Credit Code Red

by Peter Brain

  In other words, though a fall in the exchange rate to a little below purchasing-power parity with the United States is a necessary condition for long-term restructuring of the Australian economy so that it is no longer so dependent on overseas borrowing, it works much too slowly and with far too many adverse feedbacks to rely on it as a way to counter the immediate threat of crisis. Such reliance goes beyond imprudence to the level of irresponsibility, to living by the Micawber principle that ‘something will turn up’. There are precedents: in 1987 and 2004, Australia was teetering towards Code Red status, but a rapid recovery in commodity prices permitted the continuation of easy-going policies. However, in 1987 the burst of luck didn’t last, and a defensive recession was required in 1990. The mining boom came to the rescue in 2004 and 2008, but the current decline in the terms of trade indicates that that rescue was likewise impermanent.

  As we calculated in Chapters 5, 6, and 7, a scenario in which Australia attempts to continue business as usual is likely to end up in it defaulting on some of its overseas debt. The question becomes: is the government prepared for this? It is a question that cannot be answered, since any preparations must necessarily be undertaken in secret, for fear of scaring the horses. In constructing scenarios, we can go no further than entering into a broad discussion.

  We began this book with a discussion of economic catastrophes. Debt defaults are sorry events for borrowers and lenders alike: for lenders, because their assets lose value; and for borrowers, because, in general, default results from disappointed expectations and the possible loss of the defaulter’s remaining assets. This is true even for personal bankruptcies. The bigger the defaulter, the more widespread the effects, and defaults at a national scale are generally associated with economic catastrophe. As discussed in Chapter 1, the record of economic catastrophes includes falls in GDP of up to 50 per cent and increases in unemployment rates up to 40 per cent. The over-borrowing that results in default is associated with imprudent practices, such as borrowing to finance consumption and asset-price bubbles, and generates catastrophes through a breakdown of the financial system and because foreign exchange is no longer available to support established patterns of production, trade, and consumption.

  In law, default means a failure to service fixed-interest debt according to the terms agreed when the debt was contracted. At worst, default takes the form of debt repudiation, but default on overseas debt due to a shortage of foreign exchange is more likely to take the form of a postponement of payments or the exchange of fixed-interest debt for a form of borrowing where the lender bears greater risk. Where the debt concerned is the liability of a private business, debt may be converted to equity, but this is not possible for national governments. However, it may still be possible for governments to convert debt to higher-risk financial instruments, such as bonds that bear coupons tied to their country’s export earnings or to GDP.

  Country defaults do not usually occur in isolation. They generally occur in the context of a period of regional or worldwide economic and financial instability. The world is at present enduring such a period. If Australia defaults, it is unlikely to do so alone, and therefore quite likely to participate in some sort of new global deal on international borrowing and lending. The opportunities and trade-offs in such a deal are very difficult to envisage.

  The uncertainty also reflects the difficultly of finding precedents for an Australian default. This arises for two reasons. First, it will be one of the first major over-borrowing defaults to take place since globalisation, which has subsumed large parts of trade and international capital flows into the internal accounts of multinational businesses. Second, as we noted when discussing the Pitchford thesis, any default will be primarily due to over-borrowing by private financial intermediaries, not by governments. The course of the catastrophe will accordingly be strongly influenced by how much of the debt is treated as private debt and how much finds its way on to government accounts.

  An Australian default would start with the banks being unable to honour their obligations to overseas depositors. There would be no need for this to spread to domestic obligations — whatever shortages of overseas currency may develop, the Reserve Bank is able to guarantee Australian dollar deposits. However, prompt action would be required to ensure that the default did not directly affect domestic trade. This would probably require the Commonwealth government to take control of the banks.

  Even if it did not take over the management of the trading banks, the Commonwealth and its instrument, the Reserve Bank, as holder of Australia’s diminished reserves of foreign exchange, would find itself negotiating with the banks’ overseas creditors and their governments, and probably also with international agencies — the IMF has a long history of providing loans to governments that run out of foreign exchange, and of imposing onerous conditions on the provision of these loans. (One of the major unknowns is how much IMF conditions will have changed in these post-neo-liberal days.) Many important decisions would arise in the course of negotiations, such as whether to accept bail-out loans and on what conditions; whether to accept re-scheduling; and whether to insist that debt be converted to variable-coupon financial instruments.

