Has Australia been lucky again?
by John Quiggin
Writing in the 1960s, Donald Horne described Australia as ‘a lucky country run by second-rate people who share its luck’. Judging by the experience of the global financial crisis, Australia’s run of good luck has continued. There is a credible argument to be made that good economic management contributed to Australia’s escape (so far at least) from the serious impacts of the crisis experienced in most other countries. It is clear, however, that good luck played its part.
The crisis has bankrupted large numbers of financial institutions, corporations and some governments. It has also demonstrated the bankruptcy of the regulatory systems that were supposed to manage the global financial system, and the ideology of market liberalism on which those systems are based. A re-examination of both institutions and ideology is urgently needed.
The Global Financial Crisis
As long ago as the early 2000s, a handful of economists pointed to the unsustainability of the imbalances in the US and global economy that developed from the late 1990s onwards. The most obvious imbalances were the massive trade deficits that emerged in a number of, mainly English-speaking, developed economies (matched by surpluses for Asian exporters) and the huge growth of the financial sector relative to the economy as a whole. These imbalances were closely intertwined. It was only the growth of the financial sector that permitted the maintenance of consistent large deficits on the trade balance and current account, at levels that would, in earlier periods, have resulted in an economic crisis.
By contrast, the dominant market liberal ideology encouraged the view that these developments were benign. The massive growth in the volume of international financial transactions was seen as reflecting the (presumptively rational) voluntary choices of borrowers and lenders, and as a way of diversifying risk internationally. A localised failure in any one economy could not cause significant loss to investors with highly diversified portfolios. And central banks extended ‘too big to fail’ protection to any institution large enough to be critical to the sustainability of the system as a whole. The only way a system of this kind could fail was through a total global collapse.
And that, more or less, is what happened.
In scale and scope, the crisis was larger than any financial failure since the Great Depression. The estimated losses from financial failures amount to $4 trillion or about ten per cent of the world’s annual income. Losses in output from the global recession have also amounted to trillions, and recovery has barely begun.
Unlike the Great Depression, this crisis was entirely the product of financial markets. Financial markets and major banks were lightly regulated by governments under systems that relied, in large measure, on risk assessments undertaken by the banks themselves, which were based, in large measure, on the ratings issued by agencies such as Standard & Poors and Moody’s.
All of the checks and balances in the system failed comprehensively. The ratings agencies offered AAA ratings to assets that turned out to be worthless, on the basis of models that assumed that asset prices could never fall. The entire ratings agency model, in which issuers pay for ratings, proved to be fundamentally unsound. But, these very ratings were embedded in official systems of regulation. Crucial public policy decisions were, in effect, outsourced to for-profit firms that had a strong incentive to get the answers wrong.
To these systemic failures was added the exposure of long-running fraud on a massive scale. While Bernie Madoff put others in the shade, the collapse of the bubble brought to light a string of frauds involving tens or hundreds of millions of dollars.
At the beginning of 2009, the world faced the prospect of a recession more serious than any since the Great Depression. That prospect was staved off by bank bailouts and policies of fiscal and monetary stimulus were successful in containing the damage. Monetary policy was used to an unprecedented degree. Not only were interest rates cut to zero, but central banks undertook extensive ‘quantitative easing’, that is, purchasing financial assets such as corporate bonds, from financial institutions.
Despite all these measures, the global recession has been the most severe in the post war period. At the time of writing unemployment rates approached ten per cent in the US and EU. With the costs of bailouts threatening a new round of crises, a second round of recession seems likely.
Australia’s great escape
According to the popular criterion of two successive quarters of negative growth, the Australian economy escaped recession altogether. How did we do it? The main candidates for explaining this remarkable outcome are:
- Good macroeconomic management
- Good economic fundamentals, arising from the reforms to the economy undertaken since the 1980s, and
- The good luck on which Australia has always relied.
