2
Financial deregulation
During the Second World War, and not least in Australia, a great deal of effort was expended on planning for post-war reconstruction. It was agreed that the world should not be allowed to return to the conditions which had led to war; there was to be full employment and economic growth. To this end, Russia and China continued with a form of central planning that had no use for a finance sector independent of government. In Russia, central planning gradually ossified, while China experimented with variously disastrous mixtures of central and local planning, including the Great Leap Forward and the Cultural Revolution.
On the American side of the Iron Curtain, the finance sector regained some of the autonomy it had lost during the war: in the United States, in the name of freedom; and in Catholic countries, in the name of subsidiarity or the localisation of decision-making. The restoration of financial autonomy was far from complete — the memory of the role of finance in generating the Great Depression was too raw, as was the memory of the success of government planning in mobilising resources to win the war. There had also been an important intellectual development: interpreting the experience of the Great Depression, John Maynard Keynes had shown that free markets do not guarantee economic stability. 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 of production. Governments, that of Australia included, seized on this analysis in their eagerness to avoid 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. The sense 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 to require a substantial public sector, responsible for most services in health, education, and the public utilities, 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 international trade — as well as for the production of retail and many other services. Australia was to be a mixed economy, taking advantage of the strengths of both the public and private sectors. However, below the level of broad strategy it was not to be a centrally planned economy. This was in part ensured by the 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 controls over 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, and enterprise-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 that wanted 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 produce goods or services to a value greater than the amount borrowed and so yields a flow of funds both to repay the loan with interest and to add to the borrower’s income. The availability of bank loans and venture capital to start-up businesses is a major source of the dynamism of capitalism and hence of rising living standards.
In principle, nothing changes when borrowing and lending crosses national boundaries; the idea is still that net benefits arise when funds are transferred from savers to those who have opportunities to put 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 borrow and lend across national boundaries — but many cross-border flows of funds involve banks and other providers of financial services. Additional complexity arises thanks to the involvement of different currencies issued under the aegis of different governments, and the involvement of more than one public 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 short-term loans or ‘hot money’, which increase the country’s vulnerability to crisis.
During the post-war period the current account was, as always, hostage to international events. The Korean 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 prices returned to normal. Windfalls such as these are summarised by changes in the terms of trade, which are 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 in the current account: reduced export prices mean reduced revenue from exports; increased import prices 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 its currency, 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 the 1930s 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 fixed exchange rate provides a foundation for long-term planning both by governments and business. It encourages governments — including Australian governments, both Commonwealth and state — to seek to strengthen their economic position by adopting long-term policies to underpin the current account. They may diversify export and import markets, and nurture exporting and import-competing industries. Much of this can be done in the course of the regular interaction of the public and private sectors; for example, public investment in transport infrastructure can be tweaked in the interests of export-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 current account. During the post-war period these proved to be a serious impediment to the Keynesian pursuit of full employment, not only in Australia but generally across the non-communist world. The simple Keynesian answer to a threat of unemployment is to pump up demand — for example, by increasing government expenditure and reducing interest rates to encourage private borrowing and spending. However, in countries committed to fixed exchange rates (and even in countries not so committed, given the lags in price adjustments), these increases in demand result in increases in imports that can generate a current-account crisis.
In Australia’s case, the Commonwealth authorities introduced measures to curb imports whenever they judged that Australians were importing more than was justified by export earnings and were consequently borrowing overseas at a dangerous rate. The demand for imports could be reduced by quotas (the ‘import restrictions’ imposed by the Menzies government), or less directly by reducing disposable incomes so that people had less to spend on imports. Disposable incomes were reduced by increasing taxes and reducing government expenditure (fiscal policy) and by reducing the supply of credit and increasing interest rates (monetary policy, including credit squeezes). The recessions so induced were highly effective in reducing the demand for imports and releasing foreign-exchange earnings to allow debt-servicing to continue, but, in the words of a contemporary commentator, were ‘blunderbuss affairs’;1 they restricted people’s access to money without telling them specifically to cut back on imports. In other words, the deliberate reduction in incomes that was necessary to reduce the demand for imports threatened full employment.
