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

• Fragmentation
• Explaining Failures
• Global Financial Crisis: The Second Test
• Seeking a GFC Solution

Attachment: September 11: The First Test [2003]

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

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.

Looking for 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.

• Origins
• GFC Causes
• Complications
• Seeking a GFC Solution

Global Financial Crisis: The Second Test of Globalization?

Origins

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.

Complications

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.

Why?

• 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]).

• US Leadership?
• G20: Avoiding key Issues

• G20: Peace for our Time'? (Structural Indicators of Ongoing Recession + Some See Why Imbalances Matter Though G20 Officially Can't )

• Speculations about Moving Forward
• Leadership by Emerging Economies? (Who's Got Superman?)
• US Backing Away from Bretton Woods?
• Restricting the Role of Financial Services?
• Too Hard for the G20?
• Currency War? (Threats to the World + Fed's Version of Financial Warfare + Monetary Madness + Another View of Gold + Fixing the Debt Problem)
• G20 in Korea: Unreal Optimism? (Heading for the Grip of a Great Depression?; + A Good Idea that Probably Won't Work + Should Fixing the International Financial System Start in Asia?)
• G20 in Washington: Waiting for Hell to Freeze Over? (The Asian Connection in the Public Debt Problems Facing Developed Economies + Economic Recovery is Constrained by Dead Weight Economies + Interchange + Counter-cyclical policy can't solve structural problems + Sustainable World Growth Requires More than Counter-cyclical Policies + Progress Towards Ending the GFC?)

• Sovereign Defaults: Stage 2 of the GFC? (Financial Imbalances and the European sovereign debt crisis + China and Japan Need to Do More Than Contribute to Europe's 'Begging Bowel' + Beyond Eurocentric Pessimism)

• Limiting the 'consumer of last resort' (Will ending the magic credit card bring the world economy to its knees? + A Plan to Both Reduce US Debt Levels and Sustain Growth + Options to Resolve the Fiscal Cliff and Reduce Military Spending)
• US Focus on the Asia Pacific
• Creating an Effective International Financial System?
• Debt Denial: Stage 3 of the GFC? (Credit Bust First: 'Sixth Revolution' Later + A case for economic gloom amongst the pundits' optimism (Interchange))
• Resurgent Protectionism?
• An Approaching Crisis? (Economic Indicators ( Is Bitcoin a Threat? +Making the G20 Useful at Last + Trade is not Enough for Global Economic Progress + Structural Obstacles to Global Economic Recovery Need Attention ) + Geopolitical Indicators)
• Future

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 See Why Imbalances Matter Though 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 as 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
BusinessSpectator

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.

Assessment:

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?).

Alternatives

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)

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:

• Professor Roubini (validly) identified the need for China and emerging Asia to implement reforms that eliminate the need for precautionary savings (without which their domestic demand could not safely contribute to economic growth beyond their borders).  However he did not:
  • comment on the difficulty / impossibility of achieving this goal within the framework of neo-Confucian models of socio-political-economy (see Are East Asian Economic Models Sustainable?, 2009 and The Cultural Revolution needed in 'Asia' to Adapt to Western Financial Systems, 1998); or
  • apparently recognise the similar predicament that Japan (ie 'developed' Asia) faces.
• his proposals involved the Euro both appreciating (in order to help reverse Germany's current account surpluses) and depreciating (in order to boost the competitiveness of the euro-zone generally).

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?'

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, but 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 developing 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 segment of 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 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 is 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 is an interesting concept. The goal is 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 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 are sharply higher, and governments are struggling to contain the inflationary pressures. Indonesia, the Philippines, Thailand and Malaysia are 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

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 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 treats 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 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 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 unforseen, abverse and global implications [1]

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

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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?).

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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

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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
IMF

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

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

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

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

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

John Craig

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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

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

Maurice Newman,
Chairman
ABC

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

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

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

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

John Craig

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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).

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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

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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

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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:

• Japan and other countries in East Asia (eg China) that have adopted variations on the system of socio-political-economy that was the basis of Japan’s pre-1990 economic ‘miracles’ (see Structural Incompatibility Puts Global Growth at Risk, 2003 and Understanding East Asia's Neo-Confucian Systems of Socio-political-economy, 2009); and
• emerging economies elsewhere since the Asia Financial Crisis of 1997 (see Leadership by Emerging Economies?).

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

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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].

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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'.

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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

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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:

• the cultural obstacles that exist in East Asia to the creation of an international monetary / financial system that would be less vulnerable to financial crises if exposed to a market-based international financial system (eg see Understanding East Asian Systems of Socio-political-economy and Understanding the Cultural Revolution, 1998)
• the fact that a global system of any sort corresponds with Western universalist / rule of law ideals, but not with East Asian particularist / rule of man traditions - and that the current aspiration of elites in countries such as Japan and China is likely to involve continuing to undermine any sort of global order and creating a sub-global system (ie what could be called an Asian Co-prosperity Sphere) that operates in ways compatible with Confucian traditions (see Creating a New International 'Confucian' Economic and Political Order? and Wars are not only Fought with Battles)

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.

Optimism

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:

• most developed countries suffer from significant debt exposure - a corollary of high past levels of credit creation and of the initial costs of the GFC; and
• many emerging economies and others in East Asia depend on current account surpluses (achieved by suppressing domestic demand) in order avoid financial crises (eg see Leadership by Emerging Economies and Structural Incompatibility Puts Global Growth at risk, 2003+).

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:

• leads to increasing debt levels in deficit countries and render counter-cyclical fiscal and monetary policies ineffectual); and
• have proven too difficult for the global system (eg G20) to deal with because of the cultural obstacles

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

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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.

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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).

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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.

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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:

• create an effective international financial system - which is anything but an easy task (see above ) and one that has proven vastly too difficult for the G20 which was established mainly to address this issue. Some speculations about what might be required are in China May Not Have a Solution, but It seems to have a Problem;
• develop new means for economic management that do not depend on either government fiscal policies or monetary easing (see Booms and Busts: Unsatisfactory Tools for Macro-economic Management ).

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? [<]

In late 2013 there were increasing and accumulating signs of an approaching 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.

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 economic obstacles and geopolitical tensions which could disrupt such an outcome were being recognised. 

