China has no chance of controlling its economy properly unless and until it allows its currency to float.

Its current 'managed' currency is like Australia's 'crawling peg', described in its day by the Reserve Bank juniors as a 'crawling pig'.

Today we learn from Michael Stutchbury about a long report on China's economy from the Organisation for Economic Co-operation and Development (OECD).

'Pretty much as Australia figured out by the early 1980s, China’s attempt to maintain an undervalued exchange rate to promote exports comes at the expense of a loss of control over the domestic economy. To maintain its breakneck growth, Beijing will have to move from blunt credit controls to the sort of market-based financial regime that operates in advanced economies.

“China will eventually require a flexible exchange rate regime with open capital markets,” the Paris-based OECD concludes.

As we said recently: 'There is a direct but badly understood link between America’s monetary policy and China’s banking system. The essential linkage point is created by China’s relatively fixed exchange rate.  The liquidity pumped out by the US Fed spreads globally, and China’s strong economy attracts a large share of the Fed’s easy money. China’s banks find themselves able to fund greatly expanded economic activity, including property and share purchases that drive up prices in those asset markets.

'The liquidity pumped out by the US Fed spreads globally, and China's strong economy attracts a large share of the Fed's easy money. China's banks find themselves able to fund greatly expanded economic activity, including property and share purchases that drive up prices in those asset markets.

'Australia went through this damaging cycle of frustration and policy impotence in the late 1960s and early 1970s. More than 40 years on, China is grappling with this problem and will learn there are no easy answers. Instructions to the banks may work better in a strong, centrally governed nation like China than they did in Australia, but one should not bet too much on this outcome.

'How China adjusts to its rising status as a global economic powerhouse, and how the rest of the world responds, will be one of the great stories of this century. The fallout will be vital for Australia, and this will be one of RBA chief Glenn Stevens's major concerns in coming months and years.

(See also 'The China problem'.)

 But there is more, courtesy of discussions at the Davos conference.

'At Davos, People’s Bank of China deputy governor Zhu Min pleaded for time. China had taken one generation to go through the sort of get-rich industrial revolution that had taken 60-80 years in the US and 150 years in Britain.

'Zhu argued it would take time to boost consumer spending; as an old-fashioned person he would not replace a ordinary glass with crystal just because he was richer. China’s exchange rate stability had been a steadying influence during the global crisis. Now the country was “ready” to deal with the exchange rate issue as the world exited the crisis.

“You will see progress day by day, year by year. I can promise you that,” Zhu said of China’s efforts to rebalance its economic growth away from exports. The question of intense interest to Australia will be whether this progress is fast enough to keep the political economy of rapid Chinese growth on the rails.

One assumes Mr Zhu is talking of a crawling pig, China style.  Such an animal made things worse for the Australian economy while it was in place - most notoriously during and immediately after the Federal election of 1983.

Then and on other occasions speculators made buckets of money guessing correctly on the direction the pig would crawl.

Henry can believe the Chinese officials might be more clever at burning the speculators than were the 'troika' of officials managing the currency, whose quaint ethos prevented any such behaviour.

But it is just not possible to have a 'managed' currency without also having an 'unmanaged' monetary policy.

That is international economics 101.

Should central bankers be able to spot and deal with asset bubbles?

Greenspan said no; Bernanke used say no but is beginning to hedge his bets; Glenn Stevens was reported in mid-2009 as mentioning the 'bubble' word with respect to the Australian housing market.

The relevant paragraph - which contains hints about the word 'bubble' - is as follows: 'A very real challenge in the near term is the following: how to ensure that the ready availability and low cost of housing finance is translated into more dwellings, not just higher prices. ... if all we end up with is higher prices and not many more dwellings – then it will be very disappointing, indeed quite disturbing. Not only would it confirm that there are serious supply- side impediments to producing one of the things that previous generations of Australians have taken for granted, namely affordable shelter, it would also pose elevated risks of problems of over-leverage and asset price deflation down the track.

Perhaps the 'Bubble' word escaped during question time, but Henry has not heard it personally from the governors' often pursed lips.

(The relevant press reports can be found by googling 'Glenn Stevens, bubble'.)

John Mauldin has been reading (via Kindle) the book This time is different by Reinhart and Rogoff previously reviewed here.

The concluding chapters of that book, which Henry has not yet read, contain an answer to the question about bubbles and their detection.

