Showing posts with label financial crisis. Show all posts
Showing posts with label financial crisis. Show all posts

Saturday, February 1, 2020

It's official: too much banking is bad for you

When the newish boss of the International Monetary Fund, Bulgarian economist Kristalina Georgieva, contemplates the challenges of the new decade, she thinks of many things: increasing uncertainty, climate change and increasing inequality – particularly the role the financial sector in making it worse.

Georgieva foresees increasing uncertainty over geopolitical tensions, uncertainty that the trade truce between the US and China will last, and uncertainty that governments can fix the frustrations and growing populist unrest in many countries. "We know this uncertainty harms business confidence, investment and growth," she said in a recent speech.

On climate change, after observing that the "brush fires" blazing across Australia are a reminder of the toll on life that climate change exacts, she avoids saying that we are possibly the most vulnerable among the rich countries (something that might have surprised the she’ll-be-right Scott Morrison).

But she did note that it’s often the poorest and most vulnerable countries that bear the brunt of "this unfolding existential challenge". "The World Bank estimates that unless we alter the current climate path an additional 100 million people may be living in extreme poverty by 2030," she says.

The previous decade saw the rich world’s economists become much more conscious of the economic importance of inequality, with the IMF’s economists at the forefront of this realisation. "We know that excessive inequality hinders growth and hollows out a country’s foundations. It erodes trust within society and institutions. It can fuel populism and political upheaval," she says.

Many people think of using the budget to reduce inequality, which they should, "but too often we overlook the role of the financial sector, which can also have a profound and long-lasting positive or negative effect on inequality," she says.

"Our new staff research shows how a well-functioning financial sector can create new opportunities for all in the decade ahead. But it also shows how a poorly managed financial sector can amplify inequality."

"Financial deepening" refers to the size of a country’s financial services sector relative to its entire economy. Georgieva notes that, on one hand, developing countries benefit from the growth of their undeveloped financial sectors as small businesses and ordinary households gain access to credit and saving and insurance products.

The sustained growth in the financial sectors of China and India during the 1990s, for instance, paved the way for enormous economic gains in the 2000s. This, in turn, helped in lifting a billion people out of poverty.

On the other hand, the IMF’s latest research shows there’s a point at which financial deepening is associated with exacerbated inequality and less-inclusive growth. Many factors contribute to inequality, but the connection between excessive financial deepening holds across countries, she says.

Why is too much "financialisation" of an economy a bad thing? "Our thinking is that while poorer individuals benefit in the early stages of deepening, over time the growing size and complexity of the financial sector end up primarily helping the wealthy.

"The negative impact is especially visible where financial sectors are already very deep. Here, complicated financial instruments, influential lobbyists, and excessive compensation in the banking industry lead to a system that serves itself as much as it serves others."

The US has one of the most diversified economies in the world (it has a lot of everything). And yet, in 2006, financial services firms comprised nearly a quarter of the S&P500 share index and generated almost 40 per cent of all profits. (Read that again if it doesn’t amaze you.) Obviously, this made the financial sector the single biggest and most profitable part of the whole sharemarket.

Does that strike you as out of whack? What happened next – the global financial crisis and the Great Recession – tells us that excessive financial sectors increase the risk of financial instability and collapse.

The painfully slow recovery from that episode of financial crisis was the defining issue of the past decade. Research shows that, on average, a country’s financial crisis leads to a permanent loss of output (gross domestic product) of 10 per cent. This can cause a lasting change in the country’s direction and leave many people behind (as the Americans, with their opioid and middle-aged male suicide crises, know only too well).

The IMF’s latest research shows that inequality tends to increase before a financial crisis, suggesting a strong link between inequality and financial instability. But also, of course, the subsequent recession usually leads to a long-term worsening in inequality.

Much effort has been made since the global financial crisis to make the banks more stable and better regulated. But no one imagines this guarantees there couldn’t be another major crisis.

Georgieva says financial stability will remain a challenge in the decade ahead – for all the usual reasons, but also for "climate-related shocks". "Think of how stranded assets [such as now-unviable coal-fired power stations or coal mines] can trigger unexpected loss," she says. "Some estimates suggest the potential costs of devaluing these assets range from $US4 trillion to $US20 trillion."

The private sector and the banking industry, not just governments, have a critical role to play in making the financial system more stable, she says. That’s certainly the case when it comes to the climate’s effect on financial stability.

"The financial sector can play a critical role in moving the world to net zero carbon emissions and reaching the targets of the Paris agreement. To get there, firms will need to better price climate change impacts in their loans.

"Last year, climate change claimed its first bankruptcy of an S&P500 company. It is clear investors are looking for ways to adapt. If the price of a loan for an at-risk project increases, companies may simply decide the money for the project could be better spent elsewhere."

What has stopping climate change got to do with inequality? If we don’t, the consequences will fall hardest on the world’s poor (and Australians).

Monday, October 14, 2019

Barring another financial crisis, it will be a long wait for QE

It’s amazing so many people are so sure they can see where the Reserve Bank is headed. Once interest rates are down to zero it will be on to QE - “quantitative easing” – and negative interest rates, they assure us. Don’t you believe it.

What’s surprising is how heavily the self-proclaimed experts are relying on their vivid imaginations. Or maybe lack of imagination, falling back on the lazy market dealer’s assumption that we should do – and will do – whatever the Americans have done.

What few in the financial markets and financial media are doing is their due diligence: carefully examining what the Reserve – particularly its governor, Dr Philip Lowe – has actually said about its attitude towards “unconventional monetary policy tools”.

Lowe had a lot to say when he appeared before the House economics committee in August. And in the Reserve’s written response to the committee’s questions. As well, Lowe had more to say when delivering a report on the topic by a Bank for International Settlements committee (BIS), which he chaired.

People assume the Reserve is hot to trot. It ain’t. It began the written response by saying “while at this point it is unlikely that the Reserve Bank will need to employ unconventional monetary measures, the [board] considered it prudent to understand the issues involved and has studied the experience of other countries”.