Economic Indicators

Economic indicators of the possibility of a catastrophic crisis include:

• 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 have 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]

• 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 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]
• it has been suggested that quantitative easing through reducing interest rates may itself be causing deflation and that an alternative involving increasing the quantity of money may be better. However the issues are arguably more complex for reasons suggested below;
• 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;
• 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];
• 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?);
• 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, 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:

• financial exposure in countries with poorly developed financial systems resulted from quantitative easing programs by the US Federal Reserve and others (which some had seen as elements in a Currency War);
• 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 face imminent 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, capital was not seen to be important);
• in July 2014 concerns about the viability of one of Portugal's major banks (and about the fact that Portugals debt burden (eg private sector debts are 250% of GDP) will probably require defaults) cast doubt on Europe's leverage problems more generally [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 cuase 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 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 - 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 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

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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

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

Ambrose Evan’s Prichard
Telegraph

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 'lowflation' 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

There also seemed to be no consideration of real possibility that constraints on obtaining the resources required to maintain traditional patterns of economic growth seemed to: (a) potentially lead to an inflationary surge, and economic disruption, like that in the 1970s; and (b) require urgent innovation if that risk were to be avoided.  For example:

• global production of conventional oil seemed to have peaked around 2006 (see General Notes on Peak Oil), and while increased production was being achieved through 'fracking' technologies to access shale oil the rapid decline rates associated with these methods implied that such oil production was not only environmentally controversial but: (a) was proving unprofitable; and (b) would require very high oil prices and ready availability of cheap credit [1]. The latter requirement seemed incompatible with: (a) the apparent need to end the easy money policies (as the latter had distorted resource allocation and created potential asset bubbles); and (b) the likely need to rapidly bring quantitative easing to an end if inflation starts to accelerate. There is no doubt that innovation in this arena is proceeding - but whether this can be sufficient is anything but clear;
• a plausible (though not yet debated) case was developed that there was a risk of 'peak mining' in about 2017 (whose effect on product costs would be similar to 'peak oil') because it was increasingly necessary to exploit very large low quality mineral deposits through the use of highly energy intensive methods [1].
• significant risks of wars over access to water, land and food were seen to be possible because of rapidly escalating food demands unless agricultural intensification (ie getting more food from available land and water) is successful [1]

It should be noted that:

• options to dramatically improve efficiency in the extraction and use of resources were also suggested [1];
• the development of renewable energy technologies (especially solar energy) is proceeding rapidly - and this could turn the $5.4 tr invested in fossil fuel exploration and unconventional oil production over past 6 years into areas of financial loss - because their production costs are so high [1] ;
• grid-scale battery technology that could inexpensively store solar and wind energy is being developed [1]

Geopolitical Indicators

There were at the same time indicators of potential threats to the global political and economic order that went beyond those associated with financial and economic systems. For example:

• there have been signs of a China-focused attempt (eg through the development of 'bureaucratic-style' consensus amongst leaders of the BRICS countries and in numerous other ways) to create an international neo-Confucian political order administered from China which would complement the Japanese-led 'financial war' of recent decades in challenging the liberal international order based on democratic capitalist principles that had been established after WWII and been championed by the United States, (see Creating a New International 'Confucian' Financial and Political Order?). The existence and implications of such a renewed authoritarian challenge to a liberal international order are unfortunately unlikely to be apparent to most Western observers because of the complex cultural issues involved - eg because the means of gaining authoritarian power are likely to be initially subtle. Such understanding is vital because it may be the major non-capitalist economies in East Asia (ie Japan and China) face financial and political crises unless the liberal democratic capitalist post-WWII international order can be disrupted (see The Need);
• security risks seemed to be increasing as indicated by:
  • the war rumblings in North Asia that could transform into real conflicts in that region (see Fasten Seat Belts - Rough Weather Ahead);
  • the relationship between apparent attempts to create a new international neo-Confucian order in competition with the post-WWII democratic-capitalist international order and military tensions in the region (see Comments on Australia's Strategic Edge in 2030);
  • the serious and uncontained regional conflicts that appear to be emerging in the Middle East that seem to result from disagreements about what sort of system of political economy would enable Muslim-dominated nations to overcome the relative backwardness that they have experienced in recent centuries (see The Muslim World Seems to be Headed for Chaos);
    • a manifestation of the incipient Sunni-Shia sectarian civil war in Iraq in mid 2014 (ie an attempt by Islamist extremists to create an Islamic State) was seen as potentially disrupting global oil supplies and pushing oil prices to levels that would be economically disruptive [1]
  • warning from security analysts in SE Asia that terrorism from extremists trained in the Middle East is likely to escalate worldwide [1]
  • the large number of ongoing conflicts in Africa ;
  • efforts to undermine the security intelligence foundations of Western defence arrangements that seemed to be emerging (see Smarter Authoritarians).  The latter includes reference to the possible motivation of such effects, and the methods that might have been used to encourage worldwide political questioning of the intelligence gathering efforts that had their origins in the Cold War and subsequent perceived terrorism risks from Islamist extremists (potentially involving WMD). The possibility of a diversity of complementary 'attacks' coordinated from North Asia was one possible (though by no means certain) 'Art of War' interpretation of North Korea's apparently crazy threats of nuclear attacks on the US; and
  • political instability in the Ukraine (related to debts that made government unsustainable and uncertainty about whether the Ukraine should have a liberal-European or authoritarian-Russia style political regime). This led to: (a) Russian military involvement (which some compared with Hitler's 1938 invasion of the Sudetenland in 1938 while Russia declared pro-European factions in the Ukraine to be like 'Nazis'); (b) potential Western sanctions against Russia; and (c) Russian threats of counter-measures -such as confiscating Western investments in Russia and abandoning the use of $US) which could have significant costs for others. The US's case for sanctions against Russia (on the basis of Russia's invasion of another country) was weakened by the fact that the US itself had a history of intervening militarily in other countries in order to correct perceived political dysfunctions. The decision by Russia's president in May 2014 to back away from intervention in the Ukraine might reflect the influence of a quite different emergent power bloc (eg see Creating a New International 'Confucian' Economic and Political Order?);

The Future?  [<]

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

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

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

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

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

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

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

• Creating Unity
• Diplomacy Failed
• Unilateral Action
• Flaws
• Problems in Iraq
• Global Chaos?
• Governing by Crisis
• A: US Security Strategy

September 11: The First Test

Outline

The 911 attack in America in 2001 initially created the global unity needed to lead overdue reforms to the global order that would eliminate the breeding grounds of terrorism.

However no common basis for this could be arranged by top-level UK diplomacy. Also, because of the growing availability of weapons of mass destruction, the September 11 attack ensured that malfunctioning states on the global margins (who breed or support terrorism, and have often been acquiring WMD) could no longer simply be ignored or 'contained'.

Thus, instead of leading multi-lateral efforts to treat the cultural, economic and political causes of terrorism, the US administration chose to advocate general democratic political reform in the Middle East (perhaps to reverse the adverse perceptions of itself based on its past support of autocratic regimes), and also to pursue (almost unilateral) military action for regime change in the most morally and legally exposed 'rogue' state (Iraq), apparently in the expectation that 'liberation' could create a model showing how the economic and political failures that have bred terrorism might be overcome.

