by Peter Brain
Probably without realising what they were doing, Commonwealth governments in the 1990s caught themselves up in policy inconsistency. Blinded by neo-liberal economics, they promoted National Superannuation to increase household savings, without making any provision to ensure that these savings were invested in projects of national development. Instead, the governments came to depend on consumption to maintain demand. As quickly as households accumulated superannuation savings — indeed, quicker — they accumulated bank debt, with the net result of a reduction in the savings rate. This double accumulation suited the finance sector just fine.
The lesson that the banks took away from the 1990 recession was to avoid making loans to entrepreneurial businessmen. Rather than rein in their lending, they switched to an emphasis on household mortgages. Computers had reduced the administrative cost of small loans, and the banks were comfortable that these loans were secure, for three reasons. First, their borrowers were gaining assets that allowed them to save on rental costs and hence could readily be serviced, provided loans were restricted to borrowers with reasonable earnings prospects. Second, population growth generated strong demand for new houses, and the banks could argue that mortgage lending met an urgent social need. This argument justified the Commonwealth government in its encouragement of mortgage lending through its taxation system, particularly by allowing negative gearing, and also through its National Superannuation scheme, which promised lump-sum benefits to retirees that could be devoted to debt repayment. Third, the banks felt secure because, if all else failed, the properties provided collateral.
However, what seemed prudent and profitable to the banks and was convenient for the government turned out, with hindsight, to have been foolish policy from a broader macroeconomic point of view. Up until deregulation and indeed for some years thereafter, aggregate lending for housing had been limited so that the demand for new dwellings roughly equalled the capacity of the urban-development and construction industries to supply new conveniently located dwellings. When mortgage lending took off in the mid-1990s, it raised the demand for metropolitan housing to the point where it seriously outran supply, resulting in rising prices.
The limited production of new housing was no fault of the construction industry, which stood ready and willing to build. Instead it reflected a failure to create new house sites of acceptable quality. The quality most important in a house site is ready accessibility to employment. By 1995, the fringe of Australia’s major cities — the places where new house sites are most readily created — had moved beyond a reasonable travel-time distance to the centres of metropolitan employment, so that fringe houses were less and less adequate as substitutes for existing, better-located housing. Coincidentally, the decline of manufacturing industry (which was, at least partially, a result of neo-liberal policies) meant that jobs were no longer decentralising outwards from the metropolitan centres at the rate they had been in the post-war period. Instead, and in defiance of the American precedents on which the state governments in charge of metropolitan transport investment were relying, employment (and especially high-productivity employment in what became known as the knowledge economy) was re-concentrating in the city centres. It took decades for governments to realise that mass commuting from the metropolitan fringes to the city centres requires mass transit — the very public transport that neo-liberals wanted to scrap because it ran at a loss.
There are three main strategies to increase the supply of accessible housing. The first is to decentralise jobs to suburban centres and provincial cities; the second is to redevelop brownfield sites in already-accessible locations; and the third is to invest in fast mass transit connecting greenfield housing developments with employment locations. This is not the place to discuss their relative merits — in fact, there is room for all three strategies — but it is important to emphasise that each strategy requires considerable advance planning and investment; all three are slow-acting, hence the inability of the housing market to meet the avalanche of mortgage finance with an increase in supply.
The result was an increase in established house prices (or, more precisely, an increase in the price of inner- and middle-suburban land), which brought capital gains to established owners, frustration to aspiring owners, and a crisis of housing affordability. The increase in mortgage lending — in household debt — accordingly financed rising prices rather than construction. These rising prices in turn persuaded established home owners that it was safe to increase their consumption expenditures — either directly, by taking out a mortgage against the enhanced value of their home, or indirectly, when retirees sold out, harvested their capital gains, and shifted to lower-priced retirement regions.
Home-owning households were also encouraged to increase their mortgage debts by the lump-sum promises of national superannuation; within the limits of their expected lump sum, they could be persuaded that it was safe to finance consumption from a mortgage. These increases in consumption outweighed the decreases as home-buying households tightened their belts to pay high mortgage costs.
Mortgage-financed increases in consumption constitute the phenomenon of equity withdrawal. More formally, equity withdrawal comprises household debt incurred over and above the level required to support new investment in dwellings, unincorporated businesses, and not-for-profit enterprises. Looked at from a macroeconomic point of view, because it is not balanced against new investment, it is easy to see that equity withdrawal is used to finance consumption. It underlies growing dwelling prices and ultimately supports consumption expenditure via household wealth effects. By the end of 2015, household-equity withdrawal debt had reached 72 per cent of GDP, or over half of total household debt. The banks were not only lending to finance consumption directly (via credit cards and the like), but were doing so massively through their mortgage lending. Long and painful experience has shown that it is imprudent to lend (and to borrow) to finance consumption.
