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,
Chairman,
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

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).

References

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.

After making that submission (which I’ll post here shortly) I thought I’d check out my submission to the Wallis Committee–since I argued that the RBA and the regulatory authorities in general, while they may appear to have succeeded in controlling inflation, have presided over the biggest speculative bubble in world history.

The securitisation of loans was a major part of this bubble, which of course, no-one could have foreseen… or at least that’s the line from conventional economists.

Below is what I sent to the Wallis Committee on December 7th 1996 on the topic of securitisation of loans (in a follow-up letter to my oral submission):

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.

 Is it rude to say “I told you so”?

So when he comes out and says that inflation targetting is foolish and dangerous, his views are worth taking note of. Here is Stiglitz’s commentary on inflation targetting, published earlier this month.

RBA Assistant Governor Guy Debelle and I spoke at a conference on Subprimes in Adelaide last month. One aspect of my analysis that Guy queried was my emphasis upon the Debt to GDP ratio. He noted that this appeared suspect, because it was comparing a stock (the outstanding level of debt) to a flow (annual GDP).

It’s a valid point to make. The engineer-turned-economist Mickal Kalecki once caustically observed that “economics is the science of confusing stocks with flows”, and I’m a stickler myself for not making that mistake. So making a song and dance about a stock to flow comparison like debt to GDP has to be justified by a sound argument.

The most accessible argument is an analogy to global warming. Just as the growing level of C02 in the atmosphere is evidence that the ecosystem is not coping with the (relatively tiny) additional volume of carbon dioxide human activity is adding to the biosphere, the accumulation of debt relative to income is evidence that the economy is not coping with the (relatively large) volume of debt being generated by the financial system to finance speculative purchases of assets.

There are at least five strong similarities between this ecological issue and the economic one of accumulating debt:

1. The environment has an established “carbon cycle”, by which the emission of carbon dioxide into the atmosphere by animals, etc., is balanced by its re-absorbtion by plants, etc. This process is augmented by many other factors–such as the explusion of CO2 by volcanoes–and, on a geological time frame, far from stable; but over the period of human existence, the atmospheric concentration was below 300 parts per million (ppm) until industrialisation began.
2. The fact that the concentration has risen from under 300 ppm to over 380 ppm in the past century shows that the planet’s natural carbon-processing cycle is not coping with the extra CO2 added by human industrial and agricultural activity. Global Warming is the most apparent manifestation of this increased stock of CO2.
3. Even if all human industrial and agricultural activity stopped today, it would take decades for the additional CO2 we have added to the atmosphere to decline to pre-industrial levels. At present, the existing natural carbon cycle is only means to reduce that accumulation, and it could take longer to reduce the build up than it took to accumulate it, since we have damaged many of the natural “carbon sinks” in the ecosystem.
4. Persisting with present or higher levels of CO2 will cause the ecosystem to undergo both profound and uncertain change, some aspects of which can be inferred from past geological data.
5. There are feedback effects that mean any climate-altering effects of raised CO2 levels may be further amplified. For instance, the rise in temperature has reduced the area of ice in the North Pole, leading to reduced reflection of sunlight (since ice reflects most light while water mostly absorbs it), and further increasing global temperatures.

Similar propositions can be put with respect to debt:

