My Comment on the Green Paper
Senator Nick Sherry, as Minister for Superannuation and Corporate Law, has released a Green Paper Financial Services and Credit Reform: Improving, Simplifying and Standardising Financial Services and Credit Regulation (June 2008)
This is a very apt time for such an enquiry. It is now over a decade since the Wallis Committee supported further deregulation of the financial system, and the consequences of that deregulation are now evident. I doubt that a complete reversal of policy is politically feasible now, but this inquiry may set the high water mark in the belief that the less regulated financial markets are, the better.
Below is my submission.
I recommend that the Commonwealth regulate all credit (Option 1.E.2), not on the grounds that Commonwealth regulation would necessarily be superior to State regulation, but on the basis that all lenders should be regulated. The current regime only applies, in any systematic sense, to deposit-takers.
I make this recommendation, not because I believe that regulation of the pre-Wallis Report ilk would prevent financial crises of the sort we are experiencing now, but because I believe that in the aftermath to this crisis, substantial informed reform of finance will be needed.
A essential aspect of this will be making the regulation of lending, rather than deposit-taking, the centrepiece of the regulatory framework. Bringing all credit providers under national supervision now would make it easier to implement this inevitable substantial informed reform at some future date.
The current arrangements provide comprehensive—if not necessarily effective—regulation of Authorised Deposit Taking Institutions (ADIs), but less comprehensive—and far less effective—regulation of Non-Deposit Taking Institutions (non-ADIs). In particular, Money market corporations, finance companies and Securitisers, which in June 2007 accounted for 20% of the assets of credit providers, are not regulated (See Table 1).
This emphasis upon regulating deposits-takers and not lenders reflects the avowed need to protect depositors funds. However, this direct approach understates the indirect dangers to depositors posed by the excessive growth of debt. Non-ADIs have played a pivotal and direct role in the recent explosion in debt levels, while even Financial Institutions that do not lend—such as superannuation funds—have provided the impetus to increasing debt by the impact of their investment strategies upon asset prices.
Conventional economic analysis implies that controlling ADIs is sufficient to control the financial system. In this view, banks create credit by re-lending depositors funds under a fractional banking system, in which banks keep a proportion of depositors funds as reserves, and lend the rest. With the government creating so-called “Base Money” (or M0), the banks’ capacity to create money is given by dividing M0 by the reserve fraction.
Since non-ADIs by definition do not take deposits, they are not part of this credit-money-creation process, and this largely explains why existing legislation exempts them from regulatory control.
However, this perspective is flawed in at least two respects that are relevant to this Green Paper.
Firstly, it focuses upon the creation of money, but ignores the creation of debt—and as explained below, non-ADIs can create debt, even though they can’t take deposits. As is now becoming obvious, the level and rate of growth of debt have crucial effects upon the economy.
Secondly, there is ample empirical evidence that the direction of causation in the actual financial system is the reverse of that given by economic textbooks: rather than “Deposits create Loans via the money multiplier”, it appears that “Loans create Deposits”. Therefore, laws that attempt to manage the financial system by regulating only deposit-taking institutions—and thus the deposit half of the financial equation—are bound to fail, if lending remains largely uncontrolled. This is doubly so in the modern era of deregulated finance, when securitisers and other non-deposit-taking institutions are allowed to create debt via selling securitised financial products to the public.
Figure 1 shows just how much debt has risen compared to the money supply in the last half century. The ratio of debt to M3 has risen from 0.5 in the early 1960s to almost 2 now (a similar trend applies when debt is compared to Broad Money).2 Peaks and declines in the ratio bear a strong relation to asset booms and subsequent recessions in the early 1960s, 1974–5 and the mid-1980s-1990s, and the fact that this ratio is once again trending down is could be an ominous forewarning of economic conditions in the near future. Private debt has certainly reached unsustainable levels compared to income. This ratio must fall to restore the economy to eventual financial health, but its unwinding will be associated with a significant drop in aggregate demand.
