By Lawrence Summers

Against all odds, we are living in a time of plenty. Neither the after-effects of September 11 2001 nor a tripling in oil prices has prevented the world’s economy from growing faster in the past five years than in any five-year period in recorded economic history.

Given this recent performance and the pricing-in by world markets of an optimistic outlook, one might have expected this to be a moment of particularly great enthusiasm for the market system and for global integration.

Yet in many corners of the globe there is growing disillusionment.

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Being prime minister of Italy is not much fun. Last week’s downgrading of Italy’s government debt by Standard & Poor’s and Fitch Ratings must seem just another blow to a government that won a narrow election victory and has since seen its support in opinion polls slump. Yet appearances may be deceiving. Italy needs such shocks if it is to put through the needed policy changes.

The analysis by Fitch Ratings presents a dismal story.* Over the past five years, gross domestic product has grown at a compound rate of just 0.6 per cent a year. In contrast to Germany and Japan, Italy’s weak growth is also, in substantial part, the result of deteriorating external competitiveness. Domestic demand has grown by about 0.4 percentage points a year faster than GDP since 2000.

Because Italian inflation has been somewhat higher than Germany’s, monetary conditions have been relatively supportive, with real short-term interest rates averaging around zero since 2000.

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What exchange rate regime should China adopt? The answer must be: one that supports stable growth at home and, given China’s growing role in the world, also abroad. The government has already decided to shift towards greater reliance on consumption. In doing so it has willed the end. Now it must will the means.

Nicholas Lardy of the Washington-based Institute for International Economics spells out the case for such a shift in a thought-provoking new paper*. This represents just one of the host of contributions made by the Institute to the greater understanding of international economic policy issues over the past quarter of a century. I do not agree with everything it has published. That is hardly surprising. But the world would have been far worse informed and less stimulated without it. Happy birthday, IIE!

Mr Lardy’s contribution is a superb example. All, he argues, is not as healthy in the economy as headline statistics suggest. Between 2001 and 2005, investment generated a little more than half of the expansion in aggregate demand. More recently, the current account surplus has exploded from 1.3 per cent of gross domestic product in 2001 to 7.2 per cent last year and a forecast of 9.1 per cent this year. As a result, net exports of goods and services generated a quarter of additional demand last year and will generate another fifth this year. The current Chinese economic expansion is evidently both investment- and export-led.

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China will do what it considers to be in its own interest. That should surely be self-evident. What is not self-evident is how it does – and should – identify that self-interest. That is almost always more difficult than naive realists tend to suppose. This is true of its policy towards North Korea. It is just as true of its policy towards the exchange rate.

The Chinese government seems to believe its interest lies in maintaining a highly competitive real exchange rate for as long as possible. The evidence also suggests it can do so for a long time. But should it do so?

Economic theory indicates that a fast-growing developing country should have an appreciating real exchange rate. This is known as the Balassa-Samuelson effect, after the late Bela Balassa of Johns Hopkins University and the Nobel laureate Paul Samuelson, who discovered it independently of each other.

The argument is straightforward. Economies contain two sorts of activity: tradeable – manufacturing and services that can be supplied readily at a distance; and non- tradeable – haircuts, childcare and so forth. With economic development, productivity in the former tends to rise faster than in the latter.

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Congratulations are due to Ned Phelps, an esteemed member of the FT’s forum of economists, for his well-deserved Nobel Prize - better late than never, in my view. With Milton Friedman, Ned made seminal contributions in the 1960s to the idea of the "natural rate of unemployment". This demolished the naïve notion that there was a stable trade off between inflation and unemployment. The stagflation of the 1970s dramatically demonstrated the truth of this attack on primitive Keynesianism. That, in turn, led to our current understanding that structural factors determine unemployment in the medium run, while central banks determine only inflation. The best contribution central banks can make to stability is, accordingly, to be credible in their pursuit of low and stable inflation.

Ned has continued to pursue his research in many interesting directions. His work is always characterised by its intellectual independence, practicality, relevance and deep insight. I have particularly admired his work on the case for wage subsidies in high-income countried and on the sources of economic dynamism in the long run. I have still more admired the fact that Ned writes words. He is ever mindful of the fact that economics not only studies human beings, but needs to be understood by them.

China represents something new in the history of the modern world: a developing country that has a vast global impact. This is why Hank Paulson, the US treasury secretary, has followed Robert Zoellick, former deputy secretary of state, in calling for it to be a “responsible stakeholder”. But China will behave as the US wants only if it perceives that this is in its own interests. Again, the US should not be surprised. This is how Americans view their own country’s international obligations.

At present, the most vexed issue between the two countries is the payments “imbalances”. Many in the US complain that China is manipulating its currency, to preserve excessive competitiveness. Certainly, China has a large current account surplus, forecast by the International Monetary Fund at $184bn this year, or 7.2 per cent of gross domestic product. No other country has as big a surplus.

The starting point then must be whether it makes sense for a poor country to export so much capital. The answer, I would argue, is “no”. But we must then also ask why China is running such large surpluses. The short answer is that it is saving even more than it is investing at home. This is true by definition. In China’s case, this surplus is largely being invested in its vast foreign currency reserves, now some $1,000bn (or 40 per cent of gross domestic product).

The remainder of Martin Wolf’s column can be read here (FT.com subscribers only). Discussion from our guest economists is free - click ‘Comments’ below.