DAVOS, Switzerland (Reuters) - Glenn Stevens, the governor of the Reserve Bank of Australia, is an accidental hero of the global financial crisis.
A career central banker, Stevens, 52, once described himself in a newspaper article as "not a particularly great risk-taker". On the day he was appointed to the job, August 1, 2006, the exasperated photographers crammed into his spartan office were forced to ask him to smile for the camera, according to local media reports.
"That's a bit hard. I'm a central banker," he deadpanned.
Then, on October 6 of last year, Stevens was thrust into the spotlight. Australia became the first G20 nation in the wake of the financial crisis to raise interest rates, signaling an upbeat view of future economic activity. It was not a widespread sentiment.
The surprise hike came as U.S. and euro zone policymakers were still crossing their fingers, hoping their economies had escaped recession in the third quarter. It was hailed as a vote of confidence in a still uncertain recovery, pushing gold prices to a record high and global shares up nearly 2 percent.
In the end, Australia was among the few G20 nations to sidestep a brutish recession.
"We have long argued that Australia is the canary of the global economy," RBC Capital Market senior economist Su-Lin Ong said at the time. "If the Australian economy kept singing, then it was likely the world economy would avoid falling into the abyss."
It has not fallen so far.
Under ordinary circumstances, central bankers like Stevens aren't major newsmakers in world affairs. But the combination of the financial nervous breakdown and the uneven economic recovery since has turned them into the equivalent of military generals waging a war. The question is whether, in the face of political opposition, they will deploy the weapons at their disposal.
Anyone doubting central bankers are in the hot seat need only look at the fix U.S. Federal Reserve Chief Ben Bernanke found himself in. Nominated by President Barack Obama for a second term, he had been widely expected to get the Senate support he needed when a surge of public anger at big banks and their bailout made the vote look a lot closer.
What Bernanke, who squeaked by, and his fellow central bankers do from here on will likely have important implications not just for their individual countries but also for a $60 trillion global economy that is, for better or worse, becoming more financially inter-connected.
The main challenge facing central banks is how to keep economic growth going without inflating the next bubble. Put starkly, that means jacking up interest rates from their current nonexistent levels, as Australia, Israel and Norway have now done.
It also means halting the spread of cheap money, which has turned out to be the financial equivalent of crack cocaine.
Weaning the world off the liquidity drug won't be easy. The two most important economies, America and China, are moving at different paces, perfectly exemplifying the two-speed recovery that seems to be taking hold.
China and other emerging nations are zooming. The United States and Europe more or less remain stuck in neutral gear -- and face rising unemployment and a potentially crushing debt burden.
Global financial markets have been further rattled by China's moves to tighten policy settings -- raising the amount of reserves banks must hold, for example -- at the start of 2010. The fear is that this could impede the stubbornly weak global recovery and curb spending in one of the few nations with a surplus of savings -- at the expense of countries like Australia.
That nation's robust exports to commodities-hungry China is a chief reason the RBA could raise rates three times in a row in late 2009. By contrast, the U.S. Federal Reserve, the Bank of England and the European Central Bank likely will remain hunkered down on the sidelines until the end of 2010, unable to boost rates.
The "lucky country", as author Donald Horne once dubbed Australia, has made its own luck, mostly by allowing public coffers to fill with cash reserves during the previous decade of prosperity. That enabled the government to spend freely without building up debt during economic turmoil, helping to ensure a relatively easy run through the crisis.
Unlike Stevens, his counterparts at the U.S. Federal Reserve chose not to prick any asset bubbles. As a result, the United States ran huge budget deficits before the financial crisis struck -- and is now paying the price.
Eight months before Australia's Stevens took office, Bernanke, 56, assumed the U.S. Fed's helm in February 2006. He brought from his previous life in academia several strong convictions.
One was not using monetary policy to tackle asset price bubbles, arguing it is too blunt an instrument -- an approach also taken by his predecessor, Alan Greenspan.
The consensus among economists and others is that the American central bank kept credit costs too low for too long. And that, most agree, helped lay the groundwork for the 2008 crunch.
Bernanke -- who once joked that as chairman of the Princeton Economics Department his major decisions included whether to order doughnuts or bagels for staff meetings -- was criticized for his initially sluggish reaction to the crisis.
"The U.S. let the housing bubble get out of control and paid a very heavy price for it," said IHS Chief Economist Nariman Behravesh.
Though he suddenly found himself facing a tough time in the Senate, Bernanke has won over some critics with his overall decisive response. A student of the Great Depression, he once famously told Milton Friedman that he was right to blame the Fed for aggravating the 1930s crisis through a lack of support for banks, and he was determined not to repeat the same mistakes.