Australia has benefited from good economic management. Advance warnings from the collapse of Bear Stearns in March 2008 gave the government and monetary authorities time to prepare a response to the meltdown that took place the following September. The reserve bank relaxed monetary policy, and the Australian government responded more rapidly and vigorously than many others with fiscal stimulus – an immediate cash handout in December 2008 and a much larger stimulus package in early 2009, softened the recession to the point where it has been one of the milder downturns of the period since the 1970s. This was accompanied by a decision to guarantee banks retail deposits and (temporarily) their wholesale borrowings. Broadly speaking this response was effective in insulating the Australian financial sector from the global collapse.
Unlike the relaxation of monetary policy, which received broad support, the fiscal policy response to the crisis was controversial, with the stimulus package being rejected by the main Opposition parties. The success of the stimulus now seems clear. In the context of the forthcoming election, it is important to remember that on the biggest economic policy issue in decades, the Rudd-Gillard Government got the choices essentially right, and the Coalition Opposition got them completely wrong.
Good management can’t provide a full explanation of Australia’s escape from the crisis. Our starting point was much better than that of many other countries, in that only a handful of small financial institutions (mainly mortgage securitisers such as RAMS) got into difficulties, and none failed outright. Macroeconomic policy had to manage the flow-on from the global crisis, but not a domestic financial meltdown like those affecting most developed countries.
Was this the result of sound fundamentals, as has been widely claimed, or, as Donald Horne would doubtless suggest, good luck?
Claims about good fundamentals rest on both:
- the microeconomic reforms undertaken in the 1990s, and
- the suggestion that our financial sector is more soundly structured, better regulated and more conservative in its practices than those in other developed countries.
The first of these claims can be dismissed fairly easily. There is no link between microeconomic flexibility and macroeconomic stability. In fact, just as in the Asian crisis of the 1990s, the countries hardest hit by the initial round of the global financial crisis (Iceland, Ireland, the Baltic States) have been precisely those that have undertaken the most comprehensive reforms along market liberal lines.
The view that our financial system is more soundly structured than others has some validity. Australia’s system of prudential regulation helped to avoid the emergence of large-scale lending to borrowers with little or no capacity to pay, along the lines of the ‘sub-prime’ market in the US. Reserve requirements ensure that financial institutions would remain stable in the face of a moderate decline in house prices. The four pillars policy against bank mergers, long derided by supporters of financial deregulation, prevented the banks from adopting risky strategies in the pursuit of competitive advantage.
The paradox behind our good fundamentals is, as former Reserve Bank Governor Ian MacFarlane has observed, that the current structure of our financial system is a result of the rejection of market liberal policy reforms.
Much of Australia’s resilience in the face of the global crisis can only be attributed to good luck.
Despite there being plenty of Australian bankers who experienced the ‘cowboy’ era that followed financial deregulation in the 1980s, and the near-failure of major banks in the 1990s recession, that experience wasn’t enough to keep the major banks from close involvement in the financing of new speculative ventures. Examples include the Commonwealth Bank’s promotion of Storm Financial and ANZ’s financing of Opes Prime, both of which ended in disaster. Given a few more years, such activity might have expanded to the point where it threatened systemic viability.
Even aspects of our policies and economic fundamentals that seemed likely to increase our vulnerability turned out to work for the best. Our status as a net international borrower meant that our banks showed less interest in toxic US assets. As MacFarlane said “I have no doubt that if Australian banks had a surplus of domestic funds, they also would have acquired a lot of dubious assets, just as many of our counterparts did.” The current account deficit may have saved our banks from themselves, but it remains a major vulnerability if the global crisis worsens.
And the prosperity of our financial system depends, in large measure, on the fact that governments have managed to prop up housing prices, in sharp contrast to the rest of the world. Although house prices have fallen sharply in many countries, they declined only marginally in Australia, and have already recovered much of the lost ground. This strategy was probably necessary, but it remains high-risk.
The next test: will we be so lucky with the sovereign debt crisis?
By early 2010, the cost of the bailout and the likelihood of further banking failures had begun to threaten the solvency of national governments. Some peripheral countries such as Iceland and the Baltic States had already experienced sovereign debt crises. Governments in these countries lacked the resources to rescue their failed banking sectors, and were forced to adopt austerity policies that exacerbated the recession. The economic impact of the crisis in these countries was comparable to that of the Great Depression.