1. The economy has a natural capacity to process debt. Borrowing by businesses to finance investment can lead to new products whose sale enables the businesses to make a profit and repay debt over time (Schumpeter’s Theory of Economic Development gives perhaps the best explanation of this “natural debt cycle”);
2. The fact that debt levels are rising with respect to income is a sign that the economic system is not coping with the level of debt being generated today;
3. Even if all borrowing stopped today, it would take decades for the additional debt we have accumulated to be reduced to pre-debt bubble levels. The only way that debt levels can be reduced is if income is redirected from either consumption or investment into debt reduction. This is the key reason that the debt to GDP ratio is important: it tells us how much of income would be needed to reduce debt, and how long such a reduction would take. However the process of reducing debt will itself reduce income to some degree, since money that would otherwise have gone into investment will now simply be used to pay down debt levels–and incomes and employment will fall as a result;
4. Persisting with the level of debt we have now will mean a profoundly different and uncertain economic environment. The proportion of income needed to service debt will remain at levels that have only ever been experienced in the past during Depressions.
5. Finally, there are feedback effects in the economy that can mean debt to GDP ratios fall even when, ultimately, borrowers try to reduce their exposure to debt. The worst such effects are: direct reductions in investment as retained earnings are used to pay down debt rather than invest; indirect falls in investment as falls in consumption reduce cash flow and depress both earnings and expectations; and falling prices if deflation sets in, as it did during the Great Depression when prices fell as much as 10% per year.

There is also an academic economic argument that can be made about the importance of the debt to GDP ratio, deriving from Minsky’s “Financial Instability Hypothesis”. In this theory, a rising ratio is both a prediction of the model, and a force leading to greater financial instability and possible economic breakdown in a Depression. But I’ll leave a full discussion of this for a future Debtwatch.

Observations on the Data

The most recent data imply that the turnaround in debt to GDP may finally be starting. The debt to GDP ratio fell last month, from 165.25% of GDP to 165.2%. It’s not a lot, and it may still return to its 44-year long upward trend; but it is the first time in fifteen years that the ratio has fallen.

The contributor was an “unexpected” fall in the rate of growth of business borrowing (these things always seem to be “unexpected”). Though it still increased, it grew at a slower pace than GDP–as did personal borrowing. The grwoth in mortgage debt, on the other hand, continued to outstrip GDP (see Tables 1 and 2 below for details).

While in one sense this slowing down in debt growth is a good thing–in that an unsustainable trend may finally be coming to an end–it also may presage very tough economic times ahead. One aspect of my focus on the debt to GDP ratio is the contribution that change in debt then makes to aggregate spending. Aggregate demand in the economy, for everything from commodities to net asset transfers, is the sum of both income (GDP) plus the change in debt.

In a well functioning economy, that shouldn’t be much relative to GDP itself–and it wasn’t in the 1950s and 1960s. Then, the annual change in debt contributed no more than 4% of total demand.

But as the debt level rises, the change in debt can become an extremely large and volatile component of aggregate spending. That clearly is what happened from 1970 onwards: the annual change in debt began to contribute substantially more than 4% of total demand.

And it was highly volatile: notice the slump in its contribution from over 10% to just 4% in 1973-75 that coincided with the collapse of the Whitlam Government, and the fall from a peak of almost 14% of aggregate demand to minus 1.5% during “the recession we had to have”.

Today, the annual change in debt is the source of over 19% of aggregate demand. Should that turn around–as it must even to stabilise the debt to ratio at its current historically unprecedented level–then demand in the economy could “unexpectedly” evaporate.

The full Debtwatch Report, with all the graphics, is available in PDF format here.

Normally I will simply cross-post my Debtwatch blog, but on occasions I’ll write special purpose entries there. Nouriel has also assembled an interesting team of non-orthodox commentators from the academic and business sectors.

The site goes live on Monday May 12th 2008, and I recommend it to readers here. Its URL is:

http://www.rgemonitor.com/asia-monitor

The Reserve Bank Amendment (Enhanced Independence) Bill 2008, which was tabled in Parliament in March, aims to give the RBA Governor and Deputy Governor “the same level of statutory independence as the Commissioner of Taxation and the Australian Statistician” (Wayne Swann, Hansard, Thursday, 20 March 2008, p. 2381).

