Australia's aid program is an integral part of our broader foreign and security policy objectives. These are to:

• maintain our national security;
• build our national prosperity; and
• act as a good international citizen in building a stable and just international rules-based order.

Within this framework, the fundamental purpose of Australian aid is to help people overcome poverty. This also serves Australia's national interests by promoting stability and prosperity in our region and beyond.

Just in case you thought we were too focused on our own interests, the Minister goes on to say: 'We want to be judged not by how much we spend, but what results we produce – the number of lives we save, the number of children we educate, the number of people we lift out of poverty.'

The Independent Aid Review baulked at the national interest objective:

One problem with the objective of the program as it is presently stated is that it is unclear and ambiguous in relation to how the national interest should figure in the program. In the first place, Australia's interests are served by a world of prosperity and opportunity, rather than one plagued by poverty. Thus its first recommendation is: The objective of the Australian aid program should be cast as follows: The fundamental objective of Australian aid is to help people overcome poverty.

No sign of any commercial objectives here. But it creeps in later, in recommendation 22: 'The power of business should be harnessed and business innovation should be encouraged, including through an annual consultative forum.'

The detail promises a bit more than just consultation, but not much: the program should 'work through partnerships' and might 'assist Australian businesses which are seeking corporate social responsibility and/or inclusive business opportunities in developing countries.'

How will this debate fit with the Henry Review of the Asian Century? Australian business (and particularly Australian investment) generally finds Asia a bit daunting and the home turf is pretty comfortable. There is, however, a huge body of business experience, talent, specialised knowledge and technology which could be the basis of much deeper ties with Asia, but this needs some encouragement.

Just to give one example, there is now a widespread recognition that developing Asia needs to make a big push to improve infrastructure. Australia has a lot of expertise here, not just in building, but in financing and project planning. This won't do much directly for poverty, nor gender equality, child health or any of the narrowly focused Christmas tree of development objectives. But it will promote the same generalised economic growth that has done far more than all the international assistance programs to lift hundreds of millions of Chinese and Indians out of poverty.

The US doesn't share our reluctance to identify overlap between development objectives and commercial benefit. Secretary of State Hillary Clinton, in a document unashamedly titled 'The First Quadrennial Diplomacy and Development Review', puts the development objective this way:

It's ultimately about delivering results for the American people—protecting our interests and projecting our leadership in the 21st century...We will provide the strategic framework and oversight on the ground to ensure that America's civilian power is deployed as effectively as possible.

First, the starting point has a lot of slack. With the notable exception of Australia, almost all developed countries are still below (mostly well below) the 2007 GDP peak, with serious slack in the labour market. Economies in recovery phase should do much better than their average growth rate. For example, world growth in 2010 was 5%, before the recovery stalled. Thus world growth of around 3% does nothing to wind back unemployment and get back to potential output.

Second, world growth somewhere around 3% looked respectable enough when the GDP of countries like China, India and Brazil were not large enough to have a big influence on aggregate world growth, even when they were growing fast. By 2000 they were not only growing fast, but they had enough weight in world GDP to have a noticeable effect in boosting what would be considered 'normal' world growth. Instead of 3% being enough to keep economies bubbling along nicely, the new normal is at least 4%: anything less means some important countries are performing poorly.

Disaggregating the forecast identifies the laggards: the euro area is the worst, with half a per cent fall in GDP forecast for this year and less than 1% growth in 2013.

Third, all the risks seem to be on the downside. All forecasters routinely qualify their latest offering by saying that current circumstances are much more uncertain than usual. For once, this time it is true. In addition to the usual uncertainties of the economy, the politicians are doing their utmost to boost uncertainty, with a marked downward bias. Such is the down-side potential for the euro area that the Fund has explored its magnitude in a separate forecast, a sort of paratext around the central forecast story. The euro area could have a growth profile 2% below the already-stagnant path in the central forecast.

The US, forecast to grow at around 2% this year and next, faces a continuing housing recession and fiscal drag. The Fund puts it this way: '...in the absence of well-defined and credible fiscal consolidation strategies, there is the possibility of turmoil in global bond and currency markets. A more immediate risk is that an accident-prone political economy will lead to excessive fiscal tightening in the near term in the United States.'

It doesn't have to be like this. Some countries (the UK?) are stuck with low growth prospects because their debt burden has to be addressed, with the austerity this involves. But sensible policies could get Europe on the positive side of the ledger and could bring forward the US recovery. In any forecast, there must be some possibility of underestimating the economy's inherent 'reversion to mean' tendency: getting back to the potential growth path. Upside is not, however, showing in anyone's crystal ball at present.

The European Central Bank has often played an unhelpful role, resisting a Greek debt restructure and being too ready to claim that its mandate prevents it from helping more. As the US Fed showed in 2008, central banks have to stretch their mandates and put their balance sheets on the line when the stakes are this high. 

But it will be hard for the Fund to push the responsibility for the euro mess back where it belongs. The Europeans recently contributed an additional $200 billion to the IMF (which would be counted as their contribution towards the $500 billion), no doubt with some unspoken understanding that these funds, and more, would flow back to them as needed.

Part of the Fund's argument for additional resources is that if the euro founders, the collateral damage to all of us will be very substantial. Certainly it looks like a number of eastern European countries which have received very large capital inflows over the past decade will be in trouble, with Hungary as an example. But again there is a case for pushing the problem back where it belongs – in this case, to the Austrian banks which lent too much.

The Fund is hoping to tap Asian countries for this support fund, with the First Deputy Managing Director David Lipton going as far as acknowledging that 'the potential for collaboration is clouded by memories of the Asian financial crisis of 1997–98'.

In rejecting this IMF call for more funds, the US, Japan and Canada made it clear that they expected the Europeans to do most of the heavy lifting to save the euro. Australia might do well to join this side of the argument.

Photo by Flickr user Arnoooo.

Others in Asia recall the low priority the US gave to the region in the post-Vietnam War period. In the 1997 Asian Crisis, the US dominated the discussion (vetoing the idea of an Asian Monetary Fund, driving the unreasonable conditionality of IMF loans) but had no financial contribution to make in Thailand or Indonesia (Mexico, on its border, got $50 billion just a few years earlier). The Committee to Save the World might have been featured on the cover of TIME magazine, but many of us remember them as opinionated, domineering and wrong.

Since then, there has been a half-hearted attempt to give Asia representation in the international financial architecture (IMF, BIS etc) commensurate with its economic weight. Always given belatedly and grudgingly, it has left the incumbents still in full control of everything that matters. If the Henry Report is hoping to shift some of these Asian minds to think more positively about Australia, then this will not be helped by a 'through American eyes' orientation.

But in any case the principal target should be Australians, because it's we who need changing. For an Australian audience, what matters is what's happening in Asia, not in America or its relations with Asia. So what about us?