Prudence is the word. Since these are times when the unprecedented has become commonplace, Lowe is resolved to “never say never”. But don’t mistake this for enthusiasm. Read what he says -more in his remarks on his own behalf than as chair of the BIS committee – and you see how reluctant he is to start down the unconventional road.

He keeps repeating that the effectiveness of the various unconventional measures “depends upon the specific economic and financial conditions facing each economy at the time, as well as the structure of its financial system”.

That’s his way of saying, just because the Yanks did it, doesn’t mean we will.

His reference to the particular structure of a country’s financial system is especially relevant to the unconventional tool so many people assume is next: “purchasing government securities, so as to lower long-term risk-free interest rates”.

It’s a lot easier to believe this would stimulate private sector borrowing and spending in financial systems where home loans and business borrowing are geared to “the long end” – such as America’s – than in systems like ours, where lending for housing and small business is based on the short term and variable end of the interest-rate yield curve.

And Lowe’s reference to financial conditions at the time is also relevant: long-term interest rates are already at unprecedented lows. What would be gained by making them even lower?

If there’s one thing we ought to have figured out by now it’s that, whatever ails our economy at present, it ain’t that interest rates are too high.

People in the financial markets can fail to see this because, in all the trading of currencies and securities they do (many, many times more than would be necessary just to provide firms in the real economy with “deep” markets), so many of them make their living betting on the central bank’s next move.

When you’ve fallen into the habit of seeing the Reserve’s main role as holding regular race meetings, you see the conventional race days continuing until the official interest rate hits zero, obliging it to move to unconventional race days.

Trouble is, the Reserve thinks monetary policy is about the effect it has on the real economy of households and businesses, not about keeping money-market dealers in the luxury to which they’ve become accustomed.

For instance, it’s not at all clear that it will keep cutting until it hits zero. In its written response, the Reserve says that reducing the long-term bond rate “would involve reducing the cash rate to a very low level [my emphasis] and possibly purchasing government securities”.

Why get off at Redfern? Because there’s little point in cutting the official rate beyond the point where the banks are able to pass it on to their customers in the real economy.

Similarly, why would the Reserve engineer negative interest rates if the banks couldn’t get away with passing them on to their customers?

Lowe says the most clearly successful use of unconventional tools – buying private-sector securities - was at the height of the financial crisis when “the financial sector stalled and stopped doing its job, hamstrung by losses and drained of liquidity”.

However, security-buying policies aimed primarily at providing monetary stimulus were less obviously successful. So, should another financial crisis cause particular markets to freeze then, yes, sure, the Reserve would be in there taking whatever unconventional measures were needed to get them going again.

Saturday, August 24, 2019

How strange could money get if the worst came to the worse?

With our official interest rate heading ever closer to zero, there’s much talk that the Reserve Bank may be forced to join other central banks in resorting to “unconventional monetary policy,” including QE – “quantitative easing”. But how likely is this? What might it involve? Are there alternatives? And would it be good or bad?

These questions were debated by Dr Stephen Kirchner, of the United States Studies Centre at Sydney University, Dr Stephen Grenville, a former deputy governor of the Reserve now at the Lowy Institute, and Lyn Cobley, boss of Westpac’s institutional bank, at a meeting of the Australian Business Economists in Sydney this week.

But let’s start with what the Reserve’s governor, Dr Philip Lowe, said on the subject to the House’s economics committee earlier this month.

He said it was possible the official interest rate would end up at zero. Here’s the key quote: “I think it’s unlikely, but it is possible. We are prepared to do unconventional things if the circumstances warranted it.”

The Reserve had been doing a lot of thinking about unconventional policies, so as to be ready if they proved necessary, not because it thought them likely to be needed.

“I hope we can avoid that,” he said. Which I take to mean that, should they prove needed, the economy’s prospects would be much worse than they are now. But also that the Reserve doesn’t fancy having to use unconventional methods.

Conventional monetary policy involves the central bank using its “open market operations” (selling or buying Commonwealth bonds from the banks) to push its official interest rate, and hence the banks’ short-term and variable interest rates, up or down so as to discourage or encourage borrowing and spending (“demand”) in the economy.

Lowe’s list of unconventional measures includes the “negative” interest rates applying in Switzerland, the euro area and Japan (where lenders pay the borrowers tiny interest rates; don’t hold your breath waiting for this one), the central bank lending funds to banks at below-market rates provided they lend them on to businesses, the central bank buying corporate bonds or mortgage-backed securities, or intervening in the foreign exchange market to push the value of its currency down.

But the measure Lowe seemed least uncomfortable with is the central bank buying long-term government securities to try to lower risk-free long-term interest rates. This is similar to conventional policy, just at the long end rather than the short end.

Lowe also said that, if it became necessary to start buying long-term securities, you wouldn’t need to have cut the official interest rate to zero before you started. He implied he might go no lower than 0.5 per cent.

Why stop there? Because by then the banks’ deposit rates would be too low to be cut any further, meaning they couldn’t pass the cut on to their home-loan and business borrowers.

However, he admitted, if things got so bad internationally that all the other central banks had cut their official rates to zero, we might be obliged to follow suit. Another possibility would be if our economic growth slowed even further – say, into the 1 per cent range – though in that case a response would be needed from fiscal policy (the budget) as well as monetary policy.

Turning to this week’s debate, Westpac’s Cobley made it clear the banks would have trouble coping with most of the unconventional measures. Even cutting the official rate any further would hit the banks’ profits (sounds of weeping and breast-beating by the bank customers present).

Kirchner, who is among the minority of economists who believe fiscal policy is ineffective in managing demand, saw no problem with using unconventional measures, which could easily have the same effect as cutting the official rate by a further 2.5 percentage points.

He said the consensus of academic studies was that unconventional measures in the US had been quite effective. Grenville agrees with him that, for the central bank to switch from buying short-term securities to buying long-term securities in no way constitutes “printing money” (even metaphorically).

Grenville disagreed with his claim that unconventional measures don’t promote inequality by helping the rich get richer, however. They lead to higher prices in the markets for shares and property, which help expand the economy through a “wealth effect” – working best for the wealthy.

Except where unconventional measures were used to rescue financial markets that had frozen at the height of the financial crisis, Grenville was unconvinced they achieved much. The academic studies made too little distinction between different episodes.

