Brain manning credit code red; how financial deregulation and world instability are exposing australia to economic catastrophe (2017)

3 Financial deregulation and household debt4 Financial deregulation and overseas debt 5 Australia under credit watch 6 Crisis vulnerability over the next decade 7 Neo-liberalism comes fu

CREDIT CODE RED

Peter Brain’s doctoral degree, completed at the University of New South Wales, was a pioneeringanalysis of the National Accounts statistics then becoming available in time series In 1973, he wasappointed to head the Econometric Forecasting Project at the Melbourne University Institute of

Applied Economic and Social Research

After graduation from the University of Melbourne, Ian Manning taught at one of the affiliatedcolleges of the University of Madras, India, specialising in the economics of banking He returned tothe Australian National University to complete a doctorate on the economics of town planning, andthen worked on social-security policy for the National Inquiry into Poverty In 1980, he joined thestaff at the Melbourne Institute

In 1984, Peter left Melbourne University to found the National Institute of Economic and IndustryResearch (now known as National Economics) Ian joined him a year later For the past thirty yearsand more, they have both collaborated and worked independently on projects covering all aspects ofthe Australian economy, its industries, its regions, and its people

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To Angela and Alice

3 Financial deregulation and household debt

4 Financial deregulation and overseas debt

5 Australia under credit watch

6 Crisis vulnerability over the next decade

7 Neo-liberalism comes full circle

8 Economic policy after neo-liberalism

Appendix

Acknowledgements : The role of financial deregulation in the accumulation of overseas debt

Notes

Australian Bureau of Statistics ABS

European Commisssion EC

European Union EU

Gross Domestic Product GDP

Global Financial Crisis GFC

International Monetary Fund IMF

Reserve Bank of Australia RBA

Volatility Index VIX

For more than thirty years, Australian governments have pursued and promoted free-market economicreforms They have trumpeted the virtues of profitability and competition; they have asserted thatproductivity is bound to increase when business is deregulated Their reforms have been guided byneo-liberal economics, the faith that ‘the free market, unimpeded by government intervention, willanswer all human needs’.1

This faith claims a universal validity, and the Australian reforms were part

of a surge of reform that originated in the United States and washed outwards from the

When the neo-liberal theories came into fashion in Australia we were concerned that they wouldgenerate complacency We were not, perhaps, as concerned as we should have been about the

promotion of inequality — Australia has a robust social-security system that has so far resisted themost outrageous reforms, though neo-liberal tolerance of high unemployment and failure to indexbenefit rates have raised the incidence of poverty Our particular concern was that governments

would neglect the need for active policies to maintain stability and underpin future prosperity, and sowould sleepwalk Australia into crisis

Over more than three decades, we have maintained an unfashionablly broad approach to

economics, unconstrained by neo-liberal assumptions This approach warns us that Australia is indebted; its households have borrowed too much from its banks, and its banks have borrowed toomuch from overseas The neo-liberal reforms freed the banks to sell credit, and the resulting debt isbecoming unmanageable Though it avoided the Global Financial Crisis of 2008, Australia is nowdrifting towards economic breakdown and Depression In this book, we hoist the Code Red signal;drastic action is required to extricate Australia from the pitfalls that neo-liberal policy has created

over-When one encounters it in a first-year economics textbook, neo-liberal theory seems too esoteric toprovide the foundation for a reform movement Expressed in mathematics and expounded in academicarticle after academic article, it buys its internal consistency at the cost of an almost endless list ofassumptions These assumptions create an artificial world — a placid metaphysical world in whichindividual property-owners buy and sell their way to the common good Neo-liberal theory has beenmarketed as a sophisticated account of the complex interrelationships that comprise a capitalist

economy, yet it simplifies these relationships by disregarding some of the most crucial

interconnections and uncertainties within such an economy Herein lies its danger, when potential

sources of economic breakdown are assumed away by those in charge of public policy.

The governments of Australia did not turn to neo-liberal theory through infatuation with its

intellectual beauty Rather, they adopted it because it was heavily promoted by vested interests

Though its basic theories were developed in nineteenth-century Europe to defend capitalism againstMarx and other critics, their present incarnation owes much to a coterie of American billionaires, andtheir counterparts in Australia and the United Kingdom, who turned to neo-liberal economics in theirsearch for arguments to defend their wealth against pesky taxes and environmental regulations Theirfundamental contentions were that taxes, particularly those on high-income people, weaken incentives

to produce and to innovate, and that regulations raise costs, with similar debilitating effects And,further, that production foregone due to taxes and regulations is a loss to the nation as a whole, notjust to its rich minority

Neo-liberal economic theory can easily be tweaked to support these arguments, but for it to be ofany political use in defending the billionaires’ interests it had to be established that the theory

describes an attainable reality It proved hard to establish the theory as realistic — its assumptionswere just too restrictive — but its protagonists had considerable success with their assertion that freemarkets are associated with freedom from authoritarian government It helped, too, that the seemingsophistication of the theory attracted intellectuals to the think tanks and academic posts that werefounded to promote the reform program, and that journalists could readily be found to carry the

message into the media

Once academics, politicians, and the elite in general were drawn into a mental world in whichneo-liberal perfection was considered attainable, economic policy became a simple matter of

reforming economic institutions to make them look more like those assumed in the theory — in

general, by promoting competitive markets It was argued that such reforms would guarantee

increases not only in in productivity but also in incomes

As neo-liberal theory permeated into Australian universities, we developed our critique of it,which at base was that the theory was too abstract to be reliable as a guide to policy We were

especially concerned that reform was extended to an area where the underlying theory was

particularly contentious: the extension from free trade in markets for goods and services to free trade

in money In Australia, as elsewhere, financial deregulation was intended to increase the efficiency ofthe allocation of funds, but instead it has tempted banks and other financial institutions into the

reckless misallocation of funds to finance consumption, and the reckless raising of funds by overseasborrowing

By taking into account a much broader range of behaviours than those specified in neo-liberal

theory, and by allowing for a wider range of interconnections between economic actors, we wereable to foresee the disasters that would follow from the neo-liberal reforms We were not thanked, ofcourse, for predicting the financial crises that punctuated the past three decades: the Australian 1990recession, the Asian financial crisis of 1998, and the Global Financial Crisis of 2008

Happily, one of our predictions failed to eventuate — contrary to our expectations, Australia

survived the Global Financial Crisis This happened partly because the Australian government tooktimely action, but chiefly because the Chinese government did so, and generated a mining boom that

allowed the Australian finance sector to postpone the consequences of its over-exposure to overseasborrowing.

But one happy escape does not guarantee permanent immunity In this book, we trace the evolution

of Australian economic reform in the neo-liberal era and show how it has increased Australia’s

vulnerability to economic breakdown, mainly due to excessive overseas borrowing by the banks Wealso show how similar reforms in other countries (notably the United States) are increasing the

danger that Australia’s credit rating will tumble due to events over which Australia has no control,maybe to the point where its banks’ overseas borrowings can no longer be serviced At this point, theAustralian economy will collapse

We chronicle, too, how the Australian financial sector has captured 9 to 10 per cent of Australiannational income, more or less double the proportion it attracted during the post-war era of economicgrowth, and again more or less double the proportion it attracts in continental European countriestoday This is not productivity: it is the cost of excessive intermediation; the cost of an insupportableburden of debt; and the cost of too much credit imprudently sold, resulting in debt that is all too likely

to go bad

Australia is a leaky ship in rough seas We have no alternative but to hoist the danger flag anddeclare that, on current policies, Australia will shortly enter the Credit Code Red zone

We raise the alarm, not only because we fear the costs of economic breakdown — the

unemployment and the loss of income — but because we fear half-baked responses to the breakdown,based all too probably on misunderstood neo-liberal theories that fail to address the weaknesseswhich caused the breakdown We also fear responses that go too far, and that fail to recognise thecrucial role that an efficient and prudent financial system can play in maintaining prosperity and, dare

we say it, in the transition to a sustainable economic system, including rational responses to climatechange This is why we devote so much space to the history and mechanics of what has gone wrong.Even so, our suggestions as to what should be done are but tentative additions to a burgeoning

literature

By what authority do we warn that Australia’s credit code is turning red? We claim, first, authoritythat arises from the history of economics In particular, though the political mayhem of the 1930s isbeyond living memory, the influence of the Great Depression lingers in economics Those were thedays of unemployment and moonlight flits and of bad names, including those of Hitler and Stalin Yetthere were also good names Among contemporaries who attempted to understand the maelstrom ofthe times, one good name stands out — that of John Maynard Keynes