A fair case could be made for such an attempt to 'nip a new Cold War style contest between different systems of political economy in the bud', eg democratic reform to current autocratic regimes in the Middle East, might (a) be very popular (b) pre-empt revolutions by Islamist extremists and (c) result in at most a temporary shift in democratically-gained power to Islamists, as the latter's policies would not be the basis for practical governance. 

There were also many reasons to doubt that it would be an adequate or optimal response to current problems. For example, the 'freedom' that the US leadership rightly sees as the basis of its economic and political strength (and hopes to 'export' to allow others to improve their circumstances) depends on many complementary cultural features - a constraint that has universally been put in the 'too hard' basket. And democratic government requires supporting civil institutions and community attitudes that would take many years to develop. In the longer term, unilateral US action to impose conditions that, contrary to its expectations, would not actually allow all to achieve prosperity risks increasing the political exclusion that leads extremists to resort to terrorism.

In practice the attempt to leverage transformation of the Middle East by changing Iraq regime seemed by late 2003 likely to have only limited impact, and to be being downgraded. And by early  2004 it appeared that the outcome could be a significant deterioration of the situation in the region. Changes in tactics (mainly involving use of military forces to protect communities rather than to attack militants) stabilized the situation but did not make it possible to claim that the initiative had been a success.

Moreover there are real prospects that US influence might be overwhelmed by the attempt to find a unilateral solution, as: the US could never have enough resources; unexpected military, financial or trade retaliations might emerge; or a global economic crisis (that would escalate political extremism) might eventuate from the combined effect of: financial imbalances that may reflect structural incompatibilities between major economic models; or loss of consumer confidence if the 'war against terrorists with WMD' is not resolved; etc. The possibility that the attack in America could have been manufactured in order to justify US involvement in efforts to stabilize the Middle East (though implausible) was widely canvassed.

The power vacuum that could emerge would not be filled quickly or democratically.

The modern world was presented with a perilous and most-urgent three-way choice between (a) following the US administration and trying to make its 'solution' work or (b) creating a successful global multilateral order or perhaps (c) decades of political chaos and economic reversals.

It may be that precipitating a crisis was expected to change global institutions on the basis of a MADness (mutually assured destruction) similar to that which prevented serious conflicts during the Cold War. 

It may also be that China has been attempting to capture the high ground in global institutions on the assumption that its neo-Confucian traditions provide a better (and profoundly different) way to manage a multi-cultural global order than Western-style democratic capitalism does.

The Attack in America created Unity

In this environment, the September 11 2001 attack in America created a massive strategic opportunity for leading nations to achieve constructive change by:

• mobilizing and strengthening the US (eg in terms of: building unity by providing an external threat; raising morale by gaining the moral high ground; transforming self-obsession into a purpose; breeding 'heroes'; and giving key positions and resources to determined people and reducing constraints on their actions);
• allowing the US to assemble an historically unprecedented global coalition with a determination to eliminate terrorists and terrorism. Because terrorists who are capable of mass destruction are a threat to the global economy and to most states, and because only the US has the military capability to rapidly and effectively deploy forces in the most remote locations, the terrorists virtually forced all states to fall in behind US leaders [1, 2]. 
• allowing an asset bubble (whose bursting could have crippled the US economy) to be deflated in an environment in which other issues were more important;  

• encouraging many Muslim communities to improve their relationships with the West - because of concern to avoid a real clash of civilizations [1]

The need for response to terrorism that eliminated the factors that caused it (rather than a primarily military response) was obviously well recognized [1, 2, 3, 4], as was the critical role that nation building played - especially in Asia - in ultimate success in the Cold War [1].

Military options could never be adequate in dealing with Islamist extremism (as outlined in Competing Civilizations) because:

• extremist Islamists may be strongest and most active outside majority Muslim communities - in Western societies in particular;
• extremists are seen by their supporters to be struggling to achieve noble goals - and this will continue until those goals are seriously debated;
• the resentments extremists express are partly justified - including frictions in the Middle East associated with the establishment of the state of Israel to try to solve Europe's 'Jewish problem'. ;
• trying to locate extremists is likely to result in more injustices (especially if they are not members of the mainstream Muslim communities in which others search for them);
• removal of deprivation that contributes to resentment requires economic advancement - and this has cultural implications which hard-line tactics will not remove;

The author put forward preliminary speculations (see Defusing a Clash?) that goals for reform might have included (for example): seeking an environment in which all peoples could reasonably hope to succeed; reducing the incidence of despotic governments that give rise to terrorism; and creating effective mechanisms for global governance based generally on democratic-capitalist principles.  Such goals might be achieved by steps such as:

• strengthening the support institutions that enable democratic governments to be effective, and outlawing 'covert operations';
• ethical renewal - including a more serious metaphysics;
• enhancing cross-cultural communication;
• reform of key global institutions;
• new practices to accelerate development (including attention to the practical consequences of different cultural assumptions); and
• reviewing the economic role of money, and methods used for corporate governance;

The author also speculated that the most effective way to roll-back Islamist extremism might be to ensure that its 'spiritual leaders' gain enough democratic legitimacy to allow their likely lack of practical solutions to become obvious to potential followers (see Discouraging Pointless Extremism).

Diplomacy did not Produce Agreement

Britain's Prime Minister publicly advocated broadly-based global reform as the solution to international terrorism on behalf of the US-led coalition against terror [1].

However, despite travelling for months seeking international agreement, success apparently proved elusive.

While the nature of those discussions are not publicly known (a fact that makes meaningful public discussion of the world's response to terrorism now virtually impossible), it is likely that agreement was elusive because of a combination of:

• friction arising out of the current unsatisfactory global situation, the 'secret histories' of the Cold War [1], or resistance to incipient US unilateralism (which is likely to have been in evidence as it has been suggested that planning for regime change in Iraq predated September 11 [1]; and
• seeking broad agreement based on a 'political-economy package' that corresponded to Western (especially Anglo-American) assumptions - which neglected the practical (political / economic) consequences of different cultural assumptions.