I shall quote from these chapters courtesy John Mauldin and return to the subject once the next parcel arrives from Amazon.

'... the outsized U.S. borrowing from abroad that occurred prior to the crisis (manifested in a sequence of gaping current account and trade balance deficits) was hardly the only warning signal. In fact, the U.S. economy, at the epicenter of the crisis, showed many other signs of being on the brink of a deep financial crisis. Other measures such as asset price inflation, most notably in the real estate sector, rising household leverage, and the slowing output - standard leading indicators of financial crises - all revealed worrisome symptoms. Indeed, from a purely quantitative perspective, the run-up to the U.S. financial crisis showed all the signs of an accident waiting to happen. Of course, the United States was hardly alone in showing classic warning signs of a financial crisis, with Great Britain, Spain, and Ireland, among other countries, experiencing many of the same symptoms'.

As to the facts the Fed should have noticed, and worried more about:
* '... the rise in asset prices was being fueled by a relentless increase in the ratio of household debt to GDP, against a backdrop of record lows in the personal saving rate. This ratio, which had been roughly stable at close to 80 percent of personal income until 1993, had risen to 120 percent in 2003 and to nearly 130 percent by mid-2006'.
* 'Outsized financial market returns were in fact greatly exaggerated by capital inflows, just as would be the case in emerging markets. What could in retrospect be recognized as huge regulatory mistakes, including the deregulation of the subprime mortgage market and the 2004 decision of the Securities and Exchange Commission to allow investment banks to triple their leverage ratios (that is, the ratio measuring the amount of risk to capital), appeared benign at the time'.
* 'Capital inflows pushed up borrowing and asset prices while reducing spreads on all sorts of risky assets, leading the International Monetary Fund to conclude in April 2007, in its twice-annual World Economic Outlook, that risks to the global economy had become extremely low and that, for the moment, there were no great worries. When the international agency charged with being the global watchdog declares that there are no risks, there is no surer sign that this time is different'.
* 'Above all, the huge run-up in housing prices - over 100 percent nationally over five years - should have been an alarm, especially fueled as it was by rising leverage. At the beginning of 2008, the total value of mortgages in the United States was approximately 90 percent of GDP. Policy makers should have decided several years prior to the crisis to deliberately take some steam out of the system. Unfortunately, efforts to maintain growth and prevent significant sharp stock market declines had the effect of taking the safety valve off the pressure cooker'. 

'Freshwater' economists, when they see a dollar coin on a footpart, never stoop to pick it up.

Is this because they get paid so much that one dollar is not worth the effort?

Not so, in general.  Rather the mind set is 'if it really were a dollar it would have already been picked up'.

(This delightful anecdote refers to the 'efficient markets hypothesis' so beloved of 'freshwater economists', ie those trained at or teaching in the University of Chicago. 'Saltwater' economists are the others, ie believers in persistent economic disequilibrium, requiring policy change.)

The point is that any capital market outcome in a free market economy by definition represents the considered outcome of all the market participants, and cannot therefore be thought of as a 'bubble' that might burst, bringing serious economic catastrophe in its wake.

The best of the 'freshwater' economists explain ten percent US unemployment (20 percent in Spain, and about to go higher) as due to some transitory misperception about the price of labor or technical breakthrough.

Reinhart and Rogoff's book about eight centuries of financial folly will, over time, be a serious antidote to the nonsense peddled by the so-called 'freshwater' economists.

Is Glenn Stevens a freshie or a saltie?

Would someone who was present at his speech of 28 July 2009 please let Henry know if the word 'bubble' really excaped those gubernatorial lips?

(Contact Henry here. )  

As what to do, when you find a bubble, the point is either:
* Add asset inflation to the measure of 'inflation' used to guide monetary policy; or
* Add asset inflation to the check list used to qualify goods and service inflation in setting monetary policy.

Henry's much read article on the subject is linked here.

How does the Reserve Bank do it - come up with the same theme as Henry?

Compare Henry three weeks ago with the RBA's latest economic commentary.

Sid Maher and Ewin Hannan report: 'THE Reserve Bank has warned of a wages blowout and higher inflation if the resources sector grows faster than expected, as it upgraded its economic forecasts and said unemployment had peaked.

'As Kevin Rudd and Tony Abbott squared off over the government's industrial relations policies, the RBA said capacity constraints in the construction sector remained a key risk to the economy. [Doesn't mention the war, RBA, WorkChoices v Fair Work.]

