Credit Code Red

by Peter Brain

  As Battellino explained, the objectives of financial regulation, now called financial suppression (in hostile literature), were:

  To enable the monetary authorities to directly manage the level of liquidity in the economy and hence strongly influence the level of activity;

  To create a captive market for government securities and so allow the government to borrow at interest rates that were below what would have prevailed in a deregulated economy;

  To limit the risks banks could take;

  To allocate credit to areas of the economy that the government thought should get priority; and

  To maintain a competitive exchange rate for the benefit of local industry, except during periods when a high exchange rate was tolerated for its contribution to the control of inflation.

  Financial deregulation involved the sacrifice of these five objectives to neo-liberal faith in the supreme benefits of profit maximisation in the economy at large and in the finance sector in particular. Though this was the primary reason for deregulation, there was also an element of surrender: the finance sector had become adept at dodging regulation by setting up non-bank financial intermediaries, and bank deregulation had the virtue of bringing all financial institutions into one lightly regulated pool. There would no longer be any advantage in setting up businesses that accepted deposits and made loans but were not legally banks. The banks gradually absorbed much of the non-bank financial sector, including their own non-bank subsidiaries and previously independent building societies, consumer-credit corporations, and the like.

  More significantly, the deregulated pursuit of profit brought major change to banking operations. Under bank regulation, the funds that the banks had available to lend were strictly limited, and the margins between the rates of interest at which they could lend and their cost of funds (the costs of services to depositors and of any interest they might be paid) were likewise strictly limited. Under these regulations, banks had a strong incentive to avoid bad debts. They assessed credit-worthiness carefully and, in addition, they watched their business loans and dispensed advice on how to stay solvent. The non-bank financial intermediaries served riskier borrowers and charged higher interest rates to cover the cost of a greater incidence of bad debts; but, like the banks, their lending was limited by the funds they could raise, either from the banks or from the general public.

  Deregulation altered all this, and resulted in a dramatic change in bank culture. Four major curbs to profit maximisation were removed. The first applied both to the banks and to the non-bank financial intermediaries. This was the removal of restrictions on overseas borrowing by Australian deposit-taking institutions. The other three applied specifically to the banks. They were the effective removal of compulsory loans to the government, the removal of restrictions on interest rates (and specifically on the spread between borrowing and lending rates), and the removal of restrictions on the size of bank balance sheets (the move away from central management of the liquidity of the economy). Before deregulation, the banks maximised their profits by careful attention to the avoidance of bad debts; under the new dispensation, they maximised their profits by maximising lending, by widening the gap between loan interest rates and the cost of funds, and by imposing service fees and charges.8

  The banks recognised that increased lending would raise the incidence of bad debts, but under deregulation this could be accommodated as a business cost by increasing the spread between the lending rate and the cost of funds. The banks calculated that it was cheaper to suffer the occasional bad debt than to incur the costs of careful surveillance of their loan books. They reduced their costs by computerising loan assessment, as indeed they computerised account-keeping generally. Further, the domestic deposit base no longer limited their capacity to make loans, since, after deregulation, deficiencies in the domestic deposit base could be made good by borrowing overseas. The only limits to balance-sheet expansion were the supply of borrowers, the cost of overseas funds, and the remaining regulations administered by the Reserve Bank, which were later hived off to the Australian Prudential Regulation Authority.

  These remaining restrictions were not initially at all onerous. So long as the return on funds exceeded the cost of funds, bank profits were maximised by making as many loans as possible. Incentive structures within the banks were overhauled to reward staff who sold bank products; in other words, those who successfully sold debt. This included selling debt to borrowers of doubtful credit-worthiness who subsequently deeply regretted their borrowing. In Roy Morgan’s surveys, the proportion of the Australian public who rated bank managers as having very high or high standards of ethics and honesty plunged from 58 per cent in 1987 to a low of 26 per cent in 2000. In aggregate, the banks’ single-minded pursuit of profit resulted in an increase in consumer debt balanced by an increase in overseas debt — changes that we have already spotted in our discussion of the EC indicators of incipient trouble.

  By its emphasis on annual (indeed quarterly) bank profitability as a guide to financial management, deregulation reversed the previous trend towards qualitative control of the financial system. The pre-deregulation system in Australia had gained some of the characteristics of qualitative bank control, though without the highly purposive long-term planning that underpinned qualitative regulation in countries as diverse as Germany, France, the Scandinavian countries, Japan, and China. Deregulation reversed this trend; the Commonwealth government gave up both the policy objectives and the powers listed by Battellino. This required a major curtailment of the powers of the Reserve Bank.

  Although the Reserve Bank retains a number of objectives, including full employment and maximising the welfare of the people of Australia, one objective achieved primary status over the last three decades: stability of the currency. This is expressed in terms of maintaining the annual inflation rate at between 2 to 3 per cent on average over the cycle, and is pursued by manipulating the one control that remains to the bank — its power to influence short-term interest rates by buying and selling government securities. This objective was formalised in an agreement between the government and the Reserve Bank in 1996 expressed in the Statement of Conduct of Monetary Policy. The statement contains the inflation objective, asserts its primacy, and notes the independence of the Reserve Bank board.