Under the current Reserve Bank Act, the Governor and Deputy are appointed by the Treasurer, and the Treasurer must remove them from their positions if either of them:

“(a) becomes permanently incapable of performing his or her duties; or
(b) engages in any paid employment outside the duties of his or her office; or
(c) becomes bankrupt, applies to take the benefit of any law for the relief of bankrupt or insolvent debtors, compounds with his or her creditors or makes an assignment of his or her salary for their benefit;”

Under the Amendment:

• The Governor General replaces the Treasurer as the appointer (and terminator);
• their removal under those same three conditions becomes optional rather than compulsory–the wording changes from “the Treasurer shall terminate his appointment” to “The Governor-General may terminate the appointment”; and
• there is a procedure that must be followed for that option to be exercised:

1. The Governor-General has to suspend the RBA Governor or Deputy, on one of the three grounds;
2. Within 7 days of that, the Treasurer has to give both Houses a statement justifying the suspension;
3. Within 15 days of that, each House has to vote to approve terminating the appointment; and
4. If either House votes against termination, the suspension is revoked and the appointment continues.

There are some “Gilbert and Sullivan” aspects to this Amendment–we could, for example, have a comatose and bankrupt Governor kept in office indefinitely by a hung Parliament.

But leaving aside even that eventuality, the principle underlying the Amendment is flawed. Though the aim to put monetary policy above politics is noble, the faith it puts in economics is misguided. Economists–even those running the Reserve Bank–do not deserve the status this Act gives them.

There are good reasons to put the Tax Commissioner above politics. We don’t want a Tax Commissioner using the office to run political vendettas (and the tax laws the Commissioner enforces are passed by Parliament anyway, so in that sense the office is under political control).

Equally, no-one wants a official statistician who is subject to political pressure–a good look at Stalin’s Russia shows where that might lead. The process of collecting and interpreting statistical data is also a well-established science.

Therein lies the rub: economics is not a well-established science, but this Act treats economics as if it were one.

If it were, then the Act would make sense. Then, only economists should control the economy–just as only physicists should run a nuclear power station. But economists don’t understand the economy anywhere near as well as physicists understand nuclear fission. Far from preventing economic meltdowns, economists can cause them, by applying theories about how the economy works that are, in fact, wrong.

Of course, physicists can make mistakes, and the inherent safety of nuclear power is a matter of debate. But even critics of nuclear power have to admit that nuclear accidents have been a lot rarer than financial crises.

Now look at the current state of world financial markets, and ask yourself whether they resemble a well-functioning reactor, or Chernobyl on a bad day. Since the mid-1990s–when Central Banks have been more independent of government control than at any time in history–asset markets have reached stratospheric levels of over-valuation. If Central Banks were supposed to be managing the nuclear reactors of finance, then they have taken the control rods out and let the system go gangbusters.

The fuel that has fed this nuclear fire is private debt, which has risen at a faster rate than ever, and to levels that are unprecedented in human history. What was a fun ride on the way up promises to be anything but fun on the way down.

Obviously many parties share responsibility for this mess, but without doubt economists–including Central Bankers–shoulder a large part of the blame.

Firstly, the last two decades have been a period of unprecedented independence for Central Banks. After the high inflation of the 1970s and 80s, when politicians were last in direct control of monetary policy, politicians willingly ceded control to the Central Bankers–largely to avoid the political pain of being blamed for high interest rates.

Inflation has certainly been lower since the Central Bankers too over, but at the same time there have been more–and ever larger–financial crises than when politicians held the reins. We’ve had the Asian Financial Crisis (1997), the Russian Financial Crisis (1998), the Long Term Capital Management Financial Crisis (1998), the Internet Bubble and NASDAQ Financial Crisis (2000), and now, the Subprime Financial Crisis–all since Central Banks cast off the shackles of political control.

That’s not a track record that inspires the confidence in Central Bankers. I’d be inclined to give them less independence, rather than more, on that evidence alone.

Secondly, economic theory itself has contributed to the financial excesses that caused these crises. Economists developed models of how markets were supposed to behave–such as the “Efficient Markets Hypothesis”–that championed the explosive growth of financial markets. Yet these theories were wildly inaccurate models of how markets actually behave.