Figure 2, which shows the ratio of the rates of growth of debt and M3, indicates how little control is exercised over debt by controlling the money supply. Attempting to control the financial system solely by controlling deposits (M3) is rather like trying to control a tiger by holding its tail.
During the period of monetary targetting (as opposed to interest rate targetting), debt grew between as much as 250 percent faster than M3,3 and 30 percent slower. Explosions in the ratio of the rates of growth are also clearly coincident with speculative booms (from the days of Cambridge Credit through to the Internet Bubble), while collapses coincide with busts.
The emphasis upon controlling deposits rather than loans allowed the blowout in debt to occur even when bank lenders dominated the system. However, this lending could have exhausted itself in the 1990s. Non-bank lenders, who were allowed to undertake a much larger role in the Australian scheme by the Wallis Committee’s backing for securitised lending,4 have played a pivotal role in the continuing growth of debt after the 1990s recession.
That non-bank lenders can create debt should be obvious, but “textbook” economic treatments of money creation don’t perceive this, because they focus solely upon the “money multiplier” route to creating debt.
A non-bank lender effectively borrows money from a bank,5 and on-lends that money to borrowers. When it does so, the non-ADI’s account at the bank falls, while the borrower’s account rises—thus no deposits are created. But the borrower now has a debt to the non-ADI. Thus debt has been created, without a balancing creation of deposits.6 This growth of debt has both propelled economic activity in Australia, and now imperils its future.
Of course, debt of itself is not a bad thing—any more than carbon dioxide is of itself “bad”. Without carbon dioxide, the planet’s temperature would be below zero, and life would not be possible. Equally, without debt, the economic system could not function. Debt is necessary to enable consumers to purchase housing and several other long-lived consumer products, and to provide business with both working capital and finance for new investments.
The problem comes when that debt is used, not for consumption smoothing (purchasing an abode, car, etc.) or business turnover or investment purposes, but to finance speculation on asset prices. The former uses are akin to the generation of carbon dioxide by the planet’s endogenous carbon cycle; the last is rather like humanity’s unintentional addition to CO2 levels by the burning of fossil fuels.
Just as we are now learning, via Global Warming, that we have to limit our production of CO2, we must learn that we have to control the financial system’s proclivity to produce debt. If that can be limited to the debt demanded for consumption smoothing and business investment, then the financial system will function well. If that debt is instead driven by speculation on asset prices, we will face the equivalent of Global Warming in our financial system.
That, unfortunately, is how the recent explosion in debt has been used, both domestically, in the USA, and across most of the OECD. Driven by debt-financed speculation, the ratio of asset price to commodity prices has reached levels that have never been seen before. This ratio is the best guide as to whether we are in a bubble or not, and according to it, the current financial bubble is the biggest in human history, dwarfing the Roaring Twenties and even the 1987 Stock Market bubble (See Figure 3).
Also, in contradiction to Alan Greenspan’s oft-expressed view that a bubble could only be identified in its aftermath, the USA Stock Market Bubble obviously began in 1995—note the acceleration in the rate of growth of the CPI-deflated index. By the end of that year it had already overtaken all previous stock market bubbles in scale.
The previous record bubble in the US stock market in 1966 was not accompanied by a bubble in real estate, while the 1920s were in fact a time of below average house prices. Therefore the current bubble, unlike all previous ones, embraces the housing market as well as the stock market. In America, it has driven the housing market from just above its long term average to more than twice this level in a period of under ten years (See Figure 4; 1997 can also be identified, by the acceleration in the CPI-deflated index, as the start of this housing bubble).
The Australian data I have does not go back as far as the American, but even with this more limited data it is obvious that the current stock market bubble dwarfs the 1980s. Even after the recent fall in the index, the ASX is still more overvalued than it was before the crash in October 1987 (See Figure 5).
The Australian housing market is overvalued even with reference to the period since 1986, when prices were already high on a historical basis. Nigel Stapledon’s PhD thesis7 implies that house prices in Australia are of the order of three times the long term average. Even leaving that long term perspective out of the equation, it is obvious that house prices have doubled in real terms in the past decade (See Figure 6).
