Credit Code Red

by Peter Brain

  Such long-term policies, however, are subject to the changes and chances that affect the current account. During the post-war period these proved to be a serious impediment to the Keynesian pursuit of full employment, not only in Australia but generally across the non-communist world. The simple Keynesian answer to a threat of unemployment is to pump up demand — for example, by increasing government expenditure and reducing interest rates to encourage private borrowing and spending. However, in countries committed to fixed exchange rates (and even in countries not so committed, given the lags in price adjustments), these increases in demand result in increases in imports that can generate a current-account crisis.

  In Australia’s case, the Commonwealth authorities introduced measures to curb imports whenever they judged that Australians were importing more than was justified by export earnings and were consequently borrowing overseas at a dangerous rate. The demand for imports could be reduced by quotas (the ‘import restrictions’ imposed by the Menzies government), or less directly by reducing disposable incomes so that people had less to spend on imports. Disposable incomes were reduced by increasing taxes and reducing government expenditure (fiscal policy) and by reducing the supply of credit and increasing interest rates (monetary policy, including credit squeezes). The recessions so induced were highly effective in reducing the demand for imports and releasing foreign-exchange earnings to allow debt-servicing to continue, but, in the words of a contemporary commentator, were ‘blunderbuss affairs’;1 they restricted people’s access to money without telling them specifically to cut back on imports. In other words, the deliberate reduction in incomes that was necessary to reduce the demand for imports threatened full employment.

  A potential answer to this dilemma, then as now, is world cooperation. One country’s imports are another’s exports, so coordinated action to raise demand is less likely than solo action would be to hit current-account limitations. This reasoning underlay the foundation of the IMF, but the task of coordinating world monetary policies proved to be more than an institution based in Washington DC could manage. Only when countries experience slack demand together, and agree that this is a problem (as in the immediate aftermath of the Global Financial Crisis of 2008), has it been possible for them to raise demand in concert. Sadly, the consensus quickly falls apart when different countries make different assessments of the scope for raising demand.

  As Australia settled down to business during the long prime ministership of R.G. Menzies, a split developed between the banks, some of which were government-owned, and the rest of the financial sector. The banks were fairly tightly regulated, at first by the central banking department of the Commonwealth Bank, and from 1960 by the Reserve Bank of Australia; the rest of the finance sector, less so. In return for regulation, the banks were licensed to deal in foreign exchange, provided they kept their foreign-exchange balances with the Reserve Bank. Reserves of foreign exchange were accordingly centralised, and the allocation of foreign exchange to the banks’ domestic customers was managed to maintain the constant exchange rate. There were also effective limits to the extent to which the banks, or anybody else, could borrow overseas. In the domestic market, the banks could decide whether or not to make particular loans, but instructions were issued from time to time as to the sectors to be favoured in lending, and formal regulations included requirements to make loans to the Commonwealth government, specifications of the interest rates (both on deposits and loans), and effective limits on the banks’ ability to lend and to borrow.

  Prelude to deregulation

  This regulatory system began to unravel in three ways: institutionally through the growth of non-bank financial intermediaries, internationally through fluctuating exchange rates, and in terms of macroeconomic management through cost inflation.

  In the post-war period, the Australian finance sector comprised a mixture of public-sector and private-sector institutions, including the stock market, life-insurance and general-insurance companies, and the banks, some of which were private while others were in the public sector. The banking system created money and managed transactions and accounts, providing a convenient and reasonably risk-free way to save. In the process, the banks gathered savings from savers and on-lent these savings to borrowers. Though these functions — the settlement of transactions, the storage of value, and borrowing and lending — are conceptually distinct, they have long been bundled as the core activities of banks. Recent economic crises have caused some questioning of this bundling, a topic that is highly salient to the future reform of the finance sector.

  During the post-war period, the trading banks gathered funds mainly from business, on which they did not pay interest but incurred significant costs in providing transactions services (mainly cheques), and specialised in loans to small businesses, mainly by way of overdrafts at regulated interest rates. The savings banks gathered household savings and lent them mainly to households that were buying houses; they paid interest to their depositors and charged interest to their mortgagees at low, regulated rates. Building societies ran on a similar model.

  Although their licences to deal in foreign exchange, along with their privileged access to the Reserve Bank, provided the banks with a quid pro quo for regulation, they argued that the regulations disadvantaged them in competition with other financial institutions. The regulations governing bank borrowing and lending could be avoided completely by direct deals between borrowers and lenders, which served the needs of big businesses, but was not so useful to small savers and borrowers.