'Despite its domestic concerns, the RBA remains wary about the strength of the recovery of the global economy. World sharemarkets plunged yesterday after worse than expected jobless numbers in the US and concerns about government debt in Greece, Spain and Portugal stoked fears about the pace of world recovery'.

Read the RBA report for yourself here.

Also Terry McCrann's unusually forensic column - 'This time its different'.

The demise of WorkChoices may turn out to be one of Rudd's Labor's greatest mistake.

Julia Gillard has scrambled to correct her initial response to the case of the sacked young men from Terang, but there will be too many such cases to be 'solved' by divine intervention from Canberra.

The coming new global economic system.

Anatoly Kaletsky writes: 'THE most important statements are often those that are left unsaid. Among the millions of words spoken at last week's World Economic Forum in Davos, the comment that nobody quite dared to utter was clear. After the crisis of 2007-09, the global capitalist system is in a period of transition comparable with the great transitions of the 1930s and 1970s.

'The question that nobody wants to raise is whether the new model of capitalism that emerges to dominate the world will be a radically reformed version of the Western democratic system or some variant of the authoritarian state-led capitalism favoured in China, Russia and some other emerging economies.

'As a leading US diplomat told me: "Since the crisis, developing countries have lost interest in the old Washington consensus that promoted democracy and liberal economics.

"Wherever I go in the world, governments and business leaders talk about the new Beijing consensus -- the Chinese route to prosperity and power.

"The West must come up with a new model of capitalism that's consistent with our political values. Either we reinvent ourselves or we will lose."

Focus on China

Graeme Mills has been hard at work and here is his weekly report.  It contains a link to his 'Where to now America'.

From the archives - Henry's articles from China, plus one by a youngun.

The bus trip, Feb 2004  
Trip to China, Sept 2005  
Trains, Tiny Taxis, Tea and Grannies 
The coming Chinese productivity surge  
The emerging Chinese superpower  

Cartoon of the week

 Courtesy The Australian

The whole debate on climate change has lifted to a new level, as a result of the gritty but failed talks in copenhagen.

Henry's account of the current Australian debate is linked here.

Replacing Howard's WorkChoices with Rudd's Fair Work industrial relations system was a massive mistake, one that will greatly increase Australia's rate of inflation and nip in the bud the resurgent mining boom.

We said in mid-January, in commenting on the 'surprise' reduction of the rate of unemployment in December:

'Unemployment far better than expectations owes something to the strength of the rebound in China's economy.  Perhaps also to the stimulus packages, wasteful though most of that spending was.

'But it undoubtedly owes a fair bit to the much demonised WorkChoices legislation, much of which remained in place until the end of 2009.

'Now Australia is operating with all of Labor's new Fair Work legislation, starting January one of this year.

'Henry's fearless prediction is that from now labor market data will surprise on the downside.  If it does, we can only hope that the politicians can understand the message.  This includes the current Liberal leadership, who say that WorkChoices was a mistake.  Perhaps a political mistake, though it now looks as if nothing could have saved the Howard government by late 2007.

'If Henry's prediction turns out to be correct, abandoning WorkChoices will be seen as a big economic policy mistake, and the voters will have no-one to call upon, except Mr. Howard himself, assuming he could be coaxed out of retirement.  (About as likely as Shane Warne coming back for the next Ashes series, I suspect.)

Now, reports Andrew Burrell, in Australia's remote mining cornucopia, 'Rio Tinto warns of Pilbara industrial relations war' . 

'MINING giant Rio Tinto has warned that growing industrial unrest in Australia's booming resources sector could spread to its critical iron ore mines, as it prepares to start bargaining with unions over workers' pay and conditions for the first time in 15 years.

'The warning came as Fair Work Australia deputy president Brendan McCarthy was last night locked in a meeting with Woodside Energy in a last-ditch bid to stop workers building its $12 billion Pluto gas plant in the Pilbara from walking off the job again as early as today.

'In an internal memo obtained by The Australian, Rio Tinto Iron Ore chief executive Sam Walsh warned staff that the ramp-up in industrial activity under the Rudd government's new workplace laws could serve as an omen for Rio Tinto and other companies in the Pilbara.

'Mr Walsh described last week's illegal strike by 1600 Pluto workers over accommodation demands as "disappointing" and "unnecessary", and said the action had been "encouraged" by the militant Construction Forestry Mining and Energy Union'.

