Two incidents in the last week have highlighted that the new ‘new world order’ is a dangerous place, and not just in obvious war hot spots such as Afghanistan, Iraq and Somalia. In China, iron ore negotiator Stern Hu has been detained under state security laws along with three other Rio Tinto employees. Mr Hu is lucky; he is still alive. The shooting murder of Drew Grant at West Papua’s Freeport gold mine is far more tragic, but was it also a negotiation ploy? Was he murdered, or allowed to be murdered to preserve lucrative security contracts for the Indonesian military?

In the context of the great progress Indonesia has made in achieving stability under the leadership of the newly re-elected Susilo Bambang Yudhoyono the death of Mr Grant and others at Freeport should jolt us out of complacency. The outcome of investigations, particularly allegations of military involvement should represent an important test of whether civilian government has really achieved supremacy in the archipelago. The participation of Australian Federal police in the investigation is a good sign, results will count for more, but they can’t undo the tragedy for the families involved.

Signs are not so good with China, but at least the harm can be undone.

The global financial crisis has reordered global power arrangements; the G8 and G7 meetings are now secondary to the G20. China sees itself as ascendant, America as over-stretched.

Such power plays are very dangerous times. The emergence of Germany as the most economic and demographically dynamic nation in Europe set the stage for World War I. The emergence of Japan and Germany’s grievances from the ending of first war led to World War II. The combined result of the wars was the fall of Europe and the rise of America and the Soviet Union. China is not unaware of the lessons of history and is plotting its path very carefully. Detaining Mr Hu is a political move, but has it misread the tea leaves? On the other hand, is Australia ready for the gambit?

It is sometimes said that if you owe $100,000 that is your problem, if you owe $100 million, that is the banks problem. America owes China over $1 trillion, but it is actually China that is in a vulnerable position. While economically in the dumps, the fundamental State of the Union is strong, China on the other hand is held together by the jackboot and the firing squad.

If the US follows the obvious solution, printing money and allowing the value of the US dollar to fall, increasing its competitiveness and reducing the real value of its debts then the main loser is China. It faces the choice of either allowing the Yuan to rise, reducing its competitiveness, or it imports inflation and creates the risk of increased internal social tension. This is perhaps why the Chinese see the iron-ore price as so important, and why it is willing to put on the jack boots in its negotiations with Rio Tinto. China needs price stability for social stability, Australia wants high prices to cushion the Australian economy from the global recession.

The case of Stern Hu appears to be one where the aggressive move is used to cover internal weakness. Rather than seeing the Hu case as one which highlights the diplomatic weakness of the Australian government, it is better to see that 20 years after Tiananmen Square, little has really changed. Events in Urumchi illustrate both points. The Liberal Opposition should not be hectoring the government into to making a false move, instead they should be loyal to Australia and support the government’s slow calculating approach. China’s strategic blunder in detaining Mr Hu should be treated as an opportunity. China has removed its mask of civility.

The longer Mr Hu is detained, the stronger the case can be put that the world needs more than one workshop of the world, that business should be investing in Vietnam, Bangladesh, India and Indonesia for low cost manufacturing. The longer Mr Hu is detained, the stronger is the case that not only Australia, but every nation of the world should preserve some manufacturing capacity for strategic security, for example uniforms, vehicles and other necessities for a nation at war. The iron-ore joint-venture between Rio-Tinto and BHP, which I would normally dismiss as anti-competitive, can and should be considered more positively. China has replaced its iron-ore negotiator with a government controlled panel, if buyers coordinate, so should the sellers.

There is some argument that China is more important to Australia than Australia is to China, and we should therefore ‘kowtow’ as visiting diplomats were required to do to the Chinese Emperors of old.

I disagree.

China is simply a workshop, very cost-competitive and with important ‘hub’ effects for particular industries, but there is nothing it makes that can’t be replicated elsewhere in the world. And in providing the rising living standards that are necessary for stability, part of China’s cost competitiveness will inevitably disappear. Australia’s advantages are not so easy to substitute. We are politically stable, resource rich and a relatively shorting shipping distance not only to China, but also anywhere else in South and East Asia. What China desires, India, Korea and Japan also desire. Perhaps growth won’t be as fast, but given even the iron-ore mountains won’t last forever, we shouldn’t be rushing to sell our children’s inheritance at bargain prices. While we may sell more in the short-run by kowtowing, it is a Faustian bargain that will make us poorer in the long-run.

