Are central banks destroying capitalism?
Dave: We'd like to welcome you to tonight's Masterclass, which is titled "Are Central Banks Destroying Capitalism?"
Dave: Warren Hogan and our team of expert panellists, who Kylie will introduce more formally shortly, they'll be discussing the topical issue of whether monetary policy has gone beyond its effective limits and jeopardising the efficient operation of free market economies.
Dave: Before we begin and on behalf of all present, I'd like to acknowledge the Gadigal people of the Eora Nation upon whose ancestral lands the UTS campus now stands. We'd also like to pay respect to the elders both past and present, acknowledging them as the traditional custodians of knowledge for this land.
Dave: Now I'll hand over to our emcee for tonight, Kylie Richards.
Kylie Richards: Thanks very much, Dave.
Kylie Richards: Now when Warren first proposed the topic "Are Central Banks Destroying Capitalism?" there was no question that it was going to be an interesting one and a popular one. What we didn't expect, however, were that registrations would fill up in two days and we'd be madly scrambling for a much bigger venue. On that note, I do thank you all for taking the time to come along tonight. I'm sure it's going to be quite a provocative discussion on a very important topic.
Kylie Richards: Now the format for tonight's event will involve Warren presenting for about half an hour, then we'll follow up with commentary from our panellists, and then we'll open the floor, of course, for audience commentary and questions.
Kylie Richards: Before I hand over to Warren, I'll formally introduce our panellists. On the end here, we have Warren Hogan, he's our Industry Professor at the UTS Business School. He's been here since 2018. He's had previous roles as Chief Economist at ANZ, Principal Advisor at Commonwealth Treasury, Chief Economist and Head of Interest Rate Research at Credit Suisse.
Kylie Richards: Next we have Tony Morris. He's a Director at Bank of America with Merrill Lynch since 2014. His previous roles include Global Head of Interest Rate Research at ANZ, a Senior Economist at New South Wales Treasury Corporation, Market Strategist at Bankers Trust Australia and Managing Analyst for Asia for Thompson Financial.
Kylie Richards: Next we have Adam Creighton. He's an Economics and Finance Journalist at The Australian and he's been there since 2012. He's a Member of the National Archives Advisory Council. His previous roles include Business Anchor at Your Money, Reporter for the Wall Street Journal, a Journalist for The Economist, Senior Advisor to the leader of the Opposition, the Honourable Tony Abbott.
Kylie Richards: Then finally, we've got Joseph Healy. He's a Co-Founder and CEO of Judo Bank since 2015. His previous roles include Group Executive/Divisional CEO at NAB Business Banking, Executive positions at ANZ, CIBC World Market, Citibank and Lloyds Bank. He's also the Author of Breaking the Banks, published in 2019. Chinese Firms Going Global, Can They Succeed and Corporate Governance and Wealth Creation.
Kylie Richards: There's no question that we've got excellent expertise on our panel, it's quite the introduction, I think, for all four of them. I'd now like you to join me in welcoming Warren for his presentation.
Warren Hogan: Thanks, Kylie. Is everyone hear that okay? It's a small room.
Speaker 4: Yeah.
Warren Hogan: Great.
Warren Hogan: Well, thank you, everyone, for coming tonight. We originally set up an event to try and get about 40 or 50 people here, and I said to Kylie, "We've got to have a really good title." So there might be a little bit of overreach on the title, but the effective limits of monetary policy, let's stick with that, hey?
Warren Hogan: I'm going to get stuck straight into it. This is massive topic and I want to try and bring out sort of a mix of the common sense, the data, and a bit of Economics behind it, and, hopefully, I get that right and give you some interesting insights, and yeah, some of my thinking about why we need to seriously think about what we're doing with monetary policy in this country, because we've got a lot of evidence from overseas about the problems.
Warren Hogan: This is essentially a question that goes back to the start of Economics or at least a 150 years. It's about the role of money, from Marshfield, Caines, Tobin, Friedman, they all addressed it, and the classical view was that money didn't matter, that money was neutral, that you put more money in the system and it would just end up in inflation, that what really mattered for an economy was relative price changes. Of course, this is way too simple and I think we all understand that and, of course, Caines is accredited with these innovations that we don't live in a perfect world and that we need stabilisation policies and he was the one who was very instrumental in this idea that monetary policy has a role to play, interest rates have a role to play.
Warren Hogan: I think my perspective, I think, summed up here ... I am hoping this works, because ... There we go. Lots of words, it's not too many words. So I'm going to put forward a proposition. This is a policy debate. This is not a lecture and I'm an Industry Professor, not a real professor, so I can throw a bunch of propositions at you.