Such systemic problems emerged first in Greece. During the 1990s, Greek governments had nominally complied with the euro convergence targets, requiring them to reduce budget deficits to less than three per cent of GDP, and public debt to less than 60 per cent. In reality however, they had engaged in a range of expedients to hide debt, using financial instruments designed by the same financial sector institutions (most notably Goldman Sachs) that had produced the subprime crisis in the US.
The EU has acted, with a vigour and determination surprising in that normally unwieldy body, to establish a fund of around $500 billion euros to prevent defaults on government debt. It seems clear, however, that bondholders will have to bear significant losses, whether these are brought about through rescheduling, renegotiation or simply through inflation.
Further rounds of crisis, possibly involving the UK and US, seem very likely. The stability of the global financial system is being tested once again, this time with much less capacity for a public bailout. Australia needs to be prepared for such an eventuality.
A prescription for financial restructuring
In view of the spectacular failure of financial regulation around the world, which was broadly similar to regulation in Australia, it might be expected that the need for a fundamental review of our regulatory systems would be generally accepted, if only to identify “what went right” in Australia compared with the problems overseas. In fact, there is no such agreement.
The Commonwealth has rejected calls for a broad-ranging inquiry into the financial system; though there were some hints that the situation might be reviewed when financial regulation was no longer in crisis mode. More pointedly, Terry McCrann suggested that reform of the financial system is unnecessary because the global financial crisis hasn’t affected us. In his words, ‘Not many dead or even injured in Australia. From any systemic fault, that’s to say.’
It’s true that Australia has come through the crisis without major financial disasters. But it is absurd to suggest that this fortunate outcome implies that our existing system has worked as planned. Decisions such as giving an unlimited guarantee of bank deposits and the government’s establishment of the Ozcar scheme, in response to the anticipated withdrawal from the Australian market of the major providers of car loans, were taken on an emergency basis, justified only by the belief that the alternative would be disastrous.
The most fundamental criticism of the status quo has come from Ian Harper, the former Reserve Bank Economist who played the dominant intellectual role on the Wallis Committee. Harper is a strong supporter of free markets, and an economist of unquestioned intellectual integrity, not prone to blow with the wind of fashion. Harper has observed that the entire intellectual framework of the 1997 inquiry had been rendered redundant by the financial crisis.
‘Our framework was essentially the efficient markets theory,” he said. “We thought we had found the ultimate fixed point in the universe, namely the market price, and so we built on top of that the regulatory framework. But then there was no market price. The evolution we expected has stopped, reversed and gone the other way.’
The reversal of financial globalisation
One of the most striking developments of the late 20th Century was the explosion in the volume, speed and complexity of international financial transactions, and the resulting breakdown of effective regulatory control over the global financial system. The speed with which this process has gone into reverse since the onset of the financial crisis has been equally striking.
Transactions in the global foreign exchange market, once confined to financing trade flows, peaked at around $4 trillion per day in mid-2008. At that pace, two days of foreign exchange trading would be sufficient to finance an entire year’s trade flows. The growth of private credit reached an annualised rate of $10 trillion at the same time.
The market collapsed in the crisis of late 2008. According to the International Monetary Fund (2009), private sector credit growth fell by 90 per cent, and ‘Emerging bond markets virtually shut down for a period of time in the fourth quarter’.
Although rescue measures by governments have restored some credit flows, the long term tendency is towards a reversal of financial globalisation. Banks that have been bailed out or nationalised are being encouraged, and sometimes forced, to sell off overseas assets and focus on their home market. Public policy is simply reinforcing the pressures of the market.
In one of many similar examples, the Rudd-Gillard Government was forced to intervene in the market for motor vehicle finance and, on a larger scale, in the commercial property finance market, in response to the withdrawal of foreign lenders from the market.
The European crisis, driven primarily by excessive lending by French and German banks will entail a further retrenchment, and the strengthening of financial controls applied at the level of the eurozone as a whole.
By the time financial markets have been stabilised, the global financial system that prevailed before the GFC will have contracted rapidly, with many markets and institutions disappearing altogether. The challenge facing governments and regulators will be to construct a new financial system and a regulatory architecture strong enough to prevent a recurrence of the bubble and meltdown that has largely destroyed the existing unregulated system.
