Credit Code Red

by Peter Brain

  At present, the evidence is that the government intends to let things slide. One indication is the absence from the most recent budget papers of any projections of foreign debt and available foreign-exchange reserves. A second worrying indication is the use of interest rates to encourage household borrowing, so as to boost dwelling prices and nominal wealth, and so justify yet more equity withdrawal. Consumption thus financed results in ever-increasing household debt-to-GDP ratios and additional foreign borrowings. Again, the government has shown little concern for the survival of import-competing industries damaged by the high exchange rates of the recent past. In the following chapter, we consider the steps the Australian government could take to restructure the economy so it acquires greater resilience. There is so far no sign that such policies are under consideration, or even any recognition that there is a need for them.

  Our conclusion must be, regretfully, that current policies can have no other outcome than economic catastrophe, or, at best, a severe crisis-avoiding recession. Current policy accordingly merits a Code Red alert.

  8

  Economic policy after neo-liberalism

  In 2016, the Washington Consensus collapsed as a policy paradigm in the United States and the United Kingdom — the two countries that, three decades before, had adopted it most enthusiastically. It was simply voted out. In this sense, everything has changed. It is no longer possible to defend economic policies on the grounds that they implement neo-liberal principles.

  In another sense, nothing has changed. This is because the immediate beneficiaries of the disruptive political forces unleashed during 2016 have not been left-of-centre parties that, despite dalliances with neo-liberal economics, have at least recognised the costs of the Consensus policy package, and have developed rational if weak policies that address these costs. The beneficiaries have instead been ‘populist’ coalitions with political philosophies and economic policies anchored in the recent neo-liberal past. In the United States, the policy is to sacrifice free trade to save the central small-government thrust of the Consensus. In the United Kingdom, a key intellectual component of the argument for Brexit was that the regulatory and trade-diversionary impacts of the European Union had pushed the economic potential of the country below the levels that would have been generated had it been able to fully implement Consensus policies. In both countries, the perpetrators of inequality have survived the backlash against it, admittedly in tattered ideological clothes.

  How was this possible? From our Keynesian viewpoint, it was possible because the electorate had been bamboozled by three decades of neo-liberal indoctrination. The left-of-centre parties, during their periods in power, had lost legitimacy by doing too little to address the costs of Consensus policies; indeed, at times they offered bipartisan support for neo-liberal reforms.

  The time will come when the economically disadvantaged supporters of the 2016 disruptions in American and British politics will recognise that they have been cheated yet again. When they realise that their relative positions have once again declined, they are likely to lash out. The direction that their anger will take cannot be known. All that can be said with any confidence is that with each year that passes of inappropriate and ineffective policies, the resources available to fundamentally restructure the economic system will decline, and political dysfunctionality will worsen. Political and economic history is replete with vicious as well as virtuous cycles. It looks as though the main Anglophone countries, which benefited so much from virtuous cycles in the post-war period, are now condemned to a generation or more of vicious cycles.

  The government of China no doubt interprets the current economic and political disintegration of the United States as fulfilling the Marxian prediction that advanced capitalist economies will inevitably collapse, due to irreconcilable contradictions in their economic structure. It is likely that China perceives an opportunity to place itself at the centre of a bloc of developing and emerging economies. This opportunity will open wide if the United States withdraws from its role of protector and regulator of the current world trading system, as is likely if it fails to move beyond its infatuation with small government.

  If a central cause of the collapse of Washington Consensus in advanced economies can be identified, it would be the failure of the leading neo-liberal countries, the United States and the United Kingdom, to distribute the rewards of increases in productivity fairly to those who contributed to the increases, and their failure to implement industry-assistance measures to give declining industries and regions a chance to re-invent themselves on a firmer economic basis.1 Both countries failed to ensure that all boats rose on the tide of globalisation. They assumed that markets were more rational, and indeed more virtuous, than can reasonably be expected of businesspeople acting in self-interest. The alternative was for governments to adopt a more complex policy model than the Consensus — a model that recognises multiple economic targets, and that permits the use of wide-ranging economic-policy instruments to achieve those targets. This model would recognise the limitations of governments; it would leave scope and provide finance for individual enterprises, while guiding the general direction of economic development.

  In particular, financial deregulation has proved to be a very poor choice. We have recounted how, in the 1970s and 1980s, the developed capitalist countries had the option of moving from a failing system of quantitative financial controls to a more nuanced qualitative system, but chose deregulation and the Consensus instead. What the North Atlantic countries rejected, China adopted, contra to all contemporary expectations. By implementing economic planning that combines qualitative bank controls at the strategic level with considerable freedom of action at the enterprise level, it achieved the leap forward that had eluded its communist government in the 1960s.

