ECONOMIC AFFAIRS: by Colin TeeseNews Weekly
Market failure and the difficult path ahead
, November 8, 2008
Much still needs to be done if the real economy is to be insulated against the consequences of market failure, writes Colin Teese.Former chairman of the United States Federal Reserve, Alan Greenspan, admits that he is in "a state of shocked disbelief" as the ideological underpinnings of his economic philosophy crumble about him.
National leaders around the world can't afford that luxury. Realistically and necessarily, they have agreed on precipitate, interventionist action to save the banks. De facto
, they are acknowledging that the financial crisis is an example of market failure - and it threatens to infect the real economy that produces goods and services.
They had no option but to recapitalise the ailing banking system. It wasn't, as some had hopefully asserted, a liquidity crisis generated by fear, but a solvency crisis. What the banks needed, outside Australia, was an injection of capital - in effect, part-nationalisation, with governments taking up equity positions in banks.Complicated
But don't expect governments to come out and say so. Debating the issues of "market breakdown" and "nationalisation", in the context of a gathering of government leaders aimed at devising bailout packages, would only have further complicated an already difficult negotiation.
Australia's Prime Minister Kevin Rudd took his own initiative. The problems of our banks were different. Their need was to keep up the flow of imported capital to sustain their lending operations.
Given Australia's massive level of overseas indebtedness, the fear was that foreign investors might be panicked into withdrawing their funds from Australian banks. Accordingly, Mr Rudd was advised to guarantee the deposits of all lenders to Australian banks.
In the beginning, the Opposition supported the move; later, it backtracked from offering unqualified support.
Some of the flow-on effects of the Rudd Government's intervention are now revealed to be of concern, notably, owing to the fact that the guarantee does not cover non-bank mortgage lenders.
Understandably, depositors with these institutions quickly decided they wanted to retreat to the safe haven of banks enjoying the umbrella of government guarantee, and have begun withdrawing their funds.
These institutions, to safeguard their deposit base, have put a freeze on withdrawals. They could not have behaved otherwise. Allowing a run on their funds would have destroyed their deposit bases.
Could and should this possible outcome have been anticipated by the government? Perhaps. But what could have been done? Traditionally, government assistance in time of crisis has always been confined to banks. Besides, depositors with non-bank institutions were probably there because of superior returns over banks. And superior returns necessarily carry additional risk.
There can be no doubt that the Rudd Government's action will carry some political backlash. The federal Opposition will see to that. Sometimes that is the fate of governments - whether or not it is well merited.
But there is a more interesting question. Why were Australian banks not drawn into the same destructive web of irresponsible lending which has apparently captured most of the West's major institutions? To find the answer, we must go back to the postwar prime ministership of R.G. Menzies (1949-1966).
Mr Menzies, it will be remembered, rode into office in 1949 on the back of an abortive attempt by the then Labor Prime Minister, Ben Chiefly, to nationalise the banks. This was an important plank of the Labor Party's then commitment to socialism.
Prime Minister Menzies was, of course, totally opposed to socialism; but as time passed he saw a need for changes in the way banking was structured in Australia. Nine years later, in 1958, he decided to do something about it. As a result of legislation passed in that year, a new architecture was created for our banking industry.
The Reserve Bank of Australia (RBA) was established, not independently of government as now, but with the responsibility of managing monetary policy with the aim of maintaining full employment and containing inflation.
Another part of its responsibility was oversight of the private banks. Banks were required to hold a percentage of their capital on interest-bearing deposits at the RBA. In the last resort, these funds, called statutory reserve deposits (SRDs), would act as a financial stabilising influence for the banks.
The new Reserve Bank exercised much control over the way the banks operated. Some even said that, such were the controls, the private banks operated as mere agents of the RBA, with responsibility for providing nothing more than normal retail banking services to customers.
Still others have observed that the Menzies legislation gained, indirectly, that measure of control over bank operations that his Labor predecessor tried and failed to gain directly. Maybe. But one thing is certain - Menzies received better advice from the Treasury than has been the fortune of any succeeding prime minister. That having been said, however, the current secretary of the federal Treasury, Dr Ken Henry - who on many issues of economics does not share the views of this writer - seems to be well serving Mr Rudd.