Then there is the tale of the youths no longer able to be employed for a few hours a week at the local hardware store, told with dramatic evidence from the coalface at Terang by Nicolas Perpitch.

A young man sacked said he is not happy about the change. "I was pretty annoyed," said Matthew, who had worked in the shop's timber yard for three years.

"I needed the job to keep a bit of money coming in, because I just bought a car with help from Mum and Dad. Without working, I can't pay them back."

He said the law was too strict.

"It doesn't cater for kids like me who want to do 1.5 hours after school to get a little bit of money and get a taste for work."

The mother of this young man is quoted as saying: "It's crazy. I'd rather see these kids work 1.5 hours than nothing," she said. "It's not just these kids it affects, it's everyone who has a casual job.

'The Terang co-operative is a owned by about 1800 shareholders from the surrounding community. It includes a Super IGA, a Home Hardware store and a CRT rural supplies store.

'The store is the single largest employer in Terang, employing about 110 people.

The store owner said there was not much other work around and it gave youths a crucial start.

"For a lot of kids, this is a starting point for them."

"They learn a lot by us employing them at that age. They save up to buy a first car, it teaches them to save money, to engage with the public, it prepares them to go out into the workforce. That's going to be gone -- it's tragic, I think."

Astoundingly, Julia Gillard did NOT immediately say something like 'Clearly this is an unintended consequence of our reform process, one we will fix immediately'.

Instead a 'spokesman' is quoted as saying:  "The government does not think it's unreasonable to have a set of minimum standards for employees, including the minimum number of hours they can work across Australia, as has been brought in under the simplified modern system."

Simplified? Modern?

Fair go comrades!

This is the nanny/bully state at full throttle.

And why am I not surprised that the rate of unemployment as measured by Roy Morgan has risen in January from 6.8 to 7.5 percent of a greatly increased workforce?  (Some offset comes from a reduction in underemployment, so the result is only suggestive).

Regular readers will recall that this rate has been falling, and in fact predicted that the (less accurate) ABS rate would fall sharply, as it did to great fanfare by Treasurer Swan, in December.

While monthly movements in both series can be volatile and therefore need to be taken with a grain of salt, the Roy Morgan unemployment number is a signal the tide may have turned for Australia's unemployment rate.

Economy watchers will also recall that job ads fell sharply in January.  Just a seasonal aberration?  Maybe.

[Footnote: By early afternoon Kevin Rudd and Jilia Gillard were saying the'd look into the Terang matter.  There will be many more such incidents, 'looking into' which will occupy great time and effort. What is needed, comrades, is 'A free labor market for free Australians'.].

Tony Abbott's becoming Liberal Party and opposition leader has changed the game on climate change in Australia. 

Of course, the fiasco that was Copenhagen played into his hands, but now some of the real options are getting airtime.

Lord Monckton has been striding our stages, rolling this memorable eyes, throwing abuse at the climate change worriers and advocating unchanged policy in his to Henry patronising, often simply rude, manner.

Glaciergate has hideously embarrassed the United Nations climate change fanatics, and done great damage to the cause of those who think there is a problem.

Australia's Chief Scientist, Professor Penny Sackett, has finally entered the debate, pleading it seems to Henry for a science-based approach to the subject and recognition that 'skeptic' should not be a term of abuse in any science-based debate.

Labor has reintroduced its ETS legislation, and there are fresh mutterings about a double dissolution election.  'Bring it on' says Tony Abbott.

Consensus seems to be building that solar, wind, tidal, geothermal and other 'renewable' resources cannot contribute much in any practical timeframe, though all these activities should be implemented, or at least trialled.  Perhaps solar has the best natural opportunity, depending as it does on the output of a powerful nuclear furnace in the galactic near neighbourhood.

While new methods of powering our civilisation are being developed, widespread use of nuclear power with severe limits on air travel and private use of motor vehicles might make a difference.  But there are big objections to nuclear power in Australia (though we are happy to export uranium) and any travel limit, or even serious tax-based hike in prices of petrol and airline fuel, would be greeted with howls of rage.

Malcolm Turnbull's biochar has been revived as part of Tony Abbott's plan to reduce carbon emissions by 5 %.  (Five percent, gadzooks!)

Former Keating minister Gary Johns today reports research that suggests forests may not be the carbon sink we had all assumed - Henry's weekend tree planting and watering efforts may need to be scaled back.

The focus should be on adaptation says Gary Johns, but one of his concluding paragraphs hit several nails on the head.