If we really were 'breathless with excitement' about the Asian growth story, we would have expired long ago: it's been going for three decades in China (it's well over twenty years since Ross Garnaut wrote 'Australia and the North Asian Ascendancy') and much longer elsewhere in Asia. But as the 'tyranny of distance' was replaced by the 'opportunity of proximity' (sorry, breathless again), how has Australia responded? Asia changed us demographically and gastronomically. We got off the sheep's back, and now ride the resources wave, thanks to Asian growth.

But Australian business venturing into the region generally still finds itself in unfamiliar and uncomfortable territory (the enclaves of Hong Kong and Singapore aside), and our investment in the region is small. The Foreign Minister urges Australian businesses to invest in Indonesia while at the same time his Department's Travel Advisory recommends that they don't set foot in the place. Study of Asian languages has almost died out in Australian universities. The cadre of Asian specialists is little bigger today than it was forty years ago.

In countries like Indonesia, our diplomatic influence may be less today than forty years ago. Having decided to 'play hard to get' in joining regional forums, we found ourselves the wallflowers at the dance, belatedly scurrying around to try to find some links into the vigorous regional dialogue that had by then been going on for decades. The coverage of Asia in the Australian media is so thin it's hardly visible. And it's not just the commercial channels: SBS covers the Middle East (thanks to the Al Jazeera feed) better than it covers Asia.

The Henry Task Force has only just got under way, so any thoughts here are no more than suggestions for their consideration. The central task is not to draw up a plan for getting ourselves into lock-step with the US 'pivot' into Asia. It is to change the Australian mindset so that we can take stock of how well we have made use of the opportunities given to us, as a small, rich technologically-advanced country on the edge of the world's most dynamic region. Do we ride the resources wave into the beach and then spread out a towel for a sunbake? Or do we address what seems to be a long list of missed or half-taken opportunities?

Photo by Flickr user woohoo!!.

The extra element was the extraordinary innovations in the financial sector. Honeymoon teaser low-interest interest-only loans were offered to borrowers previously considered to be unbankable. Loan-to-valuation ratios explored new highs. A whole new class of borrower was brought into home ownership, with the ownership rate going from its historical rate around 64% of homes, to 69%. All this took place in full view of various regulators, but no-one saw it as their duty to blow the whistle or try to stop the party.

In response to newly-empowered demand and the incentive of ever-increasing prices, housing construction was pulled forward in time, anticipating future demand. The result was not just too much house-building, but too much of it owned by people who couldn't afford it.

The second half of this story focuses on the pro-cyclical nature of financing and the inability of monetary policy to counter this. As soon as the downturn arrived, the easy money disappeared and credit standards were tightened. The policy rate was dramatically reduced to essentially zero, but little of this easing was passed through to over-stretched borrowers.

The variable-rate funding associated with sub-prime dried up. Conventional housing finance — thirty-year mortgages — have come down from around 6% to around 4%, but the fall is of little use to many borrowers. In normal circumstances they would be able to refinance their loans at the new lower rate, but this option is not available to six million mortgagees currently stuck with loans at 6% or more. They are ineligible for a number of reasons: the most common is that their loans are underwater; in some cases their circumstances have changed (perhaps they are included in the near-9% of the workforce now unemployed); or their credit score no longer meets the toughened lending requirements.

The government-sponsored enterprises (GSEs) — Fannie and Freddie — are caught in the ambiguity of their half-government/half-private status: they can improve their own financial strength by recalling some of the refinancing previously given to other lending institutions (thus improving their own bankrupt position), but in so doing make the overall situation worse. Funding from non-GSE sources has essentially dried up.

In an unusual step, the Fed has just sent a White Paper to Congress setting out the situation and suggesting some measures. Maybe the Government can devise more generous ways to spread the current lower mortgage rates to a wider group of borrowers (it already guarantees more than half of them), but it will be at the expense of the investors (including the GSEs) who currently hold the mortgages.

Eventually demographics will reassert themselves: people need a roof over their heads and rents are rising, which will bring out landlord investors. But the high stock of repossessed houses is a glut on the market, and official estimates see more than a million extra repossessed home added to the market in each of 2012 and 2013.

In due course things will be back where they started. The abiding lesson is that housing drives the cycle. The new lesson is that inadequate financial supervision in the upswing makes things much worse, and monetary policy is a weak instrument for cleaning up the wreckage afterwards.

Photo by Flickr user American Backroom.

If DFAT does need to be in the business of travel advice, what is a sensible way forward? Why not set out a full enumeration of the key risks (health, traffic, terrorism etc), and stop there: let people (and companies) decide what risks they want to bear, without setting them up for a lawyer's field-day.

While we're on potential litigation that makes it hard to do business in Indonesia, what about this quote from a Business Spectator article headed 'No more brown envelopes under the table', just a few days before Rudd urged Australian business to seize the opportunity:

Regardless, Australian business finds itself in this new era...Australian business should now consider that, to the extent the facilitation payments defence ever had any life under Australian laws, it will soon be dead. Any Australian business operating in countries where demands for such payments are common, including fast emerging African economies, should act to prohibit the making of such payments by their employees and others. Business impacts of refusing such demands will also need to be anticipated and planned for. To do otherwise risks the employee, the business and its directors committing criminal offences punishable in Australia, irrespective of where the facilitation payment is made.

Indonesia is fabulously exciting country and provides a wonderful opportunity for Australia to expand its horizons, to everyone's benefit. But it is a hard country to work in, and the Australian Government makes it just a bit more difficult.

Photo by Flick user danes96.

• Did anyone change their mind?
• Is policy better as a result?

The answer to both questions seems to be 'no'. Try searching blogs for phrases like 'I was wrong' or 'I've changed my mind'. Instead, some become shriller while others use the debate to reinforce and sharpen the hard edge of their opinions. And it's clear that policy is not doing what any of the bloggers recommend.

Why is it so? Is it part of the bloggers' intrinsic style to hold views strongly — to have 'conviction'? Are there fewer requirements for hard evidence, facts or a rigorous analytical framework? Are they 'fractious and inclined to mock each other' (as The Economist puts it) and so less open to compromise? Can determined bloggers continue to pontificate, even in the face of an established track record of predictive failure?

The answer is 'all of the above'. Why is this so? The nature of the US political system encourages bloggers to declare their politics pretty explicitly. As we have seen among the Republican presidential candidates, there are some amazing economic views put forward as candidates compete to get traction with voters and commentators. Bloggers can either go the middle-of-the-road way by ignoring this (ie. be boring and irrelevant), or take sides. Once they do, you know what they are going to say on most policy issues and they aren't going to be swayed by counter-arguments. Marty Feldstein and Paul Krugman (both academically mainstream) can be relied on to advocate very different policies.

In any case, economics doesn't have much to offer on what are essentially political choices. A good part of the US debate is about the appropriate size of the government sector and the degree of government intervention in pursuit of social objectives. International experience shows that you can have a successful economy with a large government sector, high taxes, reasonably equal distribution of income (the Scandinavians). Or you can go to the opposite end of the spectrum (Japan, the US). Both work, so economists taking sides in this debate are exercising their political judgment.