When put into practice, these theories gave us products–such as derivatives–that were supposed to help investors hedge against uncertainty, but were instead used for leveraged gambling. They gave us policies–such as deregulation–that were supposed to lead to greater efficiency, and instead caused speculative bubbles.

The same will prove to be true of the RBA’s current emphasis upon controlling the rate of inflation using interest rates. I expect this policy–which is based on an economic model known as the Taylor Rule–to fail in several important ways:

• It will, as happened with high interest rates in the ’90s, make the approaching recession worse;
• It will fail to control inflation anyway, since many of the causes of inflation are immune to movements in Australia’s interest rates; and
• It downplays the importance of the over-arching need to ensure the soundness of the financial system, at a time when the system is more fragile than it has been since the Great Depression.

I am certainly not saying that politicians would have done a better job of managing monetary policy than economists in the last two decades. Political policies like the Howard Government’s doubling of the First Home Buyers Grant, and halving the rate of capital gains tax, definitely stoked the speculative fire beneath Australian house prices earlier this decade.

But at least politicians are ultimately accountable. This Act would put economists above accountability, not so much to politicians, but to the Australian people.

Of course, I could be wrong, and the Reserve could be right. Events could prove its focus on fighting inflation to be correct, and experience could thus show that the RBA deserves more independence than it currently has. So let’s defer this Act until we know from experience that this is the best way to manage monetary policy.

END OF COMMENTARY

Comment on Data

There are signs that Australia’s debt bubble is finally approaching bursting point. Though debt is still rising faster than GDP, the rate of increase is slowing–and even on the aggregate debt to GDP chart below, there are signs of a turn towards what Michael McNamara of Australian Property Monitors so aptly christened “Peak Debt”.

If we are indeed approaching “Peak Debt”, then it will be the third such mountain in Australia’s economic history–the other two being 1892 and 1931 respectively. This still-growing Peak, however, already dwarfs the other two. The fact that debt has reached such towering proportions during a period when Central Banks (and other regulators) are supposed to be exercising prudential control over the financial system is one of the main reasons that I am opposed to granting them any more independence:

Last month, aggregate private debt rose by 0.86 percent–still faster than the monthly rate of growth of nominal GDP (running at 0.59 percent), but not overwhelmingly so, as has been the rule for the previous fifteen years.

Significantly, personal debt fell for the third month running (though business and mortgage debt continued to rise). It appears that Australian households might be finally trying to bring debt under control, starting with its most expensive component.

If a slowdown is finally happening, then–though in a financial sense that is a good thing–there may well be an “inexplicable” decline in economic activity in its wake.

Since aggregate spending is the sum of income plus the change in debt, when that change in debt slows down, so does demand. Since the change in debt last year accounted for 19.4 percent of aggregate spending, any slowdown will hit spending–on asset markets, or consumption, or both–like a brick.

“The Australian Government is committed to modernising our economy so that we can compete with the leading nations in a world economy that is being transformed by globalisation, new technologies, and the rise of China and India. While we take full advantage of the mining boom, we must also build long term competitive strengths in the global industries of tomorrow - industries that will provide the high-paying jobs of the future.

The Australia 2020 Summit will examine:

• After a long period of sustained economic growth and with the added benefits of the global mining boom, how do we best invest the proceeds of this prosperity to lay the foundations for future economic growth?
• How we best prepare for a global economy that will increasingly be based upon advanced skills, advanced technology, low carbon energy sources and integration with global supply chains?
• How we take advantage of Australia’s proximity to the fast growing economies in the world?
• How we boost public and private investment in economic infrastructure?
• Foster innovation in the workplace; encouraging the transfer of ideas across businesses and economies? “

My submission

I add a 6th point: “Cope with a financially fragile economic system”.Fragility is indicated by the proportion of GDP needed to service debt; the higher this proportion is, the less there is available to both consume and invest. Economists habitually excuse any private borrowing on the assumption that it will lead to increased output, and thus finance itself. But 90% of the debt incurred in the past 3 decades has financed speculation rather than investment. Productive capacity has risen far less than debt, so that the debt ratio has grown exponentially.