'If in future historians of public policy dig through the entrails of climate change they will find a fascinating combination of millenarianism, ego-driven scientists, business that preferred to use the environment as a sales device, a propensity by governments to allow NGOs to get too close to the policy process, a media that mistook stunts for debate, lying former politicians, and current politicians who wanted to ride the hero's wave, retiring before their purported policies bore no fruit'.

One of the comfort factors for Kevin Rudd was the polls showed a large majority of Australians wanted climate change action.

Henry's friends seem about equally divided between worriers and skeptics, though the latter do not hold back in deriding his precautionary approach - let's act in case there is a problem, and if it turns out to have been unnecessary there will be net benefits anyway.

Lord Monckton's example of children starving because of biofuel production replacing food production shows it ain't necessarily so.  But there are other examples like less smog, cleaner waterways and greater species diversity that might show net benefits, the great lord's assertions to the contrary.

But on the polls, is it possible that Australians said 'yes' to questions about their concerns for two reasons - the first because it seemed the socially appropriate thing to do, and the second because the actions to reduce carbon emissions were implicitly regarded as costless?

Now the debate has got serious, it is clear there are no easy options, no free clean air, pure water or unpolluting electricity.

So it should be no surprise if the polls begin to shift in the skeptic's direction, and a double dissolution election, or any election in the next year or so, may give Kevin Rudd the fright of his life.

Those who wish to comment may contact Henry here.

WE was wrong -- or were we? The Reserve Bank of Australia surprised just about everyone by leaving interest rates on hold yesterday.

The accompanying statement is longer than usual, but let us deconstruct it to find the reason we were wrong, or discover the basis of what was a surprising decision.

"The global economy is growing, and world GDP is expected to rise at close to trend pace in 2010 and 2011."

Tick for a rate hike, especially as “Chinese authorities are now seeking to reduce the degree of stimulus to their economy".

"In Australia, economic conditions have been stronger than expected, after a mild downturn a year ago."

Tick for a rate hike, especially since “The rate of unemployment appears to have peaked at a much lower level than earlier expected”.

"Inflation has, as expected, declined in underlying terms from its peak in 2008 ...” and “Inflation is expected to be consistent with the target in 2010."

Cross for a rate hike. Since this is the main target for monetary policy, it should be the end of the debate, provided of course the members of the board have confidence in the forecasts. Given his notoriously poor forecasting record -- recall 8.5 per cent unemployment - the Treasury secretary at least is entitled to be sceptical.

But there's more. "Why?" I hear you cry.

The RBA statement said: "Credit for housing has been expanding at a solid pace, and dwelling prices have risen significantly over the past year."

Tick for a rate hike, though the caveat that “credit conditions remain difficult for many smaller businesses” perhaps offsets that. Let’s say three quarters of a tick.

"With the risk of serious economic contraction in Australia having passed, the Board had moved at recent meetings to lessen the degree of monetary stimulus that was put in place when the outlook appeared to be much weaker. Lenders have generally raised rates a little more than the cash rate over recent months and most loan rates have risen by close to a percentage point. Since information about the early impact of those changes is still limited, the Board judged it appropriate to hold a steady setting of monetary policy for the time being.”

Starts as a tick for a rate hike, but fades into an excuse for holding steady for the time being.(*)

Finally: "Interest rates to most borrowers nonetheless remain lower than average. If economic conditions evolve broadly as expected, the Board considers it likely that monetary policy will, over time, need to be adjusted further in order to ensure that inflation remains consistent with the target over the medium term."

Strong tick for a rate hike before long.

But here's the rub.

"Inflation is expected to be consistent with the target in 2010." Yet there is a strong warning of rate hikes to come, and implicit acknowledgment that rates are not yet at a point that will stifle inflationary pressures.

Henry is a big believer that consistency is the sign of a middle class mind, but that is not the issue in this case.

This decision smacks of a staff recommendation being overturned by the practical persons on the board, perhaps led by the Secretary of the Treasury.

The big risk -- almost certainly not factored into staff or Treasury forecasts -- is that the end of WorkChoices facilitates the spread of the renewed boom in the resource states and industries.

To be continued ...

* See also report on business confidence below, which was available to the board yesterday. But I must protest that slowing sales at Woolworth's would have, or should have, no impact on the decision.  Check out the still brisk rate of growth - Australia is not trying to be the world champion consumerist nation, surely?