So he opposes taking interest rates lower and moving on to unconventional measures. Rather, the Reserve should tell the government monetary policy had gone as far as it reasonably could – was already “pedal to the metal” – so now it was over to fiscal policy.

Unconventional measures (I think “quantitative easing” is misleading) would probably achieve lower long-term interest rates, inflate asset prices (particularly shares), encourage financial risk-taking and lower the exchange rate, Grenville said.

None of those things seemed particularly desirable, he said. Lower long-term interest rates wouldn’t help much because, unlike in America, Australian households and businesses borrow at the short end. We’ve had plenty of asset-price inflation already.

A lower dollar helps our exporters, but it’s a “beggar-thy-neighbour” policy (inviting others to do the same to us) and, in any case, the dollar is already low enough to make any viable exporter profitable.

When unconventional measures are discussed, some people think of “helicopter money” – governments distributing cash to ordinary punters, from a metaphorical helicopter. But central bankers insist such a measure is not monetary policy and would have to come from the government as part of fiscal policy.

If the government covered the cost of the cash by borrowing from the public in the usual way, such a stimulus measure would be quite conventional – a la Kevin Rudd’s 2008 “cash splash” into people’s bank accounts.

If the government simply ordered the Reserve to credit people’s bank accounts, that would be “printing money” and highly unconventional. Again, don’t hold your breath.

Monday, November 12, 2018

The G20 is a talkfest we need to keep talking

If it’s 10 years since the global financial crisis, it must be 10 years since the elevation of the Group of 20 to the status of a “leaders’ summit” – the next of which will be in Buenos Aires in two weeks’ time.

You could say the decision to supplant the G7 with the G20 as the premier forum for global economic co-operation is the one good thing to come out of the financial crisis.

The G7, like the various international bodies set up after World War II, is too Western and Eurocentric, being limited to rich North America, Europe and Japan.

The G20, by contrast, adds in the developing countries and all parts of the globe, encompassing the G7, all five permanent members of the UN Security Council and all five emerging-economy BRICS – Brazil, Russia, India, China and South Africa.

And did I mention it gives Australia a seat at the top table for the first time?

While the G7 accounts for only about 30 per cent of the world economy (measured according to purchasing-power parity), which is projected to have fallen below a quarter by 2040, the G20 accounts for almost 85 per cent of the world economy, which should still be about that in 2040.

The G20 also accounts for 84 per cent of global investment and 63 per cent of the world’s population.

The rich and poor worlds could have spent years arguing over the formation and composition of such a group, but in the heat of the financial crisis, no one doubted that a representative but not unwieldy whole-world body was needed to quickly achieve a co-ordinated response to the threat of a global depression.

The avoidance of such a calamity is all the proof anyone should need that the G20 has justified its existence.

At the time of the crisis, the G20 achieved co-ordinated discretionary fiscal (budgetary) stimulus averaging more than 2 per cent of world GDP in both 2009 and 2010.

It tripled the International Monetary Fund’s lending capacity and facilitated an increase in lending from multilateral development banks of $US 235 billion, at a time when private sector sources of finance were scarce.

Later, it established the Financial Stability Board to tighten up regulation of the world's financial institutions, including banks judged too big to fail.

It’s also working with the OECD to reduce tax avoidance by multinationals, through its BEPS project – base erosion and profit shifting – and having more success than many imagined it could.

But if you want to argue that, in the years since then, the G20 has done a lot of meeting, talking and passing of resolutions without achieving all that much, you wouldn’t be wrong.

You would, however, have missed the point. Do you imagine this was the last economic crisis the world’s leaders will have to cope with? Or that the next crisis is sure to be decades away?

As Scott Morrison’s G20 “sherpa” (every leader ascending summits needs the assistance of a personal sherpa), Dr David Gruen, said in a recent speech, the G20 is best thought of as an institution that comes into its own when it’s most needed - “more a ‘rough weather’ friend than a ‘fair weather' friend".

It is, he says, like a global fire department. It may sit around for days not doing much, but as soon as the need arises it rushes off to put out the conflagration.

What gives the G20 its fire power is its status as a “leaders’ summit” – all G20 leaders attend summit meetings, almost without exception. And when they attend, they talk to each other, just as Donald Trump and Xi Jinping are scheduled to have a meeting on the sidelines at the summit in Argentina, no doubt to chat about their little trade war.

Let me ask you, which would you prefer – world leaders who knew each other and talked regularly, or leaders who didn’t?

The more meeting and chatting they do, the safer the rest of us are.

Gruen reminds us it was the legendary American economist Thomas Schelling who realised international conflicts can arise simply because one side can't understand what’s eating the other side. That messages sent in public may differ from messages sent in private.

A book Schelling wrote led to the installation of the hotline between the White House and the Kremlin. The annual G20 summits are a big step up from that. Nor does it hurt to have the countries’ finance ministers and central bankers meeting regularly.

With Trump’s America behaving so crazily, picking fights with its allies and major trading partners and threatening the rules-based international order the Americans laboured so long to build, we need the G20 to hang together and keep our leaders talking to each other more than ever.

Monday, September 17, 2018

Long way to go to get banks back in their box

Have we learnt from the mistakes of the global financial crisis, now 10 years ago? Yes, but not nearly as much as we should have.

Of course, the answer is different for the Americans and the other major advanced economies to what it is for us, who managed to avoid bank failures and the Great Recession.

Globally, much has been done under the Basel rules to strengthen requirements for banks to hold more capital and liquidity, reducing the likelihood of them getting themselves into difficulties.

It would be naive, however, to imagine this has eliminated the possibility of any future financial crisis. Recurring financial crises are a feature of capitalist economies through the centuries.

All we can do is work on reducing their frequency and severity. On that score, the rich countries could have done a better job of rationalising the division of responsibility between the various buck-passing authorities supposed to be regulating their financial system.

The root cause of the GFC was ideological: the belief that the more lightly regulated the banks and other financial players were, the better they’d serve the wider economy’s interests, allied with the belief that their greater freedom wouldn’t tempt them to take excessive risks because that would be contrary to their interests.

