional and too big for reserve bank actions to counteract)

 Derivatives can be seen to be dangerous - and are likely to wreak global havoc soon. Brexit could be a major turning point - because Europe is headed for major contagion events. EC has been elitist and incompetent. If UK had remained in EU when sovereign debt crisis hits, City of London would have been destroyed. But a lot of capital will now want to escape Europe. Europe is facing major banking crisis with Deutsche Bank at the centre. It failed US stress tests - and has huge derivatives exposure (ie about 10% of total global derivatives market - and 2399 times its current market capitalization). A lot of this is hedged - but still faces risks from counter-party failure. IMF suggests that Deutsche Bank is the most important contributor to systemic risk [1]

The global economy faces major risks. The greatest danger arises when things look fine. Britain might be unable to fund its current account deficit (7% of GDP) - and this could lead capital outflow. But EU has the bigger problem (noting that markets there fell much more after Brexit vote). EU is a free trade bloc - but  the only one specifying free movement of people also. At heart it was attempt to reduce risk of war amongst members. To survive EU will need to block free movement of people. Brexit might point to broader move against globalization / capitalization - because of rising inequality (which also powers Trump campaign in US). This could lead to loss of investor confidence as in 2008. Higher developing economy wages and rise of robotics reduce incentives for globalization. China's slowdown and weak Western growth is leading to falls in world trade. Next will be recognition that monetary policy has failed to deliver prosperity after 8 years and that innovation should be left to those who want to make money rather than those who create it. Belief that free markets should apply to everything but money is a major global risk, as is large fiscal deficits and the regulation of banks - which encouraged them to invest much more in real estate. China is the world's second largest, second most leveraged and second least transparent economy. China's total debt was $24.6tr at the end of 2015 (250% of GDP) and has since risen to $28tr. It used to be spent on real things (infrastructure / property) even though they were often not needed. Now $1tr per quarter is being devoted to speculation (eg establishing something like CDOs that caused US collapse in 2008). The chain reaction from a China default could threaten assets worth 35% of GDP. Wealth Management Products are now investing in each other [1]

There is debate about whether government budget deficits should be reduced. The costs of doing so in terms of social suffering and undermining the basis of democracy and international cooperation would be high. Governments can increase debts in their own currency without adverse consequences. There is no fiscal crisis [1

Central bankers have created the risk of a financial crisis worse than the last one. The BIS recognises growing doubt about central banks' action. Given financial markets' dependence on central banks' policy, the result of a loss of confidence could be a major economic disruption. The ECB is seen to have lost confidence with financial markets. Central banks dismiss concerns about the link between financial speculation and economic harm. Those who suffer from financial crises are collateral damage. Central banks' goals are to inflate asset prices, not ensure social cohesion and equity. That is governments' task. Governments have contributed to the problem - having spent future capital on consumption. Global debts are $US200tr - about 3x world  product - having risen $US57tr since 2008. Economic growth forecasts for US and Europe are weak. Von Mises predicted the 1930s' Depression on the basis of the need to readjust business activities to the real state of market data - ie shifting from reliance on credit expansion. Lenin argued that the best way to destroy capitalism was to debauch the currency - and the world seems likely to find out if this is true. A one-off rescue operation has become permanent. Bad economic news has become financial markets' good news - so all that is left is bad news. BIS has rung the alarm. Reserve Banks don't know how to fix the mess they have created. Governments look on mired in their own economic mistakes. The markets invisible and heavy hand will make the necessary adjustments - and these will be indiscriminate, unpredictable, socially far-reaching and politically ugly [1]

There has been a surprising post-Brexit market bounce - due to high level of stimulus measures.  Japan's problems (a deflationary spiral and an aging / declining population) are close to encouraging a 'helicopter money' solution. Western world is buried under debts - incurred during baby boomer years that will be harder to handle in future. Debts grew as 15-64 year old population was increasing - but in future the economically-productive demographic will shrink. In future the debt load will rise as its economic foundation shrinks. This will force deflation. Workers get smaller pay rises. Governments have to cut services. Robotics will reduce workforces. Europe faces a deflationary storm. Banks may soon charge people to deposit money - which means that money will be removed from financial system to be placed elsewhere (eg to be chase yield in unsafe areas). Deflation is inevitable because of debt levels and changing demographics. [1