It can be noted that:

• many do not support the Western ideals of democracy and political liberty. In particular:
  • endorsement of democracy is not universal - and in the absence of competent supporting institutions, democracy can be ineffective (see below);
  • there is determined opposition to the dominance of (eg socially-liberal) Western values [1] a resistance which in future could be associated with 'Southern' Christianity [1] even more than with Islam;
• the assumptions that are made under an Anglo-American world-views can lead to powerful economic outcomes, while others have had varying degrees of difficulty (see Competing Civilizations); in particular  
• the source of Islamist extremism is probably a fear for the future of Islam if Western economic and cultural traditions are globalized - a fear that is probably well-founded because the social and political rigidities that Islam prescribes make it very hard for affected communities to achieve the rate of change that a productive economy requires;
• the universalistic ethical systems that imply concern for 'the least, the last and the lost' in Western societies are not shared in East Asia's communitarian world-views - where obligations to consider other's welfare do not extend past those with whom one has a clear relationship;
• a general failure to analyze the practical consequences of different cultural assumptions means that disadvantaged communities have not known how to improve their situation and some have instead listened to conspiracy theories that suggest that their problems are simply due to deliberate oppression by those who are economically successful;
• some just object to 'Europeans' trying to run the world again [1]; and
• even in 'Europe' there are significant differences in outlook - which have contributed to divergence on many policy issues [1]. In particular this applies to the character of a potential global order and to the relevance of military force in solving problems  [1]. One observers suggested that many Europeans viewed the US response to terrorist attacks as 'Bismarchian' [1], a 19th century European approach to diplomacy which was seen as primitive  There are also institutional differences in the roles of the state (see above)

It is likely that in most cases the points of disagreement would be different. Moreover there is no common conceptual framework for debating such issues.

Thus there was probably no alternative proposal that would gain agreement - merely resistance to the suggested proposal.

In this environment, the US administration's ideas about responding to terrorism were outlined in its National Security Strategy: 2002.

In brief the NSS suggested (in effect) that:

• freedom must be the foundation of future models of political economy;
• the US is powerful (and should not allow that power to be challenged), but will not use that power for its own advantage, but to create a world in which free people can make their own lives better;
• defense requirements have been changed by the combination of radicalism with weapons of mass destruction. Threats must now be met before being fully formed;
• the need that all states have for security against such threats provides an unprecedented opportunity to build a stable international order;
• the US will support the spread of freedoms' economic and political benefits;
• weak states can be as dangerous as strong states, because they can breed terrorism and drug cartels; and
• multilateral arrangements are vital - but resulting obligations are serious.

This represented a more assertive policy, because rather than participating in multilateral discussions and complaining that they are going nowhere, the US stated that it had a solution and was going to implement it (and in doing so wanted to encourage multilateral institutions to become more effective).

A Parallel: a story is told of a person appointed to manage a nuclear power station which had a large problem in storing radio-active waste. Solving this problem had defeated his predecessor because numerous complex and contradictory regulatory requirements had to be met. The new manager decided to ignore all the regulations and just solve the problem. Everyone said 'You can't do that'. He said, 'I just did'. So for years afterwards his power station was visited by study groups trying to learn the secret of his success.

However, if everything had not gone well, the manager would have been jailed for breaking the very laws that made practical progress impossible.

Another parallel: might be drawn between this proposal and the Europe 92 process to overcome (so-called) 'euro-sclerosis' (which had blocked the establishment of an integrated European community because every possible step was blocked by some opposing interests). Progress was achieved by initiative outside the political process to develop an integrated vision. If this parallel has any validity then it would be expected that supporting and credible 'sub-visions' building on the NSS proposal will emerge.

And another: might be drawn with the assertive strategies adopted by Microsoft in its dominance of some software systems.

Unilateral Action

In the 1990s as the effectiveness of the UN declined and the effect of disorder and economic failures in marginal states started to spread, some in the US defence establishment became increasingly attracted by the 'neo-con' idea of using its power to create unilateral security solutions.

As a diplomatic search for consensus was not seen to have produced a satisfactory solution in the post 911 era, such influences dominated and the US apparently pursued a multi-dimensional strategy involving:

• general withdrawal of support for autocratic regimes in the Middle East - and an advocacy of democracy. This strategy, Wolfowitz (seen as leading thinker) argued, had been developing since 1986 [1] - and was clearly based on accepting the validity of 'blow-back' theories (ie that past US support of autocratic regimes on the basis of geo-political 'realism' produced problems which rebounded on the US);
• military action to overthrow the most legally and morally exposed 'rogue' regime, that in Iraq;
• a significant recasting of its post WWII security alliances [1].

However, military action in Iraq generated opposition from many sources on the basis of: the perceived humanitarian cost; a lack of coherent rationalization of the plan; concern that it could not be effective; suspected linkages with the Israel / Palestine conflict; the presumed self-interested motives of those developing such plans; and extremists' alternative visions for 'revolution' in the Middle East.

The difficulty of evaluating very complex issues (because of the way human brains are wired) can be noted in considering this debate [1]

Fatal Flaws?

However there seemed to be a critical problem in any unilateral option which focused on replacing Iraq's rogue regime.

The NSS presented 'freedom' as the key ingredient needed to create prosperity and thus inhibit a collapse into political authoritarianism. Other analysts suggested more details of possible institutional requirements that would allow 'freedom' to be effective.

The problem facing Iraq (which was once one of the most successful Middle Eastern societies) was seen to be like that in Europe at the time of the Marshall Plan - where there were already many established economic institutions and only constraint was bad leadership. The main reforms needed were seen as involving: central bank; secular educationists; honest courts; and a road map to independence [1]

The Japanese precedent needs to be considered where victors tinkered with the media, the education system, the textbooks. [Ajami]

Iraq requires unity; free press; end to special militias; and removal of all of old regime [1]

Office of Reconstruction and Humanitarian Aid is focusing on: restarting and increasing oil production; telecommunication; getting civil service working; small business loans; reconstruction of state enterprises; currency; securing foreign investment [1]

The expectation that 'freedom' can lead to prosperity may have been be based on some recent developments in economic growth theory.

Theories of Economic Growth - an unavoidably simplistic view:

Economists have a long tradition of seeking explanations of economic growth (eg see Historical views and website on growth theory).

Until the 1990s, an influential view was that developed by Robert Solow in the 1950s. Under this view, growth was analyzed through a production function whose inputs were labour and capital. Solow showed that most growth was not associated with those inputs but came from a third factor which was ascribed to knowledge or technological change.

In the 1990s economists tired of the 'exogenous' theories under which most economic growth was not explained by their models, and at the suggestion (initially) of Paul Romer many efforts have been made to develop 'endogenous' theories under which knowledge / information could be treated as an input to a production function.

In parallel, there has been debate about why it was that economic growth initially and primarily occurred in Western societies. In this respect two views have been said to dominate [1] - namely the view of radical sociologists that growth is a disease which is the result of particular cultural characteristics, and Robert Lucas's view (derived from 'new' growth theory) which assumes that growth can be achieved in any culture when households begin to envisage the possibility of changing their circumstances.

It may be that there may have been a presumption that 'freedom' can create the perception that change is possible and thus provide the basis for growth.  

Furthermore there seems little doubt that individual freedom has been a major factor in the economic gains made by Western (especially Anglo-American) societies (see Cultural Foundations of Western Dominance).  

None-the-less the short term economic benefits of 'freedom' to others are uncertain:

It has been argued that on several occasions over the last two centuries earlier US administrations have sought to ensure progress in backward states through enforcement of Western standards with little success [1].