Wrong. This badly misread the perverse incentives bank executives faced – heads I win big bonuses; tails my shareholders do their dough – and the way the heat of competition can induce business people to do things they know they shouldn’t, not to mention the “moral hazard” of knowing that, should the worst come to the worst, the government will have no choice but to bail us out.

As actually happened. In the North Atlantic economies, politicians and central bankers did the right thing in rescuing failing banks. Had they not, the whole financial system would have collapsed and the loss of wealth and employment would have been many times greater than it was.

But don’t try telling that to a public that watched governments racking up billions in debt to save banks and bankers, who then proceeded to turn out on the street people who could no longer afford the mortgages they should never have been granted.

The US authorities’ mistake was failing to draw a clear distinction between saving banks to protect their customers and stop the system collapsing, and punishing the failed banks’ managers and shareholders for screwing up.

Why didn’t they? In short, because the banks are too powerful politically.

Which brings us to Australia’s response to the GFC and how we escaped the Great Recession. Our big banks didn’t fall over because our econocrats never believed the banks wouldn’t be silly enough to take risks that could endanger their survival. Our banks didn’t buy toxic assets because our prudential supervisors wouldn’t let ‘em.

That didn’t stop the GFC dealing a blow to business and consumer confidence, such that real gross domestic product contracted by 0.5 per cent in December quarter 2008. That we avoided recession is thanks to the quick action of the Reserve Bank in slashing interest rates and the Rudd government in applying huge fiscal stimulus, which stopped the economy unravelling.

At another level, however, the econocrats did believe the banks should be lightly regulated in their relations with customers, and could be trusted not to mistreat them. Outfits such as the Australian Securities and Investments Commission had their funding cut and were given the nod not to be overactive.

The absence of a crash meant our governments didn’t learn that, in the non-textbook world, market forces can cause, as well as limit, the mistreatment of customers. Our own banks’ great political influence reinforced this naivety, prompting governments to wave aside the mounting evidence of bank misconduct and the public’s mounting disquiet and distrust.

So, in a sense, the banking royal commission is the product of our earlier failure to learn what we should have from the GFC.

But there’s a much broader lesson we’ve yet to learn from the crisis, one that applies to all the advanced economies. It’s that the banking and “financial services” sector is far bigger than we need, is bloated by rent-seeking, involves many times more trading between banks (a form of gambling) than trading between banks and real-economy customers, and is thus a waste of economic resources.

When financial services’ share of our economy (and most other advanced countries’) was expanding rapidly in the decades preceding the crisis, economists told us we were benefiting from financial innovation and advances in the management of financial risk.

The GFC revealed that rationale as about 95 per cent bulldust. To misquote Keynes, the economy would be better off if most of the people making big bucks in finance got useful jobs such as being dentists.

Monday, February 12, 2018

Economists do little to promote bank competition

The royal commission into banking, whose public hearings start on Monday, won't get a lot of help from the Productivity Commission's report on competition within the sector. It's very limp-wristed.

The report's inability to deny the obvious - that competition in banking is weak, that the big four banks have considerable pricing power, abuse the trust of their customers and are excessively profitable – won it an enthusiastic reception from the media.

Trouble is, its distorted explanation of why competitive pressure is so weak and its unconvincing suggestions for fixing the problem. It offered one good (but oversold) proposal, one fatuous proposal (to abolish the four pillars policy because other laws make it "redundant") and a lot of fiddling round the edges.

It placed most of the blame for weak competition on the Australian Prudential Regulation Authority, egged on by the Reserve Bank, for its ham-fisted implementation of international rules requiring banks to hold more capital, and for its use of "macro-prudential" measures to slow the housing boom by capping the banks' ability to issue interest-only loans on investment properties.

The banks had passed the costs of both measures straight on to their customers. It amounted to an overemphasis on financial stability (ensuring we avoid a financial crisis like the Americans and Europeans suffered) at the expense of reduced competitive pressure on the banks.

This argument is exaggerated. Even so, it's quite likely that, in their zeal to minimise the risk of a crisis, APRA and the Reserve don't worry as much as they should about keeping banking as competitive as possible.

The report's proposal that an outfit such as the Australian Competition and Consumer Commission be made the bureaucratic champion of banking competition, to act as a countervailing force on the committee that makes decisions about prudential supervision, is a good one.

The report's second most important explanation for weak competition is inadequacies in the information banks are required to provide to their customers. Really? That simple, eh?

See what's weird about this? It's blaming the banks' bad behaviour on the regulators, not the banks. If only the bureaucrats hadn't overregulated the banks, competition would be much stronger.

Why would the bureaucrats in the Productivity Commission be blaming other bureaucrats for the banks' misdeeds? Because this is the prejudiced, pseudo-economic ideology that has blighted the thinking of Canberra's "economic rationalist" econocrats for decades.

Whatever the problem in whatever market, it can never be blamed on business, because businesses merely respond rationally (that is, greedily) to whatever incentives they face. If those incentives produce bad outcomes, this can only be because market incentives have been distorted by faulty government intervention.

Market behaviour is always above criticism; government intervention in markets is always sus.

When the report asserted that the big banks had used the cap on interest-only loans as an excuse for raising interest rates, and would pass the new bank tax straight on to customers, there was no hint of criticism of them for doing so. They were merely doing what you'd expect.

In shifting the blame for these failures onto politicians and bureaucrats, the report fails to admit that the distortion that makes interest-only loans a worry in the first place is Australia's unusual tolerance of negative gearing and our excessive capital gains tax discount.

In criticising the bank tax, the report brushes aside the case for taxpayers' recouping from the banks the benefit the banks gain from their implicit government guarantee, and the case for taxing the big banks' super-normal profits (economic rent), doing so in a way that stops the impost being shunted from shareholders to customers.

Here we see a hint that the rationalists' private-good/public-bad prejudgement​ is only a step away from Treasury being "captured" by the bankers it's supposed to be regulating in the public's interest, in just the way it (rightly) accuses other departments of being captured.

The report's criticism of existing interventions would be music to the bankers' ears. Its fiddling-round-the-edges proposals for increasing competitive pressure have one thing in common: minimum annoyance to the bankers.