  Australian governments can still engage in fiscal policy by running budget deficits and by borrowing, though their inclination to do so has been much reduced by the replacement in the public service, the finance sector, and the media of the post-war generation of Keynesians by economists trained in the revived neo-liberal tradition. In any case, the financial sector, via ratings agencies and by constant assessments of government policy settings, now limits the range of active fiscal policy. In effect, the finance sector now allows fiscal expansion only when it is required to support private-sector cash flow, as during the Global Financial Crisis or in a recession. At all other times, private-sector interests take primacy in the setting of the economy’s liquidity needs and resource allocation. Governments that offend performance standards set by the finance sector in relation to debt, budget deficits, and expenditure growth risk downgraded credit ratings and the accompanying penalties of raised interest rates.

  3

  Financial deregulation and household debt

  In the post-war decades, the political elite in Australia, along with its confrères in other countries who had experienced the Great Depression, was acutely aware of the costs of Depression and determined to avoid a repeat. Depressions are the great destroyers of full employment and rising living standards, so the avoidance of Depression was congruent with these two other great aims of post-war economic policy — yet not always completely.

  There were several occasions when Australia’s policy-makers did not hesitate to risk full employment when they considered this was necessary to avoid a Depression. In terms of the European Commission’s bellwether indicators of economic crisis,
these occasions arose when Australia was in danger of over-borrowing from overseas. The medicine was simple: a lull in the growth of disposable incomes to reduce the demand for imports and hence reduce overseas borrowing. This was a thoroughly coherent response to a threat of over-borrowing that derived from a fall in the terms of trade. Effectively, the dampening of demand by fiscal and monetary policy speeded an adjustment that would otherwise have been at the mercy of slow and potentially disruptive changes in prices and real wage rates.

  The 1970s were a perplexing time for those Keynesians who had failed to incorporate capacity limitations and the potential for cost inflation into their systematic thinking. Cost inflation broke the rule of thumb adopted by Treasuries in the post-war years, which was that any threatened incresase in unemployment should be addressed by expanding demand. This could be done without raising the threat of inflation, because the spare capacity inherent in unemployment would prevent price rises; conversely, the threat of inflation was to be addressed by dampening demand, which could be done without risking a risie in unemployment, because the over-utilisation of capacity meant that there were enough jobs to go around even if demand was reduced. Cost inflation spoilt this simple trade-off, and its control became the economic-policy issue of the decade.

  Among countries on the American side of the Iron Curtain, a split developed between those that controlled cost inflation by corporatist means, centring on high-level negotiations which included trade unions and was backed up by qualitative financial controls, and countries that relied on the revived neo-liberal approach which centred on breaking the power of trade unions. In its arbitration system, Australia had an institution that could readily have been adapted to control cost-inflation by corporatist agreement, but two important groups were blind to this opportunity: the big-business elite, for whom the neo-liberal United States was the great exemplar; and the new generation of economists returning from initiation into the wonderful models of neo-liberal economics, primarily in American graduate schools. Australia lurched into neo-liberalism, not in one decisive event but in a series of decisions taken by governments both Labor and Liberal/National. The relevant governments called this process macroeconomic and microeconomic reform, and gloried in it.

  This transition was only possible because the memory of the Great Depression had receded. The forgetfulness reached the point, in the United States, if not in Australia, where neo-liberal economists claimed that, because (by assumption) in General Equilibrium there could not be a Great Depression, the Depression must have been caused by government intervention. Suffice to say that when countries adopted neo-liberal policies, they generally dropped their guard against the threat of economic crisis. As discussed in Chapter 1, this nonchalance was associated with an increase in the frequency of national economic breakdowns such that, by 2010, enough crises had occurred to allow statisticians to identify bellwether indicators of the onrush of economic catastrophe. The authoritative work by the EC that we have already discussed identified ten such indicators, five of which are currently flashing red for Australia. These flashing indicators fall into two groups: the first group is primarily concerned with domestic debt, and the second with international debt. It would be irresponsible not to take these indicators seriously and to ask how they are related to the adoption of neo-liberal policies, particularly financial deregulation.

  Private-sector debt

  The three EC indicators that raise the alarm over Australian private debt are the rate of private-sector credit flow, the level of private-sector debt, and the rate of increase of house prices.

  Despite its prominence in Australian media commentary, the government debt indicator is not flashing red. Neo-liberal economics provides a simple reason for this concentration of commentary: government borrowing is under government control, whereas private debt results from market activity, which by assumption guarantees equilibrium. It does not occur to neo-liberals that decisions made in more-or-less competitive private markets could add up to macroeconomic danger, just as it does not occur to them that borrowing by government is not always dangerous.