Perhaps the problem is that economics should have a large element of 'on the one hand...on the other hand...'. Often optimal policies are situation-specific ('it all depends…'). One of the basic lessons of economics is that 'anything is possible, nothing is certain, and everything depends on everything else'. To join the policy debate, the blogger has to take sides on the doctrinal issues and back this with whatever facts (or factoids) can be cobbled together. In resolving the technical economics underlying this, these blogs are of little more use than a politician's soap-box oratory.

Photo by Flickr user StreetFly JZ.

The European Central Bank (ECB) has the opportunity to play a key role in pulling the world back from crisis. It seems well on the way to fumbling this opportunity through timidity. It was slow to see the problem, raising interest rates as recently as July; it stood in the way of Greek debt rescheduling, which would probably have nipped the crisis in the bud if implemented in early 2010; and it is now twiddling its thumbs in the hope that someone else will save the situation.

Of course others need to play their part in getting these economies in order. But austerity is not enough. It is equally clear that doubts about sovereign debt will feed on themselves unless a circuit-breaker can instill some confidence that Italy, Spain and France are still good credit risks. Only the ECB can do this. Yet it remains hobbled by doctrinal debates and obfuscation about the details of its mandate.

How can there be doubt about its legal ability to help? It has already purchased large amounts of government debt (including around US$50 billion of Greek debt). Now it could do something to support economies which, unlike Greece, have good prospects of sustainability.

The trance-like drift towards economic disaster reminds one European economist of the descent into World War I: the British and Germans were close (in fact, they had a royal family in common) and had no good reason to sacrifice the flower of their youth in mass slaughter. And yet events unrolled in ways that brought this result, without anyone feeling responsible for standing in the way or devising means to avoid this terrible outcome. This is the thought which should be on the minds of the ECB board, not a legalistic debate about the extent of its mandate.

Photo by Flickr user Gertrud K.

The credit rating agencies were equally blinkered, with one of them keeping Greece at investment grade even after the full extent of the disaster was apparent to all. The IMF's surveillance operation was either tardy in identifying the problems or reluctant to blow the whistle.

Perhaps the bond-holders were sanguine because they anticipated that they would be bailed out. They had no good reason for this view: there is a specific clause in the euro agreement designed to prevent this. Nor is there some sacred principle that precludes sovereign defaults. Such defaults have been common enough; there was Argentina in 2001, and Iceland defaulted on its bank debt in 2008.

There seemed an opportunity in early 2010 to fix this fundamental issue by allowing Greece to default (in the form of a rescheduling). Certainly, strong mutual support would have been needed to withstand the inevitable contagion. But default would have re-established the role of risk as the primary discipline on profligate governments. Creditors who lost would be entitled to vent their anger on the credit rating agencies, which might have sharpened the agencies' performance. The euro authorities who insisted that all euro sovereign debt should be treated as AAA for the purpose of prudential supervision, thus encouraging banks to hold excessive amounts of risky debt, might have corrected their mistake.

Instead, this robust channel for enforcing discipline seems to have been abandoned altogether. Part of the 'Merkozy' agreement reached last week promised that there would be no 'private sector involvement' in any future rescue operations: no compulsory bail-in of bond-holders.

If this idea gets built into future arrangement, it will be a truly amazing outcome. How could something so clearly at variance with the basic functioning of markets come about?

Perhaps the answer is that the euro crisis has seriously distorted sensible decision-making. Each of the involved parties has a good reason for supporting this aberrant outcome. The bondholders, of course, want to maximise their returns (and managed to negotiate a favourable voluntary outcome for the Greek debt). The debtor countries are very ready to avow that in future they will not default. The European Central Bank is already holding very large amounts of sovereign debt from risky countries, and wants an outcome which avoids losses. The financial institutions which underwrote the debt through credit default swaps and other guarantees favour a world of no defaults. The euro prudential supervisors would rather avoid the balance sheet carnage that would result if their banks' bond-holdings incur big losses.

The IMF should have demanded a rescheduling of Greek debt when it first got involved in this mess in early 2010. It has now lost the opportunity. The short-term imperative to keep bond-holders happy is over-riding the longer-term need for market discipline on sovereign borrowers.

Photo by Flickr user beppo1953.

...noted Harvard economist Martin Feldstein (you may recall his cameo appearance in 'Inside Job') claims that if Italy just did a decent job with its budget, nothing more (specifically, no support from the European Central Bank) would be needed. Financial markets would quickly see that Italian debt was low risk and would put interest rates down again.

Actually, Italy has done a better job than most European countries with its budget: it has a primary surplus (ie. before interest payments) and only ten years ago demonstrated its capacity to get the debt down, under more benign economic conditions.

No doubt there are things that can be done now to improve Italy's budget, even in the short-term. But if this is done at the expense of growth (currently forecast by the OECD to be negative next year and barely positive the year after), it's hard to see that the current technocratic government will be given time for its strategy to bear fruit. ECB support for Italian bonds is needed now.

Other academics have weighed in, backed by the rigorous logic of economic models. Daniel Gros argues that debt reduction must succeed, probably in the short term, and definitely in the longer-term. The problem is that his simple model leaves out the vital link: cutting expenditure doesn't just affect income through the text-book multiplier. As explained above, there is also feedback that makes the budget deficit (and hence debt) worse.

But for Gros, this is not a problem. His model says that the economy has strong self-righting properties that will take GDP quickly back to the original trend growth path. The possibility that this takes considerable time, and that years of unemployment will actually lower the economy's productive potential, isn't part of his model.

Perhaps the most disturbing feature of these differences of prescription is that they seem to be largely based on political affiliations. We know, from his US writing, that Feldstein will always favour tough austerity (though not, mind you, by taxing the rich). Just as, on the other side of the US debate, Paul Krugman will favour increased budget expenditure, without being too specific about just how the longer-term problem of excessive government debt will be handled.

Perhaps if Truman were President today, he would be asking for an economist who could give advice based on the state of the economy, not political prejudice.

Photo courtesy of Wikipedia.

Despite strong international advice after the Asian crisis to adopt freely floating exchange rates, a pure free float has not been adopted by any of these countries. They have managed their exchange rates, not only to smooth out volatility, but to resist appreciation pressures which would diminish their international competitiveness. As their production structures have become increasingly integrated through supply-chain frameworks, maintaining competitive parities with neighbours has become more important.

So far this maintenance of competitive parity has been an informal affair. It could be given more regional structure. If each country maintained stability (perhaps within a band) vis-à-vis a common basket of currencies which included a heavy weighting of Asian currencies, this would have some of the characteristics of the early stages of Europe's move to the euro.

This sort of structure creates tighter relativities but sets up potential vulnerabilities. In Europe, the euro's precursors — the 'snake' and the ERM — both broke down. Thus part-and-parcel of any tighter currency arrangements would be support arrangements of the type offered by the ECB. Emerging East Asian economies might get help from the International Monetary Fund, but many still carry bitter memories of the Fund's failures in 1997. The Chiang Mai Initiative is exactly the sort of arrangement which might do the job, but it proved unusable when it was needed in 2008 and in its present form provides only trivial support.