A potential answer to this dilemma, then as now, is world cooperation. One country’s imports are another’s exports, so coordinated action to raise demand is less likely than solo action would be to hit current-account limitations. This reasoning underlay the foundation of the IMF, but the task of coordinating world monetary policies proved to be more than an institution based in Washington DC could manage. Only when countries experience slack demand together, and agree that this is a problem (as in the immediate aftermath of the Global Financial Crisis of 2008), has it been possible for them to raise demand in concert. Sadly, the consensus quickly falls apart when different countries make different assessments of the scope for raising demand.
As Australia settled down to business during the long prime ministership of R.G. Menzies, a split developed between the banks, some of which were government-owned, and the rest of the financial sector. The banks were fairly tightly regulated, at first by the central banking department of the Commonwealth Bank, and from 1960 by the Reserve Bank of Australia; the rest of the finance sector, less so. In return for regulation, the banks were licensed to deal in foreign exchange, provided they kept their foreign-exchange balances with the Reserve Bank. Reserves of foreign exchange were accordingly centralised, and the allocation of foreign exchange to the banks’ domestic customers was managed to maintain the constant exchange rate. There were also effective limits to the extent to which the banks, or anybody else, could borrow overseas. In the domestic market, the banks could decide whether or not to make particular loans, but instructions were issued from time to time as to the sectors to be favoured in lending, and formal regulations included requirements to make loans to the Commonwealth government, specifications of the interest rates (both on deposits and loans), and effective limits on the banks’ ability to lend and to borrow.
Prelude to deregulation
This regulatory system began to unravel in three ways: institutionally through the growth of non-bank financial intermediaries, internationally through fluctuating exchange rates, and in terms of macroeconomic management through cost inflation.
In the post-war period, the Australian finance sector comprised a mixture of public-sector and private-sector institutions, including the stock market, life-insurance and general-insurance companies, and the banks, some of which were private while others were in the public sector. The banking system created money and managed transactions and accounts, providing a convenient and reasonably risk-free way to save. In the process, the banks gathered savings from savers and on-lent these savings to borrowers. Though these functions — the settlement of transactions, the storage of value, and borrowing and lending — are conceptually distinct, they have long been bundled as the core activities of banks. Recent economic crises have caused some questioning of this bundling, a topic that is highly salient to the future reform of the finance sector.
During the post-war period, the trading banks gathered funds mainly from business, on which they did not pay interest but incurred significant costs in providing transactions services (mainly cheques), and specialised in loans to small businesses, mainly by way of overdrafts at regulated interest rates. The savings banks gathered household savings and lent them mainly to households that were buying houses; they paid interest to their depositors and charged interest to their mortgagees at low, regulated rates. Building societies ran on a similar model.
Although their licences to deal in foreign exchange, along with their privileged access to the Reserve Bank, provided the banks with a quid pro quo for regulation, they argued that the regulations disadvantaged them in competition with other financial institutions. The regulations governing bank borrowing and lending could be avoided completely by direct deals between borrowers and lenders, which served the needs of big businesses, but was not so useful to small savers and borrowers.
The scope for bypassing regulation increased when financial entrepreneurs found that they could avoid the regulation of interest rates by raising funds directly from the public (chiefly by selling debentures), and could lend to small borrowers (typically for hire-purchase, but increasingly for second mortgages on houses). The banks joined the game by increasingly routing their lending through wholly owned non-bank subsidiaries. By the 1970s, the proliferation of non-bank financial intermediaries had considerably weakened the regulation of the finance sector, presenting the Australian government with a choice: either dismantle regulation or extend it to the finance sector as a whole.
The growth in unregulated financial intermediaries within the Australian financial sector mirrored the growth in unregulated money in the world generally. The first money to be freely traded in the post-war period comprised United States dollar deposits held in Europe and hence outside the control of the US Federal Reserve Bank. Speculators soon found that they could use such funds to bet on exchange rates, with profitable but destabilising effects. On the official side, the United States government, which had never been particularly keen on long-term planning as a reason for maintaining exchange-rate stability, decided in 1971 to cut the tie between its dollar and gold, while the Organisation of Petroleum Exporting Countries disrupted the established pattern of world trade by raising the price of oil.
It became accepted that exchange rates should fluctuate in accordance with short-term current-account requirements, including those imposed by currency speculators. Though money continued to be a national institution, with each independent state having its own currency, there was now to be free trade in money. The spectre of competitive devaluation reappeared, and long-term business planning became more difficult.