The economists of the time, the progenitors of today’s neo-liberals, practised as they were in thedefence of idealised free markets against the vituperations of socialists and communists, were

nonplussed by the Depression In their theoretical world, such disasters simply couldn’t happen.Keynes offered an alternative vision in which free markets, while essential to the working of

productive economies, provided no guarantee of full employment In a flurry of intellectual activity,previously puzzled scholars and practitioners developed, corrected, and elaborated his insights.Professors of economics continued to ask the same questions on their exam papers, but diametricallychanged the answers

We were too young to participate in this burst of creative thinking; that was the privilege of ourteachers and mentors However, we lived through the challenge that a revived free-market economics,now termed neo-liberal, posed to the simplified policy-Keynesianism of the 1960s We contributed,

as well as we could, to the Australian Keynesian response to this challenge Here lies our secondclaim to authority

We took the criticisms of the neo-liberals seriously, adjusted our Keynesian framework to takethem into account, and tested the results by preparing economic forecasts As time passed, we wereable to check our short-term forecasts — and, in due course, our medium-term forecasts as well —against what actually happened We learned from the successes and failures of our predictions, andupdated the Keynesian framework so that it not only provided accurate forecasts but also generatedthe best policy answers of the day.2

At the heart of this updated policy framework is a recognition ofthe need for active and, in some cases, big government

Contra to the neo-liberal paradigm, we believe that Australian governments should use all the

policy instruments at their disposal to maintain control over the finance sector, constraining its sizeand hence the level of debt, and aim for moderate current-account surpluses to avoid balance-of-payments crises and defaults on foreign obligations They should aim for a stable or slowly evolvingexchange rate between the Australian dollar and overseas currencies so as not to undermine industrycompetitiveness, and should use a range of industry-assistance instruments to ensure that the structure

of the economy is compatible with sustainable long-run prosperity They should also recognise thatsustainable prosperity requires the maintenance of reasonable equality in the distribution of incomevia appropriate wage, tax, and social-security policies

Our predictions from the 1970s onwards proved accurate, made as they were on the basis thatgovernments would ignore the activist policy framework that we recommended, and would remainstuck in the neo-liberal rut We saw in the mid-1970s that the oil-price shocks would lower the long-term Gross Domestic Product (GDP )growth rate to well below previous trend levels; we predicted

in 1984 that within five years there would be a recession as a consequence of financial deregulationand indifference towards the current-account deficit; we predicted the Asian economic crises of 1998from the indicators available in 1994; and we predicted the Global Financial Crisis of 2008 fromtrends developing nearly ten years before In 1999, we clearly saw that the continued adherence of theAnglosphere countries to the neo-liberal model which they had adopted in the 1980s would result ineconomic instability and difficulties in adapting to the rise of knowledge-based industries, and theeconomic, social, and political pressures that this would create:

The increasing inequalities both between and within economies will make it clear that things have to change Change will come after 2006 The only question is whether it will be forced by depression and the seizure of power by anti-democratic radical

alternatives with similar violent consequences as in the 1930s or whether change can be planned and managed to spread

opportunities for growth more evenly throughout the world 3

However, accurate prediction by us and others has made no difference Neo-liberalism had closedthe minds of the policy establishment Despite its hegemonic status in the decades following the

Second World War, Keynesian economics never completely supplanted its predecessor For some,

chiefly academics, the Keynesian approach called into question too much of the intellectual capitalthat had been built up over the preceding century; they concentrated on reconciling Keynes with theclassics, and in the process relinquished most of Keynes’s distinctive insights.

For others, such as Friedrich Hayek and Milton Friedman, who were more politically engaged, theguidance that Keynesian economics gave to active government of the market raised the spectre of

authoritarianism; they could not accept the Keynesian approach as a via media between ungoverned

capitalism and over-governing socialism This group expended great effort in modernising the

traditional defence of free markets against socialism, and gave it sophisticated mathematical garb, inwhich dress it became known as neo-liberal economics With considerable financial aid from

American billionaires interested centrally in tax minimisation, this group became the pundits of

neo-liberal reform, of a return to pre-Keynesian policies by implementing an economic-policy programthat became known in due course as the Washington Consensus They sold themselves as the

champions of freedom, yet the policies they advocated have led to accumulations of debt that degradefreedom as surely as authoritarian government does — the difference being that the dictator is nolonger home-grown, but a junta of overseas creditors

We argued, to no avail, that active governance is a necessary but not sufficient condition for

sustainable prosperity Active governments should be guided by realistic theory based on accuratestatistics and behavioural assumptions, and they should be honest — serving general, not sectional,interests Instead, rather than recognising the need for informed yet disinterested government action,the neo-liberals constantly repeated the simplistic message that since some governments are

incompetent, all governments should be cut back to the minimum Many countries, but not all, heededthis message, and we are now in a position to compare and contrast the results

The best example of a country where the government adopted an appropriate framework for high,sustainable growth is China, which refined the old Soviet comprehensive and rigid planning

framework to concentrate its policy focus and resources on the 15 to 20 per cent of the economy that

is essential for sustainable growth — namely the high-technology sectors, the sectors where scale capital resources are important for competitive success, the infrastructure-service sectors, andthose sectors whose world trade share is going to grow relatively rapidly The rest could be left tomarket responses The Chinese learned from the Japanese, the Germans, and the Taiwanese that

large-targeted control of market forces can be a highly efficient way of achieving national economic

Faced with this dilemma, the anti-Keynesians will argue that active government is incompatiblewith economic freedoms They are wrong Europe and East Asia both include countries that havecombined democracy with active government A particularly apposite exemplar for Australia isNorway, which over the past decade and more has shown that a democratic version of the Chinese

model can manage a resources boom to permanently enrich its citizens — in complete contrast to theAustralian case, where the recent mining boom resulted in excessive debt and rising prospects ofeconomic catastrophe Norway astutely retained ownership of its minerals until their final sale onworld markets, employing multinational companies as contractors for the production process; bycontrast, the Australian states sold their minerals in situ, in the ground, so that the multinational

mining companies cornered nearly all of the final sales value of the minerals

In this book, we draw on our Keynesian background and on recent developments in practical

economics to critique Australian economic policies implemented over the past thirty years, and topresent an admittedly gloomy view of the immediate future if current policies continue Our gloomarises not from a lack of alternatives, but from the cramped mindset of the present political,

academic, and media elite It arises because this cramped mindset is so wilfully unaware of its

limitations We have been trying to point these out for decades

How do we challenge the neo-liberal mindset? Not by denying the basics of demand and supply;traditional market analysis provides a very useful account of the interaction between highly motivatedbuyers and sellers.4

However, we insist that economic analysis cannot be abstracted from the march

of time Economies lurch through time; they are often the prisoners of their past, the playthings oftechnological change, the pawns of international circumstance This contrasts with the ideal of

timeless optimality embedded deeply in the neo-liberal account of market activity We deny that thisbasic calculus adequately describes market behaviour; we eschew the concept of equilibrium Theparticular resource endowments of regions and nations matter, as do the processes by which theseendowments change and are managed and governed

We try to constantly remind ourselves that economies are infinitely complex; that relationshipswhich are important in some times and places are unimportant in others, and that this changes overtime No matter how many variables and relationships are programmed into the computer, economicanalysis inevitably simplifies reality The challenge is to extract from all the complexity a relevant,comprehensive, yet comprehensible account of each economic question: an account that gives dueweight to the uncertainties which arise as we look into the future The best that can be done is to try tolearn from history, from other places, and from developments in all the fields of study that affecteconomic outcomes — which, in turn, become the inputs for the next round of history Let the readerjudge whether we succeed

Economic breakdown as a threat to

prosperity

Australia has long been a country of high incomes, one in which it is easy to take prosperity for

granted However, neither God nor nature guarantees the Australian standard of living

It is now certain that Australians who are currently children will face the challenge of responding

to climate change, which will involve modifying the way of life to which they have been born

Whether this can be done without permanent sacrifice of their standard of living is unknown and atpresent unknowable

Australia has had little experience of environmental limitations to prosperity, though it has hadsome: right across the country at a latitude of 30 to 35 degrees there stand the ruins of farmhousesabandoned due to drought, often in combination with a sheen of salt on once-fertile paddocks In thecourse of their long occupation of the island-continent, the Aboriginal peoples survived an Ice Ageand a major rise in sea levels, while today, across wide swathes of the country, the former Aboriginalhunter-gatherer lifestyle is no longer possible due to loss of the plants that Aboriginal people

gathered and the animals that they hunted The threat of climate change is real, but this is not a bookabout it — not, that is, until we discuss policy responses in the last chapter