It is also worth noting that you don’t need to be allies to trade. The idea that trade stability requires friendship or hegemony is a myth that has led to many a war, take Japan’s ill fated East Asian co-prosperity sphere for example. During the cold war between the western nations and the Soviet Union, significant trade took place, particularly from 1973, with Russia supplying gas to Germany and the United States supplying wheat to Russia.

While it may seem cold-hearted, the best way to secure Mr Hu’s release and the future freedom of other business men in China is not through hectoring, mega-phone diplomacy or seeking any one-on-one understanding between our Prime Minister and the Chinese President. Instead it is through reinvigorating our engagement with Asian democracies, particularly India, Japan and Taiwan at a diplomatic, economic and military level. Make it clear that the detention of Mr Hu is not to Australia’s cost, but China’s. In its barbarity it is China that loses face.

So far so good for the Australian government’s response to the economic crisis, not so in the US and much of Europe.  Why is this happening and what is to be done about it?

The Rudd government’s response to the financial crisis has so far been a good effort, strong spending, rapidly applied and strong support to states to maintain their spending activities.

The only misstep seems to be on the banks.  While some form of guarantee was necessary to stop contagion of the wholesale bank funding collapse spreading to the Australian markets, the simplistic implementation has resulted in the ‘Big Four’ now looking to dominate the Australian market at the expense of consumers and then expand internationally on the back of a public guarantee.  While it can be argued that the Australian financial system has so far weathered the financial crisis well, this is more due to luck than design.  Australian banks were focusing on the booming Australian mortgage market rather than buying dodgy US mortgage assets, and the Australian housing market has so far had a soft landing, supported by China’s commodities buy-up, resilient employment and first home buyers subsidies.  However allowing this to then evolve into a cosy banking oligopoly could have dire consequences on Australia’s long-run competitiveness, and when competitiveness fails, house prices will eventually follow.

It was wrong for the competition authorities to allow the ‘Big Four’ to vacuum up the regional 5th mini pillars such as BankWest and St George that were the greatest source of competition and innovation in the market.  Perhaps these institutions took some risks in building market share, but there was never any question as to their solvency.  The authorities were simply caught in the financial panic they were trying to overcome.  By allowing financial institutions that are not systematically important to be swallowed up, the overall systematic risk actually increases, investors do not learn from the necessary occasional failure and those that remain believe themselves invincible.  Also, by allowing the banks to form an oligopoly, the Reserve Bank of Australia’s monetary policy capacity, the ability to influence the macro-economy by changing official interest rates has been severely weakened.  This is not so much a problem in the short-run, quite frankly any interest rate below 3% will fuel bubbles in susceptible asset markets more rapidly than genuine economic activity.  However the problem comes in supporting investment by businesses in the long-run and the cost that must be borne by the Australian economy in supporting oligopoly profits and or international empire building.

Monetary policy impotence is now a global phenomenon (with the exception of China) with zero or near zero interest rates across most of the rich world.  This has left fiscal policy, basically government expenditure and tax plans, to try and raise the world out of crisis.  In Australia this has worked so far, assisted by robust exports.  In Europe this has been hamstrung, firstly by a lack of coordinated effort and the fall in exports.  Some countries like Germany fear the debt and inflation bogeyman and hide behind their automatic stabilisers, effectively generous unemployment benefit regimes, to say they are doing enough.  Unfortunately paying people to stay at home or only to work part time is not the same as stimulating economic activity.  It may support some levels of spending, but people will still not have the confidence to make the major purchases that get factories working.  They will also not try as hard to find new work by being willing to move, geographically or into new sectors.  These payments are palliative, not stimulatory, effectively the government making payments that in the US would be made up from private savings, private insurance, asset sale or borrowing.