This has all been on the basis of speculative, debt-financed purchasing—effectively, a Ponzi Scheme. Debt-financed purchasers of housing lose money on the cash flow from their investments—indeed, the peculiarly Australian institution of negative gearing promotes loss-making investments in real estate.
The only way that an individual speculator profits from real estate speculation is by either selling to someone with a higher income—who can therefore afford a higher purchase price—or by selling to another individual with a similar income, who takes on sufficient debt to buy the property at a price that exceeds the speculator’s purchase price plus accumulated net losses from debt servicing. That is a recipe, not just for an asset price bubble, but for exploding debt levels compared to income. Lenders have unwittingly contributed to this Ponzi Scheme, and the focus of regulation upon deposit-taking rather than lending has equally unwittingly allowed this to happen.
Unfortunately, while an individual can escape from an excessive debt servicing burden by selling a property for a profit, the country as a whole cannot do that. The ultimate source of revenue for paying off debt is the sale of commodities and the incomes this generates, and the debt bubble that has built up under the current regulatory regime poses an enormous challenge for future economic policy by driving up the debt to GDP ratio (see Figure 7).
The ratio of debt to GDP gives a simple measure of the debt burden, by showing how many years worth of national income would be needed to eliminate the debt. Though, as noted above, eliminating debt entirely is not desirable, reducing it to a level where it reflects predominantly productive uses of debt is desirable. On the long term data, this implies a reduction in debt from its current level of 1.65 years of GDP, to of the order of half a year of GDP.
A substantial reduction of debt will occur (if not necessarily that absolute scale) because most of the debt accumulated in the last twenty years financed wasteful speculation on asset prices rather than real investment. The vast majority of the increased debt taken on since 1990 was incurred by households (see Figure 8), and most of that borrowing financed not the construction of new housing, but speculation on the price of existing houses.
Since, by the early 2000s, less than 10% of money borrowed for housing finance the construction of new dwellings, 90% of that money was borrowed for the purposes of speculation rather than investment (see Figure 9).
We have now reached the end point of that speculation, when it is simply not possible for future buyers to take on more debt than current “investors” have done.
Therefore existing speculators will start to lose money on their real estate positions, leading to a fall in Australian housing prices and ultimately a fall in the debt to GDP ratio. As that takes hold, spending will also fall precipitously, as the change in debt starts to detract from aggregate spending, rather than supplementing it.
There is evidence that this process has already begun. The growth in the private debt to GDP ratio has slowed noticeably in the last two months, and as a result the contribution that change in debt makes to aggregate demand8 has started to fall (see Figure 10).
This great de-leveraging will pose enormous difficulties for economic policy. It will also make obvious that our current deposit-focused regulatory regime for finance has failed. Clearly, regulating deposit-taking institutions, but not regulating lenders in general, has contributed to the development of the greatest financial crisis since World War II. The regulatory philosophy that largely relied upon lenders to self-regulate has also failed.
Therefore, as difficult as these future times are likely to be, they should also be used to put in place a financial system that discourages speculative lending and borrowing.
Decades ago, Hyman Minsky argued that the role of regulation should be to create “a ‘good financial society’ in which the tendency by businesses and bankers to engage in speculative finance is constrained” (Minsky 1977, 1982: 69). The reform proposed in Option 1.E.2, by proposing that all lenders fall under Commonwealth regulation, is a step in this direction For that reason, I commend it to Parliament.
Appendix One: My supplementary remarks on securitised lending to the Wallis Committee
After an event like the subprime crisis, it is not uncommon to have people argue that it was something that could not have been foreseen. That is nonsense. It takes a particular set of intellectual blinkers not to see the potential that “reforms” such as allowing securitised lending had to lead to an ultimate financial crisis. Unfortunately, conventional economic thinking provided just that set of blinkers, and the Wallis Committee followed conventional economic advice in its recommendations.