The Productivity Commission's rationalists can't admit that the fundamental reason for weak competition in banking comes from the market itself: as with many industries, the presence of huge economies of scale naturally (and sensibly) leads to markets dominated by a few big firms.

Market power and a studied ability to avoid price competition come with the territory of oligopoly. Have the rationalists spent much time thinking about sophisticated interventions to encourage price competition in oligopolies? Nope.

Have they learnt anything from 30 years of behavioural economics? Nope. When you've learnt the 101 textbook off by heart, what more do you need?

Saturday, June 3, 2017

How and Why we've escaped recession for so long

When Glenn Stevens took over from Ian Macfarlane as governor of the Reserve Bank in September 2006, both men knew the new boy was being handed a poison chalice.

By the time of the deep recession of the early 1990s, Australians – like the citizens of most developed economies – had got used to enduring a recession roughly every seven years.

But Macfarlane had been governor for 10 years, and had been extraordinary lucky to get through all that time without a severe downturn.

It was obvious to both men that Stevens wouldn't be as lucky. We were overdue for a recession and it was bound to occur sometime during Stevens' term, probably early on.

Except that it didn't. When, after his own 10-year stint, Stevens handed over to his government-chosen successor as governor, Dr Philip Lowe, in September last year, he was leaving the job with his record unsullied.

This time there were no forebodings about a doomed inheritance, even though it's only natural to fear that each successive quarter of this world record run must surely increase the likelihood of it coming to a sticky end.

Certainly, there would be few economists so foolhardy as to predict that their profession had finally conquered the booms and busts of the business cycle. Most remember that such bouts of hubris had afflicted – and in the end, mightily embarrassed – the dismal scientists before.

No one wants ultimately to be caught having made that stupid mistake a second time. So, a commercial message sponsored by your local friendly economist: rest assured, we'll have another bad recession sooner or later.

Human nature being what it is, keeping in the forefront of their minds the very real risk of another recession is the best way the managers of our economy can avoid the negligent overconfidence that could bring our record run to an ignominious end.

Of course, the politician with the strength of character to avoid complacency and self-congratulation for a remarkably good performance has probably yet to be born.

That's why this story began, and will continue, as a story about the people who have most say over the day-to-day management of the economy: not the politicians, but the bureaucrats in our central bank.

It's important to remember that Australia's run without a severe recession became a personal best, so to speak, many years ago, and for many years has exceeded the records achieved in all other developed countries – bar the Netherlands, with its freakish record of 103 quarters, almost 26 years, of continuous growth. Until now, as the world record passes to us.

An obvious question to ask is how Australia managed to avoid serious damage from the global financial crisis of 2008, when almost every other advanced economy was laid so low by the Great Recession.

The short answer is first that, thanks partly to the bureaucratic bum-kicking Peter Costello did after the collapse of the HIH insurance group in 2001, our bank regulators kept our banks under a tight rein, preventing them from doing all the risky things the American and European banks were allowed to.

Second, the Reserve Bank positively slashed interest rates the moment it realised the severity of the crisis, while the Rudd government ignored the dodgy advice it was getting from then-opposition leader Malcolm Turnbull and sections of the media, and splashed around a lot of cash.

Both the rate cuts and the cash splash had the intended effect of steadying the badly shaken confidence of businesses and consumers, thus quickly arresting the self-reinforcing downward spiral of fear and belt-tightening that causes all deep recessions.

Third, whereas many employers had previously responded to a downturn in demand for their product by laying off staff, this time many of them, hoping the downturn would be temporary, limited themselves to putting all their staff on a period of short-time working.

This restraint on the part of business proved a much less damaging approach for everyone.

But remember this: most advanced economies have suffered not one, but two or three deep recessions since the world recession of the early 1990s.

So there has to be more to our 26-year record than just our deft response to the GFC.

The deeper reasons for our success start with the factor already alluded to: our politicians' decision in the first half of the 1990s to hand control of interest rates to the central bank, acting independently of the elected government.

Turns out moving interests rates up and down in response to the business cycle, as opposed to the proximity of elections, is a big improvement in keeping the economy chugging steadily along.

The other beneficial change was all the "micro-economic reform" undertaken mainly during the term of the Hawke-Keating government, often with bipartisan support from the opposition, led by John Howard and Dr John Hewson.

Deregulating the financial system, floating the dollar, rolling back protection against imports, decentralising wage fixing and the deregulation of many particular industries had the combined effect of making the economy more flexible, less inflation-prone and better able to reduce unemployment.

The era of micro reform didn't achieve the hoped for continuing improvement in productivity, and had various adverse side-effects, but it did make it much easier for the central bankers to keep the economy on an even keel.

Monday, April 25, 2016

Is the world ruled by ideas or by interests?

Most economists believe John Maynard Keynes (rhymes with "brains" not "beans") was the greatest economist of the 20th century. But his most famous quote is one I've never been sure I agree with.

He claimed that "the ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood.

"Indeed, the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.

"Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back."

One man who definitely agrees is Barry Schwartz, a professor of psychology at Swarthmore College in Pennsylvania. He writes in his book Why We Work that, where once our ideas about human nature may have come from our parents, our community leaders and our religious texts, these days they come mostly from social science.

"In addition to creating things, science creates concepts, ways of understanding the world and our place in it, that have an enormous effect on how we think and act," Schwartz says.

"If we understand birth defects as acts of God, we pray. If we understand them as acts of chance, we grit our teeth and roll the dice. If we understand them as the product of prenatal neglect, we take better care of pregnant women."

Schwartz says that because ideas aren't objects, to be seen, purchased and touched, they can suffuse through the culture and have profound effects on people before they are even noticed.

And ideas, unlike things, can have profound effects on people even if those ideas are false.

I don't doubt that, in this, both Schwartz and Keynes are right. The social world is far too complex for any of us to really understand how it works. So we observe what's happening and then come up with theories - "models" - about how it works.

Those theories inevitably influence the way we think about the world, the way we react to it and the way we try to get some control over it.

But the world is so complex that we can have lots of different theories about it, or different aspects of it. Many of those theories will have an element of truth and an element of error.