An important element of any reform should be a tax on financial transactions, low enough that it does not interfere with ordinary borrowing and lending, but high enough to ensure that the massive short-term speculation that still dominates financial markets is ended once and for all. Even at very low rates of taxation (say 0.1 per cent), it would be impossible to maintain financial markets with turnover in the hundreds of trillions, as at present. And even with a drastically reduced volume of financial transactions, the effective tax on financial sector operations would be large enough to offset the cost to the public of the guarantees required by the system.
The five pillars of financial stability
The essential features of a system of financial regulation to support market stability and prevent another meltdown are:
- Linking and integrating national financial systems to produce a sustainable international financial architecture
- Decoupling exchange rates from the vicissitudes of financial markets – the Tobin Tax
- Guaranteeing and regulating the banks
- Regulating innovation
- An effective ratings system
A new financial architecture
The idea of a ‘global financial architecture’ is both misleading and unattainable. The keystone for any financial architecture is the institution that acts as lender of last resort for others. This function is, and is likely to remain, one undertaken by national governments and their central banks.1 It follows that there can be no global financial architecture. Rather national systems of financial regulation must be linked and integrated to produce a sustainable international financial architecture.
To achieve this, there must be no ‘offshore’ financial system, outside the agreements that govern the international financial architecture, but nevertheless allowed to transact with institutions inside the system. This issue has already arisen in relation to international tax avoidance and evasion, and will arise in an even more acute form in relation to the Tobin tax, discussed below. Fortunately, the OECD has already developed a strategy to address tax avoidance that will serve as a model for financial regulation.
The OECD prepared an internationally agreed tax standard allowing countries to choose their own tax rates, but requiring exchange of information to prevent avoidance and evasion. Jurisdictions which implemented the standard were placed on a white list, while those that refused were placed on a black list. Countries that promised to implement the standard but had not yet done so were placed on a grey list. Blacklisted jurisdictions were threatened with sanctions, largely unspecified, but sufficiently effective that, by October 2009, no jurisdictions surveyed by the OECD global forum remained on the blacklist.
The tax standard is inadequate in many respects, and open to the evasive tactics for which tax havens are famous. But it seems clear that the standard will be tightened progressively, and that no jurisdiction will be willing to risk the consequences of refusal to implement them.
The Financial Stability Board, established as part of the response to the global financial crisis has already indicated that the tax haven model will be applied to ‘regulatory havens’ offering lax financial regulation. As with taxation, the process will undoubtedly be slow, but the mechanisms are in place to ensure that evasion of financial regulation through the use of offshore transactions can be prevented.
The Tobin tax
The long-advocated and long-resisted idea of a small tax on financial transactions, commonly called a Tobin tax,2 is the most promising option for ensuring that exchange rate movements reflect the economic fundamentals of trade and long-term capital flows, rather than the vicissitudes of financial markets.
A tax at a rate of 0.1 per cent would be insignificant in relation to the transaction costs associated with international trade or long-term investments. On the other hand, daily transactions of $3 trillion would yield revenue of $30 billion per day, or nearly $1 trillion per year. Since this amount exceeds the total profits of the financial sector (profits that are likely to be much smaller in future) an effective Tobin tax would imply a drastic reduction in the volume of short-term financial flows. It follows that the revenue from a Tobin tax, while significant, would not be sufficient to replace the main existing sources of taxation, such as income tax.
The large literature on Tobin taxes has identified two significant problems with the simple proposal for a tax on international financial transactions.
First, it is possible to replicate spot transactions on foreign exchange markets with combinations of forward, futures and swap transactions. To make a Tobin tax effective, it would have to be applied to all financial transactions, including domestic transactions. During the bubble era, when the few remaining taxes on domestic financial transactions were being scrapped to facilitate the growth of the financial sector, this was seen as a fatal objection. It has become apparent, however, that the destabilising effects of explosive growth in the volume of financial transactions are much the same, whether the transactions are domestic or international.