The third malfunction that threatened the working of the post-war economy was cost inflation: the ultimately pointless spiral of wage increases followed by price increases followed by wage increases. This was diagnosed as arising from a lack of agreement between labour and capital. In 1985, one of us, Ian Manning, published a book advocating negotiation to solve this dilemma,2 and in 1987 the Australian Council of Trade Unions, after observing the effectiveness of agreements between peak employer and labour bodies in controlling inflation in Germany and other ‘corporatist’ countries, proposed that similar institutions be developed in Australia.3 However, by this time institutional developments in Australia were proceeding headlong in an altogether different direction.
A contemporary observer noted that, even if cost inflation could be brought under control, the Keynesian pursuit of full employment was incompatible with free trade in money and required the replacement of the existing system of quantitative financial controls — broad-brush fiscal and monetary policies — with the imposition of what he called qualitative bank controls covering the whole financial sector in the country. He explained that qualitative bank controls are ‘a mild form of banker’s planning, especially by way of exchange control. For to isolate a country from international disturbances one needs a new monetary system, one not based on free trade in money.’4
Though governments had lost control over offshore money, they were still able to control the aggregate level of borrowing and lending, to influence domestic institutions as they borrowed and lent overseas, and to influence the direction of lending. While these instruments could not guarantee a fixed exchange rate, they could stabilise the rate and simultaneously ensure that national patterns of savings and investment were broadly compatible with the maintenance of prosperity.
This development of the Keynesian approach to economic management built on financial controls of the kind already quite advanced in France and Japan and incipient even in Australia, with its preferential allocations of credit to the rural sector and to government infrastructure construction. An Australian version of this system would control cost inflation by development of the arbitration system into the arbiter of the broad distribution of disposable income, and would control the current account primarily by allocating credit to exporters and to import-competing industries when excessive deficits threatened. It would depend on a fairly small but expert public service, which could be subject to general democratic control, but not to detailed instruction as to the industries that had most to contribute to prosperity. Provided it channelled funds to innovative and small business, such a system could reconcile the restless innovative spirit of capitalism with the maintenance of full employment, and would certainly foster a spirit of international economic competition. However, Australia missed this opportunity, which was altogether too corporatist for its business elite.
The theory of deregulation
Crucially for the future of the international economy, the two largest Anglophone countries, the United States and the United KIngdom, failed to make the transition from quantitative financial control to qualitative controls. In these two countries, the most strident opponents of the transition were doughty Austrian opponents of central planning in both its fascist and communist variants, who regarded Keynesian government of a national economy as the thin edge of the totalitarian wedge.5 As a political philosophy, they championed freedom; they wanted government political power decentralised to individuals, who should be allowed to do whatever they wanted, provided they respected the similar freedom of other individuals. These opponents of government planning argued that competitive free markets guarantee an optimal allocation of incomes and resources, the best of all possible worlds.
In practice, they extended this guarantee to all private-enterprise markets, whether competitive or not. Their critics accused them of glorifying self-interest, particularly the self-interest of the rich, and of diminishing the noble American ideal of freedom to the freedom to sell, the freedom to buy, and the freedom to create value through advertising. These were freedoms that elevated ‘market value to the only value — so surrendering to the corporatisation, commodification and marketization of more or less everything’.6
Meanwhile, academics located mostly in American universities spearheaded the revival of pre-Keynesian economics that became known as neo-liberalism. The crowning achievement of this intellectual school was a procedure known as Computable General Equilibrium modelling, by which the benefits of free trade in goods, services, and money were given real-world dimensions according to an exceedingly abstract but mathematically beautiful economic theory. As Keynesians, we are happy to concede the intellectual coherence of this system. Its assumptions are carefully adumbrated; given its assumptions, its logic is unassailable. The problem is one of relevance. The assumptions of General Equilibrium are so refined and the system is so otherworldly that it provides no useful earthly guidance, a line taken in 1971 by Janos Kornai in his book Anti-equilibrium.