The Daily Telegraph lived up to its nickname of “The Daily Terror” last week, with a frontpage attack on Reserve Bank of Australia Governor Glenn Stevens entitled “Is he Australia’s most useless?“, and an editorial that was no less provocative: “RBA boss is losing interest“.

It would be easy to criticise the Telegraph’s comments on the technicalities, many of which they got wrong (I’ll outline some of those below). But what I saw behind the comments was a sense of frustration that, I believe, is justified.

Why? Because over a decade ago, our Government ceded control of monetary policy to the RBA, in keeping with a worldwide belief that “Central Bank Independence” would result in better monetary policy.  We were told that if we took monetary policy out of the hands of the politicians, and handed it over to the experts, the financial system would work a lot better.

If that’s the case, then something has gone terribly wrong. Far from giving us stability, the period of Central Bank Independence has ushered in an unprecedented financial crisis, and extreme financial hardship for many ordinary working families (to use a Kevinism).

This is what motivated the Telegraph’s ire—especially since Stevens’s testimony appeared to downplay both the seriousness of the crisis, and the damage that a dysfunctional financial system has done, and is doing, to the rest of society.

Stevens’s testimony emphasised the RBA’s role in fighting inflation above all else. But the broad job description of Central Banks is to ensure the soundness of the financial system, and on that Central Banks worldwide have clearly failed.

Think about it. If this policy had been successful, then the Daily Telegraph’s spray wouldn’t have happened, because finance would have been on the boring back pages of the paper.

So how did Central Banks get it so wrong?

Largely because they followed accepted economic theory about what their role should be. At the time Central Banks were allowed to set monetary policy independently of governments, the conventional economic wisdom was that they should:

• ignore stock and housing markets;
• forget about trying to control the money supply;
• deregulate the financial system to make it more efficient; and
• just use short term interest rates to control inflation.

If their success is measured solely on the front of controlling inflation, then the RBA has met its target of keeping inflation in the range of 2-3 percent over the medium term. The average value from 1996 till now is smack in the middle of this range.

However, while the part of the system that Central Banks have focused on has done pretty well, the rest has gone to hell in a handbasket.

The finance markets were overtaken by alchemists who promised to turn lead into gold—or subprime mortgages into AAA secure bonds. Instead, they delivered lead aplenty to borrowers and investors, and absconded with the gold themselves. Debt reached levels that have never occurred before in human history. Asset prices reached unsustainable (and for housing, unaffordable) levels, and are now crashing, and taking peoples’ housing and livelihoods with them.

It’s worth getting a handle on just how badly the period of Central Bank Independence has gone wrong—and not only in Australia.

The Great Depression began with private debt levels in the USA equal to one and a half times its GDP, and then deflation—falling prices—and falling output drove it up to 215 percent by 1932. Today, US debt is 280 percent of GDP.

Australia peaked at 77 percent of GDP in 1932; we’re already at 165 percent—when the RBA appears to think everything is functioning well. And another 14 major OECD countries are in the same pickle (the only major exception is France).

Asset prices are also simply crazy.

The best measure here is to compare them with the consumer price index, and on that basis US house prices bubbled from 12 percent above the long term trend, to 120 percent above it in the first ten years of Greenspan’s independence.

Our housing price bubble was even worse than that, and though it has not yet started to deflate as has America’s—where prices have fallen 16% in real terms in the last two year—ultimately it must.

If politicians had been responsible for a policy mess like this, the press would have had their guts for garters—and rightly so. But since the so-called experts are in control, they can’t be held to account—and hence the Telegraph’s frustration, which boiled over last week.