Asia might also heed the lesson that currency blocks should choose their participants carefully. One suggestion is that a smaller yuan-based grouping of ASEAN, China, Hong Kong and Taiwan might make more sense that a region-wide linkage.

All this leaves Asian exchange rates in an awkward policy space. The managed rates of the post-1997 period have worked well enough, but continued reserve accumulation is not sustainable, and running chronic current account surpluses is not optimal. Capital should be flowing 'downhill' to these emerging countries, not in the reverse direction. Establishing a stable range of relativities among a sub-set of the region might be a start in the right direction.

Photo by Flickr user Images_of_Money.

The early Thatcher years have also been put forward as an example. No matter how necessary her reforms were to set the UK on an economically sustainable path, this period doesn't even remotely fit with the idea of expansionary pain-free budget austerity. Her initial measures stopped the economy in its tracks, not to regain its 1979 GDP level until 1984. Meanwhile, unemployment went from 1.5 million to 3.4 million in 1984; it was still over 2 million when she left office in 1990.

Thatcher's early policies certainly didn't produce an outpouring of confidence. She was the second-most unpopular prime minister in the post-World War II period. It's hard to image that you could get 364 economists to agree on anything, but they all signed a protest letter setting out their lack of confidence.

Her ultimate success was a result of her determination ('this lady is not for turning' and 'TINA: there is no alternative'). The Falklands victory saved her from electoral defeat in 1983, fortuitously giving her time to show that her policies could eventually work. She got no help from the confidence fairy.

Meanwhile, back in the present tense, the IMF sees 'an unmistakable need to restore fiscal sustainability through credible consolidation plans.' But with so many countries wanting to consolidate at the same time, they can't all get help from a depreciated exchange rate. The Greek attempt at austerity seems doomed. As they tighten, the economy falls deeper into a downward deficit spiral that no political system can survive. Sooner or later the Greeks will decide that it is less painful to renege on the debt, even if this means that they can't run a budget deficit, because no-one will lend to them. Locked into the euro (from which there is no easy escape), they can't get the benefit of a depreciation.

The less clear case is the UK austerity, which an earlier post described as 'courageous', in the Sir Humphrey sense. The UK can, at least, get help from a lower exchange rate. GDP is still well below the 2007 level. Perhaps, as in Mrs Thatcher's case, the economy will get beyond the short-term contractionary effect and start to grow again. Let's hope so.

History suggests that debt/GDP ratios are reduced by changing the denominator either through real growth or inflation. Cutting expenditure is hard work: even Mrs Thatcher couldn't stop budget expenditure from increasing; see this table of her time in office:

Photo courtesy of s~revenge. 

This outcome might be rationalised as an appropriate reward for leading the economy in a period of good performance. But the immediate post-WWII decades had even stronger growth, while income distribution became more equal. And the bank CEOs who led their institutions into the 2008 global financial crisis don't deserve this largesse.

What has this got to do with economic policy? Isn't this either moral philosophy or class war?

Economics does have something to say on how to help those at the bottom of the income distribution. Ever since the globalisation/technology squeeze was identified, the answer has been seen in terms of more education and skill-enhancement: you have to become smarter than the Chinese and the machines.

But what can be done at the other end of the income distribution; the rise of the oligarchs? In a country where the Horatio Alger stories of rags-to-riches are embedded in the social psyche, there will be disagreement. Nevertheless, two issues are being debated: the first is taxation (addressed in an earlier post); the second is about how CEO pay is determined.

In the UK there is a suggestion that bonuses based on return-on-assets rather than return-on-equity would get the incentives in the right place (reducing the incentive to take risks) and reduce top pay levels. On this basis, the top US bank CEOs would have received earnings only 69 times average household income (instead of 500 times) and might have been less eager to leverage up their balance sheets through borrowing. In the US, one suggestion is that bonuses should be banned.

No-one has a good answer yet and there are still those who loudly defend this outcome as the proper and desirable result of 'letting the market work'.

Meanwhile, out in Zuccotti Park, the protesters claiming to represent the 'other 99 per cent' will disperse as winter sets in. It's easy to pour derision on their diverse, often-self-centred and inchoate motivation. But it's harder to justify this socially-divisive inequality: it's just one more example where the market's much-vaunted price discovery process produces results which make no economic sense.

Photo by Flickr user David_Shankbone.

The other southern Europeans, under extreme threat themselves, are clear supporters. The creditors of these countries are loudly reminding the policy-makers of the dangers of contagion. The European Central Bank, with perhaps €50 billion of Greek debt on its balance sheet, has never supported debt rescheduling. The Greek Government has no interest in declaring default so long as they are receiving new funds from the bail-out package.

It might actually be in the interests of the Greek people to reschedule and start again with a manageable debt load. Iceland has demonstrated that a new government can quickly re-establish credibility after total default. It's also possible that a Greek default is in the interests of the world economy, accepting a once-off hit to confidence rather than the current (and prospective) death-by-a-thousand- cuts.

This would, at least, restore the market assessment of sovereign debt to a sensible basis. Rather than attempt to maintain the pretence that all euro sovereign debt is equally strong, markets could get back to where they should have been ever since Greece joined the euro. It had a common currency with Germany, but debt issued by the Greek Government was not the same as debt issued by Germany and would require higher yields. With this reality established, rescheduling would not seem so inconceivable.

Instead of this painful but feasible path, commentators are grappling with the idea of moving towards a fiscal union in which all debt would be backed by the euro area as a whole. Such as fiscal union seems decades away, and the Greek problem is here today.

Europe has, perforce, moved beyond the strange and anomalous convergence of interest rates that occurred as the euro was formed. This is a positive step. Now that Italy has to pay a yield that reflects the risks of default, the incentives for fiscal rectitude are in the right place.

Some are blaming the Basel II prudential rules for the anomalous market valuation of euro debt. This seems a lame excuse. True, these rules applied a zero-risk weight for all sovereign debt. But that was only because Basel didn't want to get into the business of rating sovereigns. The market has never had any trouble distinguishing between good and not-so-good sovereigns outside Europe. What happened with the market evaluation of euro debt has to be squarely blamed on the market itself.

Photo by Flickr user alles-schlumpf.

As usual there is no free lunch. The effect of introducing covered bonds is to widen the extent of the government guarantee that stands behind banks. The issue of such covered bonds was resisted over the years by the bank regulators for this very reason: bond-holders would rank ahead of depositors.

The banks have now won this extra advantage, at the expense of the taxpayers who are the ultimate guarantors. Whatever you think about the banks getting more government help, there is no doubt they are a bit safer now than they were before.

The banks might be safer, but this creates, at least at the margin, an increased macro-vulnerability for the country as a whole. Someone has to fund Australia's substantial current account deficit. At the moment this is largely done by the Australian banks' overseas borrowing. If the banks issue covered bonds up to the limit envisaged by the regulators, the banks will be able to obtain most of their funding requirements from domestic depositors and from investors such as the Australian superannuation funds.