  Whatever the negotiated terms of default, the Commonwealth would find it necessary to re-impose exchange controls, probably in conjunction with raised supervision of the accounts of multinational traders and hence the need for yet further international negotiations. The basic purpose of exchange controls would be to strengthen the current account, and would include the prioritisation of imports of inputs to domestic production (including capital goods) over imports for current consumption. In the process, the exchange rate would be fixed at low levels. Logically, exchange controls would extend to more general controls over credit allocation, with an increased emphasis on business loans and a severe brake on loans for consumption. Urban land prices would fall, and there would be a need for a general renegotiation of mortgages — yet another reason why the banks would have to come under government control. Australia, which under financial deregulation stepped back from the quantitative control of finance, would find itself bundled almost overnight into the world of qualitative control of credit. It can only be hoped that the authorities foresee this eventuality and are conducting the necessary background planning for it.

  The terms of the government takeover of financial intermediaries would be contentious. Should all bankrupt institutions be taken over, or some left to soldier on in receivership? Should systemically important institutions be taken over, even if not bankrupt? What would be the role of the executives and directors who were legally responsible for the defaults? Would anything be left for shareholders? If bank shares became valueless, what would be done to honour the promises inherent in national superannuation? A welter of difficult questions would arise, many of which cannot be anticipated, and yet a return to prosperity would require that answers be found. Further, these answers would need to be aimed at reforming the financial system so that it could underpin a return to sustainable prosperity.

  On balance, given Australia’s present over-indebtedness, we consider that the catastrophe of default is likely to be preferable to a recession of the depth and duration that would be required to push its EC macroeconomic indicators back to manageable values. Our main reason is that default will force a re-think of Australia’s financial architecture, whereas a recession will leave the financial system essentially unchanged and as prone as ever to excess overseas borrowing. A default from which the country emerges reasonably quickly and more efficiently managed is likely to be less costly in the long run than a recession that becomes the secular trend.

  A catastrophe involving default would require many decisions to be made on the run. It would be helpful if such decisions were guided by an artificial scenario in which Australia was given time to implement qualitative financial controls without the cost of a slump in GDP. This is a dream scenario, in that we do not believe that such time will be
given, nor do we believe that its adoption is politically feasible, except as a response to catastrophe. Even so, it is worth outlining.

  #3: Economic restructuring as an alternative to either recession or catastrophe

  Could the prudential regulation of overseas borrowing be restored, and the qualitative regulation of finance be adopted more generally, without the heavy losses involved in financial catastrophe? This does not mean a return to bank regulation as it was practised up to 1983, but would require a return to Australia’s former pragmatism, with elements drawn from historical experience, adjusted for changes in technology and in the world economy.4 This would be likely to require the following changes:

  The substitution of domestic savings for Australia’s current dependence on overseas savings. This would require a fall in consumption, achievable if the household sector stops borrowing and concentrates on repaying its debts. Of itself, this would cause a slump, but not if investment in capital and education rises to take up the slack.

  Government re-entry into the loan market for the finance of infrastructure, especially that which promotes an improvement in the balance of trade. This may be facilitated by innovative financial instruments and tax arrangements.

  Measures to direct bank lending towards the finance of trade-exposed business and away from the finance of consumption. This would involve a rethink of housing finance, including action to increase the supply of housing in locations with good job access. It would require a return to conservatism in financial institution culture.

  Measures to facilitate the maintenance and upgrading of productive capital equipment, particularly in trade-exposed industries, including the replacement of equipment that is becoming prematurely obsolete due to climate change.

  Education policies complementary to the new emphasis on real investment.

  Initial (yet urgent) steps in the implementation of this program would involve government action to save what is left of Australian steel capacity and to pay the remaining motor vehicle manufacturers whatever it takes to keep them operating. This sounds drastic, but is appropriate when a foreign-exchange crisis is looming — in other words, when additional overseas borrowing is no longer possible due to excessive overseas debt. As we have argued, price mechanisms generally act too slowly to rectify a balance-of-payments deficit; instead, the practical response is an induced recession that reduces incomes so that residents buy fewer imports.

  The cost of a general reduction in incomes is that domestic productive capacity becomes unemployed — a phenomenon known as the balance-of-payments constraint to growth. In these circumstances, any action that either earns or conserves foreign exchange will have multiplier benefits, since it allows a relaxation of the income reductions and an increase in employment. Typically, a dollar of foreign exchange conserved by an import-replacement program (or earned through an export-promotion program) will produce an increase in GDP of between two to four dollars, along with an increase in employment. Accordingly, when employment and capacity utilisation are constrained by the balance of payments, government expenditure to conserve foreign exchange can bring net benefits.5

  Though emergency action to conserve foreign exchange is likely to form an important initial part of the strategy of structural change, it is most appropriate as a short-run response when resources are unemployed. However, our proposed economic restructuring would go well beyond this; the five areas of change we have briefly specified are appropriate even if resources are fully employed. These changes would be much easier to implement should the international environment change, so as to address global environmental problems while countering the chronic deficiency of global demand that has marked the neo-liberal era. Helpful changes that can only be implemented with international cooperation include stopping multinational businesses from sequestering purchasing power into tax havens, and a coherent response to climate change that is shorn of free riders. Sadly, the portents are not auspicious, and it is quite likely that, as in the 1920s, Australia will be obliged to soldier through the 2020s in an atmosphere of international distrust in which especial care has to be devoted to the control of debt.