Warren Hogan: The main one is "Persistently easy monetary policy has consequences for the economy and society." The political channel is critical, because this stuff's important, right? "Over and above an undesirable rise in consumer price inflation." Because we all know, obviously, central banks target inflation, which is [inaudible 00:05:48] appropriate, but there's more to it than that. Monetary policy has effective limits and essentially in the current debate here in Australia, we say with fiscal policy has to do more. I'd argue that let's think about what that fiscal policy is, but it's structural changes in the economy and then there's also the question is governments can only do so much. There are certain adjustments that are going on out there that there's not much that can be done about by any government policy.
Warren Hogan: I'm going to define the effective limit as a change in monetary policy that has a negative net benefit to the economy's performance over the long run. I'll introduce the first of the RBAs, the governor's latest terms, because I think it's really important to keep in the here and now and this this welfare maximisation. Long run, what's the best in the long run for all of us and it's really pleasing ... and I know the RBA always do think like that ... and it's pleasing to hear that come into the public commentary right now.
Warren Hogan: I'm going to say monetary policy is a short term stabilisation tool and that's it. It can't do anything in the long run. Monetary policy, in fact, down in the bottom there ... This is my big statement ... has no role to play in the prosperity of nations, other than to stuff it up. It has to just do its job. It can't make things happen, it can just get it wrong, instead of facilitate the functioning of the economy. Yeah, maybe I'm over stretching it, but you get the idea.
Warren Hogan: Because the reason I'd point that out, okay, we're going ... This is working backwards, that's fine. That's because I've got it around the wrong way. Very good. The reason I want to point that out right now is way too much is being asked of monetary policy. It's all about independence, monetary policy's golden era, globally, particularly in this country, from the advent of inflation targeting in the early '90s right through the global financial crisis, where it did very well. There's a few personalities involved in monetary policy around the world, that probably turned it into this rockstar sort of thing, but we're now up to the point where there's political dysfunction or all that success in the past where way too much has been asked of this policy instrument and the people who are trying to execute it, it's a nightmare for them, in my view.
Warren Hogan: Let's gets started, how do we judge monetary policy's stance, really important starting point and I've been looking at this stuff, particularly from a financial market's point of view and the good thing about Sydney as an economist and financial markets is you find out very quickly when you're wrong, because there's a lot of people who are managing financial risk around it. Look, there's lots of ways to think about the stands of policy, let's make it simple.
Warren Hogan: This is the real Fed funds rate mapped against the real rate of growth of the US economy since 1957, excellent, 65 years of data, and they're pretty, they move pretty well together. They're two big variables and so the basic proposition is a neutral stance of policy is when the real interest rate brought the alliance with the real rate of growth in the economy, you want to tighten policy, you take it up above that rate of growth, and below ... it's a lot more complex than that, obviously.
Warren Hogan: Let's have a look at some history, so I don't really want to talk much about the '60s, but that was some pretty easy monetary policy. We won't have an argument about what caused the '70s. Let's talk about this one, Volcker, this was one of the greatest acts of monetary policy in the modern era. The amount of pressure that guy had on him to tighten up US monetary policy to drive inflation out of that economy. Carter blamed him for losing that election. His own people at the Fed were getting very upset with him, even Reagan was tricky, but that's when he took policy tight and he knocked that economy into recession ... I'm not arguing that central banks should be knocking economies into recession, but he knew, he had a conviction about this is the right thing, to do, he got inflation out of the US economy.
Warren Hogan: That played a big role in the subsequent couple of decades, I think, but look back here, easy monetary policy, a real rights below growth out of recessions, utterly appropriate, data lags, central banks want to make sure the recovery's got traction, so you've got there, this is Bernanke. I know Greenspan was in charge after the tech break, but I think Bernanke thought this was 1930's all over. I mean, he'd been studying it so much he was just waiting for it to happen again and of course, the normalisation process really bad central banking in my view. Do not raise interest rates 25 bases points every month for three years in a row. That's a really bad way to muck around with risk [inaudible 00:10:18], risk [inaudible 00:10:18] of the market. Anyway, we won't go into that tonight.
Warren Hogan: Here we go, modern era, persistently easy monetary policy, real interest rates, to use a technical term, miles below the real rate of growth in the economy for almost 10 years now, and obviously, you've got quantitative easing in there and unconventional policy but we don't even need to go there. We can just look at that and you can see it.
Warren Hogan: Now look, the Fed funds rate is average 1.3, real GDP is every 3.1, you'll say, "Well, look, it doesn't match up," and it's not but there's a lot of funding in the US that happens in long term interest rate. So I just thought, I'd chuck in the nominal rate of growth of the US economy and the nominal 10 year Treasury yield because even more, he just apprised off the 10 year, a lot of corporate fundings out there, and that's where you get the alignment here, there's a lot of expectations which is ... It's actually really rich stuff in here, but the point I'm saying is this relationship ... Can you take interest rates away from the rate of growth in the economy for long period of time? Are things going to happen out there? They're going to try and force it back? I mean, I'm not going to try and answer that now, but there is an island.