A second threat is easier to imagine, because there are instances of it in the historic record, though

no longer within living memory This is the threat of war During both the First and Second WorldWars, the Australian standard of living fell appreciably Consumption fell by 24 per cent between

1913 and 1918, and by 30 per cent between 1938 and 1944.1

During wars, resources are divertedfrom consumption to defence, so the decline in the value of Gross Domestic Product (GDP) was less,though still significant — 12 per cent during the First World War, and 15 per cent during the Second

As with climate change, the threat of war is real, but this is not a book about it, either

And then there is the threat of economic breakdown, which is the subject of this book

The concept of economic breakdown

Economic breakdowns come in a great variety The closure of a single factory can be enough to breakthe economy of a country town; the closure of an industry can break the economic prospects of a

generation of skilled workers A breakdown may be regional — a dust bowl, a rust belt — but it mayequally be nationwide, or indeed part of a worldwide slump Apart from the two World Wars,

Australia has twice experienced national economic breakdown Between 1891 and 1897, GDP fell by

27 per cent, and between 1928 and 1933 it fell by 22 per cent.2

There are two sources of economic breakdown widespread enough to affect whole countries,

rather than merely particular regions or industries One source is overseas, in the form of depressedexport sales for a wide range of industries and regions (as, for Australia, in the Depression of the

1930s); the other source is domestic, lying in the mismanagement of the two sectors that have dealingsright across the national economy These two sectors are government and finance (which, in

Australia, were jointly responsible for the Depression of the 1890s)

Needless to say, a breakdown can have mixed causes — an adverse external shock is much morelikely to tip a country into economic breakdown if its public or finance sectors have been

mismanaged, and when a breakdown originates overseas, the government and finance sectors quicklyfind themselves at the centre of events The reason why the government and finance sectors are socentral is that economic breakdown arises from bad debts Borrowing and lending are central to thecapitalist system, and, thanks to the uncertainty of economic affairs, carry an unavoidable risk thatdebts will go bad Economic crises arise when so many debts threaten to go bad that the system

breaks down

Though economic breakdown always involves defaults and threats of default that are generalised tothe whole economy via the public sector, the financial sector, or both, they vary in their origin Theymay be generated primarily overseas, or in the domestic government or financial sectors; they maygenerate different flow-on combinations of economic woes, including unemployment and inflation;

they may be mild or severe In their book on the international history of financial crises, This Time is

Different, C M Reinhart and K S Rogoff distinguish several main types of crisis The first type is an inflation crisis, for which they set a threshold of general prices rising by 40 per cent a year or more,

usually as a result of mismanagement of the public finances (Inflation is a time-honoured way of

defaulting on public debt.) Closely related are currency crashes, where a country’s currency

depreciates against the currency of its trading partners by 25 per cent a year or more

Mismanagement in the private sector more often results in a banking crisis, a crisis in which banks

and other financial institutions encounter difficulty in meeting their obligations The primary source ofsuch difficulties generally lies on the asset side of bank balance sheets, in the form of bad debts to thebanks (sometimes glossed over as ‘non-performing loans’), but a bank can also run into trouble on theliability side of its balance sheet when the cost of one particular liability (typically ‘loans raisedoverseas’) rises so much that the bank is unable to meet its obligations for other liabilities (say,

‘domestic deposits’) Banking crises do not always reach the stage of outright default, since this isoften averted by the reconstruction of major parts of the financial system, usually with governmentinvolvement

The public-sector counterpart of a banking crisis is a government debt crisis It has been claimedthat governments do not default on debts contracted in their own currency, since they can always printmoney and so relieve themselves of debt by causing inflation, but Reinhart and Rogoff instance

episodes in which governments have preferred default to printing More commonly, governments infinancial crisis may default on debts incurred in external currencies These might be debts incurredthrough government overseas borrowing, but may have been originally incurred through private

borrowing and transferred to the government in its capacity as manager of a country’s

foreign-exchange reserves

Armed with these definitions, Reinhart and Rogoff find that, over the long haul since the earlynineteenth century, Australia has been reasonably free of inflation (only during the 1850s gold rush

did the rate breach their 40 per cent threshold), and Australian governments have honoured their

debts, both external and domestic (When New South Wales attempted to default in the early 1930s, itwas brought to heel by the Commonwealth.) However, Australia (or at least its eastern states)

underwent a major banking crisis in 1893, involving bank closures, the severe curtailment of credit,and a Depression with soaring unemployment Like many of his fellow Victorians, one of our

grandfathers weathered the Depression on the goldfields at Kalgoorlie in Western Australia

It is notable that Australia survived the Great Depression of the 1930s without a banking crisis.The economic breakdown of those years was transmitted from abroad — a major contrast to the

Depression of the 1890s, which occurred despite reasonably buoyant world trading conditions

Thus summarised, Australia’s largely forgotten history of economic breakdown has much in

common with that of other countries: severe costs during the World Wars and the Great Depression,plus a home-made Depression in the late nineteenth century The Second World War was followed bysix decades during which Australia shared in the post-war economic recovery and then in the generalprosperity and economic growth of the wealthy countries

The post-war intention on both sides of the Iron Curtain was to eliminate economic crises and theassociated Depressions So long as the policy agencies in each country concentrated on this aim therewas a degree of success, and few countries experienced economic crisis in the two decades

following 1945 However, as the 1930s receded into history, the various national policy agenciesfaced new challenges, such as the change in the distribution of world wealth that followed from

increased oil prices All the wealthy countries, Australia included, shared in the 1970s combination

of stagnation and inflation, which they muddled through without any of them incurring the feared

hyper-inflation or serious Depression

However, the decade of stagflation prompted fundamental revisions to economic policy, based onthe revival of neo-liberal economics We describe this revival in more detail in Chapter 2; here, it issufficient to note that it originated in the United States, and was adopted with some enthusiasm inother Anglophone countries, although with less enthusiasm by countries subject to the ministrations ofthe International Monetary Fund (IMF) Here, we stick to the background story of the internationalincidence of banking crises

Economic breakdowns from the 1970s onwards

As the post-war period receded into history, crises involving serious falls in GDP became more

common Starting in the economically less robust countries, particularly in Latin America, in 1998 thetrail of crisis moved to the ‘Tiger Economies’ of East Asia, and finally in 2008 reached the core ofthe global economy in the United States and Europe Economic crises had not, after all, been

consigned to history

An economic crisis is worse than the recessions of the kind that, from time to time, arrested

economic growth during the post-war period It is catastrophic; a conflagration that leaves no citizenunaffected, no element in the capital stock untouched, and which so devastates the foundations of theeconomy that a complete restructure is required

Across the world, the years since 1980 have seen economic catastrophes from both war and

hyper-inflation, but these have been confined to low-income or, at the most, middle-income countries Thehigh-income countries have been affected but not thrown into crisis by the costs of war, and they haveexperienced inflation, but again not so badly as to suffer catastrophe Neither war nor hyper-inflationare current threats in the high-income countries, but unfortunately this does not preclude banking

crises that, uncontrolled, snowball into economic catastrophes

As Reinhart and Rogoff emphasise, banking crises arise out of bad debts; more specifically, fromdefaults on financial contracts Banking crises arise fundamentally out of failed attempts to take therisk out of lending by the issue of supposedly risk-free debt, rather than by equity instruments in

which the lender shares the risk The genius of capitalism is that it is able to raise funds for riskyinvestments by equity financing — this underlies its record of innovation But let the investor beware:the investment prospectus may be shonky; the risks may be under-stated, and even if they are correctlyperceived, the uncertainties of innovation are such that much of the equity invested in innovation will

go bad

The precise purpose of equity markets is to deal with this, and because they deal in uncertainty theyare inherently unstable and prone to cycles of optimism and pessimism, boom and bust It is importantthat equity markets are able to rise and fall without seriously affecting the ordinary flow of production

— as, for example, the dot.com bubble of 1995–2001 inflated and burst without causing serious

economic breakdown The bursting of such an equity bubble creates financial losses, but they are notlikely to be unmanageable unless they have been converted into bad-debt losses by investors who arenot in a position to bear uncertainty

In theory, the same story should apply in property markets, since property is an equity investment.However, equity in property is usually leveraged with debt, which means that property bubbles are adangerous source of bad debts