Who, then, will do the overseas borrowing, funding the current account deficit? In normal times foreign capital flows can come through a wide variety of channels: foreign purchase of equities or bonds, direct borrowing from foreigners, and foreign investment. Any slack from the banks' smaller foreign borrowing will be made up by other borrowers.

But should there be a repeat of September 2008, which dried up many of these channels, the easy option used at that time — ensuring the continuation of bank funding through the government guarantee — will no longer do the job.

Photo courtesy of Flickr user antwerpenR.

America doesn't elect extremist presidents, so the Fed is probably safe enough. But the fact that this mindless condemnation of the Fed goes largely without critical comment is symptomatic of the pathetic state of economic debate in the US. The handling of the 2008 financial meltdown was not flawless, and a good case can be made that Chairman Greenspan's tenure as 'maestro' of the Fed is at least partly responsible for the mess.

But these are topics for a serious debate on specific vexed policy issues: the impotence of interest rates to counter a strong recession when over-leveraging weighs on confidence; the dilemmas of 'too-big-to-fail' financial institutions; how to handle asset-price booms and the pro-cyclical nature of financial intermediation; how to balance prudential concerns with a dynamic financial sector.

US monetary policy in the current recession has been laboring under the substantial handicap that the macro instrument most relevant for these circumstances — fiscal policy — has been emasculated by political veto. Bernanke himself has readily asserted that 'central bankers alone cannot solve the world's problems'.

The true dilemmas of monetary policy, as emphasised by recent experience, have been set out in a more useful way by the Bank for International Settlements' Claudio Borio. Will persistent low policy interest rates distort longer-term price signals? Has the sheer weight of government debt (itself largely a reflection of the financial problems of 2008) distorted portfolio decisions in ways that weaken monetary policy?

Borio says: 'An overarching challenge will be to manage expectations, recognising the limitations of policy as a tool to manage the economy. Central banks were never as powerful as generally believed.' Practitioners of monetary policy have much to be modest about. But the Republican candidates are clueless when it comes to making policy work better.

Photo courtesy of IowaPolitics.com.

This amazing bias might be explained as a legacy of the times when these countries were in fact intrinsically risky. But that reveals just one more example of the rear-vision view of the credit agencies, which have been slow to recognise the improved performance of the emerging countries, particularly in Asia, now the main source of world growth and whose modest volume of debt looks very secure.

The agencies have also been very slow to recognise that the sovereign debt of mature economies has become risky. Governments took over the debt of failing banks in 2008. As well, the specific Euro arrangements encouraged over-borrowing by the southern European members, making them poor credit risks.

To make sense of current risk realities, the rating agencies need to shift drastically on both fronts, to upgrade the emerging countries and downgrade the mature.

Meanwhile, financial markets are way ahead of the rating agencies, shifting their investments towards the high-yield countries such as Brazil and, in doing so, creating another problem: too much capital inflow and upward pressure on exchange rates. At the same time, markets have taken no notice of the Standard and Poor's downgrade of the US at the time of the debt ceiling impasse. A downgrade should have encouraged bond investors to demand a higher yield, but instead US yields have fallen sharply: investors, at least, still think the US is a safe bet.

Photo by Flickr user Images_of_Money.

The starting point is that the world's investors are now so pathologically risk-averse that they have retreated into extraordinarily low-return assets – US, Japanese and Swiss government bonds. The US government can now borrow ten-year-money for less than 2%. To be able to borrow at negative real interest rates should be a golden opportunity to fund investment, but the countries which can tap these low-cost funds have binding political constraints on their ability to borrow more.

What about the G20 directing one of the international institutions (say, the highly credit-worthy World Bank) to seize this opportunity to fund a Marshall-program-style stimulus to the world, building infrastructure?

Where should this infrastructure be built? It could be in the fast-growth infrastructure-deficient countries of East Asia, such as Indonesia. It might be in the UK, whose experiment with fiscal austerity has brought the economy to a grinding halt. It could be in the US, where years of neglect have left a dilapidated capital stock. The criteria would be two-fold. First, what projects are 'shovel-ready'? Second, even almost-free money has to be paid back eventually; borrowers must be able to do this.

There are many cogent reasons why this idea is too difficult to execute. One of the badges of leadership is the ability to cut through the bureaucratic procrastinators and sharp-pencil cost-benefit nay-sayers. Leadership is about seeing the connection between low interest rates, stagnant world activity and unmet infrastructure needs. This would make a better discussion than lecturing the Europeans and the US on issues their politicians can't resolve.

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More recently, high-frequency trading (now a large part of all modern financial exchanges) is hard to defend as a necessary part of the price-discovery process. The usual rationale that it adds liquidity to the market rings hollow as it is clear that this sort of liquidity evaporates as soon as markets come under pressure.

Thus the criticism that a Tobin Tax would reduce transaction volume no longer wins the argument. Indeed, Tobin was well ahead of his time in arguing that the very purpose of such a tax was to slow the transaction flow: to 'put sand in the wheels' of excessive international capital flows, which had been an important part of the breakdown of the fixed exchange rate Bretton Woods system.

The more practical counter-argument may still win the day: it is almost impossible to make the tax universal. Financial transactions, footloose in nature, will quickly gravitate to whichever countries decide to opt out. It's true that leading international financial centres such as London already have a stamp-duty transaction tax. But it is small enough to not outweigh the advantages London has as an established financial centre with complex legal infrastructure and intellectual capital.

Any attempt to pluck serious amounts of tax from the banking goose would cause more than squawking. At every mention of new prudential measures or capital requirements, bankers have threatened to move shop to less demanding jurisdictions. Thus a Tobin Tax seems an unlikely answer to the Euro's current problems.

This proposal does, however, serve as a reminder of the tax's attractions. If the idea that the Tobin Tax is a huge revenue raiser is abandoned, and if it could be placed on an activity which is generally regarded as socially useless or even harmful, it just might get up one day.

The performance of the financial sector in the GFC leaves the sector open to the charge that some of its functions are 'socially useless'. Bill Gates has been commissioned by the G20 to investigate a tax on financial transactions, with the revenue devoted to international aid. Nor is the financial sector the only target. In a carbon-conscious world, international air travel is often mentioned as a suitable case for Tobin-tax treatment.

Is the Tobin Tax an idea whose time has come? Not in relation to the urgent needs of the Euro crisis. But nor has it disappeared from the wider debate.

Photo by Flickr user Kris *V*.

As recently as end-June, the Bank for International Settlements (the central bankers' 'club' in Basel) still foresaw such a strong recovery that they began their Annual Report by saying: 'Pessimism has become tiresome, so optimism is gaining a foothold.' Their policy prescription was for tighter monetary settings together with 'swift and credible action to bring debt levels down to sustainable levels'. Pervasive market pessimism has overtaken this misreading of the mood but no revised policy prescription has been forthcoming.