Warren Hogan: Let's come to Australia, I'm not even going to bother with Europe, Japan. We'll be here all night. This is Oz, where we do have short funding. Okay, mortgages, most corporate fundings after three years. It's short rate here, which the RBA controls is aligned to the [inaudible 00:11:42]. I don't even want to talk about the 1960s and '70s in this country. That was our recession, we had to have high short rates in the '80s, that got inflation out of our system what Volcker did in the early '80s, we had the recession we had to have.
Warren Hogan: Look at this, I'm sure this is the data, I've done this many times. That is our goal in there. That was the RBA executing to perfection. We had wealth creation on the back of a great economic performance. We had a lot of things. We had the micro-reforms, but it was working. The RBA, that's the crisis, the RBA was holding in there, and then, kaboom, we've got it here. We've got that persistently easy monetary policy, so we're there now.
Warren Hogan: We have got persistently easy monetary policy and it's very easy. Now in this country, it's very easy, it's not unconventional yet and I haven't even gone into all of that, as I said. Let's talk about whether we should be thinking about that. My proposition is that there are costs to very easy monetary policy or persistently easy monetary policy other than just rising CPI.
Warren Hogan: Okay, so the Philips curve frame is, yeah, we've got a target, get inflation up there, now we'll get unemployment down there. If inflation's below target, ease, ease, ease. I mean I've been watching this for 30 years, 25 years. In the late '90s the core CPI, we looked at back then was under target for quite a few quarters actually. It was mechanicanicalistically saying, "It's under target," and there's no consideration of lags in policy, just ease, and that thinking is really wrong, but even beyond that, we need to think about what'll happen by just keeping on easy policy.
Warren Hogan: Impact on savings, now the first one there, reduced spending capacity, let's not worry about that. We know about that. The RBA talks about that, but there is a social issue here. These are retirees who never in any conception in the last decade thought about 1% interest rate or were given a heads up about that, and it's real. This is the opposite end of tight monetary policy. When tight monetary policy is happening, and we haven't had a lot of that in the last 20 years, but what it is it's the debt holders who are at the forefront of the adjustment, people who've got floating rate mortgages, that sort of thing. So you could argue, well, it's just the savings that [inaudible 00:14:18] this stage of the game and helping the broader social adjustment.
Warren Hogan: Increased savings, forward guidance, now this is something I'll just throw out there, but when you say, "We're going to keep the rates low," for a long time, the perverse effect could be, for those people approaching retirement, is to say, "Well, if I'm only going to get 1% on my term deposits, because I don't particularly want to go with some person who's advertising strange financial products and can give me a good yield and chuck money in equities or basically raise my risk profile, if I can only get 15 in retirement, I'm going to get a bigger nest egg," whether you're five years out, 10 years out, or you have to keep working longer, whatever. The perverse effect of these low rates, with forward guidance, could be to actually to cause the savings rate to go up, because people need a bigger nest egg.
Warren Hogan: I'll leave that, that's fine. Health of the banking system, very political in Australia, so I don't want to get into that too much. I'll let Joe cover some of that in the panel session, but there's no doubt that our banking systems function, nee capacity, is being jeopardised as rates approach zero, and of course, QE and a whole range of other things could make it even trickier. I won't delve into that too much now.
Warren Hogan: Asset price inflation, I think, is well understood. Our governor was at the forefront of this analysis. 17 years ago, you get a lot of asset price inflation, it creates financial instability. I think it's very well understood, I won't go into that too much. Distorts investment decisions, that's an economic sort of argument we can talk about but really, the one I think is the inequality effects. You know, we can sit there with an economic model and an economic theory and we can talk about it, but we all know that asset price inflation worsens inequality, particularly wealth inequality and we all know that it's not helpful for a broader political environment.
Warren Hogan: I'm going to touch on that more and then of course, this is the one that's getting more coverage from some very serious economists and that is this idea that really low interest rates is undermining the efficient allocation of capital within our society, not because it's stopping capital being allocated to the most efficient opportunities, investments. We have great capital markets in this country, all around the world, that's probably still happening. The problem is we're not pulling capital out of inefficient firms. The zombie firms are surviving for longer and we're moving away from the efficient frontier, productivity's lower for it, therefore wages is lower for it. There's a political mechanism there, too, in that as well, so I'll go through that.