  Is there any way in which these changes could be wrought without reducing consumption? Unfortunately, there isn’t. The avoidance of over-borrowing implies increased self-reliance, and the need for investment to upgrade the capital stock requires an increase in savings. As Keynesians, we well know that some of the required finance may be made available by working existing assets harder, but this depends on the right equipment and skills being in place. We fear that there is not sufficient spare capacity, in the right industries, for this to be possible on a wide scale. In particular, Australian output is limited by the capacity to import — a limitation that any restructuring program should address as a major priority.

  If a fall in consumption is inevitable, must the same be said of a fall in income? The answer is that, with competent macroeconomic management, it should be possible to maintain incomes while reducing consumption. The resulting increase in savings can be applied to the investments needed to rectify Australia’s structural weaknesses. Let there be no mistake: Australia’s structural weaknesses can only be overcome by a program of investment that, given its balance-of-payments position, will have to be domestically financed, requiring an increase in domestic savings. Such a program is a coherent and logical response to Australia’s predicament, and similar programs have indeed been implemented in various countries. However, the program suffers from two obvious disadvantages: how can investment in new capital be boosted in the face of a consumption slump, and how can a democratic government justify a cut in consumption — a fall, if only temporary, in living standards?

  The necessary investment would in part have to be undertaken by governments, extending their long-term responsibility for public infrastructure, but would also be undertaken by far-sighted businesses that could see the opportunities created by a reconstruction program. To encourage far-sighted business investment, it would be important for governments to stabilise long-term prices, such as the exchange rate and (in a whisper) the price of carbon emissions. With such a program in place, the necessary increase in savings would be readily justifiable by appeal to folk wisdom — you cannot reap before you’ve sown — and more generally would flow from the exercise of the virtue of prudence, including a willingness to learn from experience and to apply reason, shrewdness, caution, and foresight in the development and implementation of policy.

  The idea that governments should be prudently active is foreign to neo-liberalism, which rather requires that they should be passive and preferably dormant. However, the recent past has produced examples of governments that have prudently recognised that markets work best when guided towards a range of national targets on a time horizon measured in decades rather than months. These governments, including (not necessarily all of the time) those of China, Japan, Singapore, Taiwan, South Korea, and the northern European countries, have shown themselves to be able to successfully apply multiple policy instruments to implement multiple-target policy regimes, where an important (but not the only) target is prudence in matters affecting the balance of payments.

  Should a prudently active government take office in Australia, the first thing it would recognise is that short-term thinking is not enough; prosperity is not to be guaranteed by struggling through the two years that follow an election to produce a cornucopia of largesse in the third. Such strategies do not impress either international or domestic investors, who reach their conclusions about the viability of the Australian economy not only by assessing current indicators, but by projecting these indicators into the years ahead. It is critical that they should be persuaded that the Australian government, whatever its party label, is realistically determined to reduce the current-account deficit and Australia’s current reliance on foreign debt. Growth must emphasise net exports, whether achieved by export growth or import replacement.6

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bsp; Such a government would recognise that a strategy to defend, let alone increase, incomes in an unhelpful world afflicted by climate change and undercurrents of aggression requires the pursuit of a complex array of objectives and hence an array of policy instruments. The current Australian policy regime, which attempts to achieve multiple targets using interest rates as its only effective policy instrument, is a mathematical absurdity. A prudent government would broaden its range of instruments, including restoring such controls over the finance sector as are necessary to manage the total quantum of credit available and to allocate credit to strategic sectors and infrastructure investments. The availability of multiple policy instruments, including qualitative credit controls, would also help it in the task of managing the exchange rate at a level that supports growth in net exports while managing the risk of exchange rate undershoot. This exchange-rate target would be in the vicinity of 60 US cents to the Australian dollar, and would have to be held stable at near that rate for a lengthy period of time.

  Having achieved the degree of control necessary to steer the economy clear of balance-of-payments crises, the essential strategic policy objective would be to overcome years of excessive emphasis on consumption by switching resources into investment, with the emphasis on investment to increase exports, replace imports, and generally update a capital stock that has deteriorated due to rapid technological change, not to speak of the effect of climate change in rendering obsolete much of the equipment used in the energy and transport industries. This strategy requires that employment should be maintained and the capital stock utilised as fully as possible while increasing the savings rate and hence controlling consumption. All of this would have to be done while ensuring that economic activity operates within the balance-of-payments constraint, requiring at worst a low current-account deficit.