In fact, economists aren’t experts about the economy in the same fashion that physicists are about nuclear energy. As George Soros argued recently in the Financial Times, the approach Central Banks have been following has clearly failed, and it’s time we gave a new approach a try—one that doesn’t subscribe to the myth that the best market is a deregulated one.

The errors in the Daily Telegraph’s article

The RBA’s job isn’t to tell banks what to charge on mortgages. The one rate they have control over is the inter-bank rate, which is used when one bank has to pay interest to another when their accounts don’t balance. That sets the floor for short term rates–and the RBA supplies as much liquidity as it needs to make sure this rate applies.

Then banks set their own longer term rate in accordance with this base rate and market conditions. In the recent past, competitive pressure from non-bank lenders made the gap between the (short) RBA interest rate and (long) mortgage rates the lowest they’d ever been–but much of that reflects what is now euphemistically called “a mis-pricing of risk”.

The dilemma for the bank is that the credit crunch has caused this once narrow gap between short term and long term rates to balloon–and there’s literally nothing they can do about it. In one sense, it helps keep banks solvent–since they make money from the spread between short and long term interest rates–but it makes the RBA even less able to influence mortgage rates.

The Commonwealth Bank also didn’t increase its rates just because of Stevens’s speech. They would have done their calculations about their increased cost of funding courtesy of the credit crunch, and how much this was costing them, well before the speech. Maybe it did however make them think that “now’s the time” to move on it.

The real issue, as I outline above, is that the era of Central Bank Independence hasn’t “taken finance off the front pages”, but made it front and centre with the biggest financial crisis in world history.

Further reading

• This blog. I started it one and a half years ago, when I concluded that a serious debt-driven financial crisis was inevitable, and someone had to raise the alarm about the possibility of one happening. Here you will find:
  • The Debtwatch Report (21 to date) which come out just before the RBA meets each month to set rates, and takes a topical look at economics and the rate decision in particular;
  • Academic papers that focus on the topics of debt deflation and the monetary system;
  • A Podcast recorded after each DebtWatch report by Stuart Cameron of Rife Media
• My report And Deeper in Debt published by the Centre for Policy Development last September.
• Debunking Economics, a website that supports my book of the same name, and stores my lectures on economics and finance at the University of Western Sydney.
  • The most relevant lectures to explain the approach I take to finance are those on Financial Economics
  • The most accessible lectures on my non-orthodox approach to economics in general are those on Managerial Economics
• Blogs by other commentators whom I believe have a handle on what has happened. For a decade or more, these writers have been “contrarians”, railing against the stupidity of Wall Street and accommodative Central Banks while the rest of the pundits applauded such financial innovations as … subprime loans:
  • Doug Noland and the Credit Bubble Bulletin for the Prudent Bear mutual fund;
  • iTulip, a website first set up by Eric Janszen to critique and satirise the Internet Bubble, and revived when the US housing bubble supplanted it. Eric frequently interviews academic and industry specialists; check out in particular:
    • Interview with Michael Hudson and his analysis of what he terms the “FIRE Economy”–Finance, Insurance and Real Estate
    • My interview on the Financial Instability Hypothesis
  • Robert Shiller’s excellent empirical analysis. Robert coined the phrase “irrational exuberance” that was later made famous by a speech by Alan Greenspan–who unfortunately understood the issues there about as well as Donald Rumsfeld understood Iraq.
    • Shiller maintains a historical database on finance, with freely downloadable data
  • The US Housing Crash Blog
  • Global House Price Crash Blog
  • Housing Affordability Blog
• Lest it be thought that I’m a critic of everything the RBA does:
  • Most of my Australian data comes straight from the RBA Bulletin Statistical Tables
  • The RBA Conference on Asset Prices and Monetary Stability has some excellent papers. I only wish that the orientation set in this conference had guided subsequent RBA policy.
  • This RBA paper comparing the Great Depression to the 1890s Depression is one of the most informative historical analyses I’ve ever read
• Ditto for the US Federal Reserve. While I believe that the “Greenspan Put” has encouraged “moral hazard” behaviour that has made this the worst financial bubble ever, the Fed has also been a bastion of free and accessible data. My US data largely comes from its Flow of Funds report.