Warren Hogan: Okay, so first of all, just on the asset price inflation, it's a tricky one, in many respects. Easy to argue down, dismiss, so great. I don't think we have to talk about our particular asset price vulnerability in this country, because the point I want to make here is that every country, the liquidity will blow out through asset prices in different ways. In this country, it is clearly residential property is the flashpoint. In the United States, it is the equity market in my view. This is Robert Schiller's PE, which he does all these adjustment for. It's all free on his website. Right now, US equities are the second most expensive valuation in history after the tech ref and the Great Depression and I think most measures would say that [inaudible 00:17:55] certainly is at the highest it's been for 30 years, so completely at odds.
Warren Hogan: So there is asset price inflation going in. In Germany, funnily enough, again just to pick this one, it seems like commercial properties were blows out, because they don't have a very vibrant residential market, there's only a small amount of personal ownership, so it seems there. So it's in different countries asset price inflation manifests itself in different ways.
Warren Hogan: What does it do? Process, just go through it. Asset price worsens inequality, touched on that. Really, that's obviously debatable. There are economists who will say that it doesn't. I don't believe them. I believe it does and I think if you persistently use the asset price mechanism, if policy is persistently away from some neutral setting, then you will. I don't think there's any doubts, so I got Ray Dalio's quote here that ... Yeah, so he's saying a bit, he's got a fairly broad judgement on these things, that it leads to problems in the community. I think we're seeing that. I mean, obviously, there's other things that drive inequality, not just monetary policy, but it's obviously adding to existing trends.
Warren Hogan: Of course, we're seeing the political outcomes and the key point for me is if monetary policy's not the thing to lean on now and I would argue that fiscal stimulus, whatever that is, but short term fiscal stimulus is and it's structural economic reform. The things we need are politically tough, if though that this process gets you people in power in democracies who are going to do the opposite. They're not going to do politically tough long term visionary economic reforms. They're more likely to do the opposite.
Warren Hogan: I mean some would argue Trump's done a couple of good things, but I wouldn't say a Trade War is sort of what we need right now and, of course, we can look at what's happening in Europe as well. Japan was a leader in this low rate ultra easy monetary policy role. That social structure's very different from Europe, America, and Australia. So just happy to talk about that another frame.
Warren Hogan: Let's move on to zombies, that is those firms that are still in business because the bankruptcy mechanism has been short circuited by holding interest rates really low. In Japan, in Europe, the evidence is coming out now, it's a very difficult topic for academic level research. I have the data to prove, we have a visiting academic from Europe who's spent four years, young academic, spent four years building a database. He's having to get a lot of journal articles out of it, but we're getting the evidence through. The BIS has put it out.
Warren Hogan: I mean essentially a zombie firm is a firm that if interest rates were at a more normal level would probably not be around, and there's obviously broader issues about the health of the banking system and so forth around this, but the point is the research is showing that the keeping of these inefficient firms in the economy, short circuiting the efficient allocation of capital, which does mean extraction, as well as allocation, is hurting productivity and therefore, living standards.
Warren Hogan: From the BIS, they made these few points, which I won't labour, you can read them there. An interesting one down the bottom, coming through is you need to think about the future, because these firms that technically have a lot of leverage aren't making a lot of money that would look from a sort of analytical point of view, like the zombies, you raise rates and they'll be out sort of thing, but they're called start ups and they're called high productivity new firms, so you need to look at their future as well.
Warren Hogan: Continuing it on, I think this is the point, the conclusion from them in this BIS paper was essentially, there is a trade off here. That it's about keeping people in jobs and keeping the economy supportive versus inhibiting the productivity of the economy and problems that could cause down the track and there's a lot more work to be done on this issue was their conclusion.
Warren Hogan: The fact that the BIS and the BIS is one of the finest economic research institutions in this world is under this, is very positive, and I think this has real legs. I mean, maybe its the equivalent of Phil Lowe's work on financial stability seven, eight years ago.
Warren Hogan: Here in Australia, I just thought add a bit of data, and the data, I think this is fairly weak relationship but this is ASIC Insolvency data, so the number of firms that are essentially going bankrupt in Australia each year. It's been on the decline for the last eight years and we're not in zombie territory in this country. This is something we don't want to get to, I mean, but these trends are evident in other countries and so this idea of a less dynamic economy is coming through.
Warren Hogan: Okay, so why are central banks doing this? I've still got a few minutes, so I want to get through this bit, so I'm speeding up now. Obviously, it's keep people in jobs. Your trade off is to keep monetary policy stimulatory. It stops the firms going bankrupt, it keeps people in jobs. I would argue that we saw this with the big change in manufacturing, 20, 30 years ago. We were very poor at dealing with the people who were displaced through that period and I'd argue the second big shift in the services sector, which is happening, related to future of work, digital technologies is happening, and as a society, we should be thinking about how we deal with that, how we support those people, how do we re-skill them, up-skill, and get them into other useful work or whatever it is but it's not up to monetary policy.