Business confidence sags, attributed to rate hikes.

'CONFIDENCE levels amongst Australian business owners slumped during December, hurt by three interest rate hikes in a row, according to an industry survey released today.

'But sentiment remains above its long run average with employment conditions especially strong, the survey showed.

'Corporate sentiment weakened across the retail, transport and recreation sectors in particular, likely illustrating growing strain from higher borrowing costs and a strong Australian dollar.

'However, a measure of confidence in the labour market jumped in the month to its highest level since May 2008, indicating employers are busy rehiring again'.

The world's leading journalists have been mingling with the great and the good at the Davos yapfest.

Michael Stutchbury sums up: 'THE dissonance was striking. The high priests of globalisation, gathered for their annual summit in the Swiss Alps resort of Davos, were relieved that they had pulled the world economy back from the brink of collapse.

'But their worshipped North Atlantic financial capitalism was in the stocks for causing the worst economic crisis since the 1930s. Worse still, the peasants were revolting against those cufflinked Wall Street bankers who had taken their taxpayer bailouts and then ripped out massive bonuses for themselves'.

There were other, more specific fears to reduce the usual sense of high-octane self regard.  Anatole Kaletsky says 'The elephant in the room tiptoed out at Davos'.

'Over everything, however, there hung the pall of two unspoken terrors: the possibility that last year’s financial heart attack might merely have been the precursor to the “Big One”, which really would prove fatal; and the certainty that, while America and Europe were quietly doing jigsaws in the rehabilitation ward, China was powering ahead'.

No-one wanted to discuss this awkward question.  'Could this have been the historic moment when Western liberal democracy lost its self-confidence and global prestige, leaving the authoritarian, government-led capitalism of China as the dominant politico-economic model destined to rule the world for centuries ahead?'

Like the conference participants, Kaletsky then returned to more prosaic matters.

His column discusses three specific questions, concerning Greece and the euro; the political stalemate in Washington; and the outlook for fiscal and monetary policy around the world.

On Henry's favourite subject of global economic policy, there were three conclusions:

* '... reducing public deficits was absolutely necessary in the long run, but less urgent than markets and public opinion seemed to believe'.
* '... given that political pressure is mounting everywhere to tighten fiscal policy more quickly than is desirable, interest rates will have to stay even lower for even longer than the markets expect'.
* Fixing the apparent US political deadlock would occur by including 'Republican goals blocked by the Democrats and Democratic objectives previously unacceptable to Republicans. An example was the new energy policy proposed in President Obama’s State of the Union speech. By including strong commitments to nuclear power and oil drilling, the Democrats may garner enough Republican support to pass an energy Bill that also includes carbon limits and emissions trading'.

Here is a link to Kaletsky's column, which is also reprinted in today's Australian.

So too is Henry's latest advice to the board of the Reserve. The headline is simple: 'Reserve to move but danger looms'.

For Henry, the elephant in the world economy is the direct but poorly understood link between America’s monetary policy and China’s banking system. The essential linkage point is created by China’s relatively fixed exchange rate.  The liquidity pumped out by the US Fed spreads globally, and China’s strong economy attracts a large share of the Fed’s easy money. China’s banks find themselves able to fund greatly expanded economic activity, including property and share purchases that drive up prices in those asset markets.

Australia went through this damaging cycle of frustration and policy impotence in the late 1960s and early 1970s.  More than forty years on, China is grappling with this problem and will learn there are no easy answers. Instructions to the banks may work better in a strong, centrally governed nation like China than they did in Australia, but one should not bet too much on this outcome.

How China adjusts to its rising status as a global economic powerhouse, and how the rest of the world responds, will be one of the great stories of this century.  The fallout will be vital for Australia, and this will be one of the RBA Chief, Glenn Stevens’, major concerns in coming months and years.

Australia is caught between its developed nation status and structure and its ‘developing nation’ heritage as a major producer of gold, food and other raw materials.  Like the world economy, Australia is a two speed economy. Resource producing areas and companies are already growing rapidly again, with renewed demands for skilled labor. These demands will quickly run up against renewed union power and constraints of the Labor government’s Fair work legislation.

Henry's column is linked here.

The American economy grew 5.7% (annual rate) during the last quarter of 2009, according to new government figures.

Smart analysts have been quick to say the December quarter surge is temporary, but concede the recession is over.  Absent another adverse economic shock, growth should be slower but positive in 2010.