The historical experience is that fixed-interest lending can deal with a certain level of bad debts.Banks have historically been major sources of finance for businesses too small to have access toequity markets Though the risky nature of small business provides a strong argument for equity ratherthan debt support, banks are an established source of funds, especially to businesses that can providecollateral and accept basic management advice as a condition of the loan However, fixed-interestlending becomes dangerous when it finances propositions more suited to equity lending — if indeedthey are suited to lending at all The old golden rule was that a lender who finances consumption istaking on a high risk of default

No matter what the country, the government and finance sectors both have the potential to generate

a banking crisis that ends in economic catastrophe by incurring more debts than they can handle

Governments are constantly caught between the Scylla of expenditure demands and the Charybdis oftax resistance; they are tempted to the insidious accumulation of debt that turns bad when it fails togenerate additional tax revenues Similarly, financial institutions are under constant temptation to seekhigh returns by accepting high levels of risk When they succumb to this temptation they also may findthemselves lumbered with unmanageable bad debts The temptation to engage in excessive borrowingtends to be strongest in times of euphoria, when uncertainty is downplayed — hence the association

of excess debt with booms, particularly consumption booms

As is often the case with temptations, behaviour that is desirable or at least tolerable in moderationbecomes disastrous when carried to excess Current rhetoric would have it that government deficits

— government borrowing — are always and everywhere undesirable But the truth is that, in

moderation, they can help to accumulate public capital that pays for itself through increased tax

revenues Deficits can also be appropriate when they finance the utilisation of resources that wouldotherwise be unemployed — once again yielding revenue that would not otherwise be received

Conversely, current rhetoric would have it that bank borrowing to finance credit for home-buyers isgenerally desirable; but when such lending ends up financing rising urban land prices, rather thanactual construction, the loans have a nasty propensity to turn bad

The risks inherent in overseas borrowing

Moderation is a particularly important central principle for countries that borrow overseas

Borrowing overseas must not only generate cash flow to service the loan; it must do so in the context

of a balance of payments sufficiently robust to generate that flow in foreign exchange acceptable tothe lender The United States is in a special position in this regard — despite its persistent balance-of-payments deficits, its dollars and Treasury Bills are still widely acceptable internationally, andfrequently comprise the greater part of the foreign-exchange reserves of other countries No othercountry is in a position to borrow overseas so readily and so completely in its own currency Despitethe overhang of overseas debt accumulated during decades of heavy overseas borrowing, the greatAmerican recession of 2008 did not result from problems in financing overseas borrowing, but frombad debts contracted by an excessively clever finance sector In this, the United States is a specialcase; no other country has such ready access to overseas credit, and countries that ape Americaninsouciance regarding overseas borrowing are courting disaster

Australia has a long history of overseas borrowing, much of which has been win-win in nature —

it accelerated economic development to the benefit of domestic consumers and overseas investorsalike However, in the nineteenth century the Australian colonists discovered how easy it was to

borrow in London, and the country has been tempted ever since to borrow overseas more than itsbalance of payments can bear

Of the forty or fifty economic catastrophes that have occurred over the past three decades in

countries with developed financial systems, thirty or forty have taken place in countries that havesignificant overseas debt These crises were generated when the country’s creditors came to fear thatthey might not be repaid on time and in an acceptable currency Once afflicted by such fears, creditorswant their money back quickly Each crisis has followed its own course, as determined by the

economic structure of the borrowing country and the decisions of its policy authorities and its

creditors However, the number of heavily indebted countries that have experienced catastrophe, inthe form of a rapid and significant decline in GDP and rise in unemployment, now exceeds the numberthat have not, and they have provided sufficient combined experience for researchers to generalisefrom them The researchers have concluded that excessive overseas borrowing has been a majorsource of economic breakdown The second is that, once a crisis begins, it feeds on itself and

becomes very hard to arrest

There are different forms of overseas borrowing, each with its costs and benefits, including directequity investment, portfolio investment in equities, property investment, interest-bearing loans toprivate businesses, and fixed-interest loans to financial intermediaries and governments.

The form of overseas borrowing that is least likely, dollar for dollar, to generate economic

breakdown is direct equity investment by overseas businesses, usually in the form of subsidiary

companies From the recipient country’s point of view, such equity investment is a form of overseasborrowing, but the equity arrangements take uncertainty into account The owners monitor the

performance of these businesses, and may withdraw their funds if business prospects dim This ismost commonly accomplished by subtle means, such as over-invoicing for inputs from the parent firm

of a multinational business, a slow process that may underlie a crisis but is unlikely to be the

precipitating factor Even if disinvestment involves an outright sell-out, the effects are likely to be atthe industry or at most regional level, and not a cause of general crisis Many overseas fixed-interestloans direct to non-financial businesses have similar characteristics, though some are more akin toportfolio investments

Overseas portfolio investors in equities participate in the alternating capital gains and losses of theshare market Overseas loss of confidence in the market is most likely to occur when a speculativebubble bursts, and can precipitate a crisis as overseas investors sell off and seek to repatriate theirmoney immediately However, overseas portfolio investors may also have steadier nerves than

domestic investors, in which case they may ameliorate the effects of a burst bubble On the whole,overseas portfolio investment can accentuate crises, but is not particularly likely to precipitate one

Overseas equity investment differs from portfolio investment in that it is location-specific; it canexacerbate booms and busts in the property market in particular locations It also interacts with

domestic investment in property, much of which is financed from mortgage loans As with portfolioinvestment in equities, it can accentuate or dampen domestic price trends; but, unlike portfolio

investment in equities, these movements will be multiplied by resulting trends in domestic debt Ifoverseas property investors lose confidence and decide to exit the market, prices will fall and therewill be a multiplier effect as domestic mortgages go bad, with regional and probably national effects

Overseas fixed-interest loans to governments and financial intermediaries are under constant appraisal, not only by individual lenders (whose lending position may be affected by developments intheir home market), but by ratings agencies — not that the agencies have proved at all prescient as toimpending crisis.3

Reviews of the quality of debt — its probability of repayment on time and in full

— are affected by the balance-sheet and cash-flow position of the banks and governments issuing thedebt, and also by the balance-sheet and cash-flow position of the country as a whole, particularly byany fall in export revenue (whether due to falling export prices or falling quantities) Falls in exportrevenue reduce the flow of foreign exchange available for servicing overseas borrowing Even in theabsence of trade shocks, debt may be downgraded simply because the country’s creditors begin tothink that it has borrowed too much, or maybe because they perceive similarities to countries thathave borrowed too much There is a long history of countries that have seen their debt downgradedbecause the hotshots of New York made false comparisons, as when Wall Street downgraded

Norway because of defaults in Iceland

As regards exposure to economic breakdown, the most dangerous form of overseas borrowing isborrowing by the finance sector, in particular by banks This is because changes in the terms andconditions of overseas borrowing by banks translate directly into the terms and conditions of theirdomestic lending Government borrowing is also dangerous in that changes in the interest rates thatgovernments are obliged to pay on their overseas borrowing are likely to translate directly into

domestic interest rates

Whatever the cause of the change in a borrowing country’s credit rating, a banking crisis will

ensue if a significant number of foreign investors come to the conclusion that their money is seriously

at risk When the creditors thus change their minds, they demand that their loans be repaid as they falldue Banks that have borrowed overseas will scramble for foreign exchange with which to repay theirdebts, an obvious step being to offer higher interest rates to reward overseas lenders for rolling overtheir loans This requires an increase in the interest rates charged to the banks’ domestic borrowers,which can have the mild effect of reducing domestic demand for new borrowing and the salutaryeffect of increasing the proportion of bad debts in the banks’ domestic-lending portfolio

This, in turn, can generate a vicious cycle The rise in interest rates plunges the economy into

recession Slack demand increases the default rate on business loans, and rising unemployment

increases the default rate on household loans, further weakening bank balance sheets and so

worsening the recession by curtailing the supply of credit The outwards rush of funds also triggers anexchange-rate crisis (that is, a rapid fall in the currency), which feeds on itself by undermining theconfidence of other foreign and domestic investors This not only reinforces the falling exchange rate;

it can unleash intense inflationary pressures as capital and labour fight to retain their share of a

diminished national income This fight has the potential to convert recession into Depression