Warren Hogan: Are we going to use a very blunt instrument ... I love this ... blunt instrument from ownership policy was always about tightening and a blunt instrument on the way down, too, when it's easy. It's a blunt instrument to try and keep people in jobs. Other policies should be trying to work out how to get people into the right roles and get the right skills and so forth. That's one point of view.
Warren Hogan: The zero lower bound is obviously alive and well. That's the function of a highly indebted society and that's why they want to try and avoid deflation, because their policy becomes even harder and, obviously, you get into talk of unconventional policy. That's why they're doing this and then, of course, I will argue, just quickly to finish off, that their inflation targets and their independence is a major issue here, too.
Warren Hogan: Quickly, inflation targeting, it's fantastic. I don't think we should get rid of it. It's exactly right it's the primary, but as I've been arguing there's more to it than that and I think my argument is essentially that, there's only so much any central bank can do. Once you get to the point where you are no longer really effective then you're out and no one wants to hear that. The central bank themselves are going, "Well, we've got no role to play here." It is a bad policy thing [inaudible 00:24:59]. Right now the reserve bank doesn't want to tell people in this country, "There's no more we can do. It's up to Josh Frydenberg from here on end." Geez, that's a great way to put consumer confidence in the ...
Warren Hogan: Anyway, price stability was what the targets were all about. The arguments from the '90s, there's a bit of rewriting of history going on here. There were no ... Arguments for the '90s was all about the sort of classical definition of relative price changes versus absolute price changes, is that price stability is a rate of inflation that's not too high, [inaudible 00:25:25] we're just coming from a very high inflation period, but it's not too low that the relative price changes can't function. The idea here is relative price changes in reality don't happen instantaneously, they can take years to play out, so you don't want to have a zero inflation target and stop relative price changes occurring. That would be very, very bad and I believe that was the idea about a small amount of inflation.
Warren Hogan: The definition of the Fed's website, I believe now, is that you don't want too high an inflation, probably what we had back then, but you don't want to get too close to the lower bound. No one was talking about lower bounds in the early '90s when they were setting up these targets. Anyway, you get the idea of what it is.
Warren Hogan: I'd like to bring up another important idea here is can a central bank pick an inflation target, any rate at once? Can they target 6%, 12%, 4.37%? Can they target any inflation they want or is price stability a natural place for inflation to settle with a well managed central bank? Maybe in a fully closed economy they can target any target inflation that they want. Maybe in a big partially closed, maybe in a large economy.
Warren Hogan: In 2019, my strong view is that the RBA can't chose their inflation target. They can't. Inflation is not only a globalised process, it's a very tricky tool to target. What's happened? I'll argue that since we put our inflation target in place globally, the concept of price stability has dropped. I'm going to argue it. I can't prove it. I haven't done the work on this mathematically, but I think price stability is no longer an inflation rate of two, it could be one and a half, 1.4, 1.6, one? I don't know the number but it's probably low. Why? Because of all the technology, price transparency, competition, global supply chains.
Warren Hogan: This one hasn't come up. Back in the early '90s big part of the literature on monetary policy was target breakdown. You never hear it anymore. I had to go back to a Fed paper for the '90s to get this quote. It's essentially, back when central banks would target all sorts of things like credit growth and monetary aggregates and as soon as they started targeting, the relationship between their policy instrument and what they were targeting would breakdown and it's summed up by that "knowledge in the market that the behaviour of the measure is being used by the authorities to make policy decisions is very likely to alter that behaviour."
Warren Hogan: No one's talking about this with inflation targets, so I thought, "How could this work? How could it breakdown?" Then you look at what's happened in the last 30 years, if you're a big corporate, particularly a big global corporate and you sit there and you've got to fix your PNL up and get some profitability happening, you're not going to put up prices. That will just cause interest rates to go up. That'll either cost you more because you're carrying a certain amount of debt or it'll hurt the economy which won't hurt you because ...
Warren Hogan: So you cut costs, so there is potentially some weakening of this and it has affected behaviour because everyone's so aware of that and I think it's pretty obvious to all that the corporate sector is much more focused on costs and things like from wages to supplies, globally and it's not just a cyclical thing. I remember maybe years ago, people say, "Oh, well, the [inaudible 00:28:43] all the profitability drive on Wall Street's about keeping costs down." Now this is structural for 10 years, that could be part of what's going on.