• Date: Wednesday April 2nd
• Venue: Sydney Mechanics School of Arts, 280 Pitt St, Sydney NSW 2000 (near Town Hall)
• Time: 6.30pm-8pm
• For more information, contact Troy Henderson (troyh@search.org.au), or just rock up on the night.

My main topic this month is a comparison of the economic events of today to those of 1973-75, but the most recent Case-Shiller data on US house prices simply has to be “the Chart of the Month”. Last *month* the index dropped by 2.3 percent–implying an annual rate of decline in the realm of 25%! US house prices are down 13% from the peak in mid-2006, and in free-fall now.

Meanwhile, back in the 1970s…

In late 1972, Whitlam’s Labor defeated the McMahon’s Liberals, and embarked on an ambitious program of social reform. Two years later, the economy had gone to hell in a handbasket. Inflation tripled from under 5 to over 15 percent, unemployment doubled from under 2 to over 4 percent, and Labor’s reputation as an economic manager was ruined. Labor was slaughtered at the 1975 election, and “stagflation” was the paramount reason for its defeat.

In late 2007, Rudd’s Labor defeated Howard’s Liberals, and embarked on an ambitious program of social reform. Two years later…

Will 1975 make a comeback? Some commentators see ominous signs, with a booming economy and rising inflation: will “stagflation” once again kill a Labor government? Clearly the Rudd Labor Government is determined to avoid this fate. A symbolic freezing of MPs’ salaries was its second policy initiative after the opening of Parliament, while virtually every statement by Treasurer Swan emphasises fighting inflation.

However, identifying stagflation as the villian in 1975 may be a mistake. The real culprit was something entirely different, but strangely familiar: the collapse of a debt-driven boom.

In 1972, the rate of growth of debt accelerated as a speculative boom (mainly in shares) took hold, and just two years later, the debt to GDP ratio had increased by almost a third. Unemployment, which had dropped from 2.5 to 1.7 percent as the boom accelerated, suddenly turned around, hitting 4.75 by the time Whitlam was turfed out of office.

The boom itself was short-lived, and in the context of an overall bear market since the Poseidon bubble of 1970. But it was followed by one hell of a slump, with share prices tumbling almost 60% in two years.

The engine behind the boom and its subsequent bust was the acceleration, and then sudden deceleration, in the rate of growth of debt. Aggregate spending in the economy is the sum of GDP plus the change in debt. With the boom of 1972-73, the change in debt went from providing under 3 percent to over 10 percent of demand.

Then the boom ended, debt went into reverse, and demand fell well below its previous peak.

The collapse in debt gave us the “stag” in stagflation. The “flation” component came from a wages push in a truly fully employed economy (that 1.75 percent unemployment rate should put the recent celebration of “a 33 year low in unemployment” in perspective), and OPEC’s oil embargo and price rises from October ‘73 to March ‘74. If the surge in inflation hadn’t happened, then the downturn caused by the collapse in debt may well have been worse.

The same story played itself out again in 1990 when “the recession we had to have” hit our shores. This time, there was no pre-existing inflationary surge, and inflation fell drastically as the economy went into recession. So the inflation-unemployment story was very different to 1975.

The debt-unemployment dynamics, on the other hand, played to the same tune. The 1980s share and commercial property bubbles were debt-financed, and as debt levels accelerated from 54 to 85 percent of GDP (a rise of almost 60%) unemployment plunged from 9.5 to 5.6 percent.

Then the rate of growth of debt decelerated–as the bubble in commercial property became obviously ridiculous, and the RBA’s dramatic increase in rates finally bit–and the economy went into its deepest recession since WWII.