At the point where the outflow of overseas currency exhausts the country’s reserves of foreignexchange, it is no longer possible to pay for imports The country will then suffer further economicdisruption, not only because consumers can no longer buy imported goods and services, but becausedomestic producers are unable to buy the imports that are necessary to their operations Further, if thebanking sector had been active as a transmission mechanism for foreign loans, and has significantforeign liabilities on its balance sheets, the sector’s problems due to bad debts will be greatly

exacerbated by the rising domestic-currency value of its overseas borrowings, leading most likely to

a banking collapse with further dire consequences for economic activity

In recent crises in various countries, official reactions to the fall in the exchange rate have includedthe imposition of international capital controls, sometimes combined with attempts to fix the exchangerate at low levels Quotas have been imposed on imports by rationing foreign exchange, sometimeswith multiple exchange rates for different categories of goods and services There are precedents forthe policy authorities moving to augment the resources available to repay overseas lenders by thecompulsory acquisition of residents’ foreign assets, and by large-scale government borrowings fromthe IMF and/or from consortia of ‘friendly’ countries The last resort is full or partial default on

foreign debts, perhaps including ‘haircuts’ imposed on foreign lenders, with a consequent fall in thecountry’s credit rating and a reduced access to overseas borrowing

In recent crises in countries similar in size to Australia, the conditions imposed by creditors have

included minimum government surpluses; fixed repayment schedules for foreign debt (especiallydebts to foreign governments or their agencies incurred during the crisis); imposed structural-reformmeasures; limits on nominal wage increases; limits on particular types of expenditures, includingsocial security and other safety-net expenditures; and minimum net tax rates on household incomes.All of these measures curtail the power of the government of the indebted country and commit it toprioritising the expectations of its creditors over the needs of its citizens Since the Global FinancialCrisis (known in the United States as the Great Recession), the effectiveness of these measures hasbeen debated, but they remain a risk that indebted countries should take into account.

Financial crises originating in excess overseas borrowing vary in severity The Asian financialcrisis of 1998, though sharp, turned out to be relatively mild The cessation of borrowing coupledwith measures to reduce imports (which diverted foreign-exchange earnings to loan servicing) andfresh international loans (or, in the Malaysian case, a mild rescheduling of repayments) proved

sufficient to restore confidence The regional fall in GDP was limited to 5 to 10 per cent, followed by

a quite rapid recovery Elsewhere, crises have included serious foreign-debt defaults and have

generated peak-to-trough falls in GDP in the 20-to-30 per cent range In recent times, the most

extreme example of a country experiencing a severe crisis was Greece, with a 50 per cent fall in itsGDP However, the Greek case was atypical, because Greece is a member of the Eurozone, and itsexchange rate is fixed It is possible that the fall in GDP would have been less had it had its owncurrency to devalue

Can economic breakdowns be avoided?

These costs are very large indeed, much greater than the cost of a typical recession A major, if

negative, goal of economic policy must therefore be the avoidance of such economic catastrophes.However, this goal has to be placed in context In a medium-sized, open economy such as Australia,the threat of catastrophe is inherent in the country’s principal source of prosperity: trading and

investment relationships with the rest of the world The risk of this type of catastrophe can only becompletely removed by eliminating overseas borrowing A more workable choice is to accept that thethreat of catastrophe lurks amid the opportunities opened up by international trade and investment,and to try to manage the threat The need is for moderation in borrowing, and the adoption of a

prudent approach to international economic relationships, as indeed there is a need for prudence indomestic economic relationships

In the light of recent experience, many observers would write off calls for moderation and

prudence as no more than pious hopes Both optimism and pessimism are contagious, and what hopehas moderation when faced with a fearlessly buoyant finance sector, or equally when trying to enticethe sector out of a blue funk? Who is to keep a level head when all around are losing theirs? Since it

is noticeable that busts generally follow booms, pessimism follows optimism, and funk follows

elation, the calls for moderation concentrate on restraining over-optimistic behaviour Once an

economic breakdown threatens, and even more when it is under way, the actions required to limit thedamage and reconstruct the economy are very challenging indeed Hence the importance of avoidingcrises, if at all possible

As always, the pursuit of moderation itself requires moderation It is too much to expect any humanperson or institution to observe continuous moderation in all things; too much moderation is not onlyinhuman, but may also suppress the restless spirit of innovation that is an important element in

capitalism However, it may not be too hard to invent institutions that identify and counterbalancethreats of serious economic crisis — government and financial institutions that provide shelter fromthe excitements of everyday market action, and cultural institutions that can stand back from the

excitements of the day The particular challenge is to put in place institutions that can stand their

ground, not only when memories of disaster are fresh, but during the following periods of

complacency The post-war experience is relevant: was the increased global incidence of bankingcrises after 1980 due to fading memories, or was it due to a failure to maintain defensive institutions?

Some of the concerned institutions will be internal to the sectors that are most at risk As a matter

of internal culture, it is important for governments and banks to value moderation and prudence,

leaving the response to emerging opportunities to those with a real appetite for risk, and ensuring thatthese entrepreneurs have access to equity and venture finance As regards institutions, within

government it is the duty of Treasuries to counsel moderation, particularly as regards overseas

borrowing They should oppose borrowing that is unlikely to generate foreign exchange for servicing; they should champion borrowing with good prospects of repayment plus a surplus Withinbanks, it is the duty of treasuries to act in the long-term interests of the bank and to identify and

loan-oppose risky lending, no matter how juicy the apparent short-term profits

We will argue that individual bank treasuries cannot do this unaided, particularly as regards loansfinanced from overseas borrowing This requires the imposition of a second line of defence —

national authorities charged to ensure that risky financial activity is confined to people who know thatthey are taking a gamble, and is not foisted off, unknown, onto a trusting public Such prudential

authorities, as well as the national Treasury, should be the custodians of the lessons of history andhave the power to act, if not to maintain their economy on a precisely even keel, at least to head offcatastrophe They will therefore be attentive to the signs of economic breakdown and be ready withstrategies to avoid it, if possible, or at least to minimise its impact In this task of watching for dangersignals, the prudential authorities (and, more broadly, economic analysts and the media) can takeadvantage of recent experience in countries that have experienced an economic breakdown In

particular, the European Union (EU), has made a concerted effort to learn from recent experiencesboth within and outside the union

The European Commission indicators of macroeconomic imbalance

In recent years, much has been written about the dysfunctionality of the European Union, and, as wenote in Chapter 8, the British public has voted that they would be better off out of it This

dysfunctionality is highly political, and is not helped by poor institutional design To its credit, theEuropean Commission (EC) has recognised the need for governments to coordinate economic policy,and is seeking to control the incidence of bad debts internationally by discouraging both over-lendingand over-borrowing To this end, it has persuaded its members to participate in a ‘macroeconomicimbalance procedure’ Though, in theory, the procedure aims to identify which countries are over-

lending as well as those that are over-borrowing, in practice the emphasis has been on the excessiveaccumulation of debt that results in financial crisis.

In 2011, the commission identified ten statistical indicators that, it argued, provided an early

warning of macroeconomic imbalance sufficiently reliable to warrant corrective action being

embarked upon, and also gave sufficient warning time to allow such action to be taken.4

The tenindicators are used to identify countries that are at enough risk of crisis to warrant a detailed

investigation — following which, use would be made of ‘auxiliary indicators’ to allow a more

nuanced assessment of the position A year later, the commission promoted one of the auxiliary

indicators to scoreboard status,5

and three years later it raised the status of three more.6

In the interests of ease of interpretation and statistical accuracy, the number of indicators was

initially restricted to ten, with an emphasis on the competitiveness of each economy and on

weaknesses that had in the recent past led up to economic catastrophe The list emphasises indicators

of structural weakness in trade and international investment, and that provide warnings of potentialcatastrophe for the information of the policy authorities in each country and also for each country’spartners in trade and investment Within the EU, the indicators underpin policy discussions; outsidethe EU, they have no such formal status, but are still valid as warnings based on recent experience Itremains uncertain whether the indicators will give sufficient early warning to permit corrective

action, and even less certain what that corrective action might be, or whether corrective action ispolitically possible However, an early warning is at least a beginning

The EC has specified a threshold for each indicator (for some, two thresholds, upper and lower),defined as the value of the indicator that, if exceeded for a period of time, has the potential to push thecountry into crisis If several of the threshold levels are exceeded simultaneously, and if further

investigation of other aspects of the economic position corroborates the indicator findings, an alertmay be issued that a crisis threatens and that it would be prudent for the authorities to make whateverpolicy changes might be possible to avert the danger

Rated by the EC indicators, Australia’s performance ranges from exemplary to atrocious.7

Australia assessed by the EC indicators

Indicators of satisfactory performance

The EC indicator for which Australian performance has been most exemplary is government debt.The EC threshold for this indicator is set at 60 per cent of GDP Above this level, the EC considersthat current and future economic-growth prospects may be diminished by expenditure reductions

and/or tax increases required to keep faith with government creditors At 28 per cent, Australia’scurrent level of national, state, and local government borrowing is at less than half the level that

would ring alarm bells at the EC Australian governments have been less addicted to borrowing tofinance tax cuts and expenditure increases than their equivalents in Europe, not to speak of the UnitedStates This is not to argue that all is well: the tax cuts that accompanied the early phase of the miningboom are now widely regretted as imprudent, while the expenditure constraints have seriously

curtailed government infrastructure investment Again, the trend is unfavourable, and the current level

of 28 per cent is the highest recorded over the years since 1992.