  Fortunately, the EC has rid itself of these delusions, and selected its indicators of macroeconomic imbalance by empirical analysis of experience across the world. It has included rapid private-sector credit flow (the total of new borrowing by households and businesses as a percentage of GDP) among its indicators of impending crisis, because of its track record as a warning indicator. Rapid credit growth is associated with poor allocation of credit. For Australia, the indicator remained well below EC alarm levels during the post-war period; it may have risen above this level in the late 1980s,1 and it definitely moved above the EC alarm level in 1998, with a further rise in 1999. The next years of alarmingly high credit flow were the six years from 2003 to 2008. The Global Financial Crisis caused a pause, but dangerous levels resumed in 2014 and 2015.2

  The second indicator of private-sector debt, which cumulates credit flow, is the level of household and business financial liabilities in relation to GDP. There is recent evidence that an excessively large financial sector is associated with a low economic growth rate, and very little doubt that high private-sector debt increases both vulnerability to financial crisis and the intensity of any crisis that occurs. In Australia, strictly comparable time series are not available for the post-war period, but such numbers as are available suggest that private-sector debt, though gradually increasing, remained well below the EC alarm level during the post-war period, but began to rise with deregulation. The indicator breached the danger level in 1998, and ever since has been above it. This increase was almost entirely due to an increase in household debt, which rose from 53 per cent of GDP in 1992 to 134 per cent in 2015, compared with an increase in the debt of incorporated businesses from 105 per cent of GDP to 110 per cent. Since 1992, though not necessarily in the first decade of deregulation, the increase in private-sector debt has been chiefly due to an increase in household-sector debt.

  It has long been observed that booms in asset prices frequently turn out to be bubbles that, when they burst, generate financial catastrophe. The EC indicators zoom in on booms in house prices. The commission does not deny that booms in other asset prices can be harmful, but housing-price booms are particularly so. The wide spread of house ownership means that a bubble in house prices directly affects a much higher proportion of the population than does a bubble in share prices — since financial deregulation, Australian share prices have twice fallen by 40–50 per cent without precipitating a general economic crisis.3 By contrast, and in line with the alarming increase in household debt, house prices have risen with no comparable shakeouts, and are now the cause of considerable complaints focussing on poor affordability. Average house prices adjusted for the general level of inflation, having risen by around 1.4 per cent a year during the 1980s,4 increased by more than the EU alarm threshold of 6 per cent a year in several bursts: 2000, 2002–03, 2007, 2010, and then each year from 2013 to 2015.

  In the post-war period, Australia accordingly remained below the EC alarm level signalled by its three private-debt indicators, but definitely rose above them in the late 1990s, around fifteen years after the main phase of financial deregulation. The rise in three indicators related to private debt was not, therefore, an immediate result of financial deregulation. However, a relationship appears once we explore further.

  The first five years of deregulation

  Touted as an epochal reform that applied neo-liberal principles to Australian policy, financial deregulation relaxed previous constraints on the ability of the banks to exploit market opportunities to increase their income-earning assets. Though their capital adequacy was still regulated, this was initially no constraint, thanks to the unlocking of funds previously sequestered in low-interest loans to the Commonwealth government. The banks also gained unregulated access to overseas lenders, and so long as the returns they received from domestic lending exceeded their costs of overseas
borrowing, they could turn a profit on domestic loans financed by borrowing overseas.

  Once freed from constraint, the banks rushed to add to their loan books, arguing that the more loans they could make, the greater would be their interest receipts and the greater their profits. Reinhart and Rogoff remark that a banking crisis tends to follow within five years or so of financial deregulation. The United States observed this rule; its ‘savings and loan’ banking crisis followed deregulatory moves in the 1980s. Australia was no exception. From 1984, Australia’s newly deregulated banks scurried to make loans to ‘entrepreneurial’ companies and to developers of commercial real estate — not, at that stage, to households, because they calculated that high administrative costs would restrict the profitability of small loans.

  The 1987 crash of various global stock markets, including Australia’s, revealed that the large loans to entrepreneurial companies were imprudent, but it was not till the 1989 crash of the commercial property market that the banks found themselves in difficulties from bad debts. Right on time, five years after deregulation, ‘the 1990s began with the banking industry experiencing its worst losses in almost a century’.5 This banking crisis was associated with a dangerous level of overseas borrowing and a recession that was severe but stopped short of catastrophe. The banks wobbled, but survived.

  Mortgages and equity withdrawal

  In the early 1990s, the Commonwealth government was at its wit’s end as to how to promote recovery from the recession. After all, neo-liberal theory assumes that recessions do not happen. The authorities attempted to return to the post-war response of increasing demand by borrowing to finance public infrastructure investment, but found that the remaining public-sector infrastructure owners did not have sufficient shovel-ready projects available to make a quick difference. They therefore resorted to encouraging households to add to demand. The partial deregulation of gambling increased household expenditure at the expense of saving, but the measure that really raised consumption was increased bank lending to households.