I claim no special powers of prescience, but merely the benefit of analysing finance from the point of view of Minsky’s “Financial Instability Hypothesis”—a model of how the finance sector operates that I presented to the Wallis Committee Inquiry in 1996. As a follow up to my verbal submission, I sent a letter to the Committee on December 7th 1996. My comments on securitised lending in that letter accurately predicted the Subprime Crisis (see under point 2 below):
“Mr Stan Wallis,
Financial System Inquiry
Dear Mr Wallis,
Thank you for the opportunity to present my views personally to your Committee yesterday. There were two points on which I was not satisfied with the quality of answers I gave to questions from the Committee, and I am writing this note to attempt to improve upon yesterday’s performance…
(2) The impact of securitisation
The securitisation of debt documents such as residential mortgages does not alter the key issue, which is the ability of borrowers to commit themselves to debt on the basis of “euphoric” expectations during an asset price boom. The ability of such borrowers to repay their debt is dependent upon the maintenance of the boom, and as the share market reactions to yesterday’s comments by Alan Greenspan reminded us, such conditions cannot be maintained indefinitely.
Should a substantial proportion of eligible assets (e.g., residential houses during a real estate boom like that of 87–89) be financed by securitised instruments, the inability of borrowers to pay their debts on a large scale will not, of course, directly affect liquidity in the same fashion that a failure of bank debtors does. Instead, the impact will be felt by those who purchased the securities, or by insurance firms who underwrote the repayment.
- Where this is a government, the impact on liquidity will again be slight, since public debt will replace private.
- Where this is a financial institution, such as a bank, it will be in a very similar situation to the State Bank of Victoria (and many others) after the last real estate crash, with similar consequences.
- Where this is an insurance company, it could be driven into bankruptcy, with an impact on liquidity via its shareholders and its own creditors. However this would not be as serious as the second instance above.
- Where the securities are tradeable, there would obviously be a collapse in the tradeable price, and, potentially, the bankrupting of many of the investors—depending again on their own financing arrangements.
Overall I would agree that direct regulation of securitisers is not warranted. What is needed instead is prudential overview of the extent to which banks, insurance firms and superannuation institutions invest in securitisers and their products. However, I would object strongly to the proposal from Aussie Home Loans (p. 135, paragraph 5.94) that securitisers should be able to call themselves banks.”
As might be expected, the Wallis Committee was substantially more sanguine about the impact of securitisation than I was. Now that events have unfolded and it is obvious the Committee’s relaxed posture towards financial market deregulation was not justified, it is to be hoped that this and future enquiries will be more cogniscant of the need to control the growth of debt.
Appendix Two: The Wallis Committee’s Overview on Securisation
Securitisation refers to the process of issuing marketable securities against an income stream derived from a pool of otherwise illiquid assets. It involves sales of loans or other assets into specially designed trusts which then issue securities directly into the capital market. In Australia, securitisation has become a force in home mortgage finance.
It has also emerged in some other retail markets, such as credit card receivables and motor vehicle loans, although at this stage only on a small scale.
Like disintermediation, securitisation represents the substitution of trade on financial markets for functions traditionally performed via the balance sheet of financial intermediaries. By originating loans and providing recourse to an insurer in the event of default, financial institutions screen loans and enhance their creditworthiness sufficiently for the loans to be traded in open financial markets. The role of the institution is not displaced entirely by this process but it is substantially restricted in scope. In many cases, it is the institutions themselves which are using securitisation as a means of better managing their capital.
The prospects for growth of securitisation will depend on its cost effectiveness relative to balance sheet intermediation. The question also arises as to possible limits to securitisation. At present, securitisation is largely restricted to assets which have very low, even negligible, risk or which represent a homogeneous class on which risk can be statistically estimated and priced. Whether there will be a market for higher risk or less homogeneous assets is unclear. The test will come with assets like loans to small businesses (some mortgage backed lending has recently emerged in this area).
Hyman Minsky (1977), “The Financial Instability Hypothesis: an interpretation of Keynes and an alternative to ‘standard’ theory”, Nebraska Journal of Economics and Business, reprinted in Minsky 1982, 59–70.
Hyman Minsky (1982), Inflation, Recession and Economic Policy, Wheatsheaf, Sussex.