Hamish McRae: What global economic challenges would a 'G10' agenda have to meet?

'The increase in the use of biofuels is hitting some of the poorest people in the world, who have to pay more for food'

The G8 meeting next week will be dominated by the usual suspects: US/Russian tensions over a missile shield, global warming, coordinating aid to Africa and so on. All these, and the several others, are worthy enough issues but they are not the stuff of immediate concern to people interested in the development of the world economy. It is almost as though the durability of the long boom is taken for granted. The summits, originally called to help tackle global economic problems, assume that the economy is fine: globalisation and growth roll on forever.

In one sense we should be relieved. When the first economic summit was called by the then French president President Valéry Giscard d'Estaing at the chateau of Rambouillet near Paris in November 1975, the world was struggling to cope with the consequences of the first oil shock. It was a world of rising inflation, rising unemployment and stagnant growth. It was also a half-world, for some 60 per cent of the world's population did not live in a functioning market economy. The market reforms in China, Russia, eastern Europe and India were still between four and 17 years away.

But before rejoicing at the global reach of the market system, we should recognise that while there is something close to a single market economy, the political mechanisms for co-ordinating economic are arguably weaker now than they were in 1975. Then, the six countries at Rambouillet generated about two-thirds of world GDP and the proportion was rising. Now the eight next week at Heiligendamm generate about half world GDP and that share is shrinking. While China and India attend the summit, they do so as observers rather than members. It is not clear that they would want to join, even if asked. China refuses to commit itself, while India has made it clear that it wants nothing to do with some of the issues at the G8, most notably controls on carbon emissions.

Yet we were reminded just yesterday of the way in which events outside the ambit of the G8 affect them: a rise in Chinese share trading duty led to sharp falls on the Shanghai stock market, which in turn rippled across the rest of the world.

So the G8 should be expanded to include China and India. But were that to happen, the agenda would be different. Were one constructing a "shadow G10" agenda, what would be on it?

Issue one would surely be the global imbalances: the extent to which some 80 per cent of the world's net savings come from Asia and the Middle East. The conventional answer to that is that the US has drawn in too much of those savings to support its consumer boom and that China and Japan (the main sources of the savings) have been complicit with this. China has held down its exchange rate to boost exports; Japan has held down interest rates, and hence the exchange rate, to the same effect.

But another way of looking at this would be to ask: why there are not more opportunities for investment in China and Japan? Funds flow to the place where they are likely to get the best return. So money coming out of China and Japan into the US is in a sense rejecting domestic opportunities. Is it that markets are too narrow? Or, in the case of Japan, has the low interest-rate policy led to misallocation of capital? You can understand the oil exporters of the Middle East finding it hard to invest the sudden increase in the flow of funds but surely not in China or Japan.

In an ideal world this sort of gigantic economic issue would be one that could be informally discussed at an economic summit. The original idea of these summits was that they should be very informal: a place to exchange concerns rather than to produce set-piece policies. Right now there is no such place to do so.

Other issues would include the extent to which instability in one set of financial markets in one part of the world might affect others. For example the past 18 months has seen very strong growth in share prices in the emerging markets, together with a corresponding fall in bond yields. If this were just a part of a more general improvement in financial conditions in these markets, that would be admirable. But if it were a sign of a financial bubble then it would be alarming.

Another "shadow G10" issue would be commodity prices. The issue is not just what has been happening to the oil price, or indeed other commodity prices, it is what has also been happening to global food prices. Grain prices are being pushed up by demand for maize for bio-fuels, which in turn is pushing meat prices. It is really troubling that the perfectly proper desire to increase the use of bio-fuels is having the effect of hitting some of the poorest people in the world, who have to pay more for their food.

Still another issue is the extent to which world financial markets have become happy to take on risk at a very low premium for that risk, while possibly not understanding the risk that they are accepting. That final graph shows what has been happening to US high-quality bond yields compared with the financing needs of companies. The point here, well made in a new review of investment by Citigroup, is that you could either describe the world markets as having excess liquidity or as having a robust appetite for risk. It inclines towards the latter characterisation but it notes that there are challenges ahead.

To say that is not to predict that there is something terrible round the corner. The point is more that should some external shock unseat financial markets' present self-confidence, then the markets would be pretty much on their own. They could not rely on the world's main governments producing a co-ordinated response. Now you could argue that this is no bad thing. Governments have not a very good record at intervention in global economic matters. Better to let the markets get on with it, choreographed if need be by the main central banks. But that ignores the markets' ability to head off in spurts of over-enthusiasm: Maynard Keynes' "animal spirits" and Alan Greenspan's "irrational exuberance".

In the last global downturn the West's central banks, and in particular the US Fed, slashed interest rates and thereby supported the world economy. But that had a cost and a similar policy might not work again. This time it would need the Chinese and the Indian authorities to participate too. Are the links there? Not really. That is what is troubling about the G8 meeting next week.