Reserve to move on interest rates ... but danger looms

Bankers everywhere are inclined to be a bit short on the lessons of history. China's bankers have been lending like there is no tomorrow. Added to the Chinese government's massive fiscal stimulus, the bankers' largesse has fostered revival with immense rapidity, and the economy is headed for double-digit growth in 2010. The world, and especially Australians and other resource exporters, have cheered. China's leaders are now trying to rein in their bankers, but like bankers everywhere, they also feel the hot wind of economic forces.

There is a direct but badly understood link between US 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 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.

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 labour. These demands will quickly run up against renewed union power and constraints of the Labor government's Fair Work legislation.

Filled with optimism, in stark contrast to the deep pessimism experienced for much of the past two years, Treasury officials and senior ministers are speaking of the challenges of a much larger population and the need for greater productivity.

Australia coped well during the global downturn. We could afford a large dose of fiscal stimulus - although not the waste and debt that were its inevitable by-products. Our flexible labour market helped limit increases to unemployment though, as in other "developed" nations, one can add large numbers to the official estimates for discouraged workers and the underemployed.

But now the labour market is far less flexible, and recovery is occurring from a still inflationary economy. This fact alone will keep the Reserve Bank leaders' minds on the need to briskly withdraw "emergency" monetary policy.