This said, the media rarely congratulate Australian governments on their exceptionally low

deficits, nor do they point to the scope for government borrowing to finance infrastructure investment.Indeed, analysts either directly or indirectly associated with the finance sector have been allowed todominate public discourse on economic policy, and spend their time harping on the dangers of

government-sector debt, so diverting attention from the accumulating debt of the private banks

A second area where Australian performance has been reasonably good compared to the EC

threshold is the labour market The EC sets a threshold for the unemployment rate of 10 per cent, withhigher levels indicating a lack of adjustment capacity in the economy Australia, as a whole, has notrecorded this level of unemployment since 1992

A related indicator is the three-year percentage increase in unit labour costs, where the EC

threshold is set at 12 per cent Above this rate, the EC fears that inflation will rise to the point whereprofits and investment are compressed, and economic growth is curtailed Once again, Australianperformance over the past quarter-century has been good, with the indicator rising above the

threshold level in only three years: 2006, 2008, and 2011

A further indicator measures the competitiveness of a country’s exports by the change in its share

of the market in the countries to which it exports Australian performance on the basis of this indicatorhas again been satisfactory, but the indicator does not take into account the fact that, as a commodityand particularly a minerals exporter, Australia is subject to wild fluctuations in the prices it receivesfor its exports

By contrast with government debt, labour-market flexibility, and, with caveats, export

competitiveness, Australia’s performance has been less than satisfactory when measured by two

groups of indicators, both closely associated with the generation of financial crisis via bad debts: itsfinancial relationships with the rest of the world, and the level of household debt

Indicators of unsatisfactory performance: international trade

The EC scoreboard includes three indicators of a country’s economic relationships with the rest ofthe world The first relates to the volatility of its exchange rate, as measured by the three-year

percentage change in its real effective exchange rate against the currencies of other countries Twothresholds apply If the exchange rate rises by more than 11 per cent over three years, there are likely

to be unmanageable price pressures on domestic producers, resulting in long-run loss of

competitiveness In the other direction, if the exchange rate falls by more than 11 per cent over threeyears, there are likely to be unmanageable inflationary pressures Australia has suffered both theseevils In six of the past 25 years, the exchange rate has been more than 11 per cent below the rateapplying three years previously, and in nine of the past 25 years it has been more than 11 per centabove An exchange rate that gyrates like this is a severe handicap to long-term planning in trade-exposed industries, so it is no wonder that Australia’s trade performance has been less than

satisfactory and has resulted in a dangerously high level of overseas debt

Second, the EC measures the flow of overseas borrowings by the three-year backward movingaverage of the current-account balance, taken as a percentage of GDP (The current account offsetsforeign exchange received from export earnings, income earned overseas, and gifts from overseas

against foreign exchange spent on imports, income payable to overseas investors, and gifts to

overseas.) When seriously negative, this is an indirect indicator of unsustainable overseas borrowing

or, at best, an indicator that international investment in Australia is growing too rapidly for comfort.The threshold here is set at -4 per cent There is also an upper threshold, of less relevance to

Australia: if the current-account balance rises above +6 per cent, the EC argues that the country isengaged in unsustainable lending Between 1992 and 2010, the Australian economy more often thannot exceeded the 4 per cent current-account-deficit threshold At the end of 2016, commodity pricesrallied to produce a relatively low current-account deficit for 2016–17 However, the rally was due

to temporary factors that are expected to fade, including the unfortunate combination of waning

demand for commodities as world growth falters and increases in their supply as capacity-enhancinginvestments come on stream

The third of the group of three indicators covering relationships with the rest of the world is the netinternational investment position (excluding equity investment) as a percentage of GDP The EC

threshold is 35 per cent; above this level of debt, a country is likely to have difficulty managing anycrisis in international banking that may come its way As a consequence of its persistent current-account deficits, Australian performance on this indicator has been consistently woeful, with thethreshold value exceeded by at least 14 percentage points in all of the past 25 years Currently, theindicator value is 57 per cent compared to the threshold value of 35 per cent Australia has elected tolive with the high-level risk that its external borrowing will prove to be unmanageable

Indicators of unsatisfactory performance: debt

The obvious question is, why has Australia borrowed so much? Thanks to the imprudent behaviour ofgovernments in the United States and Europe, the international literature comes close to making itaxiomatic that excessive overseas borrowing arises from government deficits Australian

governments have, relatively speaking, controlled their deficits, so why is the level of overseas

borrowing so dangerously high? The answer lies with the private sector, which the EC scoreboardcovers with a further three indicators

The first of these indicators of private-sector debt accumulation is private-sector credit flow as apercentage of GDP The EC threshold for this indicator is 14 per cent, above which level there must

be grave doubts as to the quality of the loans being made Australia has exceeded the EC threshold forten of the past 25 years, chiefly in the late 1990s, the mid-2000s, and in 2013, 2014, and 2015

The EC scoreboard also includes gross private financial liabilities (excluding equity) as a

percentage of GDP Excessive private debt constrains both business investment and household

expenditures, and hence constrains economic activity The EC threshold is 160 per cent of GDP, alevel that Australia reached in 1998 The level has since risen to 245 per cent, providing a

counterpart to the high level of overseas borrowing Most of the increase has been due to borrowing

by the household sector that, having in 1992 accounted for one-third of private-sector debt, was

responsible for 55 per cent of such debt by the eve of the Global Financial Crisis This proportionhas been maintained since

One of the major influences on household borrowing is the level of house prices The EC

scoreboard includes the annual change in real house prices (that is, the excess of house price

increases over the consumer price index) Increases in real house prices encourage households toborrow: households aspiring to ownership borrow more to cover the enhanced prices, while

households that are already owners are encouraged to borrow because of their increased wealth.Mild increases in relative house prices are manageable, but rapid increases are associated with

destabilising bubbles Reinhart and Rogoff list real housing prices along with changes in the realexchange rate as the best available warnings of an imminent banking crisis.8

The EC has set itsthreshold of manageability at 6 per cent a year Taking house prices nationally (and so disregardingthe differences between its many geographically separate house markets), Australia exceeded thisthreshold in eight of the past 25 years — the early 2000s and, of more concern, every year from 2013

to 2015

Currently, five of the 10 original EC scoreboard indicators for Australia are flashing red That is,they exceed their threshold values The EC has found that, typically, in the European Union countriesthat had recently fallen into crisis — namely Greece, Spain, and Ireland — the thresholds of five orsix indicators had been exceeded on the eve of their crises There has been little improvement since:

in 2014, Ireland was in breach of six indicators; Spain, five; and Greece, four

The European Commission’s macroeconomic-imbalance scoreboard accordingly identifies

Australia as a candidate for economic breakdown The next step in the EC procedure would be toconduct an in-depth review that takes auxiliary indicators and trends into account, to judge whetherAustralia suffers excessive imbalances warranting the implementation of a corrective-action plan.These EC processes are highly political and far from perfect — corrective-action plans have not beenimposed on the three countries that are running excessive current-account surpluses — but they atleast serve to put EU member countries on notice that they, and the union more broadly, need to takeaction to avert crises

Australia is not a member of the EU, and therefore will not be subject to an in-depth review

However, the EC indicators serve as an alert, not only to borrowers in Australia but to lenders

overseas, that the time has come to think deeply about Australia’s financial structure Such a re-thinkcannot undo history, but requires an assessment of the path by which Australia has acquired its currentunenviable EC indicator values We resume the discussion of the EC indicators in Chapters 3 and 4.Before then, we need to look at how Australian economic institutions evolved after the end of theSecond World War