A major cost to the economy of the accumulation of equity-withdrawal debt lay in its counterpart on the liability side of bank balance sheets: increased vulnerability to overseas lenders. We consider this in detail below. However, even if attention is confined to the asset side of bank balance sheets, it was noticeable that the surge in lending to households crowded out lending to governments. At the end of 2015, total public-sector net debt stood at 28 per cent of GDP, while that part of total household debt which derived from equity withdrawal represented 72 per cent of GDP. If over the last decade just 20 percentage points of the equity-withdrawal debt had been transferred to the public sector and spent on infrastructure investment, the capital stock of the economy would have expanded by approximately $300 billion in 2015 prices.
Empirical estimates of the annual increase in GDP from an additional dollar of public-sector capital stock (technically, the marginal product of infrastructure capital) have generally been found to lie between 20 and 70 cents, with transport-infrastructure investment towards the higher end of the estimates. Even if a conservative marginal product estimate of 30 cents is assumed, national GDP would have been 6 per cent higher by 2015. The public-sector debt-to-GDP ratio would have been no greater than 45 per cent — well within the EC safe limit — and most likely significantly less, given the opportunity to use the extra tax revenue from the additional growth in GDP to pay down debt. The total private- and public-sector debt-to-GDP ratio would have been less than its present level.
The ease with which we can construct this alternative scenario, in which continued quantitative regulation of the finance sector would have resulted in more rapid growth of GDP than that actually achieved, points to a failure of financial deregulation, and of the neo-liberal reforms more generally, to deliver on one of their core promises. This was the promise of a rapid growth in productivity.
Productivity
It is almost a tautology that high-income countries have high productivity; that is, that they extract high incomes from their available resources. The co
ncept of productivity concentrates on outputs (income) in relation to inputs (labour, capital). Capital is exceedingly heterogeneous and difficult to convert from a financial amount into a measurable quantity of physical inputs, whereas labour, while admittedly very diverse, can be measured in such terms as workers employed or hours worked. Productivity analysis has accordingly concentrated on the ratio of outputs (generally valued as income generated) to labour inputs.
The neo-liberals promised that their reforms would revive growth in productivity after the doldrums of the 1970s. Tax cuts would sharpen incentives to work and increase productivity, particularly at the top end of the income distribution, while welfare cuts would force bludgers to become productive workers. Tariff cuts would intensify overseas competition and force Australian trade-exposed businesses to lift their game. Privatisation would force government-owned businesses to disgorge hoarded labour, raising productivity. And financial deregulation would ensure that the flow of savings was invested so as to maximise productivity.
There is no doubt that financial deregulation brought one major increase in productivity, measured as income generated per person employed. This was in the finance sector itself. From 1984 to 2004, labour productivity (income in constant dollars generated per employed person) in the finance sector grew by 5.7 per cent a year, way in front of all other industries and well above the national average rate of 1.6 per cent. Even when the rate of growth of productivity declined from the mid-2000s on, the finance sector remained ahead.6 These increases were no chimera; the incomes so generated raised bank profitability and bank executives’ rewards. According to the national accounts, the share of the finance sector in locally owned private corporation gross profits (defined as consumption of fixed capital, plus undistributed income, plus dividends payable) rose to 28 per cent by 2015, well above historic benchmarks.
Underlying this increase in profitability, the size of the Australian financial sector grew from 5.8 per cent of nominal GDP at factor prices in 1992 to 9.3 per cent in 2015, with a similar change in real terms. Had the authorities succeeded in curbing equity withdrawal, this increase would not have occurred. The banks would not have become as fantastically profitable as they appear to have been, at least until their accounts are adjusted for the final impact of their imprudent domestic loans and overseas borrowings. In so far as the prosperity of the years since 1992 was underpinned by equity withdrawal, incomes would also have been less — but how much less would depend on how the economy was managed, since debt accumulation is not the only way to keep an economy moving.
By contrast with Australia, most Western European economies eschewed equity withdrawal as a driver of economic growth. In these countries, the size of the finance sector has remained stable at between 3 and 5 per cent of GDP. Norway, which, like Australia, had to manage a large-scale resource-development boom over this period, actually experienced a decline in the share of the financial sector in real GDP to 4 per cent or less. It not only managed to slim its finance sector; it also managed the over-valuation of its exchange rate to minimise the adverse effects of its resource boom on its non-resource industries, and maintained full employment to boot.
Analysis by the Organisation for Economic Co-operation and Development (OECD) showed that, on average, for each 1 per cent per annum growth in employment of the finance sector across 21 OECD economies between 1980 and 2009, the national productivity growth rate declined by at least 0.3 per cent per annum. Figure 1 indicates a similar relationship for Australia, where the negative relationship between national productivity growth and the rate of growth of finance hours worked is also -0.3.