Some of the safeguards generated by the Menzies bank legislation - for example, the obligation to maintain SRDs with the Reserve Bank - have since been dismantled. But enough control had been retained to prevent our banks following the same disastrous policies as have most of their large Western counterparts. They should attribute their good fortune to Menzies.Guarantees
SRDs, it should be pointed out, were discontinued back in the 1980s by the Labor governments, at the request of the banks in the push for financial deregulation. Right now, Mr Rudd should be regretting that the then Prime Minister Bob Hawke and his Treasurer and successor Paul Keating had this particular rush of blood to their heads. Had the SRDs remained in place, the Rudd Government would not have had to introduce guarantees and face the problems he now has with non-bank mortgage-lenders.
Western governments, practising what might be called part-nationalisation of the banks, have probably got some kind of handle on the narrower consequences of market failure in the financial sector. That's a start. The next step will be to prevent the fallout from the financial crisis from so infecting the real economy that it induces a deep-seated and prolonged recession.
Some damage has already been done. To prevent its spread and move towards correction, we will need to cast aside at least some of the most cherished tenets of free market/ deregulationist economic philosophy.
The most headline-grabbing publicised consequences of the financial crisis are the crash in share prices around the Western world. In truth, falling share prices should not, of themselves, be a concern - except for those who took advantage of cheap money to borrow for share purchase and have seen the value of their investments tumble over the last 12 months. This apart, share price movements have minimal direct effect on the real economy.
However, they can be an influence indirectly if share speculation starves the real economy of capital needed to finance new productive investment.
As to the real economy, the flow-on market failure arising from the US financial crisis has so far been most obvious in the housing industry. Until recently, the US financial sector fed cheap money into the housing industry and fuelled the bubble in house prices. (It also did the same for share prices). One way or another, this particular virus spread around the world. The consequence was a huge bubble in housing prices, particularly in the US and Australia.
As a result, house prices soared well beyond affordability levels. If anything, Australia is more perilously exposed than even the US.
Housing is important to the real economy. The housing construction industry accounts for about six per cent of domestic economic activity in the US; it is probably similar in Australia.
The consequence for governments of market failure in housing in both the US and Australia is profound. In the US, house prices are falling, and so is demand. Australia seems to be following.
Finance is now tight. Those who need housing can't afford to buy, and the rental market is tight. Market forces are failing middle and low-income Americans - and Australians.
In the US, house prices average three times median wages. The corresponding figure for Australia is seven times.
Now governments are caught in a painful dilemma. Bringing house prices down from bubble levels to something approaching more affordable levels could mean many home-owners finding they have to pay off unaffordable mortgages on homes in which they hold negative equity. However, if prices stay at or near existing levels, housing will become less and less affordable.
Meanwhile, a rental market exists where reasonable returns to private investors offering property for rent are beyond the means of the lower income-earners to pay.
It is now clear that the house purchase and rental markets (to which the construction part of the industry is so importantly tied) are incapable of supplying the needs of those on middle and low incomes. This is largely due to the house price bubble associated with the financial market collapse.
Reconstituting financial markets in ways which can insulate against a future similar crisis is a fine and necessary first step. But much more is needed if the real economy is to be insulated against the consequences of market failure.Market forces
The way out for housing will be difficult and complicated. We can and should leave market forces to look after the needs of the upper end of the housing market, for both rental and ownership.
How we deal with the plight of home ownership and rental for the lower and middle-income earners, not to mention those home-owners who might be financially crippled by dramatic falls in house prices, is another question. It seems pretty clear that much more government involvement will be needed.
A good starting point might be to look back and see how we handled it - more or less successfully - in the past.
In considering all of this, what might have to be put behind us is the misguided belief that markets can be relied upon to be self-regulating and to solve all problems.- Colin Teese is a former deputy secretary of the Department of Trade.