Warren Hogan: The other one is price flexibility. This is the big one. There's a big part of Keynesian economics, which is good, fine, that things at a downward price sticky. Well, things are more flexible than ever before. The wages side, which is the key one, the advent of bonuses across a broad range of community, maybe that's not broad enough. Casualization, gig economy, these sorts of things, there's a lot more price flexibility. The point I'm getting at is the price stability, the effective rate of inflation, might be lower than what it was 30 years ago, and I think the evidence we're looking at is the US economy is being pushed to its limit in the last five years and it's just, just getting 2% inflation, maybe [inaudible 00:29:37] to save it for your time.
Warren Hogan: Inflation is hard to come by and maybe this is part of that story. Maybe I'm wrong. Australia needs a flexible inflation target, so global inflation 2%, maybe that's too high, well, let's not argue about that, we're at two to 3% and I think that just seems too high. Why did we go for two to 3%? For the reasons I'll argue is why we should widen it, to give the RBA more flexibility, more judgement and the key one is, when we would put up our inflation target, Bernie Fraser who is one of the key policy makers, economists involved in this just didn't want to get pinned into a corner. Australia was still inflation prone. I think New Zealand was the one talking about zero inflation or zero to two and we've heard all the strict interpretations of these inflation targets to gain credibility.
Warren Hogan: Well, a lot's changed since then. He wanted two to three to give him flexibility or a small open economy and commodity exporter, all these sorts of things were inflation prone. Well, now things have shifted and the big that shifted is so much of the inflation process is determined outside of our borders and I think that's real, so I would argue that we need to deal with this new world by not having a lower inflation target as such, but having more flexibility for the RBA. I believe that's the path they're on. They're just going to have to make that path themselves without the target.
Warren Hogan: Okay, so I actually think inflation's pretty much back to normal. You can't see it but that's one to 3%, that's the '70s. The '70s was a complete outlier. We're having these periodic sort of threats of zero inflation, the long history of inflation from the US to UK, this goes back to 1860, this goes back, it all averages out at around two. I'm not sure that the inflation rates we're seeing now are crazily out of the ball park of normal, 1.6, 1.5, two, but some of the policy remedies we're talking about are way outside the boundaries of normal, and it's a question of whether or not we should do it.
Warren Hogan: Final point, should we change the inflation target, and every time I bring this up, I feel I just get a lot of water poured all over me from every person around me, "But, no, you cannot do that." It'll unhinge inflation expectations, which is a perfectly legitimate response, particularly when we're right about the zero or lower bound and we're worried about the downside, but I would argue that this is the 10 year implied inflation expectations from Australia's financial markets. It's not great but it's good time series versus actual inflation. Hard to see, that's the centre of the RBA target, there's no doubt that the RBA target plays an anchoring role but inflation expectations, like most expectations are determined by what's going on now. People basically just project forward.
Warren Hogan: The scariest thing going on right now, I mean this is a great example. Inflation spikes before the crisis, the RBA responds but inflation expectations go with it. It's below that, there is an anchoring, it's holding it back and it does typically do that all through. Right now, though it's going the other way. Inflation expectations are moving away from both the target and from actual inflation and I would argue that you talk about credibility, shifting the target from two to three out to one to three is going to undermine inflation expectations, undermine credibility, all this sort of stuff. Well, I'd hate to see the RBA's credibility damaged by missing their target for a long time. I don't have a thorough answer for that.
Warren Hogan: To bring it back here, the Sir Leslie Melville Lecture, which was delivered last week. I'm finding some hope in this, because I think, our governor, I think this stuff is ... He knows his stuff better than me, way better than me and he's talking about our mandate as much better than some of these rigid arrangements. Well, you could argue, that's been the case for 30 years, so there's actually not all that new in that, he's emphasising it, but it's his idea of the long term maximisation of the welfare, the idea to look beyond just needing to mechanically get inflation back into its target and hopefully, this messaging is part of the process of saying, this country, which is going through a soft patch, but it's not exactly an economic crisis or disaster is not needing to go into realms where there's monetary policies.
Warren Hogan: I would actually argue, many more rate cuts and quantitative easing, while economic activity is growing around zero to two and while unemployment's around four to six, I'd say that's not the right way to go. They've got huge pressure on them and it's not about saving your powder for another day. I just say that they've got to take a long view because there are costs.
Warren Hogan: All right, I'll leave it there. Time to hand it over to the panel. Thank you.
Kylie Richards: Okay, so I'm sure we'll agree that was a excellent presentation by Warren. We'll jump straight into the panel discussion. I'll start with Joseph and with a question and then you can make your comments on Warren's presentation.
Kylie Richards: Is there anything about the Australian banking system that makes this current monetary policy environment particularly difficult?
Joseph Healy: Yes, I mean, clearly the banking system within the financial system ... and our banking system is very large within our financial system ... plays a critical role in transmission of monetary policy into the real economy and there are three things that I would like to highlight that concern me and I think it plays much to the thesis in Warren's comments.