The fact that a Tobin tax on international financial transactions would be integrated with taxes on domestic transactions suggests that, in all probability, revenue would be collected and retained by national governments. However, the suggestion that at least some of the revenue should be used to fund global projects, such as the international development goals of UNCTAD, remains worthy of consideration.
The second problem is that the tax would require global co-operation, since otherwise financial market activity would migrate to jurisdictions that did not apply the tax. Although this will remain a problem in the post-crisis world, it is likely to be much less severe than indicated by earlier discussions, because of the much smaller number of separate jurisdictions that would need to agree, following the emergence of the euro. It seems inevitable that most remaining European currencies, with the possible exception of the British pound, will disappear in the wake of the crisis, and that a Europe-wide regulatory system will emerge.
To address the problem of ‘offshore’ financial centres, such as Caribbean island states, a Tobin tax on transactions among complying jurisdictions may have to be supplemented by a punitive tax, at a rate of, say 10 per cent, on transactions with non-compliant jurisdictions. This would effectively ensure that non-compliant jurisdictions were excluded from global financial markets, though the penalty would be modest as regards trade and long-term investment flows.
Regulating the banks – Guarantees, regulation or narrow banking
The core of financial regulation is the existence of a (partial or total) guarantee that bank depositors who exercise ordinary prudence will not lose their money. Until October 2008, the guarantee system in Australia was carefully ambiguous. Governments and the Reserve Bank implicitly assured both the general public and wholesale lenders that our major banks are completely safe, while simultaneously denying that their liabilities were guaranteed. As was both predictable and predicted, 3 the contradictions in this stance were exposed the first time the system faced a serious crisis. The result was the unlimited guarantee we have now.
We must now consider whether to maintain, modify or withdraw the guarantee. Whatever we do, the crucial issue that has not been faced so far is that publicly-guaranteed institutions require much closer regulation than is consistent with policies of financial deregulation.
So, there are three policy options available:
- The first is the maintenance of the existing guarantee, and a comprehensive re-regulation of the system. This would not mean a return to the system that prevailed before the 1970s (no such return is ever possible), but it would require direct control over the allowable range of products, the setting of interest rates, fees and charges and the allocation of lending between sectors of the economy.
- Current government rhetoric suggests the desire to return to something like the old system, with deposit guarantees being withdrawn once the crisis is over. But clearly, we cannot go back to the old ambiguity. If the guarantee is withdrawn, this will be a clear statement to depositors that they must make their own judgements about the safety of their money. It was in this context that the idea of a publicly-owned and publicly guaranteed savings bank was suggested.
- The third option, in some ways a compromise, is that of narrow banking, in which publicly guaranteed banks stick to a tightly regulated range of well understood activities. This allows for a completely separate set of financial institutions, of which stock markets are the exemplar, where government guarantees are ruled out in advance. These would offer higher returns but no possibility of transferring risk to the public. This is my preferred option.
Post-crisis financial regulation should begin with a clearly defined set of institutions (such as banks and insurance companies) offering a set of well-tested financial instruments with explicit public guarantees for clients, and a public guarantee of solvency, with nationalisation as a last-resort option. Financial innovations must be treated with caution, and allowed only on the basis of a clear understanding of their effects on systemic risk.
In this context, it is crucial to maintain sharp boundaries between publicly guaranteed institutions and unprotected financial institutions such as hedge funds, finance companies, stockbroking firms and mutual funds. Institutions in the latter category must not be allowed to present a threat of systemic failure that might precipitate a public sector rescue, whether direct (as in the recent crisis) or indirect (as in the 1998 bailout of Long Term Capital Management). A number of measures are required to ensure this:
- Ownership links between protected and unprotected financial institutions must be absolutely prohibited, to avoid the risk that failure of an unregulated subsidiary will necessitate a rescue of the parent, or that an unregulated parent could seek to expose a bank subsidiary to excessive risk. Long before the current crisis, these dangers were illustrated by Australian experience with bank-owned finance companies, most notably the rescue, by the Reserve Bank, of the Bank of Adelaide in the 1970s.
- Banks should not market unregulated financial products such as share investments and hedge funds.