As a result of his experience of communist rule in Hungary, Kornai was no friend of detailed central planning, and strongly valued the vigour and innovative potential of capitalism — quite the opposite characteristics to those lauded by equilibrium theories. However, he conceded the case for strategic planning by governments and hence the need for qualitative financial controls. It is notable that he was one of three foreign economists who, in 1986, advised the government of China to adopt a form of economic planning that combined qualitative bank controls at the strategic level with considerable freedom of action at the enterprise level.7
While China was building its system of capitalism subject to qualitative controls (in the process, adopting insights from countries such as Japan and Germany), the United States and the United Kingdom were reverting to policies centred on the abolition of the quantitative economic controls of the post-war era in the faith that deregulated financial markets would guarantee equilibrium, as assumed in neo-liberal economic models. The resulting policies were packaged as the Washington Consensus, so named after the international financial institutions headquartered in the American capital that promoted them in the 1990s, only to repudiate them after the Global Financial Crisis of 2008.
The examples of Mr Reagan and Mrs Thatcher were too powerful for Australian politicians to ignore, particularly after important factions within the Labor Party swallowed the proposition that Washington Consensus policies guaranteed equilibrium economic growth that could be harvested to the benefit of all citizens. As Australian Keynesians, we looked on in dismay while our insights into the practical working of economies were displaced by elaborations on the perfections of competition — assertions that competition guarantees the best economic outcomes.
The Australian neo-liberal (or ‘economic rationalist’) reform program was wide-ranging. The reforms were initiated by Labor governments, but were heartily endorsed and extended by the Coalition. Cost inflation was attacked by accepting the increased unemployment rate that had emerged from the stagflation of the 1970s as a permanent necessity to curb excessive wage demands. This was backed up (after the election of a Coalition government in 1996) by branding trade unions as anti-competitive labour monopolies, and by working to undermine their role. Public-sector businesses were seen as inefficient and monopolistic, and were privatised wherever a short-term profit could be turned by selling them. Taxation was no longer characterised as a contribution to the common good; instead it was branded as an intolerable interference with market incentives. Tax cuts came into fashion, particularly at the higher end of the income-tax scale, and tax-avoidance opportunities were provided for businesses and high-income individuals. Among taxes, tariffs were targeted as a particular affront to free markets and were cut, unilaterally if necessary. With honourable exceptions, when John Button was minister for trade and commerce (1983–93), these cuts were implemented shorn of the sophisticated industry-support policies adopted in countries such as Germany and China.
Though labour-market reform, competition reform, and free trade were major elements in the neo-liberal program, the element most closely related to the deterioration of Australian performance as assessed by the EC indicators was financial deregulation. The rest of this book homes in on the outcomes of this policy.
The process of financial deregulation
Financial deregulation began in Australia in 1973 when direct controls on bank interest rates were weakened to allow banks to compete more effectively with non-bank financial intermediaries. In December 1983, free trade in money was adopted by abolishing external capital-account controls and floating the exchange rate. The last of the lending-rate controls (those on new owner-occupied housing loans) were abolished in April 1986. The idea that governments should own trading and savings banks to compete with the privately owned banks was anathema to the deregulators, and in 1996 they completed the privatisation of the Commonwealth Bank — which was allowed to retain its name despite the general ban on private organisations adopting names that indicate they are government entities. Within the finance sector, only the Reserve Bank remained in public ownership, and even it was required to be ‘independent’.
The differences between the pre-deregulation and post-deregulation regimes were spelled out in an address by Ric Battellino, the deputy governor of the Reserve Bank of Australia (RBA), given to the Australian Governance Program on 16 July 2007. In the period from the Second World War to financial deregulation:
As Battellino explained, the objectives of financial regulation, now called financial suppression (in hostile literature), were:
Financial deregulation involved the sacrifice of these five objectives to neo-liberal faith in the supreme benefits of profit maximisation in the economy at large and in the finance sector in particular. Though this was the primary reason for deregulation, there was also an element of surrender: the finance sector had become adept at dodging regulation by setting up non-bank financial intermediaries, and bank deregulation had the virtue of bringing all financial institutions into one lightly regulated pool. There would no longer be any advantage in setting up businesses that accepted deposits and made loans but were not legally banks. The banks gradually absorbed much of the non-bank financial sector, including their own non-bank subsidiaries and previously independent building societies, consumer-credit corporations, and the like.
More significantly, the deregulated pursuit of profit brought major change to banking operations. Under bank regulation, the funds that the banks had available to lend were strictly limited, and the margins between the rates of interest at which they could lend and their cost of funds (the costs of services to depositors and of any interest they might be paid) were likewise strictly limited. Under these regulations, banks had a strong incentive to avoid bad debts. They assessed credit-worthiness carefully and, in addition, they watched their business loans and dispensed advice on how to stay solvent. The non-bank financial intermediaries served riskier borrowers and charged higher interest rates to cover the cost of a greater incidence of bad debts; but, like the banks, their lending was limited by the funds they could raise, either from the banks or from the general public.