In a Reuters poll in mid-2009, economists gave him very high marks -- an 8 out of 10 -- for his performance during the past year, which was as difficult a year as a central banker can ever expect to meet.
But the hard part comes next.
And if Bernanke needs a reminder of what's at stake, all he need do is visit his boyhood home in small-town Dillon, South Carolina. Last year its new owners joined the ranks of those who lost their homes to foreclosure, one of a record 2.8 million U.S. homes to meet such a fate.
How Stevens, Bernanke and their fellow central bankers grapple with three critical issues -- runaway debt, looming inflation and new potential bubbles -- will help determine the fate of the global economy over the next several years, if not beyond.
Fears that the world could plunge into another Great Depression prompted governments nearly everywhere to dig deep for emergency measures to bolster economic growth and shore up the banking sector.
Judging by the growing signs of recovery, their hyperactivity paid off -- but at a potentially staggering price.
The International Monetary Fund projects government debt as a share of economic output in all advanced nations will soar as a result of the crisis, from 78 percent of GDP in 2007 to a whopping 118 percent in 2014.
That will be a drag on economic growth, put downward pressure on currencies and could also push up inflation -- unless central banks resist the temptation to keep rates low and instead hike borrowing costs. Doing so would entail some economic pain.
"It is likely to slow growth for a decade in the countries that have had an explosion of debt," said Kenneth Rogoff, an economics professor at Harvard University.
The IMF calculates the rise in debt could add 2 percentage points to real interest rates, increasing the cost of servicing debt and adding pressure on governments facing lower tax revenues as result of slower growth. Net interest payments for advanced economies are forecast to nearly double from 1.9 percent of GDP three years ago to 3.5 percent in 2014.
By then, such outlays in the United States will outstrip spending on defense, health and education combined.
To get debt down to a healthy 60 percent of GDP, the IMF says advanced economies have to transform an average deficit of 3.5 percent this year into a surplus of 4.5 percent by 2020. That's an 8 percentage-point turnaround -- and hardly a precondition for economic growth that can deliver the jobs politicians are being asked to manufacture.
In its latest Global Risks report, the World Economic Forum said the prospect of deteriorating government finances pushing economies into full-fledged debt crises was its top concern for 2010.
"Governments, in trying to stimulate their economies, in fighting the recession, are (building) unprecedented levels of debt and therefore there is a risk of sovereign default," said John Drzik, Chief Executive of management consultancy Oliver Wyman, which was one of the contributors to the WEF report.
The cost of insuring against the risk of default by European nations has reached record highs and is roughly on a par with top investment grade companies.
Among the G20, Australia, China, Saudi Arabia and Russia are the only countries to escape a deep downturn without huge debt burdens, while Japan tops the list with gross debt more the double the size of its economy.
The lucky country advanced two places in a ranking of G20 countries by size of economic output between 2006 and 2009, while economies like the UK and Canada gave up ground.
Japan has still not recovered from its 1990s financial crisis -- also sparked by a burst housing bubble. Its public debt is the result of successive waves of fiscal stimulus, which were never enough to kick-start growth and allow budget consolidation.
"You saw Italy and Japan continue for decades with very high debt," said Carlo Cottarelli, director of the IMF's Fiscal Affairs Department. "The price of this in our view is lower potential growth."
The future could look different again. Thomson Reuters research suggests South Korea may be one of the winners from the crisis, along with China and the United States.
Spiking prices are keeping more and more central bankers up at night.
If governments fail to cut back on spending, inflation might indeed shoot up and start eroding consumers' spending power. Then central banks would have little choice but to head it off by hiking rates.
Doing so likely will be tricky, as they face increasing political pressure to help governments support growth by keeping rates low and allowing inflation to decrease the value of their debt. There have already been several ominous instances of political interference in recent months.
Argentina's President Cristina Fernandez tried to sack central bank governor Martin Redrado for opposing plans to use $6.6 billion in central bank reserves to make debt payments, sparking a legal and political standoff.
And South Korea's finance ministry has been embroiled in a public spat with the central bank over the timing of monetary policy tightening in Asia's fourth-largest economy, while the Bank of Japan offered banks more emergency funds in December after weeks of political pressure to do more to avert recession.
"The incentive for central bankers is to err on the side of inflation and growth, rather than deflation and stagnation," said Ian Stewart, director of Deloitte Research.
A study by U.S. economists Joshua Aizenman and Nancy Marion compared the impact of post-World War Two inflation on debt with the situation today. It found that allowing moderate inflation of 6 percent now could reduce the debt/GDP ratio by 20 percent within four years.