World could be on the verge of another banking crisis. In 2015 NPLs were 4.3% of gross loans - compared with 4.2% before GFC. There are over $3tr in stressed assets (compared with $1tr of US sub-prime loans in 2009). European banks have $1.3tr ($400bn in Italy). China has $1.3tr (or more). . Banks elsewhere are heavily exposed to property which are overvalued by historical standards.  The resource sector is in trouble - with high debts and falling commodity prices, weak growth, overcapacity and rising borrowing costs. Low growth and deflation are making debt repayments harder. Government efforts to encourage growth through targeted increases in bank lending are having dangerous side effects (inflating asset values in developed economies so that banks lend against over-valued collateral). Weak borrowers have survived longer than they should. In developing economies capital inflows seeking yield have contributed to risky build-up of leverage. Governments are encouraging debt-funded investment to stimulate growth. To recover banks need strong earnings, capital infusions, a way to dispose of bad loans and industry reforms - yet banks ability to earn their way out of problems is limited. Current monetary policies are partly to blame (ie ultra-low interest rates). The financialization of advanced economies has arguably gone too far - and the role of banking needs to be changed  [1]

Governments (eg Japan / UK) used Brexit to pump prime their economies to stretch global economic cycle for a little longer. Fears of political instability ended austerity in Europe. This is like stimulus in 1998 when interest rates were slashed world-wide leading to dot-com bubble.  IMF has called for governments to boost infrastructure spending. growth is likely to be continued for a few more months. Global money supply is rising 10% pa (while China's rises 45% pa). This must eventually lead to inflation, and an end to global asset rally. [1

Global economic growth is accelerating sharply after months in doldrums. This suggests the possibility of escape from deflationary malaise of last 7 years. US Fed has had catalytic effect by refusing 4 opportunities to raise rates - reviving prospects in emerging markets. It acts a world's central bank. Japan is launching huge fiscal package - while Eurozone states have ended austerity. Growth is improving in Latin America and China. Money supplies are rising faster (ie about 5% pa). Brexit caused so much precautionary stimulus that it may cause US to overheat - and the Fed to slam on the breaks [1]

The global bond market is seen to be 'broken' because of its dependence on central bank low interest rate policies - and there could be severe losses because they are losing their ability to continue to support financial markets. Inflation is probably inevitable because the value of many has been debased - and if this starts it will he hard to slow down without a large increase in interest rates happens  [1]

Large numbers of ships are being destroyed and the rate of replacement has fallen from 1450 vessels pa to 293 pa - as a result of declines in global trade [1]

The US Fed has been suggested to have tools available to deal with a significant economic downturn (ie large scale purchase of assets). It is suggested that interest rates will be unable to rise beyond about 3% because of economic change, workforce aging, low productivity growth and the rise of emerging market investors [1]

US Fed has produced paper causing concern in financial circles. It was intended to re-assure markets of Fed's capacity - but has set off agitated debate because it virtually concedes that Fed has run out of ammunition.  At the same time the US economy seems to have hit the wall. Fed might cope if it can push interest rates above 3% before next recession hits - to give it ammunition then - but this might not be possible. The Fed argues that fiscal policy will need to boost economy - but the problem is that federal government debts are already too high (105% of GDP) [1

Large parts of EU are slipping deeper into a deflationary trap despite ECB's negative interest rates and quantitative easing - leaving no safety buffer when next global recession hits. ECB has exhausted its ammunition and is now looking to fiscal expansion by governments to break out of vicious circle. Europe is vulnerable to any external shock. [1]

Nominal GDP growth has fallen to 2.4% - and indicates growing deflationary forces globally. This makes recent violent rises in bond yields surprising. The correlation between bonds and equities has been strong - and this means that any rise in bond yields will affect all asset prices. Yields on benchmark US Treasuries rose 19 basis points to 1.72% since last week - despite easing of inflation risk and market belief that US Fed won't lift interest rates much or soon. ECB and BOJ may however not be able politically to continue with ultra-low interest policies. European bond yields are rising but not because growth is picking up [1