The OECD, having trimmed its forecast markedly over the past six months, noted that in the OECD area 'activity has come close to stagnation...world trade is flat...global imbalances persist...improvements in labour markets are fading...confidence has weakened...and risk perceptions have changed, with multiple sources of risk'. Despite this bleak outlook, their advice was that monetary policy 'should be kept on hold'.

On fiscal policy, the OECD warned that 'countries with limited fiscal space have restricted scope for fiscal easing and some have to tighten amid cyclical weakness.' No signs of the OECD's traditional Keynesian orientation here.

Academic economists seem hopelessly divided. On fiscal policy, the idea of an 'expansionary contraction' (where the market is so impressed by government's belt-tightening that private expenditure increases more than the contraction in public spending) still retains adherents, despite Paul Krugman's disparaging references to the 'Confidence Fairy'.

Others see the US 2009 stimulus as a failure, whereas its main deficiency was that it was too small to do the job. Too many economists have branded the current conjuncture as a 'balance sheet' recession with the implication that only time will correct it. More excuses for inaction.

Among the economic policy-makers, the US Fed seems to be the most active and inventive. But the US Fed's latest innovation, while technically sensible, has back-fired. 'Operation Twist', designed to lower the long-term interest rate, was interpreted by financial markets as a sign that the Fed, spooked by the economic prospects, was resorting to desperate measures. Thus confidence took another hit. This kind of Catch 22 market reaction reinforces policy inaction.

The 'do-nothing' view was endorsed by the much-revered former Fed Chairman Paul Volcker. His message was balanced and nuanced, but nevertheless his concern was exclusively about inflation rather than 9% US unemployment.

The European Central Bank, preoccupied with the debt problems in Greece and other southern euro countries, seems to have forgotten that it increased interest rates as recently as July because its inflation zealots were more worried about price stability than anything else.

US Treasury Secretary Tim Geithner has offered sensible advice on European fiscal policy. More recently (and urgently) he has argued that: 'The threat of cascading default, bank runs, and catastrophic risk must be taken off the table, as otherwise it will undermine all other efforts'. His call-to-action is, however, muffled by European mutterings about his inability to get his own house in order.

It's regrettable but understandable that politicians should have trouble finding a workable consensus on economic policy. There is no excuse for the current dearth of positive policy ideas among economists.

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The AIG rescue protected Goldman Sachs. The US Government's guarantee of the short-term money market kept this lifeline of funding open. The rescue of Fannie Mae and Freddie Mac kept the mortgage market alive. It's hard to believe that even the best-placed survivors such as JP Morgan Chase could have withstood the damage without the help the Government gave to the sector as a whole. Instead of accepting this, Wall Street has fought every attempt at reform, through their powerful and well-funded lobbying.

What has been the penalty for Wall Street's failure? Financial sector bonuses took a dip in 2009, but are back up again. Many of the 2008 players are still at their desks, while those who patently failed have gone into honourable and generously-remunerated retirement. Whereas eight hundred people went to jail after the relatively minor Savings-and-Loans crisis in the early 1990s, only peripheral players have suffered that fate this time.

Perhaps symbolic of the failure of reform, high-speed trading (which must be a perfect fit for Adair Turner's category of 'socially useless' financial activity) has come to dominate equity and derivative markets.

With three years now elapsed since Lehmans collapsed, the opportunity for fundamental reform is slipping away.

Photo by Flickr user Nick in excelsio.

In the UK, the Vickers Commission has proposed 'ring-fencing' routine retail banking, offering protective support to the vital credit and payments services needed to keep normal commerce going, while denying this protection to other financial activities. Retail banking accounts for only one-third of UK financial activity. Even this very moderate version of functional separation has provoked loud protests from the financial sector. 

But the main basis of these complaints just goes to demonstrate that bankers still don't get it. They say ring-fencing will increase their costs. Just so.

At the moment, all their activity receives the subsidy of an implicit government guarantee. Ring-fencing is proposed precisely to shift the cost of the broader risks away from the taxpayer. Investment bank customers and shareholders will have to pay for this risk, not the taxpayer. Perhaps, just perhaps, it might make bankers more careful.

So what of the US, the epicenter of the crisis? More on that in a follow-up post.

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Of course, deregulation opened up opportunities for over-leverage. But problems will be identified by detailed assessment, not by some simplistic aggregate ratio.

When US prime-time television was replete with ads urging NINJAs (no income, no jobs or assets) to borrow, problems were brewing. As well, honeymoon introductory interest rates confused borrowers about their servicing capacity, rising house prices offered the promise of easy profits, securitisation removed the lenders' responsibility to assess risk, the legal system allowed borrowers to walk away from their debts and government-backed lending agencies were eager to refinance almost without limit.

Taken together, this was a formula for the sub-prime disaster. To blame this on breaching some simple aggregate ratio is just poor analysis.

Japan demonstrates the inadequacy of debt/income ratios as a measure of country risk. Gross government debt to GDP has been twice the designated tipping point for decades. To assess debt, we need to know what counterpart assets the government holds, whether the debt is held domestically or by foreigners, what is the borrowing interest rate and whether the country is running a current account deficit which makes it vulnerable to sudden outflows.

When all these things are considered, Japan is sustainable and Greece, with a lower ratio, is not.

The financial system requires its own specific analysis. The critical ratio in 2008 was not debt/income, but debt/equity. The US financial system was highly leveraged, with many institutions holding only $1 of equity for $30 of debt. This was extreme, but not uncharacteristic of the financial sector everywhere. While the gearing made banks vulnerable, the more basic problem was that they lent to people who couldn't repay, backed by collateral which was grossly inadequate when housing prices fell. Even small losses extinguished banks' inadequate equity.

The knock-on problem demonstrated the classic Achilles' heel of all financial systems: when sentiment changes, the depositors demand their money back.

Japan did not experience its 'lost decade' just because debt/income was high. The key problem was a banking system weighed down by bad corporate lending. This problem was not addressed until 1999, nearly ten years into the lost decade. Nor is Greece experiencing its current problems just because its debt/income ratio is high. For a decade its grossly unsustainable fiscal position was facilitated by cheap funding made possible by Euro membership.

The debt ratio analysis fails to recognise that different countries got into trouble for different reasons. If the diagnosis differs between countries, so too does the prescription. The answer is not to put policy on hold waiting for debtors to grind down their debts by demand-sapping saving. Greek debt is unsustainable, and has to be largely written off. The knock-on effect for European bank balance sheets will require official assistance. The US needs a combination of short-term stimulus (which might include some measures of mortgage debt relief) and medium-term restoration of the fiscal position.

None of these countries will be helped by inflicting a long recession while balance sheets are gradually returned to some historical debt ratio. Nor do countries need to return to the repressed financial sectors that kept household debt ratios low. Larger, more complex balance sheets, with more assets and more liabilities, are sustainable for households and countries alike. Singapore and Switzerland have huge foreign liabilities, but also huge foreign assets.