In the United States the problem is fundamentally driven by the vertical fiscal imbalance between the States and the Federal Government.  The Federal Government is trying to spend money, but is having trouble spending it fast enough, while states are trying to cut spending to balance budgets as state revenue streams collapse.  The crisis in California, where the state government is putting public workers on furlough and is about to issue IOUs to pay its bills after failing to pass a budget through its legislature is simply the most extreme example.  In such an environment, not to mention continuing falls in house prices, the collapse of General Motors and other corporations, it is not surprising that employments is rising and the confidence in ‘green shoots’ is being snapped by frost.

The problem is fundamentally a lack of a coherent understanding of what the global economic crisis represents.  While the financial crisis was created by an excess of debt relative to income, the economic crisis is fundamentally different.  Concepts like ‘debt’ do not exist at a global macro-economic level; debtors and creditors cancel out.  The world as a whole cannot ‘indebt’ itself; there are no Martians from which to borrow and no goods that can be delivered from Mars.  The financial crisis was created at a macro level by the desire of emerging economies, particularly Asian and aging European economies to build up financial assets.  These financial assets were created by the United States financial system.  In the process both the European, Asian and US economies were able to achieve impressive levels of economic growth and stability.

There is now a global lack of demand, people are not ordering the goods that others are willing to produce, and everybody is worse off.  Part of the problem is the perverse impact of interest rates on saving.  Part of the willingness of global savers to buy ‘dodgy’ US financial assets was their rational greed for higher yield against a back drop of low financial volatility, however now faced with significant losses and even lower yields, people are trying to save more and not less.  The interest rate pricing signal is failing.  To save is to spend less than one earns, to demand a little less of others than is demanded of oneself.  Unless there are borrowers to match the savers the collective impact is a collapse in demand, and currently only governments are willing to borrow.

The fundamental problem is the lack of ‘real’ financial assets.  With the exception of gold, every financial asset represents a claim of liability against another party, be it Lehman Brothers or the Bank of England.  Understandably the price of gold has risen, but during the boom years, most financial assets were created privately, rather than publicly, so there was a risk of default.  The value of many of these assets has collapsed and while governments have significantly increased their creation of financial assets, this is not yet enough to replace the collapse in the private sector, particularly in the face of increased demand for ‘financial security’.

The solution is therefore obvious, the central banks must create more financial assets, which they are doing.  The problem is the lack of international coordination.  If one central bank creates excessive financial assets then there is the risk of a failure of confidence, the price of those financial assets fails, leading to depreciation and inflation.  Globally there cannot be inflation until demand exceeds supply, but any individual currency can collapse if confidence fails.  The doomsayers of debt are at the ready to decry any individual currency that appears to be creating too many financial assets too fast.  Of the significant economies, the British Pound seems most at risk, while only posturing politicians need be worried about Australia’s low levels of debt.  The elephant in the room is the United States dollar.  As the global reserve currency, an expanding supply of US financial assets is fundamental to resolving the global money shortage, but with such massive holdings of US dollar assets by other central banks such as China, and a policy of denial by the European Central Bank, there may well be turbulence on the road.  Any slow-down of US financial asset creation will doom the world to long period of recession, depression and deflation.  There is talk of another US stimulus plan, this is probably necessary, but will it be enough if other countries won’t play their part.

An alternative source of global financial assets would be a significant large issuance of Special Drawing Rights or SDRs by the IMF.  The benefit of such instruments is that they are not coloured by the United States origins of the financial crisis and could also be used to finance demand at an international level.  The G-20 authorised the creation of $250 billion in new SDRs in April 2009 to support IMF members, but the mechanism for its allocation has not been finalised.  The coming global talks on climate change in Copenhagen are another opportunity.  These talks need to succeed to create a reason for investment and new demand that will help feed a global economic recovery.  A sticking point is the creation and funding of a $120 billion climate adjustment fund for developing economies.  This fund could be managed by the World Bank and funded by the creation of new SDRs by the IMF without any individual country having to indebt itself.  All countries would need to do would be to ensure that their central banks were willing to accept the SDRs in return for their own currency, be they Euros, dollars, Yen or Yuan.

While nay-sayers still talk of the global slow-down as a reason to do nothing about climate change, it is more likely that saving the planet and saving the world’s economy are intrinsically linked.