We probably should have a toolbox full of theories, choosing to use the one that best fits the particular issue we're focusing on.

But human nature - our limited cognitive processing power - leads us to simplify things, settling on the one that seems to work best and apply to most circumstances. We remember it, and forget the others.

Often, of course, we don't do a lot of thinking about which theory is best, we just go along with the one most of the people around us seem to believe.

It's also true that the theories and models we rely on, consciously or unconsciously, become, as the sociologists say, "performative" - if enough people believe the world works in certain way and act on that belief, to some extent the world does start to work that way.

There are limits to this, of course. For a few decades economists allowed their dominant model - their group's way of thinking - to convince them the deregulation of the banks had brought us to the era of Great Moderation, of low inflation and unemployment with ever rising prosperity.

Their model blinded them to the global financial crisis that was coming and the years of economic malfunction that would follow.

There could be no more costly demonstration of the inadequacy of their theory about how the world worked.

So no argument: ideas have a huge effect on the world - for good or ill. But does that mean "the world is ruled by little else"?

I doubt it. The main rival for that title is the thing economists exalt above all else: self-interest. What happened to the rich and powerful, don't they have any influence on how the world is ruled?

The more I observe our politics, the more I see it as an unending battle between powerful interest groups. The political parties, contending for their own share of power, negotiate their way around the most powerful of the various interest groups.

The problem is the power democracy still gives to ordinary punters. Should I try to win votes by promising a royal commission, or should I keep in with the banks - and their generous donations to election funds - by promising to bash them with a feather?

So, do ideas really trump vested interests? Surely we're ruled by some combination of the two.

But the more I understand the weaknesses in the economists' dominant ideas about how the economy works and should work, the more I see what a bad predictor their model is, the more I wonder how such a flawed theory remains so dominant, largely impervious even to stuff-ups as monumental as the Great Recession.

Then a terrible thought strikes: maybe their ideas remain so influential in politics and the community because they happen to suit the interests of the rich and powerful.

Wednesday, April 20, 2016

Why the banks' activities should be constrained

Is there any justification for a royal commission into the conduct of the banks? Is it just a political stunt? All royal commissions are called for political reasons and many are stunts, in the sense that their primary objective is just to bring particular issues into the public spotlight.

To me, the best justification for an inquiry into the banks is that they still don't seem to have got the message. They've been caught treating their customers badly, but so far they've shown little sign of contrition - sorry about the few bad apples, but I didn't know - and little willingness to make amends.

For years they've been locked in a race to maximise profits. They've put profits and executive bonuses ahead of the interests of their customers, and seem keen to resume profit maximising as soon as the fuss declines.

We need to keep the fuss going until the bank bosses realise how unacceptable we find their behaviour. Only then may they accept the need to stop incentivising​ their staff to exploit their customers' vulnerabilities, even at the cost of a little profit.

But if you think we have trouble with our banks, you should get out more. So far, at least, we've been let off lightly. I've just been reading the latest book about the banks' central role in causing the global financial crisis of 2008 and the Great Recession it precipitated.

Almost eight years later, the recovery has been anaemic and looks like staying that way for years yet. If China's slowdown becomes a "hard landing", it's likely to be because the financial crisis has finally caught up with it, too.

The book is Between Debt and the Devil, by Lord Adair Turner, who took over as chairman of Britain's Financial Services Authority just as the crisis struck.

Among the many reservations that may be expressed about the "financialisation" of the developed economies - the huge expansion in the share of the economy accounted for by the banks and other providers of financial services over the past 30 years - Turner is particularly critical of all the credit creation - lending - the banks have done.

For decades before the crisis, in every developed economy, bank lending grew at two or three times the rate at which the economy grew.

Central bankers and other economists came to believe this was normal and natural; how you achieved a growing economy.

In reality, it just meant that when the mountain of credit finally collapsed, plunging the world into its worst recession since the 1930s, many households and businesses were left deep in debt.

According to Turner, it's this "debt overhang" that's doing most to stop the major economies returning to healthy growth. As part of the initial response to the crisis, governments shifted much of the banks' own debt onto the government's books.

This did nothing to diminish the overall amount of debt, just made governments reluctant to increase their spending to support the economy.

But it's the continuing debts of businesses and households that do most to explain the continuing sluggishness of the major economies. When your debt far exceeds the value of your assets, you cut your spending to the bone so as to use as much of your income as possible to pay down that debt.

Trouble is, when so many others are doing the same, their spending cuts cause your income to fall, leaving you with little to use to repay debt. The economy can't really recover and, collectively, it makes little progress in "deleveraging" - getting its debt below the value of its assets.

This is the bind the North Atlantic economies find themselves in.

Turner says the huge growth in bank-created credit has been particularly pernicious because the banks much prefer to lend for purchases of real estate. They do little lending to big businesses investing in expansion, and much of their lending to small business is secured against the owner's home or other property.

Trouble is, with the banks infinitely willing to lend for housing, but with the supply of land in desirable locations strictly limited, the inevitable result is to bid up house prices.

This explains why - though local economists staunchly reject the thought - when foreign economists look at our stratospheric house prices and record rate of household debt, almost to a person they see an asset-price bubble that must one day burst.

Turner devotes much of his book to proposing radical ways the major economies can extract themselves from their unshakable debt overhang and return to healthy growth, and to proposing ways governments can curb their banks' unending credit creation so as to ensure it's a long time before their excessive lending for real estate brings on the next global financial crisis.

But ever-increasing lending is the main way the banks make their ever-increasing profits. They would put up an enormous fight to stop governments clipping their wings in this way.

Which brings us back to the royal commission. Do we want to be governed by politicians deferring to their generous backers in banking, or do we want to send politicians and bankers alike a message that the interests of customers and the wider economy must come first?

Saturday, February 6, 2016

We're a long way from getting bank regulation right

The movie version of The Big Short is so good you probably don't need to read the best-selling book by my far-and-away favourite finance writer, Michael Lewis.

If you want to go deeper than the events culminating in the global financial crisis of 2008 to a more systemic analysis of why we've had so much trouble with the financial system and will continue to unless we change the rules more radically than we have, I recommend you read Other People's Money, by a leading British economist, Professor John Kay.