Sophisticated financial sectors give households and governments enough rope to hang themselves. In the years leading up to 2008, the financial sector grew too big. It also did a poor job of intermediation, price discovery and risk management. This has to change. But simple rules-of-thumb are not much help in guiding this reform, or for avoiding prolonged recession.

Photo by Flickr user respres.

The second thread of the argument is about convergence. If a country starts out with low income and capital stock, it ought to be able to grow very quickly as it implements high-productivity techniques borrowed from overseas, as the capital stock per worker rises and as underemployed rural workers move to high-value work such as manufacturing. These above-average growth rates might continue until the economy uses up these convergence opportunities.

The classic example is Japan, where per capita annual growth was over 7% in the three decades after World War II. Japan came out of the war with its production capacity devastated, but with strong institutions, technology and entrepreneurial experience. It experienced a four-decades-long convergence catch-up. It then ran into the lost decade of the 1990s and has since grown slowly, with not the remotest prospect of returning to earlier growth rates.

Taken at face value, the convergence argument doesn't seem to foretell a slowing in China. Japan slowed only when it could no longer make the easy gains from adaptation of borrowed technology. This would suggest that China, still only one-quarter of the way towards the technological frontier, still has decades of potential convergence ahead.

Dani Rodrik and Barry Eichengreen offered more carefully argued ideas on convergence (with China in mind), at the recent Jackson Hole conference.

Of course, de-railings on the way to the technological frontier are common. But since 1950, 24 countries have averaged per capita growth of more than 4.5% for three decades or more. Rodrik tries to distill a consistent generalised story of the convergence journey from diverse country experience.

There is nothing automatic about convergence. But nor is there anything automatic about interruptions to the path. Each of the countries that slowed was unhappy in its own way. While the average fast-growth period is sixteen years, there is enormous variation around this. The lesson may be that it takes consistently smart policy (and luck) to stay on the convergence path. Not many can do it, but it is possible.

Thus if China, India, Brazil and the rest of non-Japan Asia are going to save the world economy by continuing to grow quickly, they have to get a lot right. In China's case, this is where the first thread of the Pettis' argument is crucial. China's investment pace makes it inevitable that some of the projects will be white elephants, and at some stage this extraordinary capital accumulation has to slow.

But it's not obvious that China has overbuilt in general. Economies usually need around $4 dollars of capital to produce $1 of output. On this basis, China needed to invest 40% of its GDP to create the capital required for its 10% growth. To increase the ratio of capital to output (which is part of the convergence story), China's investment had to grow even faster — which it did.

There are still many Chinese without adequate electricity and running water, and urbanisation will require further huge investment in housing and infrastructure. Increasing consumption could offset the loss of exports to advanced countries. Big wage increases would produce a de facto appreciation, reducing external imbalances. Inflation would remain uncomfortably high, but politically-critical prices can still be kept stable.

China's huge saving reflects the high retained profits of state-owned enterprises, giving room to absorb the bad debts within the overall government sector. Thus it's possible to map-out a set of adjustments which would keep China on a high-growth track.

Of course, Pettis may turn out to be right. Consumption is currently only 35% of GDP, so would have to grow much faster than GDP to have much effect. But China's policy challenges (reducing savings, getting consumption up and the current account surplus down) seem infinitely easier than the challenges faced by America, which has to narrow the huge budget deficit by raising taxes and rein in the external deficit by expanding exports.

One thing is clear: if Pettis is right, the world economy is in for a bleak period.

Photo by Flickr user Jakob Montrasio.

Against these destructive forces, the hope is that there are enough politicians who recognise that persistent 9% unemployment leaves long–term scars on the economy. They might also acknowledge that the Tea Party's small–government agenda doesn't take America back to the resilient self–sufficiency of the Founding Fathers, but to a level of government services totally inappropriate for a modern advanced country.

Whatever excuses the politicians have for inaction, there is no excuse for the failure of economists to put forward, loud and clear, the case for an active policy response to the stalling recovery. Why are economists' voices so muted?

Some called the recovery wrongly, and are reluctant to admit they made a mistake. For example, in June the Bank for International Settlements assessed the recovery to be firmly on track, and urged countries to tighten both monetary and fiscal policy. Bad call, even with the data available at the time. Other economists have not yet noticed the poor fit between the real world, and their view of how it works, which assumes that the self–equilibrating forces in the economy are very strong and efficient markets will allocate resources optimally.

Others are de–facto advocates of inaction, because they see the current recession as being different from the usual downturn. Historically, most recessions have been caused by tight policy responding to inflation. This time, the central problem was private–sector over-borrowing. There is a legacy of over-leveraged balance sheets which have to be whittled away into a sustainable shape. This takes time, and it is argued that policy can't do much to speed up the adjustment.

But is this the central issue in America? Certainly, the recession started with sub–prime over–borrowing. In the decades since financial deregulation, households have geared up, taking their debt to around 150% of income. But is this oft–quoted figure all that alarming?

A more relevant comparison is the asset/liability ratio. This has also grown since financial deregulation (this type of balance sheet expansion was, after all, the principal motivation for deregulation). But household assets have also increased and are now four times larger than liabilities. Restating this, the household debt/equity ratio is 1:3, which any company would regard as astonishingly conservative.

Speaking of companies, their balance sheets are in fine shape and their profits excellent. It's just that none of them wants to invest. What about the bank balance sheets? Of course they have bad debts to write off. Bank of America is still paying for its foolish take–over of Countrywide's mortgage portfolio just as the crisis unfolded. But with low funding costs, banks' margins are fat and their balance sheets are quickly recovering.

What about the government balance sheet? It is quickly slipping the wrong way, and will soon be in unsustainable territory. But this is largely the result of the recession. Whereas time might help household balance sheets, a long recession will make the government's position much worse.

The economics is simple. Rather than urge Bernanke to undertake QE3 (which will have little effect), mainstream economists should be calling for Congress to come up with a credible plan for a sustainable fiscal position, to be implemented when the economy recovers. As well, to hasten this recovery, economists should identify specific stimulus actions (some directed at speeding resolution of the mortgage mess, some aimed at encouraging employment).

The 2009 stimulus, hamstrung by a fractious Congress, was so timid as to be inadequate. Successful stimulus programs (eg Australia and China) are characteristically too big, and the measure of their success is that afterwards they are criticised as being unnecessary.

All this, you might say, is America's debate and foreigners should mind their own business. But this, combined with Europe's inability to sort out the minor problem of Greece, has taken the world economy into dangerous territory, for which we are all paying the price.

Photo by Flickr user Andrew Michaels.

When the Fed buys bonds, it increases the supply of 'base money'. The public doesn't want to hold any more of this base money in the form of currency, but nor does it need to get rid of the excess by buying more goods. Instead, the money is deposited in the commercial banks. The banks don't use this extra money to fund additional credit expansion: the banks have already lent to all the bankable borrowers. The extra base money accumulates in the balance sheets of the banks, with little effect.