Financial deregulation has dampened productivity growth in several ways. By reducing the care given to the management of small-business loans, it has missed opportunities and abolished a trusted source of financial advice to small business. By raising land prices, it has raised costs and reduced the competitiveness of land-using trade-exposed industries. By encouraging equity withdrawal, it has reduced the flow of savings available for the domestic finance of investment. By dampening government borrowing, it has curbed infrastructure investment.
In conjunction with the other neo-liberal reforms, financial deregulation has redistributed capital and labour resources away from high-productivity sectors to low-productivity sectors. It has redistributed labour away from the production of tradeable and high-technology goods and services towards low productive activity such as property, retail, and accommodation services. It has diverted capital resources from investment in product development, equipment, and industrial capacity, and towards commercial and residential buildings. By raising finance-sector profits and executive remuneration, it has contributed to the increase in inequality of income and wealth. These failures underlie the increased vulnerability of the Australian economy as measured by the EC indicators of private-sector debt.
Figure 1: Australia: Finance hours worked growth versus national productivity
Consumption as a source of demand
Insofar as the immediate purpose of debt accumulation is to add to purchasing power and thus to increase expenditure, one would expect an increase in debt to be associated with an increase in GDP. This relationship is measured by the ratio of the change in annual nominal GDP to the change in total private-sector debt. Between 1992 and 2012, this ratio was reasonably stable around 0.36, meaning that $3 of additional private-sector debt was associated with a $1 increase in nominal GDP. However, over the last three years the ratio has fallen to 0.18, so that $6 of additional private-sector debt is associated with a $1 increase in GDP.
Australia seems to be approaching the stage where debt accumulation is no longer effective in driving GDP. In other words, while in the 1990s and 2000s the boom in mortgage lending brought some macroeconomic benefit, this is now disappearing, leaving just the risk of crisis inherent in excessive debt.
As we have noted, the Commonwealth government condoned the surge of debt-financed consumption as a way of recovering from the 1990 recession. Given the political and timing difficulties of reviving demand through infrastructure investment other than roadbuilding, the tactic served its purpose. However, it now serves to accumulate debt without adding much to demand. Its time has passed.
The picture darkens further when we move to our last group of EC indicators: those dealing with overseas debt.
4
Financial deregulation and overseas debt
In Australia’s case, there is a direct link between the EC indicators of vulnerability to crisis due to excessive domestic debt and the indicators discussed in this chapter, those of excessive overseas debt. The two vulnerabilities are linked because the banks have financed much of their domestic lending by overseas borrowing.
In Chapter 3, we concluded that a program of mortgage lending that finances consumption via equity withdrawal encouraged by increases in land prices is very risky, for it fails to create an income stream, or even a stream of savings in rental costs, to service the debt. In this chapter, we describe how the banks compounded their vulnerability by financing much of their mortgage lending by borrowing overseas.
Even when it successfully finances dwelling construction, mortgage lending does not enhance exports and is hence risky when financed from overseas borrowing. Had they been required to finance their mortgage loans from domestic sources, the banks’ capacity to expand their loan book would have been limited by their capacity to attract domestic deposits. Their overseas borrowing avoided this limitation. The banks were well aware that they courted losses should the Australian dollar devalue, but they satisfied themselves that they could hedge against this risk while still maintaining a healthy profit margin between their mortgage lending rate and their cost of funds. From a macroeconomic point of view, this borrowing was risky, since it was not invested in a way that generated a flow of foreign exchange with which to service and repay the borrowing. The banks have disregarded these risks and received massive short-ru
n profits by doing so. More seriously, the Reserve Bank and other agencies that are charged with supervising bank behaviour have stood by and watched.
The European Commission’s indicators of dangerous levels of overseas debt
The three European Commission indicators that raise the alarm over Australia’s level of overseas debt are counterparts of the indicators for domestic debt. The counterpart of the rate of private-sector credit flow is the flow of overseas borrowing as measured by the current-account deficit; the counterpart of the level of private-sector debt is the net stock of external financial obligations; and the counterpart of the rate of increase of house prices is the real exchange rate.
The EC measures the flow of overseas borrowing by a three-year moving average of the current account as a percentage of GDP. Though the commission sets thresholds both for deficits (borrowing) and surpluses (lending), Australia has never received a warning for an excessive current-account surplus; it is, instead, currently on notice for an excessive current-account deficit, or excessive net overseas borrowing. (There is a problem of language here: the public can easily be talked into confusing the current-account deficit with the government budget deficit. Those who listen to the Australian media can be excused for believing that the government budget deficit is out of control whereas the current-account deficit is benign — exactly the opposite of the conclusion from the EC indicators.) The EC emphasises the current-account deficit in its list of bellwether indicators because such excessive deficits are a frequent precursor of financial crisis, especially when they are used to finance consumption rather than investment in areas that will generate export revenue.