The study also pointed out that average debt maturities are much shorter than in the 1940s, meaning governments would face higher rates on new debt issuance were they to do the same today.
Countries bloated with debt won't be able to easily slim down using inflation. The IMF estimates 6 percent inflation would erode only a quarter of the extra debt accumulated as a result of the crisis in advanced economies. "Inflation would not solve the problem," said the IMF's Cottarelli.
"One could argue that inflation could be brought to not 6 percent but 12 percent or 20 percent ... then you get into a spiral," he said. "But moderate inflation does not help, and nobody is calling for double-digit inflation."
Central banks also are starting to fret that their unprecedented crisis measures may be fuelling the next bubble, which begs the question of what to do about it.
German Bundesbank board member Hans-Georg Fabritius said the pre-crisis consensus for a passive approach to asset price bubbles -- sometimes called the clean-up-the-mess-afterwards theory -- was now being questioned.
"The crisis showed us painfully that we cannot trust in central banks being able to control the consequences of an asset price bubble bursting with action after the fact, either through loosening monetary policy or extending liquidity supplies," he said.
Already, cheap and generous central bank liquidity has helped push up prices of commodities such as gold and oil, enabling many banks to book solid trading profits in 2009.
Sergio Ermotti, Deputy Chief Executive Officer of Italian bank UniCredit, told Reuters that the search for safe havens had also pushed investors into suddenly riskier government bonds.
"There has been a lot of buying into government bonds as a last resort of where to put savings, and probably there has been a little bit of a bubble in the last 12 months in terms of how many people bought public debt in general," he told Reuters TV in Davos.
Nouriel Roubini, one of the few economists who accurately predicted the magnitude of the financial crisis, told a WEF session that very low U.S. interest rates were fuelling dollar-funded carry trades and pushing up asset prices.
"I think it's become too much, too fast, too soon," said Roubini. "Eventually this asset bubble ... will become excessive, there will be a massive correction and that's going to be dangerous. I think U.S. monetary policy is really imposing a significant easing bias on the rest of the world."
That brings us back to the example set by Stevens, the central banker down under.
The future could bring increased pre-emptive rate hikes by central banks to "lean against the wind" of asset price bubbles, in line with Australia's approach.
Bernanke said recently that although regulation and oversight are the best way to prevent asset bubbles from forming, if those efforts failed, central bankers should not completely exclude the use of monetary policy.
The RBA was widely credited with cooling a housing boom with its previous rate-tightening cycle starting in 2002, one of the reasons the Australian real estate market has not crashed.
But Charles Dallara, who heads the bank lobby group called the Institute of International Finance, said in developing countries, raising rates to head off asset bubbles could simply help to attract more capital.
"This creates a real dilemma for these policy makers," he told Reuters in Davos. "They can look at some form of disincentives to short-term capital flows but those kind of measures generally don't work terribly well."
As an alternative to rate hikes, central banks could limit liquidity by making banks hold more in reserves -- the tactic used this month by China, where blistering 10.7 percent growth in the fourth quarter is pushing up inflation.
Another option is an increased role in financial regulation: the ECB for example is set to receive more say in financial oversight through its leadership of a new body examining macro-prudential risks in the European Union.
Deutsche Bank chief economist Thomas Mayer said the crisis showed central banks could no longer wield interest rates in isolation from the real economy and financial sector.
"We are living in a new world," he said. "Central banks used to be, as (Bank of England governor) Mervyn King once said, like dentists, focusing on a very narrow part of the body and operating with high precision instruments, not caring about what is happening elsewhere."
"That time has gone," Mayer added. "Central banks have become general practitioners."
As Australia's Stevens has also shown, making tough calls does not come without a price. His willingness to tackle asset price bubbles, particularly in the housing market, won him few friends at home, where 75 percent of mortgages are at floating rates.
"Is this the most useless man in Australia?" asked a front-page headline in a Sydney tabloid over a less-than-flattering photo of the balding Stevens in March 2008, after the RBA hiked rates for the fourth time in eight months to a 16-year high of 7.25 percent.
Stevens said in December that at the start of 2009, he had been concerned about the outlook: "I felt that things were going to turn out rather worse than they have, but who's complaining? Not me," he said.
If Stevens had trouble finding a smile 3-1/2 years ago, it's a safe bet that he's wearing one now.
Additional reporting by Tamora Vidaillet and Natsuko Waki in Davos, Anna Willard in Paris, Wayne Cole in Sydney and Mark Felsenthal and Emily Kaiser in Washington; editing by Jim Impoco and Sara Ledwith