It's required reading for the nation's economists but, although it's very thorough, it's eminently readable by ordinary mortals. Similarly, although it doesn't deal specifically with Australia's financial system, its analysis is more readily applied to Oz than a book more focused on Wall Street.

Kay was in Australia this week, and when I spoke to him he left me in little doubt that he wasn't wildly impressed by our financial system inquiry, conducted by a panel dominated by people from the industry and led by former Commonwealth Bank boss, David Murray.

Not much there to ruffle the industry's feathers.

The Murray report does little to contradict the conventional wisdom that the huge expansion of the "financial services" industry over the past 30 years has been a great boon to the wider economy.

We've benefited from much financial innovation, deeper financial markets and a revolution in the management of financial risks.

But have we? We've certainly enjoyed much greater access to credit and much more convenient banking thanks to automatic tellers, direct debits and credits, and bill-paying on the internet.

But much of this is owed to advances in information processing and telecommunications rather than banking expertise.

Much of the "innovation" in the development of new financial products has been motivated by a desire to get around government taxes and regulations.

We're often told that all the trading of financial claims the banks and other market participants do between each other has made financial markets deeper and more liquid, thus making it possible for bank customers – individuals or businesses – to buy or sell a large block of shares or currencies without their transaction having a big, adverse effect on the market price.

Kay counters that all the trading of claims between financial institutions has, in fact, made financial markets far deeper than is required by users from the "real economy". Their need to buy and sell securities without moving the price could be met by opening the markets for a quarter of an hour a week.

But surely all that trading – in conventional securities, but also in ever-more exotic "derivatives" that get ever-more removed from the physical assets they are supposedly derived from – is aimed at helping customers manage the financial risks they face.

Well, that's what bank bosses and economists told us for years. Kay recalled the now-infamous incident in 2005, where a young Indian upstart from the International Monetary Fund attending the US Federal Reserve's annual conference at Jackson Hole, Wyoming, queried the value of recent innovation in financial markets and warned of troubles ahead.

The young fool was quickly put back in his box. One heavy defended the innovations, claiming that "by allowing institutions to diversify risk, to choose their risk profiles more precisely, and to improve the management of the risks they take on, they have made institutions more robust".

"These developments have also made the financial system more resilient and flexible – better able to absorb shocks without increasing the effects of such shocks on the real economy," he went on.

Later, another heavy agreed: "Financial institutions are able to measure and manage risk much more effectively. Risks are spread more widely, across a more diverse group of financial intermediaries, within and across countries."

You've guessed how this story ends. Within two or three years, the global financial crisis revealed all that as the opposite of the truth – to the great cost of taxpayers who had to bail out banks in the US and Europe and all the people in the real economy who lost their jobs or businesses.

It turns out the financial markets weren't managing risk by spreading it thinly across many people – as happens with an insurance policy, for instance – but were multiplying it (by gearing up and by creating derivatives of derivatives) and concentrating it in the hands of a relatively small number of big banks. Nobody knew how much risk particular banks had taken on.

The other way to "manage" risk is to find someone whose particular circumstances give them the opposite "risk profile" to yours. Do a deal and the problem is solved at each end.

In practice, however, such perfect matches are very hard to find. The best you can do is find a partner who's "risk seeking" – they want to take on the risk because there's a chance they'll clean up if you've jumped the wrong way.

In other words, they're willing to speculate. Turns out that's the main thing our bigger financial system is doing: not managing risk in any genuine sense, just making bets with each other.

These days, no central banker makes speeches extolling our bigger financial sector and much better ability to handle risk.

Trouble is, Kay says, all the tightening of regulation – including the requirement for banks to hold higher levels of capital, which the Murray report so strongly supported – hasn't done enough to ensure we don't have another crisis.

We have loads of regulation, all of it acceptable to the banks, whatever their grumbles. We could have less regulation if we regulated the right things the right way.

We could leave speculative trading between financial institutions largely unregulated provided it was separated from the normal banking activity than must always be effectively government-guaranteed. But the banks mightn't like that.

Wednesday, February 3, 2016

Good reason to be angry about the banks

Are you angry about the banks? A lot of Australians are. And a lot of people in the United States and Europe are a lot angrier than we are, with good cause.

In Oz, we're annoyed mainly by the banks' very big profits and the way they never seem to miss a trick in keeping those profits high.

In other countries, people are angry about the way the banks and other financial institutions, having stuffed up their affairs to the point where they almost brought the global economy to its knees, were promptly bailed out at taxpayers' expense, so that few went bust, with almost no executives going to jail and many not even being fired.

By now, however, you're probably used to bankers and economists saying you don't understand and are quite unreasonable in your criticisms.

That's why you need to know about the book, Other People's Money, by John Kay. Kay, who's visiting Australia and this week spoke to a meeting organised by the Grattan Institute, says he wrote the book to help ordinary people understand "what it is they're angry about".

You want the dirt on the banks? No one's better qualified to spill the beans than Kay, an economics professor from Oxford and columnist for the Financial Times, who was commissioned to write a report on the sharemarket for the British government.

He starts by noting that over the past 30 or 40 years, each of the developed economies has experienced "financialisation" – huge growth in the size of what these days is called their "financial services sector" to the point where it's among their biggest industries.

For years, we've been told this is a wonderful thing, a sign of our economy's growing sophistication and ability to manage risk. Kay doesn't believe it.

We've always had a financial sector composed of banks, insurance companies and other institutions, and we've always needed one.

We've needed it to help us make payments to each other, to bring people wanting to save together with homeowners and businesses wanting to borrow, to help us save for retirement and to help individuals and businesses manage the risks associated with daily life and economic activity (insurance policies being the obvious example).

We need a financial sector to service the needs of the "real economy" of households and businesses producing and consuming goods and services. But none of this justifies the huge growth in the financial sector we've seen.

Most of that growth has come in the form of massively increased trading between the banks themselves in "financial claims", such as shares and bonds and foreign currencies and "derivatives" (claims on claims, and even – if you've seen The Big Short – claims on claims on claims).