  The scope for bypassing regulation increased when financial entrepreneurs found that they could avoid the regulation of interest rates by raising funds directly from the public (chiefly by selling debentures), and could lend to small borrowers (typically for hire-purchase, but increasingly for second mortgages on houses). The banks joined the game by increasingly routing their lending through wholly owned non-bank subsidiaries. By the 1970s, the proliferation of non-bank financial intermediaries had considerably weakened the regulation of the finance sector, presenting the Australian government with a choice: either dismantle regulation or extend it to the finance sector as a whole.

  The growth in unregulated financial intermediaries within the Australian financial sector mirrored the growth in unregulated money in the world generally. The first money to be freely traded in the post-war period comprised United States dollar deposits held in Europe and hence outside the control of the US Federal Reserve Bank. Speculators soon found that they could use such funds to bet on exchange rates, with profitable but destabilising effects. On the official side, the United States government, which had never been particularly keen on long-term planning as a reason for maintaining exchange-rate stability, decided in 1971 to cut the tie between its dollar and gold, while the Organisation of Petroleum Exporting Countries disrupted the established pattern of world trade by raising the price of oil.

  It became accepted that exchange rates should fluctuate in accordance with short-term current-account requirements, including those imposed by currency speculators. Though money continued to be a national institution, with each independent state having its own currency, there was now to be free trade in money. The spectre of competitive devaluation reappeared, and long-term business planning became more difficult.

  The third malfunction that threatened the working of the post-war economy was cost inflation: the ultimately pointless spiral of wage increases followed by price increases followed by wage increases. This was diagnosed as arising from a lack of agreement between labour and capital. In 1985, one of us, Ian Manning, published a book advocating negotiation to solve this dilemma,2 and in 1987 the Australian Council of Trade Unions, after observing the effectiveness of agreements between peak employer and labour bodies in controlling inflation in Germany and other ‘corporatist’ countries, proposed that similar institutions be developed in Australia.3 However, by this time institutional developments in Australia were proceeding
headlong in an altogether different direction.

  A contemporary observer noted that, even if cost inflation could be brought under control, the Keynesian pursuit of full employment was incompatible with free trade in money and required the replacement of the existing system of quantitative financial controls — broad-brush fiscal and monetary policies — with the imposition of what he called qualitative bank controls covering the whole financial sector in the country. He explained that qualitative bank controls are ‘a mild form of banker’s planning, especially by way of exchange control. For to isolate a country from international disturbances one needs a new monetary system, one not based on free trade in money.’4

  Though governments had lost control over offshore money, they were still able to control the aggregate level of borrowing and lending, to influence domestic institutions as they borrowed and lent overseas, and to influence the direction of lending. While these instruments could not guarantee a fixed exchange rate, they could stabilise the rate and simultaneously ensure that national patterns of savings and investment were broadly compatible with the maintenance of prosperity.

  This development of the Keynesian approach to economic management built on financial controls of the kind already quite advanced in France and Japan and incipient even in Australia, with its preferential allocations of credit to the rural sector and to government infrastructure construction. An Australian version of this system would control cost inflation by development of the arbitration system into the arbiter of the broad distribution of disposable income, and would control the current account primarily by allocating credit to exporters and to import-competing industries when excessive deficits threatened. It would depend on a fairly small but expert public service, which could be subject to general democratic control, but not to detailed instruction as to the industries that had most to contribute to prosperity. Provided it channelled funds to innovative and small business, such a system could reconcile the restless innovative spirit of capitalism with the maintenance of full employment, and would certainly foster a spirit of international economic competition. However, Australia missed this opportunity, which was altogether too corporatist for its business elite.

  The theory of deregulation

  Crucially for the future of the international economy, the two largest Anglophone countries, the United States and the United KIngdom, failed to make the transition from quantitative financial control to qualitative controls. In these two countries, the most strident opponents of the transition were doughty Austrian opponents of central planning in both its fascist and communist variants, who regarded Keynesian government of a national economy as the thin edge of the totalitarian wedge.5 As a political philosophy, they championed freedom; they wanted government political power decentralised to individuals, who should be allowed to do whatever they wanted, provided they respected the similar freedom of other individuals. These opponents of government planning argued that competitive free markets guarantee an optimal allocation of incomes and resources, the best of all possible worlds.

  In practice, they extended this guarantee to all private-enterprise markets, whether competitive or not. Their critics accused them of glorifying self-interest, particularly the self-interest of the rich, and of diminishing the noble American ideal of freedom to the freedom to sell, the freedom to buy, and the freedom to create value through advertising. These were freedoms that elevated ‘market value to the only value — so surrendering to the corporatisation, commodification and marketization of more or less everything’.6

  Meanwhile, academics located mostly in American universities spearheaded the revival of pre-Keynesian economics that became known as neo-liberalism. The crowning achievement of this intellectual school was a procedure known as Computable General Equilibrium modelling, by which the benefits of free trade in goods, services, and money were given real-world dimensions according to an exceedingly abstract but mathematically beautiful economic theory. As Keynesians, we are happy to concede the intellectual coherence of this system. Its assumptions are carefully adumbrated; given its assumptions, its logic is unassailable. The problem is one of relevance. The assumptions of General Equilibrium are so refined and the system is so otherworldly that it provides no useful earthly guidance, a line taken in 1971 by Janos Kornai in his book Anti-equilibrium.