The motivation for QE comes from the other 'leg' of the QE transaction: the Fed's purchase of bonds. This is intended to lower medium-term interest rates, in the hope that this will stimulate demand for loans.

There is no evidence that QE has actually achieved this objective. Interest rates on 10-year bonds during the two QE operations were much the same as they had been beforehand. When QEII finished at the end of June, interest rates didn't rise (as many had predicted); they actually fell.

QE probably did have some impact on confidence. It was a declaration that the Fed cared about the weakness of the economy and would do all it could to stimulate the economy. This confidence effect probably helped the stock market, at least until recent weeks.

Bernanke has taken one further step: he has promised to keep the policy interest rates at zero for two years. This did have the expected effect on the yield curve: the two-year bond rate is now zero. This may stimulate demand for borrowing, but the effect is likely to be marginal.

If Bernanke can be faulted in principle, it is not because he has 'printed money', but because he has been supporting the government bond market. One of the key elements of central bank independence is that central banks should not be forced to fund fiscal deficits. They may choose to do so in special circumstances, but they know that they are opening a chink in their independence armour. Thus Bernanke will hope to avoid another QE operation.

Nevertheless, the spotlight is on him. By tradition, he is the key speaker at the annual central bankers' conference at Jackson Hole later in August. What he says there will not be all that important in a technical sense: he has done just about everything that a central banker can do. But his words will be parsed and finely analysed to try to squeeze meaning out of them.

He needs to go on showing that he cares about the stagnant economy. At the same time he has to do this in the face of political pressure that is as unrelenting as it is mindless.

Photo by Flickr user Gage Skidmore.

The foolish notion that government revenues cannot be increased has gathered momentum because some see no better way of addressing wasteful government expenditures: the strategy is to 'starve the beast'. If the Democrats can show that they are willing to contain expenditures, the silliness of the Tea Party position can be exposed.

Which taxes should be raised? There seem plenty of opportunities to create a system which is both more efficient (preserving incentives) and gathers more revenue. The US has no VAT at the federal level. Petrol is still cheap, thus there is room for an energy tax. Ending the Bush tax cuts for the rich would take their formal rates up to levels which most of the rest of the world would regard as moderate (the top marginal rate would be 45-50%).

More importantly, the myriad loopholes introduced by Congress to help their favoured constituents need to be put under the microscope. What about that subsidy for ethanol, which has resulted in the huge distortion of turning 40% of the corn crop into inefficient fuel?

Inaction cannot be the optimal answer. What is happening in the US is not comparable to the UK's current bold experiment (Sir Humphrey would call it 'courageous') to tackle the debt position through painful budget austerity. All the early evidence is that this isn't working and last week's riots give the debate another dimension. 

Whatever the outcome of the UK experiment, the US policy paralysis is not a balanced mixture of austerity and tax increases (the UK VAT is in the process of going up to 20%). Instead, the current US position is an accidental byproduct of dysfunctional politics. 'Starve the beast' is not a recipe for reform, but for years of stagnation. The commendable objective of reducing government waste is not sensibly achieved by a random reduction of funding.

The debt-ceiling arm-wrestle has left the protagonists exhausted, political capital and goodwill used up and doctrinaire positions more deeply entrenched. This leaves the US unable to address the serious fundamental economic issues it faces. With its own house in disarray, it is unable to lend a hand with Europe's debt mess.

Without the ongoing growth of the emerging economies, the world outlook would be dismal indeed.

Photo by Flickr user enamic5.

The GFC was good news for the big banks, which now have less competition and the opportunity to fatten up their lending margins. There was no housing over-building, so there is no wreckage from a housing collapse. The banks demonstrated in 2008 that they can survive the worst a global meltdown can hand out.

Macro policy is in good shape, with the budget headed for surplus and interest rates around normal, giving room for maneuver if needed. Government debt is negligible. The obverse of the commodity price boom is that inflation is a bit higher than normal, but wages are growing moderately, suggesting a stable inflation outlook.

Of course there are counter-points to this long merit list. The minerals boom will require a painful restructuring in other industries to make room for the extra investment. The appreciated exchange rate makes life uncomfortable for the non-resource traded sector. Households are rebuilding their balance sheets and re-thinking their savings strategies.

What about that weak government in Canberra? It's easy to get depressed by the compromises and prevarications of democratic politics, but compared with Washington, Canberra seems an oasis of rationality. There are some lost opportunities to do better, but that's life. The carbon tax was predicted to be the end of Wollongong and the entire coal industry, but even its critics are coming to realise that, compared with other forces impinging on profitability, this is small beer.

How does this compare with the rest of the advanced world? Even leaving aside the basket-cases of Greece and Ireland, both the US and Europe are in a mess, and Japan still isn't over its 1990 bubble-burst. The GFC recession has left most countries with budget deficits of around 10% of GDP and debt escalating upwards of 100% of GDP.

With unemployment at an unacceptable 9.2%, the US has long ago fired off all the ammunition in its macro armoury, with budget deficits already high and monetary policy settings at zero. The burst housing bubble has left a messy legacy for both home-owners and banks. US politics is so dysfunctional that a doctrinal arm-wrestle between the two parties brought the country to the brink of default, totally distracting policy from the underlying problems and triggering a rating down-grade.

Europe is making such a mess of the Greek rescue that contagion is now threatening Italy and Spain, countries with quite different fundamentals. The UK is on a forced-march to get its official debt position under control, with austerity as far ahead as the eye can see.

Seeing Australia's stellar performance and the parlous position overseas, you might think that overseas investment funds would be flooding in our direction, pushing up the exchange rate and equity prices to levels which pose serious risk of over-valuation. You might expect to see bond yields forced down by eager foreign investors seeking safe yield (Australia retains its AAA rating) in a risky world.

So how did markets react to last week's sharp fall in US share prices? Australian equity prices fell more than foreign markets, and the exchange rate lost five cents against a weakening US dollar. A US investor holding Australian shares at the beginning of last week would now be 15% poorer on this investment. Far from seeing bond yields bid down by eager investors, our bonds offer almost twice the yield of US bonds, and not far short of the yields which embattled Italy and Spain pay.

Perhaps, as some observers say, the market is worried about our dependence on China, and as the US weakens, this will end China's growth, dragging Australia down with it. But the GFC gave us a real-life stress-test of this possibility: China sailed through largely unaffected, thanks to active macro-policy and its own intrinsic domestic dynamic.

That leaves the possibility that our own financial markets have managed to talk themselves into discounting the product. Rather than attempt serious analysis of the underlying fundamentals, decisions are taken on the basis of some facile rule of thumb: Australia is a 'risk play'. Henny Penny professional doom-sayers with a proven track record of forecast failure are still given space on the soap-box, to proclaim that they might have been wrong about the sky falling last week, but it will fall next week for sure. Policy pundits can argue that the central bank should have raised interest rates two days before this world melt-down, and no-one blows a raspberry in their face.

If we predict disaster loudly and long, it might just happen.

Photo by Flickr user old.pappous.