Three reasons have been suggested for continuance of US bond market rout (ie there have been huge movements into bonds because of risks elsewhere; QE is losing its impact;  and everyone is now hoping for an emphasis on fiscal policy). This will change environment for investing world-wide - because rising interest rates will be introduced via rising bond yields [1]

Debt is rising rapidly (to $230tr globally - three times the level during GFC) - fuelled by central bank QE and low interest rate policies. This is distorting fundamental economic principles and will draw economies into a 'black hole'. Stocks are being bought for yield - not growth. Bond are being bought for growth in the home of ever more monetary easing. Cash may not provide the safety net that investors hope for. Despite QE inflation remains low because the velocity of money has been falling. Stock markets are reaching highs - but don't reflect the real economy.  When problems arise now reserve banks will not have scope to reduce interest rates to head them off [1

The third leg of world's depression is coming. UNCTAD economists suggest this will involve greatest debt jubilee in history - a crisis for globalized capitalism and demised af free-market orthodoxies.  Corporate debt has exploded in emerging economies to $US 25tr. Zero interest rates and QE flooded developing nations with cheap credit - and much of this was wasted. They also imported deformities of Western finance that they could not deal with. Some countries are experiencing premature de-industrialization. The middle income trap closed in on Latin America and non-oil Middle Eastern states a long time ago - and is now starting to affect Malaysia, Thailand and China. Yet the liabilities associated with QE remain. If global economy slows much of developing country debt incurred since 2008 would be unpayable. A deflationary spiral associated with capital flight, currency devaluation and collapsing asset prices would stymie growth and government revenue is possible. UNCTAD is warning of risks that are an order of magnitude greater than US sub-prime crisis that led to GFC and Greek crisis. Emerging markets experienced large capital outflows last year - and though this abated as Fed delayed rate rises this may not continue. UN's view is that 'shareholder primacy' and liberal financial markets are the problem - while fiscal austerity compounded the problem. It advocates a global new-deal which abandons neo-liberal ideology and returns to notion of developmental state. Corporations are not re-investing into production capacity, jobs or self-sustaining growth. The profit share of GDP has reached historic highs while private investment has slumped. UN advises emerging economies to impose capital controls, give preferential tax treatment for retained earnings and force assets to be held longer. UNCTAB has suggested that globalization has not worked for everybody. The world is likely to see massive and coordinated spending by governments to create demand and bring broken global system back to equilibrium  [1

Deutsche Bank is expected to fail and could create a crisis like failure of Lehman brothers in 2008 if not managed well. IMF identified it as biggest global systemic risk. It has never recovered from 2008 losses - and was subject to $14bn claim for mis-selling of mortgage-backed securities (and amount that nearly equals its current market capitalization). German Chancellor has ruled out state aid for Deutsche Bank - and has favoured compelling bond holders to be the first to take losses (ie bail ins)  [1]

If the ECB actually starts reducing its bond-buying program (which is anything but impossible) it is likely to have significant adverse effects [1]

The effects of 2008 financial crisis persist. A massive debt build-up led to the GFC and the effects remain. Total debt is now 350% of GDP.  The world hit the debt wall in 2008 and unleashed what will be a series of crises.  The real problem will emerge when costs of debt service start to rise - eg if Fed raises rates because of inflation in US. Even slight increases in rates will have a big effect on debt service costs. Even now more and more tax money goes into debt service. When this forces a cut to services there will be political ramifications. There is already a start to a 'revolt' worldwide. [1]

Higher interest rates are starting to have an effect and will lift the cost of money globally. $US Treasury bond 1- year yield rose to 1.8% up 32% from June 2016 low. This is causing sickening fall in bond values - and institutions worldwide are suffering. However an even more tense drama is playing out in London market where the situation is complicated by regulatory changes and interest rates have risen 43% since start of 2016. This will cause severe disruption of money markets and large losses. Big banks are being squeezed in their ability to provide loans by the shrinking pool of available funds. $US1tr has been shifted from prime money market funds into safer assets - eg US short term debt. What is happening in London will spread worldwide because it is the centre of global money markets   [1