Joseph Healy: The first is the unique nature of banking institutions. I will come onto that, back to that ina second. The second thing is the bias that we've seen within our banking system or certainly over the course of the last decade and asset price inflation or bubble implications that are attached to that bias and the third thing, is strong evidence of a market failure in the operation of the banking system, particularly as it relates to the small to mid size business economy.
Joseph Healy: Those are the three key themes I want to touch on, they're interlinked, but if I go to the first theme about the unique nature of our banking institutions. Banks operate in a free market as normal private sector actors, but the only thing other than normal private sector actors, they're very unique and special institutions that are protected by government and by society in three important ways or are privileged by society and by government in three important ways.
Joseph Healy: The first thing is they are protected from the risk of bankruptcy. As we saw in the United Kingdom and some evidence in the United States as well, that in extreme if the banks get into trouble through poor risk management, then the tax, they have a call option on the tax payer to step in and correct the situation. Everybody in the audience understand the reason why that call option exists, because the implications of a bank collapse and the contingent effects are just too serious across the economy to even contemplate. They have that wonderful protection from bankruptcy.
Joseph Healy: Secondly, certainly amongst the big four banks, they have the protection from take over through the so called four pillar policy. Again, incompetent management or management that's subject to a high risk, moral hazard risk, because of that tax payer call option, is also protected from take over. That incentivizes a certain way of thinking about your business if you believe you're a true private sector actor there to maximise ROE and link to ROE incentives and so that's an important thing.
Joseph Healy: Then the third thing, of course, is that the banks are also privileged by the fact that the government supports their deposit taking activities through the ADI licence that they hold that individual deposits are guaranteed up to $250,000 by the tax payer. There is no other private sector industry that you can even stop to think of that has those unique and special privileges. They make them quite separate from anything else you see in a market economy.
Joseph Healy: Now the reason I call out those unique and special privileges is that with those go responsibilities and those responsibilities can loosely be called the social licence to operate in a way that society and the economy would expect the bank to operate in the efficient allocation of capital across the economy.
Joseph Healy: This leads me onto my second point around the biases that we've seen in the banking system over the course of the last decade and that is a huge shift towards a household balance sheet away from the business sector. I won't get into all the stats because I'm sure other panel commentators or members will talk to some of that, but one of the obvious facts is if you go back to 2000, that stock of business lending through the banking system was sitting at about 63% of GDP, stock of lending to GDP was about 63%. Last year, that's figured in the mid-40s so there's been a huge drop in the banking system, even though the banks' balance sheets have grown exponentially during that period, but that growth has been in a household sector that most commentators, if not all commentators would say is very highly leveraged and represents a significant macro economic risk to this economy.
Joseph Healy: That bias is a significant one and my argument there is that that is a bias that demonstrates the banks operating without due regard to that social licence and that implicit mandate of insuring efficient allocation capital. It's banks acting as private rent seeking, maximises seeking to achieve the highest ROE that it can by allocating capital to asset classes that for some obscure reason, theoretical reason has been given such a low risk [inaudible 00:40:08] under Basel II and it's made a distortion in the way that the banks, banking system works.
Joseph Healy: This leads me on to the third factor which is a market failure and is a consequence of the second factor. What we've seen is a banking system that has really failed to meet the financing needs of our small to mid sized business economy and there are lots of proof points for this. I mean some of the research that the Judo Bank undertook through a third party research firm, quantified that unmet SMB credit demand at $90 billion. Three years ago Macquarie Bank equity team estimated that figure to be at $70 billion. Even if those of numbers were half to $45 or $35 billion, they're material gaps in the financing of our small to mid sized business economy. There's a multitude of reasons for that outcome but one of the major reasons is this bias incentivized by lower risk capital weightings resulting to Basel II.
Joseph Healy: These factors are significant, I think, distortions in ... Certainly the second and third factor are significant distortions in the way that the banking system has transmitted monetary policy. The high leverage that we see in the household sector, historically, when businesses or households were in a high level of debt, inflation was the get out of jail card, because prices rose high enough that you could actually over time, the debt burden wasn't a great concern. With the collapse of inflation as a remedy [inaudible 00:41:44] to high levels of debt, the risk in the micro economy to leverage in the household sector, I feel, is at a very high and unacceptable level largely through a banking system that has acted as a free private sector firm without due regard to some of the expectations that society will have of them.
Joseph Healy: On that note, I might conclude my remarks and pass on to Adam.
Adam Creighton: Okay, thank you very much, Joseph. There's always a bit of pressure on journalists to say something fun or interesting and fortunately this evening, I do actually have a fun fact for you and I'm going to broaden the debate slightly from central banks, per se, to the financial system or generally a look at some of the issues there. I think it's the problem of the explosion of credit if you like that's occurred in the economy over the past 10, 20 years which is really problematic.