  If financial deregulation was a very poor choice, what is to succeed it? Some form of re-regulation, doubtless, but it would also be helpful if the financial culture could regain some of the conservatism that characterised it in the post-war period — indeed, in Australia, that characterised it for the whole of the twentieth century up to the era of financial deregulation. A combination of regulation and conservative financial culture is essential if the cool voice of prudence is to be effective in countering the gung-ho assessments of quick profit that generate bubbles and equity withdrawal.

  What happened to prudence?

  Prudence was established as a moral and intellectual virtue in the days of Plato and Aristotle. According to the philosophers, prudence aids the pursuit of the Good, and includes the willingness to learn from experience and the application of reason to such learning. It includes shrewdness, caution, and foresight in decision-making. As applied to economic activity, the Good is made concrete in the aim of prosperity, but the other elements of prudence such as shrewdness and foresight remain unchanged.

  Borrowing and lending are an essential, integral part of the economic system, but are necessarily risky. It is prudent to manage the risks. The cardinal rule for lenders is that it is imprudent to lend to spendthrifts, or more generally for purposes that do not yield cash flow with which to repay the loans. From the point of view of honest borrowers who fully intend to meet their commitments, borrowing is imprudent if it is used to finance consumption and to add liabilities to one’s balance sheet without generating corresponding income-yielding assets.

  These rules of prudence apply a fortiori to financial intermediaries. Banks that wish to remain in business over the long term have strong incentives to be prudent, both when borrowing and when lending. This affects their decisions as to when and how much to borrow and lend, from whom and to whom, and their provisions for the inevitable bad debts that result from the uncertainty of economic affairs. Short-term profits from risky borrowing or lending are a constant temptation. Banks that fail as a result of succumbing to this temptation impose major costs on the economy — hence the need for prudential regulation of them.

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sp; The aim of prudential regulation is to ensure that financial intermediaries can meet their contractual obligations as borrowers. The classic form of prudential regulation concentrates on cash reserves and capital adequacy. Such regulation curbs both lending and borrowing, and encourages intermediaries to manage their risks.

  Where loans cross national boundaries, an additional prudential condition applies: there must be a flow of foreign exchange with which to repay them. Preferably, each loan should be so invested as to contribute to this flow, either directly via export-intended or import-competing production, or indirectly by supporting exporting or import-competing industries. Though it is prudent that each sum borrowed overseas be invested to yield returns in foreign exchange, in practice the foreign-exchange earnings of an economy are pooled by the Reserve Bank and the financial markets. Businesses that borrow overseas are not expected to earn their own foreign exchange with which to repay their loans; instead, they have access to the pool of foreign exchange. This is fine, so long as overseas borrowing in aggregate generates enough foreign exchange with which to repay debts, but it necessarily dilutes individual borrowers’ incentive to observe prudence in undertaking such borrowing. Prudential regulation of overseas borrowing can only be implemented at the macroeconomic level.

  Given Australia’s position, we have emphasised the costs of imprudent international borrowing. However, it should be recognised that this has a counterpart in the form of imprudent international lending. Among private investors, this takes the form of fixed-interest lending where equity investment would be more appropriate, and at government level it takes the form of an excessive accumulation of international reserves. To appropriate a word from Hayek, financially dominant countries are tempted to drive weaker countries into serfdom — into debt-servitude. Short of this, an undue concentration on the accumulation of foreign-exchange reserves, historically known as mercantilism, risks a power struggle in which dominant countries attempt to inveigle the rest into debt. If trading and investing nations lose sight of the mutual benefits of trade, and instead concentrate on trying to dominate each other, the trading system collapses. However, Australia cannot be accused of this; its problem is the imprudent accumulation of debt, not the excessive accumulation of foreign exchange reserves and other short-term financial assets.

  The imprudent lending and borrowing that we have recorded in this book occurred despite the existence of the Australian Prudential Regulation Authority and its predecessor department of the Reserve Bank. The Authority interpreted its mandate as being to ensure that financial institutions maintained sufficient reserves of cash and equity capital to meet their outgoings in the event of recession. It did indeed prevent the banks from engaging in the wilder forms of lending that were pioneered in the 2000s by the American financial sector; however, like the rest of the Australian policy establishment, the Authority remained bound by neo-liberal theory, with its magical reliance on markets to guard against imprudence at the macroeconomic level. The Authority has lately come to recognise macroeconomic risks, but the measures it has taken to counter them are likely to be too little, too late. As a result of three decades of neo-liberal policies, the Australian authorities now face a dual conundrum: how to repair the damage of the past three decades while reinstating the role of prudence, including macroeconomic prudence, in the administration of the financial sector.

  Whatever may be the case in countries where the public finances have spun out of control, in Australia direct responsibility for the risky state of the national balance sheet lies squarely with the finance sector. It will be noted that this sector is directly responsible for the current alert status of five of Australia’s European Commission macroeconomic imbalance indicators (see Chapter 1): the current-account balance, the international investment position, the real effective exchange rate, private-sector debt, and private-sector credit flow. Via mortgage lending, it also drives the annual change in real house prices.

