Former prime minister and treasurer Paul Keating says fiscal stimulus is reaching its limits and even advanced nations are at risk of debt default if they continue to amass huge budget deficits and borrowings to rescue their economies.
"There is a limit to what fiscal policy can do simply because there is a limit to fiscal policy," Mr Keating told a Lowy Institute gathering in Sydney on Thursday.
"Is this sustainable? Who is going to buy the bonds?"
He cited in particular the huge bill the United States was running up in an effort to counter the recession and to bail out its banking system and strategic companies such as the insurer AIG.
"Is America going to default on its debt or be able to issue bonds?" he asked.
Governments across the globe will seek to borrow between $US3 trillion and $US4 trillion on bond markets in the coming year to fund stimulus packages and rescue packages for ailing banks and other financial institutions.
Mr Keating also says Australia's banks are among the strongest in the world because they went through their crisis earlier, in the 1990s, when they "came out of the recession we truly had to have".
Mr Keating was speaking before a select forum of opinion-leaders who had convened at the request of the British High Commission to discuss the coming G20 meeting in London.
He urged the world's leaders to forge a new global political and economic order at that meeting - one that would supplant the post-war settlement that handed "political power to the victors of World War II".
Mr Keating says Australia and other nations have done the right thing by implementing big stimulus packages, but he argues the spending has failed to "really change the level of confidence in the national or international economy".
"The big confidence effects will come when the public see that the world is run differently," he said.
"We have to take the political opportunity rather than relying on the mechanical effects of fiscal policy."
Mr Keating said the G20 should replace the "unrepresentative G7" as the key forum for global decision-making on economic reform.
The G20 represents 19 of the world's biggest economies and the European Union. Its membership covers every continent, and countries that produce 85 per cent of the world's output.
Mr Keating says the International Monetary Fund and the World Bank - the so-called Bretton Woods institutions formed in the wake of the Second World War - should be brought under the G20's control.
"Has this meeting got the bottle to pull the rein of the IMF, to make the IMF subordinate to the G20?" Mr Keating asked.
He says China will never be convinced to float its currency and stop amassing vast foreign currency reserves and excess savings unless the IMF is reformed.
Mr Keating said bringing the IMF under the yoke of the G20 was the only way to end key economic imbalances that had contributed to the global economic crisis, including a glut of savings in "creditor nations" such as China and a savings deficit in "debtor nations" such as Britain, Australia and the United States.
A similar plan has been proposed by the former Reserve Bank official, Stephen Grenville.
Globalisation
The trigger for the current crisis, in 2007, was a rapid rise in mortgage defaults in the United States, and the spreading of that default risk across the globe through the sale of structured financial products, residential mortgage backed securities and other 'toxic assets'.
But many believe the underlying cause of the crisis was a series of structural imbalances brought about by globalisation.
As emerging economies such as China and India joined the global trading system, there was a dramatic increase in the world labour supply and a flood of low-priced goods into western markets.
This had a powerful disinflationary effect. It helped lower interest rates; the cheap debt fuelled borrowings that drove up asset prices; and the low interest rates discouraged savings.
At the same time, China - aided by state control of its exchange rate that kept down the price of its exports - amassed huge foreign currency reserves.
There was, in effect, a tacit trade off. China suppressed the value of its currency and exported low-price goods to the West; then China funded the huge Budget and current account deficit in the US by buying Treasury bonds.
The glut of savings in China and other creditor nations fuelled excessive consumption in the West.
Mr Keating says ending this imbalance is crucial.
"The surplus countries have to spend more and save less and the deficit countries have to save more and spend less," he said.
But he said it would not happen unless the United States and the leading European countries "bring China and Russia into a new world hierarchy".
Although he backed assurances that Australian banks were sound, Mr Keating said they had "one great structural weakness - about a third of their money comes from the world".
He said this big offshore funding requirement - a major source of Australia's large current account deficit - meant it had been vital for the Australian Government to guarantee banks' borrowings through its AAA credit rating, even though the banks' rank among the most highly rated in the world.
"An 'AA' rating is not enough to fund the current account deficit without the backing of the Government's 'AAA' rating," he said.