The Wall Street Journal reports, 'White House economic adviser Lawrence Summers said U.S. fourth-quarter growth figures were “favorable,” but it will take years for the economy to return to its full potential.

'The 5.7% rise in gross domestic product “confirms what we’ve recognized for some time, that the president’s policies have moved the economy back from the brink of depression and have created a basis for economic growth.”'

Summers said Obama now wanted to focus on job creation, reducing the deficit and protecting the value of the American currency.

'When asked about the dollar’s status as a reserve currency, Summers said that’s for the market to determine, but he said he believes the dollar will “have a very central role in the international financial system for a very long time to come.”

For the dollar to remain a reserve currency, however, U.S. policymakers must pursue measures that create strong fundamentals, the former Treasury secretary said.

“That’s why the emphasis on budget deficit reduction was such an important component of the president’s State of the Union [on Wednesday],” said Summers.'

US jobs are still falling, perhaps stabilising.  'Roaring' GDP growth and stable or still falling jobs suggests a big productivity surge is underway.

This will serve the US well and it is likely to be seen to be emerging strongly from recession by the middle on 2010.

This is still a minority view, but is worth considering as one thinks about equity investment strategy for the year ahead.

It will also be a significant fact when the Reserve Bank board meets tomorrow.

It will probably also get an update on bank regulation reform, discussed well by The Economist here.

Henry's usual analysis will be available here tomorrow.

Base camp Basle

'The speed of the reaction is impressive and most of the proposals look sensible. Yet a feeling remains that the fine minds have evaded the really difficult question. If the banking system resembles a line of climbers roped together, then regulators are busy making the clothes warmer, the maps more accurate, the rations more filling and the whistles louder. Unfortunately none of that is any good if someone falls over the edge, as a handful of banks are wont to do in financial crises'.

This is The Economist's comment on the latest attempt to reform banking supervision.

And in conclusion: 'But the risk now is that regulators retreat into designing cleverer ways to make the average bank safer, while ignoring the greater question. That is not how to make regulation cleverer, but how to protect taxpayers from a huge bill when all the precautions fail and a bank steps into the void'.

Ben Bernanke reappointed

'THE US Senate voted 70-30 to reappoint Ben Bernanke for a second four-year term as chairman of the Federal Reserve.

'Earlier, senators voted 77-23 to end debate, clearing the way for a final vote.

'During more than two hours of debate on the Senate floor, Bernanke backers warned that voting him down risked sparking turmoil in US and foreign markets and thwarting a budding economic recovery. They said the Fed chairman deserved an opportunity to finish what he started.

"To vote against confirmation could unnerve investors and exacerbate economic uncertainty in the marketplace, which is exactly what we do not need at this time," said Senator Robert Menendez, a Democrat of New Jersey.
"We need the wisdom of patience," he said. "Let us not judge the man or the work prematurely."

'Critics assailed him for his record ahead of the crisis, from bank supervision to mortgage regulation to the financial rescue'.

China this week

Graeme Mills presents a new feature.  This focusses on 'gossip from the forest' - actually friends in China - and discussions on an English-language Chinese '7.30 Report' - we always knew the ABC gets its ideas from China now that Russia has abandoned true communism (Just joking!)

For a more structured source of China stories, visit Graeme's Kaixin site.

Cartoon of the week

'This paper offers a detailed quantitative overview of the history of financial crises dating from the mid-fourteenth century default of Edward III of England to the present subprime crisis in the United States. Our study is based on a comprehensive new statistical dataset compiled by the authors that covers every region of the world and spans several centuries.'

The relevant paper was written by Carmen M. Reinhart and Kenneth S. Rogoff, and published as an NBER (National Bureau of Economic Research) discussion paper in March 2008.  The events of late 2008 gave fresh impetus to this work, and there is a November 2009 book with a zappier title referring to 'Eight Centuries of Financial Folly' that I am pursuing, you guessed it, through Amazon.

The database covers a great span of years and countries, and is an heroic contribution to economic history. It will also, in due course, make a major contribution to economic policy.

The theme is that people forget crises, and every time there is a new crisis the cry goes up 'this time is different.'

It is nearer the mark to remind ourselves that those who forget history are condemned to repeat it.

Even in early 2008, the authors noted that 'policymakers should not be overly cheered by the absence of major external defaults from 2003 to 2007, after the wave of defaults in the preceding two decades. Serial default remains the norm, with international waves of defaults typically separated by many years, if not decades.'