Financial deregulation

During the Second World War, and not least in Australia, a great deal of effort was expended onplanning for post-war reconstruction It was agreed that the world should not be allowed to return tothe conditions which had led to war; there was to be full employment and economic growth To thisend, Russia and China continued with a form of central planning that had no use for a finance sectorindependent of government In Russia, central planning gradually ossified, while China experimentedwith variously disastrous mixtures of central and local planning, including the Great Leap Forwardand the Cultural Revolution

On the American side of the Iron Curtain, the finance sector regained some of the autonomy it hadlost during the war: in the United States, in the name of freedom; and in Catholic countries, in thename of subsidiarity or the localisation of decision-making The restoration of financial autonomywas far from complete — the memory of the role of finance in generating the Great Depression wastoo raw, as was the memory of the success of government planning in mobilising resources to win thewar There had also been an important intellectual development: interpreting the experience of theGreat Depression, John Maynard Keynes had shown that free markets do not guarantee economicstability He argued that circumstances can arise when wise governments should intervene in markets

to ensure that demand — purchasing power — is adequate to support a full-employment level ofproduction Governments, that of Australia included, seized on this analysis in their eagerness toavoid a repeat of the Great Depression

In Australia, the strategy for full employment concentrated on economic growth; the accumulation

of both capital and labour to add to the natural resources of Australia’s considerable land mass Thesense of national unity generated during the war required that all citizens, including recent

immigrants, should both contribute to development and share in its benefits — hence the importance

of full employment combined with progressive taxation and social security Development was seen torequire a substantial public sector, responsible for most services in health, education, and the publicutilities, and an equally substantial private sector responsible for production in the pastoral, farm,mining, and manufacturing sectors — in other words, for most goods then entering into internationaltrade — as well as for the production of retail and many other services Australia was to be a mixedeconomy, taking advantage of the strengths of both the public and private sectors However, belowthe level of broad strategy it was not to be a centrally planned economy This was in part ensured bythe division of responsibility between the Commonwealth and the states, but also by a political

system that divided power between the champions of private and public enterprise

In pursuit of this overall strategy, the Commonwealth government maintained substantial controlsover the finance sector The grant of limited authority to the sector had the practical benefit of

removing political influence from the administration of personal financial assets, small loans, andenterprise-level risks This decentralisation allowed individuals and businesses to decide for

themselves whether or not to save, and provided a source of funds for individuals and businesses thatwanted to spend more than could be financed from their current income by borrowing from the

general pool of savings

In general, borrowing is of overall economic benefit when it finances the borrower to producegoods or services to a value greater than the amount borrowed and so yields a flow of funds both torepay the loan with interest and to add to the borrower’s income The availability of bank loans andventure capital to start-up businesses is a major source of the dynamism of capitalism and hence ofrising living standards

In principle, nothing changes when borrowing and lending crosses national boundaries; the idea isstill that net benefits arise when funds are transferred from savers to those who have opportunities toput savings to productive use The parties involved are not necessarily financial intermediaries —direct loans are made between branches of multinational firms, and wealthy individuals also borrowand lend across national boundaries — but many cross-border flows of funds involve banks and otherproviders of financial services Additional complexity arises thanks to the involvement of differentcurrencies issued under the aegis of different governments, and the involvement of more than onepublic service in the administration of the web of commercial obligation

Australia has a long history of borrowing from overseas, much of which has been wisely invested

so as to add to the incomes of both the borrower and the lender In the post-war period this

established practice continued However, it was recognised that the current account is of great

importance for Australia’s financial stability If the current account is in deficit, Australia — the total

of its businesses, governments, and households — is borrowing more from overseas than it is

investing overseas As noted in Chapter 1, this borrowing can take relatively benign forms —

particularly foreign direct-equity investment — but may also take dangerous forms, particularly term loans or ‘hot money’, which increase the country’s vulnerability to crisis

short-During the post-war period the current account was, as always, hostage to international events TheKorean War famously brought a windfall benefit to Australia in the form of high prices for the

country’s then chief export, wool, and was followed by an equally traumatic bust when wool pricesreturned to normal Windfalls such as these are summarised by changes in the terms of trade, whichare favourable when export prices go up and import prices go down, and adverse when prices change

in the other direction An adverse change in the terms of trade tends to result in an adverse change inthe current account: reduced export prices mean reduced revenue from exports; increased importprices raise the cost of any given flow of imports

The classic response to a serious deterioration in a country’s terms of trade is a devaluation of itscurrency, which reduces imports by increasing their price to domestic buyers, and increases exports

by reducing their price to overseas buyers However, post-war governments avoided this mechanism;they were anxious to maintain fixed exchange rates, for two reasons First, experience during the1930s had indicated that, if currency devaluation becomes popular as a means of export promotion,international trade quickly descends into a mayhem of competitive devaluations Second, a fixedexchange rate provides a foundation for long-term planning both by governments and business Itencourages governments — including Australian governments, both Commonwealth and state — to

seek to strengthen their economic position by adopting long-term policies to underpin the currentaccount They may diversify export and import markets, and nurture exporting and import-competingindustries Much of this can be done in the course of the regular interaction of the public and privatesectors; for example, public investment in transport infrastructure can be tweaked in the interests ofexport-competitiveness, and education policies can be shaped to keep in mind the needs of trade-exposed industries.

Such long-term policies, however, are subject to the changes and chances that affect the currentaccount 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 simpleKeynesian answer to a threat of unemployment is to pump up demand — for example, by increasinggovernment 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 cangenerate a current-account crisis

In Australia’s case, the Commonwealth authorities introduced measures to curb imports wheneverthey judged that Australians were importing more than was justified by export earnings and wereconsequently borrowing overseas at a dangerous rate The demand for imports could be reduced byquotas (the ‘import restrictions’ imposed by the Menzies government), or less directly by reducingdisposable 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 ofcredit and increasing interest rates (monetary policy, including credit squeezes) The recessions soinduced were highly effective in reducing the demand for imports and releasing foreign-exchangeearnings 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 tocut back on imports In other words, the deliberate reduction in incomes that was necessary to reducethe demand for imports threatened full employment

A potential answer to this dilemma, then as now, is world cooperation One country’s imports areanother’s exports, so coordinated action to raise demand is less likely than solo action would be tohit 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 DCcould 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 possiblefor them to raise demand in concert Sadly, the consensus quickly falls apart when different countriesmake different assessments of the scope for raising demand

As Australia settled down to business during the long prime ministership of R.G Menzies, a splitdeveloped between the banks, some of which were government-owned, and the rest of the financialsector 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 theykept 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 wasmanaged 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 coulddecide whether or not to make particular loans, but instructions were issued from time to time as tothe sectors to be favoured in lending, and formal regulations included requirements to make loans tothe Commonwealth government, specifications of the interest rates (both on deposits and loans), andeffective 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-bankfinancial 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 andprivate-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 Thebanking system created money and managed transactions and accounts, providing a convenient andreasonably risk-free way to save In the process, the banks gathered savings from savers and on-lentthese savings to borrowers Though these functions — the settlement of transactions, the storage ofvalue, and borrowing and lending — are conceptually distinct, they have long been bundled as thecore activities of banks Recent economic crises have caused some questioning of this bundling, atopic 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 theydid 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 buyinghouses; they paid interest to their depositors and charged interest to their mortgagees at low, regulatedrates 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 regulationsdisadvantaged them in competition with other financial institutions The regulations governing bankborrowing 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 couldavoid 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 forsecond mortgages on houses) The banks joined the game by increasingly routing their lending throughwholly 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 awhole

The growth in unregulated financial intermediaries within the Australian financial sector mirroredthe growth in unregulated money in the world generally The first money to be freely traded in thepost-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 Statesgovernment, 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, whilethe Organisation of Petroleum Exporting Countries disrupted the established pattern of world trade byraising the price of oil

It became accepted that exchange rates should fluctuate in accordance with short-term account requirements, including those imposed by currency speculators Though money continued to

current-be a national institution, with each independent state having its own currency, there was now to current-befree 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: theultimately 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 timeinstitutional 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 thereplacement 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 thewhole financial sector in the country He explained that qualitative bank controls are ‘a mild form ofbanker’s planning, especially by way of exchange control For to isolate a country from internationaldisturbances 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 lentoverseas, and to influence the direction of lending While these instruments could not guarantee afixed exchange rate, they could stabilise the rate and simultaneously ensure that national patterns ofsavings 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 AnAustralian 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 currentaccount 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, whichcould be subject to general democratic control, but not to detailed instruction as to the industries thathad 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 fullemployment, 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 UnitedStates and the United KIngdom, failed to make the transition from quantitative financial control toqualitative controls In these two countries, the most strident opponents of the transition were doughtyAustrian 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 politicalphilosophy, they championed freedom; they wanted government political power decentralised toindividuals, who should be allowed to do whatever they wanted, provided they respected the similarfreedom of other individuals These opponents of government planning argued that competitive freemarkets 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 ornot 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 thefreedom to create value through advertising These were freedoms that elevated ‘market value to theonly value — so surrendering to the corporatisation, commodification and marketization of more orless everything’.6