The 1990s downturn was more severe than the 1970s and mainly because debt was so much more important. Debt’s contribution to demand in the 1980s bubble peaked at 14 percent–compared to 10 percent during the 1970s. Its minimum was actually negative (-1.5%) as corporate Australia drastically cut its debt levels–in part, deliberately and in part under duress.

So what about today? We haven’t had a bust–yet. And by conventional measures, we have had “the longest economic expansion in Australia’s post-War history”. Unemployment has fallen from 11 to 4 percent, while inflation has been quiescent, at normally under 3 percent.

And behind this apparent success, once more, has lurked a debt bubble–the biggest in our history (and I’m talking since Captain Cook). The debt to GDP ratio bottomed out at 79 percent in mid-1993, and began a climb that is truly “the longest expansion in private debt in Australia’s recorded history”. When the “recovery” from the 1990s recession began, the debt to GDP ratio had fallen to 79 percent; it has since more than doubled to 164 percent. This, more so than China, has given us the apparent but illusory economic success of the last fifteen years.

Today, the annual increase in debt is responsible for almost 20 percent of aggregate spending in our economy. We have truly become addicted to debt.

The danger is that, if–when–the rise in debt comes to an end, so too will our apparent economic prosperity. As the 1990s collapse showed, debt can quickly go from making a positive contribution to demand to a decidedly negative one. Given that we have become so much more dependent on rising debt to fuel demand, the scale of the turnaround, when it comes, could dwarf 1990.

The secret to avoiding such problems, of course, is to develop “ a `good financial society’ in which the tendency by businesses and bankers to engage in speculative finance is constrained” –to quote Hyman Minsky from over 30 years ago. But we didn’t do that, and at some stage, we must cope with the consequences.

When that day of reckoning arrives, one thing that won’t make things better is keeping the rate of inflation low. The high inflation of the 1970s is one factor that made that downturn less extreme than it could otherwise have been; and the lower inflation (and almost deflation) of the 1990s extended that recession.

Journalists with long memories may remember Warwick Fairfax lamenting that the low inflation of that time made his woes worse. If inflation had been higher, he could have put up the cover price of the Sydney Morning Herald and perhaps avoided bankrupting the family firm.

With inflation now even lower than it was when the ’90s bubble burst, the real future danger is not rising prices, but the possibility of deflation.

END OF COMMENTARY

But as Steve Jobs sometimes says, “there’s just one more thing”. The next two charts (which appear at the end of the PDF for this month’s Debtwatch) show the nominal and real debt burden on the economy–i.e. nominal (before inflation) interest payments as a percentage of GDP, and real (after deducting the rate of inflation) interest payments.

The nominal burden is edging ever closer to the maximum in recent times: in 1990, when average interest rates were just under 20%, debt was about 80% of GDP, and interest payments represented 16.7% of GDP. The increase in rates and the ever-present trend to rising debt levels will, it seems, lead us to crossing that nominal threshold sometime this year.

However, when we adjust for the impact of inflation, the 1990 debt repayment peak gives way to 1891 and 1931, when falling prices–deflation–drove the real burden of debt up to 19% and 12.5% of GDP respectively.

We’ve already passed the 1990s level of the real (inflation-adjusted) debt burden on the economy; but notice how the recent rise in inflation has actually reduced the real burden of debt recently–even though nominal rates have increased substantially.

Nonetheless, the real burden of debt on the economy is now in the realms of the 1890s and the 1930s, when both debt levels and nominal rates of interest were much lower than today, but the burden was amplified by falling prices–deflation. We are in that same ballpark, even with inflation. The reason I am concerned about the RBA and the Government’s obsession with keeping inflation low is that we could possibly be tripped into deflation when the economy tanks. Then the real burden on the economy would skyrocket–and we would enter a true debt-deflation.