Moreover the types of profound problems that Iraq presented were replicated in various ways (though seldom as severely) in dozens of modern states.

Thus, while changing Iraq's murderous regime was desirable, a review of prevailing commercial / economic 'wisdom', the organization of global institutions and the impact of cultural constraints on political and economic systems are even more necessary. Visiting Baghdad in force was not a pre-requisite to achieving this.

The US and its allies can not achieve what is needed to suppress terrorism by making a scapegoat of Iraq's regime, any more than conspiracy theorists achieve when they make scapegoats of the US administration for its allegedly selfish motives in dealing with what are, after all, only symptoms of much more profound problems.

The potential for economic and political weakness to lead to the failure of states in Australia's immediate vicinity and insecurity (a problem that would not be overcome no matter what is achieved in the Middle East) can be noted [1].

In practice 'visiting Baghdad in force' seems to have created the opportunity for extremists (who have no ability to advance their community's welfare, or interest in doing so) to present themselves as relevant by developing a 'resistance' to outside forces [1]. This  plays into the hands of those who (like those involved in the Palestinian Intifada [1]) resort to violence to avoid having to face up to the practical difficulties of developing a modern society and thereby ensure ongoing chaos and that nobody wins.

And in the medium term, a unilateral US attempt to impose 'freedom' everywhere (which even without 'resistance' can not actually lead everyone to prosperity) must increase the numbers of people who find themselves both economically and socially disadvantaged and politically excluded.

Even in Australia, where cultural features were a less serious constraint, 'freedom' (in the form of a liberalized market economy) did not ensure that all regions would prosper - and an extremist political reaction was the result (see Assessing the Implications of Pauline Hanson's One Nation)

In less favoured environments, economic and social disadvantage and political exclusion will allow extremists to see terrorism as a way to force others to care. While it seems that extremists usually have 'rat-bag' ideas, they don't know this. Moreover they will not tend to learn much (except perhaps a self-induced sense of moral virtue and hatred of their 'oppressors') when they are shot at after they have resorted to terrorism.

Practical Problems in Iraq [Added from November 2003]

By late 2003, a successful military campaign had been followed by:

• a process of restoring infrastructure and developing an interim Iraqi administration [1, 2, 3] (for which it seemed that preliminary planning had been poorly advised);
• more open access by Iraqis to information [1]; and
• an inability to locate WMD physically [1] (despite the reported finding of documentary evidence [1] and claims about the reality of such weapons [1]) - which suggested that such items had been (a) destroyed and remained only in the heads of scientists and engineers or (b) relocated. Another view is that such weapons did not exist prior to Iraq invasion - which raised questions about the source of misleading intelligence [1] and the possibility that it related to program of deterrence by Iraq [1]

However serious difficulties were encountered in ensuring security and establishing a viable regime in Iraq [1, 2, 3]. The US sought multilateral support because of the difficulty of the challenge [1, 2] - which the UN apparently wished to provide [1] or encourage [1] though some key states were opposed. In practice the security situation was not stabilized, and attacks on Coalition forces, perceived collaborators, the UN and humanitarian agencies continued.

Rather than establishing a (democratic) constitution for Iraq before elections and a formal transfer of power, it seemed likely that power will be transferred hurriedly to a populist administration [1, 2, 3] - presumably operating under Iraq's partly-satisfactory 1925 constitution [1].  Alternately it might take the form of an Islamic state conforming to the wishes of the Shi-ite majority [1, 2]. The latter's long term prospects would presumably be poor.

The overall outcome seems likely to be:

• partial achievement of the goal of the US administration [1] (which it seems to share with Israel) of defusing terrorism risks originating in the Middle East by making countries in the region more politically and economically successful;
• a clear demonstration of the lack of effectiveness of the naive use of military force - and thus presumably a less-unsophisticated approach to the future use of power by the present US administration in the pursuit of that on-going goal [1];
• eventual transition of the interim Iraqi administration into either (a) a failed state as a result of ongoing instability (b) a 'balkanized' set of smaller states reflecting ethnic divisions [1, 2] or (c) a moderately successful modern state;

However there is also real concern that attempts to transfer power to an Iraqi administration could result in complete failure [1] and a situation in the region far worse than had previously existed [1].

A major source of the problem seems to be that, in the absence of other arrangements, US military forces were left with most responsibility for interim administration. Their focus was on security issues which were real but only a small part of the task that had to be addressed - and they clearly lacked the knowledge and skills to establish constructive rapport with the Iraqi community.

By late 2004, various observers speculated about a complete breakdown in authority [1, 2]. And US president Bush suggested that it seemed that the war against terror could never be won [1]. The loss of security in Iraq through a democratic experiment might actually discourage the region from exploring this option rather than providing a positive example [1]. By early 2005 it was suggested that escalating insurgency could destabilize the attempt to establish democratic government in Iraq, and create a pool of fighters who would extend in the Middle East generally and against the US [1]

It seems likely that the precedence given to implementing a 'free market' Economic Plan for Iraq was a factor in difficulties in establishing a viable new truly-Iraqi administration [1]. It was argued above, that such theories could not generate a viable economic solution because much more is required for a successful market economy than economic 'liberty'. An even more profound problem was that sophisticated political and economic institutions (which are not present in Iraq) are required to even understand the issues involved. It seems it was only belatedly recognized that there must thus be a divergence between the Economic Plan and any democratic consensus of Iraqis, and that this led to dangerous delays in establishing a new truly Iraqi administration.

By late 2006 the outcome was described in terms of: future control of the Middle East by radicals who will cause great harm in region and to the rest of the world; escalation of Sunni-Shia tensions; a new base for terrorists in Iraq; perceptions of democracy as leading to a loss of public order and Sunni control; reinforcement of anti-American sentiment; reduction in US influence worldwide; failure of Middle East peace process; Iran and Israel as the major powers in the region; Islam filling the political and intellectual vacuum and underpinning the politics of the region; and authoritarian and religiously intolerant Arab regimes .[1]

The Risk of Systemic Failure and the Growth of Global Chaos

The current global order is being strained by world leaders' failure to date to agree on how to deal with the immediate threat of terrorists with WMD, and the role which the economic and political failure of weak states plays in breeding terrorism or direct threats.

As noted above, the US administration has seemed to have a plan.

Other nations have been publicly divided between: those who saw the US's strategy as better than nothing; those who distrust the US leadership or the democratic capitalist model that they hope to globalize; and those who recognize a need for broadly-based global reform but do not know what model would actually work and lack the economic and military strength to achieve this without US backing.