Meanwhile, academics located mostly in American universities spearheaded the revival of Keynesian economics that became known as neo-liberalism The crowning achievement of this

pre-intellectual school was a procedure known as Computable General Equilibrium modelling, by whichthe 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 ofGeneral 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 theopposite characteristics to those lauded by equilibrium theories However, he conceded the case forstrategic planning by governments and hence the need for qualitative financial controls It is notablethat he was one of three foreign economists who, in 1986, advised the government of China to adopt aform 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 ofthe 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 WashingtonConsensus, 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 of2008

The examples of Mr Reagan and Mrs Thatcher were too powerful for Australian politicians toignore, particularly after important factions within the Labor Party swallowed the proposition thatWashington Consensus policies guaranteed equilibrium economic growth that could be harvested tothe benefit of all citizens As Australian Keynesians, we looked on in dismay while our insights intothe 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 Thereforms 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 emergedfrom the stagflation of the 1970s as a permanent necessity to curb excessive wage demands This wasbacked 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 businesseswere seen as inefficient and monopolistic, and were privatised wherever a short-term profit could beturned 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 wereprovided 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 implementedshorn 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 liberal program, the element most closely related to the deterioration of Australian performance asassessed by the EC indicators was financial deregulation The rest of this book homes in on the

neo-outcomes of this policy

The process of financial deregulation

Financial deregulation began in Australia in 1973 when direct controls on bank interest rates wereweakened to allow banks to compete more effectively with non-bank financial intermediaries InDecember 1983, free trade in money was adopted by abolishing external capital-account controls andfloating the exchange rate The last of the lending-rate controls (those on new owner-occupied

housing loans) were abolished in April 1986 The idea that governments should own trading andsavings 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 anaddress by Ric Battellino, the deputy governor of the Reserve Bank of Australia (RBA), given to theAustralian Governance Program on 16 July 2007 In the period from the Second World War to

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

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

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

6 The exchange rate was controlled tightly

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

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

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

3 To limit the risks banks could take;

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

5 To maintain a competitive exchange rate for the benefit of local industry, except during periodswhen 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 thesupreme 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: thefinance 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 onelightly regulated pool There would no longer be any advantage in setting up businesses that accepteddeposits 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 themargins between the rates of interest at which they could lend and their cost of funds (the costs ofservices to depositors and of any interest they might be paid) were likewise strictly limited Underthese regulations, banks had a strong incentive to avoid bad debts They assessed credit-worthinesscarefully and, in addition, they watched their business loans and dispensed advice on how to staysolvent The non-bank financial intermediaries served riskier borrowers and charged higher interestrates 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 toprofit maximisation were removed The first applied both to the banks and to the non-bank financialintermediaries 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 ofbank 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 baddebts; under the new dispensation, they maximised their profits by maximising lending, by wideningthe 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 underderegulation this could be accommodated as a business cost by increasing the spread between thelending rate and the cost of funds The banks calculated that it was cheaper to suffer the occasionalbad 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 theremaining regulations administered by the Reserve Bank, which were later hived off to the AustralianPrudential 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; inother words, those who successfully sold debt This included selling debt to borrowers of doubtfulcredit-worthiness who subsequently deeply regretted their borrowing In Roy Morgan’s surveys, theproportion of the Australian public who rated bank managers as having very high or high standards ofethics and honesty plunged from 58 per cent in 1987 to a low of 26 per cent in 2000 In aggregate, thebanks’ 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 incountries as diverse as Germany, France, the Scandinavian countries, Japan, and China Deregulationreversed 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 lastthree decades: stability of the currency This is expressed in terms of maintaining the annual inflationrate at between 2 to 3 per cent on average over the cycle, and is pursued by manipulating the onecontrol 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 theReserve 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 publicservice, the finance sector, and the media of the post-war generation of Keynesians by economiststrained 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 Ineffect, 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, budgetdeficits, and expenditure growth risk downgraded credit ratings and the accompanying penalties ofraised interest rates

Financial deregulation and household debt

In the post-war decades, the political elite in Australia, along with its confrères in other countrieswho 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 risingliving standards, so the avoidance of Depression was congruent with these two other great aims ofpost-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 thegrowth 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 capacitylimitations and the potential for cost inflation into their systematic thinking Cost inflation broke therule of thumb adopted by Treasuries in the post-war years, which was that any threatened incresase inunemployment should be addressed by expanding demand This could be done without raising thethreat 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 donewithout risking a risie in unemployment, because the over-utilisation of capacity meant that therewere 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 thatcontrolled cost inflation by corporatist means, centring on high-level negotiations which includedtrade unions and was backed up by qualitative financial controls, and countries that relied on therevived neo-liberal approach which centred on breaking the power of trade unions In its arbitrationsystem, Australia had an institution that could readily have been adapted to control cost-inflation bycorporatist 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 economistsreturning from initiation into the wonderful models of neo-liberal economics, primarily in Americangraduate schools Australia lurched into neo-liberalism, not in one decisive event but in a series ofdecisions taken by governments both Labor and Liberal/National The relevant governments calledthis 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 economistsclaimed 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 countriesadopted 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 flashingred 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-sectorcredit 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 decisionsmade in more-or-less competitive private markets could add up to macroeconomic danger, just as itdoes 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 macroeconomicimbalance by empirical analysis of experience across the world It has included rapid private-sectorcredit flow (the total of new borrowing by households and businesses as a percentage of GDP) amongits indicators of impending crisis, because of its track record as a warning indicator Rapid creditgrowth 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 ofalarmingly 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 householdand business financial liabilities in relation to GDP There is recent evidence that an excessivelylarge financial sector is associated with a low economic growth rate, and very little doubt that highprivate-sector debt increases both vulnerability to financial crisis and the intensity of any crisis thatoccurs In Australia, strictly comparable time series are not available for the post-war period, butsuch numbers as are available suggest that private-sector debt, though gradually increasing, remainedwell below the EC alarm level during the post-war period, but began to rise with deregulation Theindicator breached the danger level in 1998, and ever since has been above it This increase wasalmost 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 percent 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, whenthey burst, generate financial catastrophe The EC indicators zoom in on booms in house prices Thecommission does not deny that booms in other asset prices can be harmful, but housing-price boomsare particularly so The wide spread of house ownership means that a bubble in house prices directlyaffects 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 inhousehold debt, house prices have risen with no comparable shakeouts, and are now the cause ofconsiderable 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 bymore 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 itsthree private-debt indicators, but definitely rose above them in the late 1990s, around fifteen yearsafter the main phase of financial deregulation The rise in three indicators related to private debt wasnot, 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 toincrease their income-earning assets Though their capital adequacy was still regulated, this wasinitially no constraint, thanks to the unlocking of funds previously sequestered in low-interest loans tothe 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 loansthey could make, the greater would be their interest receipts and the greater their profits Reinhart andRogoff 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 deregulatorymoves in the 1980s Australia was no exception From 1984, Australia’s newly deregulated banksscurried 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 restrictthe 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 commercialproperty 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 inalmost a century’.5

This banking crisis was associated with a dangerous level of overseas borrowingand 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 recoveryfrom 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 financepublic infrastructure investment, but found that the remaining public-sector infrastructure owners didnot 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 increasedhousehold expenditure at the expense of saving, but the measure that really raised consumption wasincreased bank lending to households

Probably without realising what they were doing, Commonwealth governments in the 1990s caughtthemselves up in policy inconsistency Blinded by neo-liberal economics, they promoted NationalSuperannuation 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 savingsrate 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 bankswere comfortable that these loans were secure, for three reasons First, their borrowers were gainingassets that allowed them to save on rental costs and hence could readily be serviced, provided loanswere 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 anurgent social need This argument justified the Commonwealth government in its encouragement ofmortgage 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 propertiesprovided collateral

However, what seemed prudent and profitable to the banks and was convenient for the governmentturned 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 beenlimited so that the demand for new dwellings roughly equalled the capacity of the urban-developmentand construction industries to supply new conveniently located dwellings When mortgage lendingtook 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