If you add together all the financial assets ("claims") owned by all the banks and other financial outfits, they exceed by many times the value of the physical assets – such as houses and business buildings and equipment – which are the ultimate basis for all those claims.

The value of foreign currencies changing hands each day vastly exceeds the value of currencies needed by businesses and tourists paying for exports and imports. Similarly, the value of shares changing hands each day vastly exceeds companies' needs to raise new share capital and end-investors' needs to buy into the market or sell out.

Kay says that, in Britain, bank lending to firms and individuals in the real economy amounts to only about 3 per cent of their total lending.

All the rest is lending to other banks and institutions busy buying and selling bits of paper to each other – making bets with each other that the prices of those bits of paper will rise or fall in coming days.

Kay makes what, for an economist, is the very strong condemnation that almost all this speculative activity is "socially unproductive". It might or might not benefit the people doing the trading, but it's of no benefit to the rest of the economy.

He observes something I've noticed, too: economists have put little effort into explaining why all this trading in claims is so hugely profitable, allowing people near the top of the banks (but not their many foot soldiers) to be paid such amazing salaries.

If all they're doing is making bets with each other, why aren't the gains of the winners exactly cancelled out by the losses of the losers?

His answer is that the claims-trading parts of banks have found ways to exaggerate the profits they make by counting expected future profits they haven't actually captured – "paper profits" – but delaying recognition of expected "paper losses" until they're realised.

This game can continue for as long as everything's on the up and the bubble's getting bigger. Once it bursts, of course, former supposed profits become present, unavoidable losses. Many banks teeter on bankruptcy, but the government bails them out and they live to gamble another day.

Kay says the answer is to rigidly separate the old-fashioned parts of banking – the facilitation of payments, and lending to households and businesses; the bits that must be kept going through recessions – from all the speculative trading in claims.

It's a free country and "investment" banks should remain free to bet against each other, but there should be no taxpayer bailouts or other government protection for those that do their dough.

Saturday, July 4, 2015

Two other ways globalisation is changing things

We're still learning to cope with a globalised world. Things work a bit differently now, and we have to adjust our thinking accordingly.

Globalisation – the breaking down of barriers between countries – is leading to increased trade between economies and increased flows of financial capital around the world, not to mention greater flows of people.

Another dimension of globalisation that's having big effects without being widely noted is the globalisation of news.

News of important happenings somewhere around the world now reaches most people in the rest of the world with a delay of maybe only a few minutes.

Because humans have evolved to continuously monitor their environment in search of threats, the news that interests us most is bad news. The news media are only too happy to oblige. They ignore all the good things that are happening, and all the everyday things as well, to give us a concentrated dose of any highly unusual, bad thing that's happening anywhere in the world.

The question is whether we're capable of absorbing this quite unrepresentative picture of what's happening around us without unconsciously reaching the conclusion that the world is in much worse shape than it actually is.

One lesson we've learnt is that everything in different parts of the world is now much more interconnected. That's true – particularly in the global economy – but we can take it too far.

The classic example of the heightened economic effects of globalised news was the global financial crisis of 2008, when news of crashing sharemarkets and teetering banks in America and Europe was beamed into living rooms all around the world every night for a month.

Ordinary people in distant countries such as Australia had to judge how this absolutely frightening news might affect them. They assumed the worst. Business and consumer confidence plunged and households and businesses began battening down the hatches, moving money between banks and cutting their spending.

It turned out all our banks were safe. Thanks to our tight supervision of them, they had no "toxic debt". But the government did have to help them when the international financial markets in which they borrowed stopped operating briefly.

The point is, our consumers and businesses were so frightened by all they'd heard about troubles overseas that we could have had a local recession anyway, had the Rudd government – and the Reserve Bank – not acted so quickly and effectively to calm people down with "cash splashes" and news of its plans for stimulus spending.

Now the big news is Greece's financial troubles, about which the media assume our curiosity knows no bounds. The obvious question for news consumers to ask is, how will this affect me?

Short answer: probably it won't. We can feel sorry for the Greeks, or not, but we need to remember Greece is a country of just 11 million people, with an economy representing about 0.4 per cent of the world economy and the tiniest share of our exports.

It is true that, should Greece exit the eurozone, this would raise uncertainly about pressure on the other weak and heavily indebted member countries, and this could lead to the euro currency union coming to a messy end.

If that were to happen – which wouldn't be any time soon – it would have flow-on implications for every country. But you'd have to say that, just as living on a Greek island would be a good way to get as far away as possible from any problem in Australia you were trying to escape, the reverse also applies.

Another way we're still adjusting to how globalisation is changing things concerns the way we've always measured international trade. This story is told in the Productivity Commission's annual report on trade and assistance.

Every country has always measured the "gross" value of its trade. The full value of each exported good or service has been attributed to the last industry that handled the item and to the country it was sent to.

But the advent of "global value chains" – where the production of manufactured goods in particular is spread between countries, with parts coming from various countries to be finally assembled in another country – has made this gross value approach ever more misleading.

So the World Trade Organisation is now making more use of individual countries' "input-output tables" to measure exports on a "value-added" basis. That is, each industry sector that contributed to the production of an export item gets the credit for the value it contributed to the final price.

Doing the numbers on this more accurate basis makes a big difference. The final price of manufactured goods, for instance, includes the value of raw materials provided by agriculture or mining, plus the value provided by service industries such as transport and providers of professional and scientific services.

Looking globally, manufactured goods' share of total world exports drops from 67 per cent to 40 per cent, while services' share doubles to 40 per cent. The shares of agriculture and mining increase from 13 per cent to 20 per cent.

The new story for Australia is different because our exports are dominated by primary products. Using the most recent figures available, for 2008, the commission estimates that manufacturing's share of our total exports drops from 36 per cent to 14 per cent, while services' share jumps from 18 per cent to 42 per cent.

Agriculture's share is unchanged at about 4 per cent, while mining's share drops only a little to 40 per cent.

As for the destination of our exports, looking at the period from 2002 to 2011, North America and Europe's share rose from 23 per cent, measured on a gross basis, to 32 per cent on value-added. The shares of our Asian customers fell.

One lesson: we should worry less about the decline of manufacturing and think more about the rise of the services economy.