  As a result of his experience of communist rule in Hungary, Kornai was no friend of detailed central planning, and strongly valued the vigour and innovative potential of capitalism — quite the opposite characteristics to those lauded by equilibrium theories. However, he conceded the case for strategic planning by governments and hence the need for qualitative financial controls. It is notable that he was one of three foreign economists who, in 1986, advised the government of China to adopt a form of economic planning that combined qualitative bank controls at the strategic level with considerable freedom of action at the enterprise level.7

  While China was building its system of capitalism subject to qualitative controls (in the process, adopting insights from countries such as Japan and Germany), the United States and the United Kingdom were reverting to policies centred on the abolition of the quantitative economic controls of the post-war era in the faith that deregulated financial markets would guarantee equilibrium, as assumed in neo-liberal economic models. The resulting policies were packaged as the Washington Consensus, so named after the international financial institutions headquartered in the American capital that promoted them in the 1990s, only to repudiate them after the Global Financial Crisis of 2008.

  The examples of Mr Reagan and Mrs Thatcher were too powerful for Australian politicians to ignore, particularly after important factions within the Labor Party swallowed the proposition that Washington Consensus policies guaranteed equilibrium economic growth that could be harvested to the benefit of all citizens. As Australian Keynesians, we looked on in dismay while our insights into the practical working of economies were displaced by elaborations on the perfections of competition — assertions that competition guarantees the best economic outcomes.

  The Australian neo-liberal (or ‘economic rationalist’) reform program was wide-ranging. The reforms were initiated by Labor governments, but were heartily endorsed and extended by the Coalition. Cost inflation was attacked by accepting the increased unemployment rate that had emerged from the stagflation of the 1970s as a permanent necessity to curb excessive wage demands. This was backed up (after the election of a Coalition government in 1996) by branding trade unions as anti-competitive labour monopolies, and by working to undermine their role. Public-sector businesses were seen as inefficient and monopolistic, and were privatised wherever a short-term profit could be turned by selling them. Taxation was no longer characterised as a contribution to the common good; instead it was branded as an intolerable interference with market incentives. Tax cuts came into fashion, particularly at the higher end of the income-tax scale, and tax-avoidance opportunities were provided for businesses and high-income individuals. Among taxes, tariffs were targeted as a particular affront to free markets and were cut, unilaterally if necessary. With honourable exceptions, when John Button was minister for trade and commerce (1983–93), these cuts were implemented shorn of the sophisticated industry-support policies adopted in countries such as Germany and China.

  Though labour-market reform, competition reform, and free trade were major elements in the neo-liberal program, the element most closely related to the deterioration of Australian performance as assessed by the EC indicators was financial deregulation. The rest of this book homes in on the outcomes of this policy.

  The process of financial deregulation

  Financial deregulation began in Australia in 1973 when direct controls on bank interest rates were weakened to allow banks to compete more effectively with non-bank financial intermediaries. In December 1983, free trade in money was adopted by abolishing external capital-account controls and floating the exchange rate. The last of the lending-ra
te controls (those on new owner-occupied housing loans) were abolished in April 1986. The idea that governments should own trading and savings banks to compete with the privately owned banks was anathema to the deregulators, and in 1996 they completed the privatisation of the Commonwealth Bank — which was allowed to retain its name despite the general ban on private organisations adopting names that indicate they are government entities. Within the finance sector, only the Reserve Bank remained in public ownership, and even it was required to be ‘independent’.

  The differences between the pre-deregulation and post-deregulation regimes were spelled out in an address by Ric Battellino, the deputy governor of the Reserve Bank of Australia (RBA), given to the Australian Governance Program on 16 July 2007. In the period from the Second World War to financial deregulation:

  The interest rates that banks paid on deposits and received on loans were controlled, which limited the scope of banks to expand their balance sheets;

  Banks were subject to reserve ratios (deposits at the RBA) and liquidity ratios (holdings of government securities) which enabled the government to directly control the liquidity of the economy, including smoothing shocks to the economy from such events as a sudden increase in capital inflows or a need for government deficits;

  Banks had to follow directions as to the total quantity of loans they could make;

  Banks and other financial sector institutions specialised by types of lending or sector lent to (for example, consumer credit, and the agricultural sector);

  Overseas investment by Australians was controlled to preserve domestic savings for domestic investment; and

  The exchange rate was controlled tightly.