The growth of shadow banking (ie unregulated provision of credit and financial services by non-bank lenders) poses substantial risks in the US and worldwide. Improved technology has allowed smaller entities to provide such services - and this could cause problems. The GFC was due to shadow banking advances on mortgages. New regulations were put in place to try to reduce such risks - but what has happened in that lending (which is always risky) has tended to shift from regulated to unregulated entities [1]

A huge potential risk is seen in bond markets because funds are offering daily liquidity on the basis of bonds that they hold which are much less liquid [1]

Despite current falls in bond values (and sharp rises in yields) this is not likely to be the start of a major bond market sell-off because even though central banks want to raise interest rates persistently weak growth prevents them from doing so [1]

Investors have realised that a major bond market crash is possible [1]

Investors have been moving away from holding Gilts because of concern that Brexit could have serious consequences for UK. Its credit worthiness is now being questioned for the first time [1]

Investors are now particularly afraid of bonds (giving rise to the risk of a bond market crash) because yields are historically low and terms are longer that they traditionally were. Thus even small interest rate rises can result in relatively large losses [1]

Overall the risk of a 'credit crunch' (ie a lack of the credit that has been required to sustain global growth) seems very high despite the fact that: (a) the global 'real economy' is still in fair condition even though growth is slow; (b) investors have large cash deposits with financial institutions world-wide; and (c) there are many potential drivers of new economic activities / industries.

This is because:

  • There has been a rapid escalation of debt globally because of the easy money policies adopted by reserve banks.  This has been seen to be needed because:
    • Keynesian public spending lost credibility as a means for counter-cyclical macro-economic management in the 1970s (eg because it took so long to arrange such spending that it usually proved to be pro-cyclical);
    • 'savings gluts' associated with export-driven growth (most notably in major East Asian economies (ie Japan and China), in emerging economies in East Asia and elsewhere, in major oil exporting nations and in Germany) created a global demand deficit that would have have caused global economic growth to stagnate unless their trading partners' ability to borrow to sustain demand in excess of their incomes had been facilitated by ever-lower interest rates; and
    • substantial increases in debts increased the risks of potentially-economically-crippling financial crises - and there has been a perceived need to avoid / limit the effect of financial crises on real economies by further easing of monetary policies on various occasions since the late 1980s (especially in 2008). So long as liquidity was available, a financial crisis would have limited 'real economy' impact;
  • Those easy money policies have inflated asset values (eg equities and property) because they provided cheap credit for a speculative process that was sustainable as long as investors had confidence that interest rates would continue to go lower - but must result in a collapse in asset values (and thus a risk to financial institutions that have provided margin loans to speculators) when interest rates normalize. A significant decline in asset values would be likely in a higher interest rate environment also because this would reset the criterion against which price-earnings ratios on assets would be compared;
  • The easy monetary policies that have been invoked to deal with economic downturns and financial crises are now seen to: (a) drive up asset values, but not simulate much real economic activity; (b) thus be a source of social inequality that increasing threatens political instability; and (c) encourage governments, companies and households to incur debt levels that will be unsustainable when interest rates normalize;
  • The US Federal Reserve started 'tapering' its quantitative easing (QE) program in 2013 and ended this altogether in October 2014. Under QE it had added $3.5 tr to its balance sheet after 2009 by buying bonds to provide banks with the ability to stimulate economic recover by expanding their lending. Tapering was seen as the beginning of the end of easy monetary policies, and emerging market currencies and stock markets fell heavily in early 2014. The Fed continued its move towards normalization of interest rates by raising its policy rate 0.25% in late 2015 and indicating an intention to continue doing this in 2016;
  • China has been the major driver of global economic growth in recent years through massive state-supported expansion of credit to finance property, infrastructure and industrial capacity for which there was limited market demand. When this was recognised to be unsustainable in 2014, China's state started emphasising growth based on services and domestic consumption. The reduction in the import