By late, 2008 when Lehman Brothers was headed for bankruptcy and the global financial system was mired in oozing suspicion and lack of confidence, one can imagine the pursuit of the authors to produce a book that no doubt has already been read in many central banks and ministries of finance.

I do note that already the book is deeply discounted by Amazon, and if it is not being widely read, we should all be deeply concerned.

There are inevitable caveats about the extensive data set, and the authors ask for feedback.  They also note that their attempt to draw general conclusions inevitably overlooks details that might be important in specific cases.

Their "panoramic" overview, however, reveals important generalisations.

*  'First and foremost, we illustrate the near universality of episodes of serial default and high inflation in emerging markets, extending to Asia, Africa, and until not so long ago, Europe.

*  'We show that global debt crises have often radiated from the center through commodity prices, capital flows, interest rates, and shocks to investor confidence.

*  'We also show that the popular notion that today’s emerging markets are breaking new ground in their extensive reliance on domestic debt markets, is hardly new.

As said earlier, the 'central theme' is to discredit the view that 'this time is different.'

'There is a view today that both countries and creditors have learned from their mistakes. Thanks to better-informed macroeconomic policies and more discriminating lending practices, it is argued, the world is not likely to again see a major wave of defaults.'

'Capital flow/default cycles have been around since at least 1800 — if not before. Technology has changed, the height of humans has changed, and fashions have changed. Yet the ability of governments and investors to delude themselves, giving rise to periodic bouts of euphoria that usually end in tears, seems to have remained a constant.'

There is reason for Australians to feel proud of the fact that neither the colonies before 1900 or the Commonwealth after that, have defaulted on debt. We share this estimable result with United States, Canada and New Zealand.

But Australia has certainly experienced its share of banking failures, like the USA, the UK and Iceland in the great crash of 2008.

Following the great property bubble of the 1880s, centred on 'Marvellous Melbourne,' the bust took many banks with it. Of the 64 banks or quasi-banks operating in mid-1891, by mid-1893 54 had closed, 34 of them forever. (Trevor Sykes, Two Centuries of Panic, Allen and Unwin, 1988, Chapter 9, 'The banking crisis'.)

To return to Rienhart and Rogoff, 'Our dataset reveals that the phenomenon of serial default is a universal rite of passage through history for nearly all countries as they pass through the emerging market state of development. This includes not only Latin America, but Asia, the Middle East and Europe.

'We also find that high inflation, currency crashes, and debasements often go hand-in-hand with default. Last, but not least, we find that historically, significant waves of increased capital mobility are often followed by a string of domestic banking crises.'

With respect to sovereign debt, there are clear patterns in the data from 1800.

There are in fact five pronounced peaks of default in the data.

The first is during the Napoleonic War.

The second runs from the 1820s through the late 1840s, when, at times, nearly half the countries in the world were in default (including all of Latin America).

The third episode begins in the early 1870s and lasts for two decades - this is when an Australian/Victorian default was most likely.

The fourth episode begins in the Great Depression of the 1930s and extends through the early 1950s, when again nearly half of all countries stood in default.

The most recent default cycle encompasses the emerging market debt crises of the 1980s and 1990s.

'Indeed, when one weights countries by their share of global GDP, ... the lull of 2003-2007 stands out even more against the preceding century. Only the two decades before World War I — the halcyon days of the gold standard — exhibited tranquillity anywhere close to that of the 2003-to-2007 period.'

Sources: Lindert and Morton (1989), Macdonald (2003), Purcell and Kaufman (1993), Reinhart, Rogoff, and Savastano (2003), Suter (1992), and Standard and Poor’s (various years). Notes: Sample size includes all countries, a total of sixty six, that were independent states in the given year.

To come to the conclusion of clearest contemporary relevance: 'Looking forward, one cannot fail to note that whereas one and two decade lulls in defaults are not at all uncommon, each lull has invariably been followed by a new wave of default.'

This conclusion hints at more pain to come.  Further shocks, including another wave of bank failures, could create a major setback to the current two-speed recovery - 'tepid' in the developed Anglo nations, perhaps overheating in China, India and other developing nations.

Greece should be monitored carefully - a potential first Eurozone domino.

This is neither a threat nor a promise, just the obvious thought caused by reading about eight centuries of financial crises.

The NBER link is here, but you will be invited to pay US$5.  I found a free-to-air copy here.

This article posted today on The Australian's website.