Deregulation altered all this, and resulted in a dramatic change in bank culture. Four major curbs to profit maximisation were removed. The first applied both to the banks and to the non-bank financial intermediaries. This was the removal of restrictions on overseas borrowing by Australian deposit-taking institutions. The other three applied specifically to the banks. They were the effective removal of compulsory loans to the government, the removal of restrictions on interest rates (and specifically on the spread between borrowing and lending rates), and the removal of restrictions on the size of bank balance sheets (the move away from central management of the liquidity of the economy). Before deregulation, the banks maximised their profits by careful attention to the avoidance of bad debts; under the new dispensation, they maximised their profits by maximising lending, by widening the gap between loan interest rates and the cost of funds, and by imposing service fees and charges.8
The banks recognised that increased lending would raise the incidence of bad debts, but under deregulation this could be accommodated as a business cost by increasing the spread between the lending rate and the cost of funds. The banks calculated that it was cheaper to suffer the occasional bad debt than to incur the costs of careful surveillance of their loan books. They reduced their costs by computerising loan assessment, as indeed they computerised account-keeping generally. Further, the domestic deposit base no longer limited their capacity to make loans, since, after deregulation, deficiencies in the domestic deposit base could be made good by borrowing overseas. The only limits to balance-sheet expansion were the supply of borrowers, the cost of overseas funds, and the remaining regulations administered by the Reserve Bank, which were later hived off to the Australian Prudential Regulation Authority.
These remaining restrictions were not initially at all onerous. So long as the return on funds exceeded the cost of funds, bank profits were maximised by making as many loans as possible. Incentive structures within the banks were overhauled to reward staff who sold bank products; in other words, those who successfully sold debt. This included selling debt to borrowers of doubtful credit-worthiness who subsequently deeply regretted their borrowing. In Roy Morgan’s surveys, the proportion of the Australian public who rated bank managers as having very high or high standards of ethics and honesty plunged from 58 per cent in 1987 to a low of 26 per cent in 2000. In aggregate, the banks’ single-minded pursuit of profit resulted in an increase in consumer debt balanced by an increase in overseas debt — changes that we have already spotted in our discussion of the EC indicators of incipient trouble.
By its emphasis on annual (indeed quarterly) bank profitability as a guide to financial management, deregulation reversed the previous trend towards qualitative control of the financial system. The pre-deregulation system in Australia had gained some of the characteristics of qualitative bank control, though without the highly purposive long-term planning that underpinned qualitative regulation in countries as diverse as Germany, France, the Scandinavian countries, Japan, and China. Deregulation reversed this trend; the Commonwealth government gave up both the policy objectives and the powers listed by Battellino. This required a major curtailment of the powers of the Reserve Bank.
Although the Reserve Bank retains a number of objectives, including full employment and maximising the welfare of the people of Australia, one objective achieved primary status over the last three decades: stability of the currency. This is expressed in terms of maintaining the annual inflation rate at between 2 to 3 per cent on average over the cycle, and is pursued by manipulating the one control that remains to the bank — its power to influence short-term interest rates by buying and selling government securities. This objective was formalised in an agreement between the government and the Reserve Bank in 1996 expressed in the Statement of Conduct of Monetary Policy. The statement contains the inflation objective, asserts its primacy, and notes the independence of the Reserve Bank board.
Australian governments can still engage in fiscal policy by running budget deficits and by borrowing, though their inclination to do so has been much reduced by the replacement in the public service, the finance sector, and the media of the post-war generation of Keynesians by economists trained in the revived neo-liberal tradition. In any case, the financial sector, via ratings agencies and by constant assessments of government policy settings, now limits the range of active fiscal policy. In effect, the finance sector now allows fiscal expansion only when it is required to support private-sector cash flow, as during the Global Financial Crisis or in a recession. At all other times, private-sector interests take primacy in the setting of the economy’s liquidity needs and resource allocation. Governments that offend performance standards set by the finance sector in relation to debt, budget deficits, and expenditure growth risk downgraded credit ratings and the accompanying penalties of raised interest rates.