  If the European Commission, the International Monetary Fund, and others are correct in their argument that economic collapse is predictable once specific indicators attain unfavourable values, it follows that prudential regulation of the finance sector should target these indicators. This should be done in addition to the current emphasis on capital adequacy, and especially so in a country like Australia, which has shown itself prone to excessive overseas borrowing. In particular, when the indicators show that overseas borrowing has become excessive, prudential regulation should curtail overseas borrowing, and, on the other side of finance-sector balance sheets, should curtail new lending to the private sector — especially new lending that is driving up house prices. This would involve slimming the financial sector from its present 9 per cent (or more) of GDP to within the 4–6 per cent range. This is the range recorded in European countries that are successfully managing their financial affairs, and it still furnishes a sufficient flow of funds to reward the finance sector for the essential services that it provides.

  Be not deceived: these prudential policies would look very much like an old-fashioned credit squeeze, and their immediate result would be a recession. Such a recession can assist in avoiding a full-blown crisis by reducing imports, both directly as a result of lower incomes, and indirectly via the discouragement of import-intensive expenditures.

  Prudential policy with regard to the exchange rate is likely to be more complex, since it involves interest rates that in turn affect international capital flows. When a crisis threatens, the direction of interest rates should be upward (resulting from the credit squeeze) while the exchange rate should go down. The combined effect of the credit squeeze and the devaluation should be to bring the current-account deficit back to a sustainable level. However, it is prudent to guard against overshoot both in interest rates and the exchange rate. Hence the importance of direct-acting prudential policies — not only those that act on the finance sector, but more general fiscal and budgetary policies. For example, budgetary policies can include tax increases and expenditure decreases designed to bring on recession, but will be the more effective if, in the process, they discourage imports and encourage exports and import-competing production.

  To summarise, in the 1980s, Australia followed the United States and various other countries, notably the United Kingdom, in its adoption of neo-liberal economic policies. Financial deregulation was a major expression of these policies and had its positive aspects, including the extension of prudential regulation to all deposit-taking financial intermediaries and the retention of capital-adequacy requirements. However, the deregulation included a fatal flaw: it withdrew from prudential regulation of overseas borrowing. Whatever theories were circulating at the time, the finance sector is not in a position to self-regulate for prudence in overseas borrowing, and its inability to do so resulted in Australian institutions incurring a dangerous level of overseas debt, with its counterpart of an excessive level of household debt. Collateral damage included the contribution of the flow of mortgage lending to high land prices, raising not only problems of unaffordability but of unnecessary business costs.

  Similarly, the diversion of resources into consumption and away from infrastructure investment raised business costs and reduced business opportunities. (In this context, infrastructure investment may be defined broadly to include the many government expenditures that contribute to business competitiveness, including research and education, as well as transport and the utilities.) In addition, the rise of the finance sector contributed to the increase in the inequality of income, both directly (via the very skew distribution of labour rewards within the sector) and indirectly, via the increase in asset incomes vis a vis earned incomes. This increase in inequality tarnished the nature of Australia as an egalitarian country and reduced its prospects of economic growth. (Beyond a point that Australia passed some time ago, inequality has been shown to retard growth.) Finally, the increase in the resources devoted to finance withdrew resources from directly productive activi
ty, hence imposing a deadweight cost on Australian competitiveness.

  During the post-war period, the Australian authorities kept an eye on the balance of payments, and on three occasions instigated a precautionary recession. However, as neo-liberal economics was more and more adopted as a guide to policy, it became fashionable to leave the balance of payments to market forces. It was argued that the natural prudence of borrowers and lenders would keep the economy clear of catastrophe.

  It is true that Australian financial deregulation did not go to the extremes of American excess, and at least retained prudential regulation, concerned chiefly with capital adequacy. However, there is more to financial prudence than merely maintaining conventional reserves. In particular, as we have seen, it is imprudent to lend for consumption, and it is imprudent to borrow overseas without counterpart domestic investments that yield export revenue from which to service the borrowings. Deregulation left the Australian financial sector free to expose itself, and thereby the country, to both these types of imprudence.

  It is not that the banks are unaware of these two dangers, and in both cases they would claim to have acted prudently. They restricted consumer credit by making assessments of their customers’ capacity to pay, and hedged against risk by writing mortgages; however, this did not prevent their mortgage loans from financing consumption via a reduction in the household savings rate. Similarly, they hedged their overseas borrowing against changes in the exchange rate; this was a strategy that seemed reasonable when the mining boom was in its heyday, but looks dangerous now that Australia’s export prospects are less rosy. In neither case were the banks and other involved finance-sector institutions in a position to take a national view. Prudential regulation was needed to curb their lending for consumption and to curb their overseas borrowing for the financing of consumption.