The problem has been that:

• though the NSS probably reflected a balanced agenda (eg including the efforts that were made to find political and economic options to eliminate the breeding grounds of terrorism, and the contributions of the US State Department), its strongest visible inputs seem to have had a military bias - reflecting a 'neo-conservative' orientation favouring the humanitarian use of US power [1]. For example,  eg the NSS appears to have have been at least partly founded on the "Rebuilding America's Defenses: Strategy, Forces and Resources For a New Century," (2000 - see Project for a New American Century to whose 1997 principles many influential US officials were signatories). This highlighted the undoubted need for the US to have a vision for building on the achievements of past decades, but dealt only with defense issues without presenting a vision of a better global political and economic context to which such a defense strategy would then be a response. Its primary thrust involved pre-empting any challenges to US hegemony - including inhibiting those who might become allies of such challengers [1]. This proposal in turn seemed linked to:
  • a controversial 1992 Defense Planning Guidance (first disclosed in NY Times, 8/3/92) - which prescribed a military capability to protect US interests but did not appear to have been based on deep consideration of how security problems arose or to consider non-military solutions;
  • planning for possible regime change in Iraq which predated September 11 [1]
• none of the critics have demonstrated a plausible alternative plan for dealing what are now urgent imperatives. For example containment, that some favoured, was clearly inadequate - as 'compliance' by Iraq's regime with weapons inspections in the face of 200,000 heavily armed troops on the border was not really proof that 'the system works' [1]. And if the war against terrorism is to be won, it is vital to eliminate the economic and political weaknesses that breed it. If the US's assumption that this mainly requires 'freedom' is invalid, then it is essential to define the alternative;
• having challenged a dictator with superior military force, if this had not been carried to completion (and no one else did anything that would solve the problem), the attacks from the economically and politically 'failing' world would grow - resulting in material damage, loss of life and injury to the current global order;
• no institutional framework exists to legalize what might really need to be done - thus potentially allowing those who take responsibility to be viewed as 'war' criminals.

Moreover those who could see flaws in what was proposed were not themselves actually doing anything else to solve the problem. It was futile to just oppose others' solutions [1].

And, because it was not hard to envisage the situation deteriorating [1], perhaps catastrophically, it was equally futile to formulate plans for what might be done at some future date after current administrations had failed and been democratically replaced - as there might be too little left for future administrations to work with. 

If the strains in the current global order are not mended, it could fail leaving a huge vacuum of power that would not be filled by liberal democratic states. In particular:

• the European Union, which presents alternative democratic Western models to those which the US and its allies are advocating: has depended on the US military umbrella (as noted above); and has relatively much weaker economic capabilities (and much higher unemployment) than in (say) the US;
• East Asia (dominated by Japan and China), which now comprises about 50% of the global economy, involves many competing interests within broad political and economic traditions that are radically different to those of Western societies - in which liberal democracy is a decoration rather than a foundation;
• amongst numerous smaller states, all that have aspirations to power are autocratically governed.
  

As a result genuine global debate in the public arena is emerging for the first time about what should be done - and this will:

• perhaps force the development of workable global political institutions;
• ensure that attention is given to weaknesses that may currently exist in global economic institutions and assumptions (as speculated above);
• make it harder for nations to act unilaterally. For example:
  • the need to rebuild political capital made it essential for the next major initiative that the US took after Iraq to be diplomatic rather than military (eg noting [1], and that US influence over nation-building in Asia has been supplanted by China - partly due to US unilateralism [1]); and
  • any defects in the US national political process have become a matter for global, rather than purely domestic, debate;
• increase scope for Discouraging Pointless Extremism by exposing the 'solutions' advocated by the spiritual leaders who advocate terrorism to critical review;.

In particular China, which has achieved accelerated economic growth (see China's Development), has started operating within the international system [1], and done so with considerable sophistication.  It seems likely that China's leadership has made a strategic judgment that modernized Confucian traditions (derived from those which have supported a Chinese empire for 4000 years) are likely to prove better able to dominate in a multi-cultural global order than those of Western democratic capitalism.

Needless-to-say this would involve a global order build principles that were vastly different to those Western societies have sought in efforts to develop a global order in recent centuries (eg individualism; individual rights; universal ethics; coordination of economic transactions through financial outcomes; democracy) [eg see China as the Future of the World, The Abduction of Modernity].

This challenge seems likely to ensure that the US also attempts to rejuvenate the multilateral system.

• Beyond MADness

Global Governance by Crisis?

In evaluating what is being achieved by the more-or-less unilateral US action against terrorism, it is relevant to speculate about the possibility of either a simplistic, or a very sophisticated, strategic intent and method.

At the simplest level, the 'war against terror' has led to the emergence of a military-focused US presence in many of the world's trouble spots [1] . And this, which can be viewed as a form of 'imperium', may be all that has been intended and achieved.

However it may be that a 'hidden agenda' behind unilateral US action has been to create a situation which would force the world to take multilateral mechanisms such as the UN more seriously [1].

Indications that US unilateralism might not be designed for the US to 'run the world' imperially but just to worry various despots (and others) enough for them to try to get the UN to act realistically (even if just to put a leash on the US), or to take more practical responsibility for international issues include:

• the US would traditionally advocate establishment of a multilateral global order and was heavily involved in initial development of UN machinery which was supposed to be part of this;
• the US has a traditional ideology that is opposed to 'colonialism' and a community preference for isolationism and self-absorption - and the current President is reputed to be of this mindset. This does not pre-dispose them to want to be responsible for 'hands on' political control of other countries - or suggest that the resources required to do so would gain long-term Legislative approval;
• the US's global dominance has been quite different to that of classical 'empires' [1]. Moreover:
• conventional empires were far more costly because they did not involve multilateral institutions to reduce security and administration costs;
• the US's dominance has depend on a high  level of acceptance that its actions would generally promote a peaceful order to the benefit of all. This whole edifice would fall apart if a different general perception were to emerge;
• the 2002 NSS dramatically increased the US's emphasis on multilateral institutions - and particularly on ensuring that they are actually taken seriously;
• the anti-Americanism that results from the US's global dominance would lead to opposition to reform of the multi-lateral system if the US was seen to be organizing (rather than 'threatening') the process; 

• during the Cold War the strategy of MADness (mutually assured destruction) was used to block serious conflicts. The risk of systemic failure outlined above seems to constitute a new basis for the very familiar concept of MADness;

• the US simply lacks the resources to carry through a unilateralist agenda [1, 2, 3, 4], and faces significant limitations on its power to act alone [1]. Any future economic reversals (eg the bursting of what appears to be an asset 'bubble') could significantly reduce the US's ability to pay huge military bills.