- The provision of bank credit to unregulated financial enterprises should be limited to levels that ensure that even large-scale failure in this sector cannot threaten the solvency of the regulated system.
In the resulting system of ‘narrow banking’, the financial sector would become, in effect, an infrastructure service, like electricity or telecommunications. While the provision of financial services might be undertaken by either public or private enterprises, governments would accept a clear responsibility for the stability of the financial infrastructure.
The prevailing rule has been to allow, and indeed encourage, financial innovations unless they can be shown to represent a threat to financial stability. With an unlimited public guarantee for the liabilities of large financial institutions, this rule is a guaranteed, and proven, recipe for disaster, offering huge rewards to any innovation that increases both risks (ultimately borne by the public) and returns (captured by the innovators). There must be a reversal of the burden of proof in relation to financial innovation.
The process of financial innovation, involving either the creation of new financial instruments or the design of new financial strategies for firms (often termed ‘financial engineering’) was a central feature of the era of market liberalism. The growth of finance has been almost unstoppable. Seemingly major financial crises like the stock market crash of 1987 or the NASDAQ crash of 2000 stimulated the development of yet more innovative responses. Even the exposure of spectacular fraud at the Enron Corporation, which had been nominated by Fortune magazine as ‘America’s most innovative’ for six years in succession, did little to dent faith in the desirability of innovation.
It is now clear that unrestricted financial innovation played a major role in the advent of financial crisis, by facilitating the growth of unsound lending and by undermining systems of regulation. There is an inherent inconsistency between unrestricted financial innovation and a regulatory system aimed at preventing the failure of financial systems or at insuring market participants against such failures. Guarantees create ‘moral hazard’ by allowing financial institutions to capture the benefits of risky investments, while shifting some or all of the losses to government-backed insurance pools.
Moral hazard can only be offset by the design of regulatory mechanisms that discourage excessive risk-taking. But, as the literature on mechanism design has shown, the effectiveness of such mechanisms depends on the existence of stable relationships between the observable variables that are the subject of regulation and the risk allocation that generates them. Financial innovation changes the relationship. In the presence of moral hazard, therefore, there is an incentive to introduce innovations that increase the underlying level of risk while leaving regulatory measures of risk unchanged.
It follows that the only sustainable approach to financial innovation is one in which proposed innovations are introduced only after the implementation of necessary changes to regulatory requirements and risk measures. If reliable risk measures cannot be computed, the associated innovations should not be permitted.
A public ratings system: capital adequacy, transparency and risk assessment
Another important regulatory adjustment will be the end of the system by which prudential regulation has been, in effect, outsourced to ratings agencies such as Standard & Poor’s and Moody’s. Agency ratings have been enshrined in regulation, for example through official investment guidelines that require regulated entities to invest in assets with a high rating (AAA in some cases, investment grade in others) or provide those responsible for making bad investment decisions with a ‘safe harbour’ against claims of negligence if the assets in question carried a high rating. For these purposes at least, an international, publicly-backed non-profit system of assessing and rating investments is required.
Australia suffered only modest and indirect effects from the first round of the Global Financial Crisis. In part, this favorable outcome reflects good management, but good luck has been at least as important. Trusting to luck that we will be similarly favoured in the future would be highly unwise.
The temptation to put off until calmer times questions about our financial vulnerability has proved irresistible so far. Looking at the current global scene, however, it seems unlikely that economic calm will return any time soon. A careful examination of the vulnerabilities in our financial system will be an urgent task for the newly-elected Gillard minority Government.
Photo Credit: Gordon Banks, http://www.flickr.com/photos/wwworks/2959833537/
- The EU, where eurozone countries run their own prudential policies but share a common central bank raises some interesting questions, but is unlikely to serve as a model for the rest of the world. ↩
- Tobin, J. (1996) and ul Haq, Kaul and Grunberg (eds) The Tobin Tax: Coping with Financial Volatility ↩
- Quiggin, J. (2002) ‘Savings need a safety net’ Australian Financial Review Available online: http://www.uq.edu.au/economics/johnquiggin/news/DepositInsurance0208.html ↩