Despite critics' opinions about 'simple-mindedness', it seems likely that the US presidency is gaining advice from strong national strategic machinery. In particular: concepts used in discussing strategy (such as the need for a clear central focus) are sophisticated and show signs of learning from East Asian Art of War methods; the US President himself is a graduate of the Harvard Business School (Bookhiser R 'The mind of George Bush', FR, 28/3/03) and would thus be familiar with the major advances in corporate strategy techniques that were made in the 1990s (see Strategy Development in Business and Government); and 'unilateralism' appears to have a relationship to the concept of 'stretch' as a strategic methodology [1] which was one of those advances. Moreover taking initiatives gives one control over a situation which does not exist if one simply reacts (as the latter can potentially lead to the 'boiling frog' syndrome).  And sponsoring a democratic revolution in the Middle East would drive a wedge between radical Islamists seeking a revolution to establish non-democratic (theocratic) regimes, and Muslim communities who reportedly favour democracy [1] 

People who seems to be aware of such issues will presumably also be aware of:

• what 'imperial over-reach' means [1]; and thus
• the vital importance of effective civil institutions such as a UN to keep the peace - because of the immense cost of reliance on ongoing military action;
• that deception is a valid strategy;
• the success that Afghanistan (for example) has had in evicting invading armies (and at not much else) for the past thousand years;
• the difficulty of hands-on Western administration of a middle eastern country such as Iraq (and presumably the introduction of democracy) [1, 2], and the potential to destabilize other regimes in the region with which the US has had workable relationships [1].
• the futility of being bogged down at the ends of the earth for no purpose - but the vital necessity now to do 'something' about weak / rogue states;
• that smoldering anti-Americanism has never resulted in the formation of an opposing coalition because US power has tended to be used benevolently, and that if the US was seen to have changed (a) cooperation in the war against terror could evaporate and (b) new balance of power resistance would emerge (eg Russia and China; in the Middle East; Europe; the UN);
• the electoral oblivion that would await any administration that generated a 'balance of power' coalition against the US;

Beyond MADness

In practice it can be noted that:

• many people have become immensely concerned about the situation (eg about the need to 'contain the US'), and starting from their individual (narrow) view of the issues involved have been obliged to take an ever broader view and so achieved increased understanding of the requirements for effective global governance;
• an 'exile' option for Hussein emerged from Middle Eastern nations whose autocratic leadership would face problems if the US displaces an autocratic regime in Iraq;
• it seemed at one time that UN Security Council support for the use of force against Iraq's regime could well emerge [1];
• reform of the UN was advocated to a forum of non-aligned nations [1], and great concern was expressed by many of the world's most disaffected nations about respecting the UN Charter [1]
• the Secretary General of the UN re-emphasized the Security Council's determination to disarm Iraq [1]
• Britain's PM sought the reconstruction of key multilateral institutions [1]
• ways in which UN institutions might be reformed have been suggested [1, 2], while others have suggested the need for an entirely new framework [1]
• opposition to a multilateral solution to the regional threats posed by North Korea's nuclear weapons program which the US had sought disappeared after the rapid defeat of the Iraqi regime (Walsh M 'Home run required', Bulletin,  22/4/03)
• the EU is lobbying Australia about participation in the multilateral system [1]. Presumably it is doing the same with the US - and seeking ways to make the multilateral system more effective from the US's viewpoint.
• China's president advocated a strong role for the multilateral system [1];
• Muslim leaders in SE Asia appeared to strongly reject the extremism of some Middle Eastern Muslims - and endorsed an acceptance of modernization [1] ;
• Islamist extremists have included the UN as a claimed enemy (eg because of its role in East Timor) - and UN facilities (and other multilateral institutions such as the Red Cross) have been attacked ;
• the UN Secretary General has called for reform especially of UN security arrangements to be able to deal with problems such as terrorists and WMD - and for comprehensive reform of the UN (and of its relationship with the Bretton Woods institutions) to address the problems that breed terrorism [1];
• there are indications that the international community recognizes the need to succeed in Iraq - and that the US electorate will not tolerate anything but a multilateral approach [1];
• the US president expressed support for multilateral action [1] - a view which was restated strongly by the US Secretary of State [1];
• the need to resist al Qaeda politically (rather than militarily) was advocated by an experienced Australian political operative [1]
• the  Pope called for a more effective global order [1]. His ideal involved 'communitarian' concepts - as a middle way between collectivism and individualism / capitalism. In this (a) the centrality of religion to formation of society would be recognized and (b) the community would mobilize church resources to enable people to help themselves, and resist anti-religious movements (eg Nazism / communism) [1];
• Iraq has been said to be likely to be the first and last US 'pre-emptive' action [1];
• George Soros, in criticizing US efforts to deal with terror by the use of force; developed coherent proposals for global reform [1]
• pressure for UN involvement (including the deployment of Arab / Muslim forces) in the transition to Iraqi self-rule has emerged [1];
• UN proposals for transition to Iraqi self-rule seem likely to be acceptable [1];
• US / UK proposals for transition to self-rule in Iraq gained unanimous Security Council support [1]
• the weakness of 'hard power' when not accompanied by effective 'soft power' has been seen to be demonstrated in Iraq [1]
• when neo-con methods failed in Iraq, US administration turned the problem over to those favouring multilateral solutions [1]
• there has been a substantial extension of democratic government models - especially in the Middle East [1, 2];
• reform proposals put forward for the UN correspond very closely to traditional US views, and would eliminate the features which have led the US to downplay its significance [1, 2];
• US administration has proposed Wolfowitz to head the World Bank [1, 2]. Wolfowitz appears to have been the many architect of the policy of promoting good governance in dysfunctional states (perhaps by democratization) to reduce security threats. Based on the CIA notion of 'blowback' (ie that support for 'bad' governments creates problems) he opposed the traditional view that the US should support whoever in a country seemed favourable to US interests (even if they were brutal dictators). His ideas were apparently a factor in the US invasion of Iraq (which was rationalized by concern about WMD) and in the pressure exerted for the spread of democratic practices. A position in the World Bank (where the effectiveness of aid programs has been disabled often by poor governance) could transform Wolfowitz's agenda from a unilateral US program (through the unsatisfactory agency of the Pentagon) to a multilateral agenda.
• Europe, through the adoption of different methods (perhaps appropriately described as extending a hand of friendship) has been seen to be creating a zone of peace, while US influence declines [1]

However if this hidden agenda was real, then the possibility of an even more deeply hidden source of influence on US policy might need to be considered - because the methods being used would correspond to the role of leaders in Japanese society who traditionally stimulate change by precipitating a crisis (see A New Shogun Scenario).

• Support
• Opposition

ADDENDUM: Précis of US National Security Strategy: 2002

Introduction: The struggles between liberty and totalitarianism ended with victory for freedom—and a single sustainable model for national success: freedom, democracy, and free enterprise. Now only nations committed basic human rights and political and economic freedom will be able to assure future prosperity. The US has unparalleled military strength and great economic and political influence. It does not use its strength for unilateral advantage - but seeks a balance of power that favors freedom. In a safe world people can make their own lives better. The US will defend peace by fighting terrorists and tyrants, building good relations among great powers, and encouraging free and open societies on every continent. Defence requirements have changed. Enemies in the past needed armies and great industrial capabilities. Now, shadowy networks can bring great chaos cheaply - by using the power of modern technologies. Defence requires military power, homeland defenses, law enforcement, intelligence, and cutting terrorist financing - and is a global enterprise of uncertain duration. America will help nations in combating terror, and hold to account nations that support terror. The gravest danger comes from combining radicalism and technology. Enemies are seeking weapons of mass destruction. This will not succeed. Defenses will be built against missiles, and access to dangerous technology denied. The US will act against such emerging threats before they are fully formed - using the best intelligence and careful planning. In future, the only path to peace and security is the path of action. In defending peace, the US will take advantage of an historic opportunity to preserve the peace. The international community has the best chance since the rise of the nation-state in the seventeenth century to build a world where great powers compete in peace rather than preparing for war. The great powers are united by common dangers of terrorist violence and chaos. The US will build on these common interests to promote global security. Nations are also increasingly united by common values. The US will encourage the advancement of democracy and economic openness in Russia and China, as these are the best foundations for domestic stability and international order. Aggression from other great powers will be resisted, as the peaceful pursuit of prosperity, trade, and cultural advancement is welcomed. The US will extend the benefits of freedom across the globe - by working to bring the hope of democracy, development, free markets, and free trade to every corner of the world. 911 showed weak states, like Afghanistan, can pose as great a danger to our national interests as strong states. Poverty does not make poor people into terrorists. Yet poverty, weak institutions, and corruption can make weak states vulnerable to terrorist networks and drug cartels. The US will stand beside any nation determined to build a better future by seeking the rewards of liberty for its people. Free trade and free markets have proven their ability to lift whole societies out of poverty. The US will deliver greater development assistance through the New Millennium Challenge Account to nations that govern justly, and also reduce the toll of infectious diseases. In build a balance of power that favors freedom, the US believes that nations have responsibilities - to enjoy freedom they must fight terror; to have international stability they must prevent the spread of WMD; to have aid they must govern themselves wisely. No nation can build a safer, better world alone. Alliances and multilateral institutions are vital. But international obligations must be taken seriously - and not only symbolically. Freedom is the non-negotiable demand of human dignity. In history, freedom has often been threatened. Now, humanity has the opportunity to further freedom’s triumph. The US is happy to lead in this mission.

Overview of America's International Strategy : The United States possesses unprecedented— and unequaled—strength and influence in the world. Sustained by faith in the principles of liberty, and the value of a free society, this position comes with unparalleled responsibilities, obligations, and opportunity. The great strength of this nation must be used to promote a balance of power that favors freedom. For most of the twentieth century, the world was divided by a great struggle over ideas: destructive totalitarian visions versus freedom and equality. That great struggle is over. The militant visions of class, nation, and race which promised utopia and delivered misery have been defeated and discredited. America is now threatened less by conquering states than we are by failing ones. We are menaced less by fleets and armies than by catastrophic technologies in the hands of the embittered few. We must defeat these threats to our Nation, allies, and friends. This is also a time of opportunity for America. We will work to translate this moment of influence into decades of peace, prosperity, and liberty. The U.S. national security strategy will be based on a distinctly American internationalism that reflects the union of our values and our national interests. The aim of this strategy is to help make the world not just safer but better. Our goals on the path to progress are clear: political and economic freedom, peaceful relations with other states, and respect for human dignity. And this path is not America’s alone. It is open to all. To achieve these goals, the United States will:

• champion aspirations for human dignity;
• strengthen alliances to defeat global terrorism and work to prevent attacks against us and our friends;
• work with others to defuse regional conflicts;
• prevent our enemies from threatening us, our allies, and our friends, with weapons of mass destruction;
• ignite a new era of global economic growth through free markets and free trade;
• expand the circle of development by opening societies and building the infrastructure of democracy;
• develop agendas for cooperative action with other main centers of global power; and
• transform America’s national security institutions to meet the challenges and opportunities of the twenty-first century.

A supportive view

It is only recently in history that nations have commented on their national strategies - as compared with expecting historians to deduce them. Kissinger's State of the World reports had been candid. But it was the DoD Reorganization Act of 1986 that obliged presidents to report regularly on National Security Strategy. Most such reports have restated past practices. However the National Security Strategy: 2002 has stirred controversy. The terrorist attacks have prepared the war for a new strategic approach.  The differences from statements under Clinton are interesting - it refers to defending peace (rather than assuming it); it calls for cooperating amongst great powers. It seeks free and open societies world-wide, where Clinton advocated democracy and human rights. It is more forceful and multilateral than its predecessor. A significant innovation is equating terrorists with tyrants as sources of danger. This is because such persons now have access to WMD. The strategy stresses the legality of nations taking action (before being attacked against forces that threaten attack. This strategy relies on hegemony - which in turn relies upon cooperation amongst the great powers (where Clinton's concern had only been with the weak). It also assumes that others prefer the stability that a hegemon brings, and that the US's universalist values are a better basis for this than many others. Finally the strategy reflects the view that it was not poverty that motivated terrorism, but rather the absence of representative institutions in their own countries that turned political dissidence into religious fanaticism. Thus the goal of US strategy must be to spread democracy everywhere - the job that Woodrow Wilson started. The strategy differs from Clintons in that it is proactive; it is coherent (which Clinton's simultaneous cultivation and humiliation of Russia never achieved); reflects an advanced view of hegemony; and combines power and principles. However it doesn't rationalize Bush's 'axis of evil' comments- which may have been ill-advised. Why go after Hussein? The probably reason is the power of victory. In Afghanistan the US got a taste of being welcomed as liberators, and it is assumed that this would happen again in Iraq (which is the most feasible place to now achieve this). The intent could be to undermine and remove reactionary regimes in the Middle East - thus eliminating the breeding grounds of terrorism. In the process this can save the UN from the irrelevant into which it would descend if its resolutions continue to be neglected. If this is so, then it is a truly grand strategy whose goal is to modernize the entire Middle East. There is no way to tell if this would work. Success requires being able to do many things simultaneously. It is not that authoritarian regimes support terrorism, but that they produce generations of disaffected people from whom terrorists draw recruits. Authoritarians have been relied upon in the past - but this may not continue in future. The strategy also relies on (a)  being welcomed as liberators in Iraq (b) maintaining the high moral ground. The relationship between terrorism and WMD means that authoritarian regimes anywhere can no longer be tolerated.   (Gaddis J., A Grand Strategy of Transformation, Foreign Policy, March April 2003)

Opposing views

Typical opposing views can be identified as links from the above document.