Adam Creighton: Now I want you to ... the price of a median dwelling in Sydney at the moment is about $818,000 and the price in gold is 378 ounces, and that's about 10 kilogrammes in case you're wondering, so it's half ... Basically half the carryon on a standard Qantas flight. That is equivalent to a median Sydney dwelling and I thought, "Well, what was the price of a median Sydney dwelling in 2009?" Well, it was 373 ounces of gold. It's basically not changed at all. There's been huge discussion, of course, about massive house price appreciation but if you actually look at the price of a median Sydney dwelling in what used to be currency, for a very long time in history it basically hasn't changed at all. It's gone at 1.3%, so there's been a 75% increase in Australian dollar terms. There's been a 1.3% increase in terms of gold.
Adam Creighton: The reason I give you that statistic is just to think a little bit differently about whether it's really asset price appreciation that we've been seeing, and actually rather a huge depreciation of the Australian dollar, huge depreciation in terms of what you can buy. It takes a lot more dollars now to buy a house than it did back in 2009, when the median dwelling price was $470,000, now it's $818,000. I just wanted you to see the world slightly differently and realise that with the extraordinary explosion of credit that that has actually debased the value of each of those units.
Adam Creighton: Your credit in Australia just in the past 10 years has gone up from $1.9 trillion to $2.9 trillion in just 10 years. Now that's quite extraordinary increase. The reason I think people don't pay much attention to this is because most people think that banks lend out money. I mean as a journalist, we always write borrow and lend all the time, we say lending, but actually banks create money. They are manufacturers. They could almost be classified in the manufacturing sector. I mean they basically manufacture credit.
Adam Creighton: Two years ago, I mean, I got a mortgage, so let's say I borrowed a million dollars, right? So I went to the bank and that bank obviously credited a million dollar asset and at the same time it credited a million dollars on its liability side. So that was new money, that million dollars was not there before. I did not borrow from anyone. No lent to me. That is new money and so that is how on a mass scale, over a long period of time you get extraordinary increase in the amount of money circulating in the economy, and have gone from $1.9 to $2.9 trillion.
Adam Creighton: Now over that period, the household saving ratio was extraordinarily low, right, so just to challenge you, if you're thinking on or "You must be wrong, Adam, this is crazy ..." Well, if the household saving ratio is basically zero for a very long period of time, then how on earth could the amount of credit have increased from $1.9 trillion to $2.9 trillion, unless it was new money that was created by the financial system?
Adam Creighton: Okay, so just think about that and so my point there is that we have this system where privately created money, as credit, and this is the money that is created by the banks, there's an incentive for more and more of it to always be created. Banks have an incentive, a private incentive to keep creating credit, because they profit from the difference obviously. I mean it's an amazing business ... I was just saying to Joseph and he certainly agree ... I imagine that in a way the bank makes a loan, it gets the net interest margin of this new money. It's a fantastic business.
Adam Creighton: Of course, it's a licenced business, you must have a banking licence to do that, but so I really think that we need to focus more on the broader financial system, rather than just focus on central banks and look for instance, consider the Reserve Bank, its balance sheet is a $168 billion, I think, roughly at the moment, right? That's obviously a lot but the Commonwealth Bank alone is $975 billion, so I would argue, the Commonwealth Bank has vastly more impact on the Australian economy than Reserve Bank does. I mean certainly in a hiring and firing sense it does, but also in terms of what it does with its balance sheet, and remember, that's just one of the Big Four banks, right, now with $975 billion.
Adam Creighton: So the Reserve Bank's a really, really small financial institution, so my first point is basically think more about the creation of money as a potential problem. Second point, and this is just some very brief remarks on some of the things that weren't said, impact on savers, should we be really worried about saver? Kind of my comment would be not as much, because I don't ... I mean the Reserve Banks even said recently that only a very small percentage of households are really relying on a lot of interest income. I mean overwhelmingly, households are net borrowers.
Adam Creighton: The health of banks, should we be concerned about the health of banks? I mean I don't think this is a major concern. I mean if our bankers are earning $500,000 a year instead of $700,000 a year, I don't really think that that's a public policy matter, but look more seriously, Japan has had zero interest rates for about 20 years and net interest margins there are still 0.8 and the banking sector is still thriving. There are still very well paid bankers in Japan, I assure you, so I don't think we need to worry about banks as the official interest rates go to zero.
Adam Creighton: Other point, yeah, we talk so much about zero interest rates all the time, but I mean, are we really living in a zero interest rate world? I mean do you experience zero interest rates ever in your life? I mean I wrote a story recently in the RBA that showed actually, well, the RBA cut rates three times ... That's for any Australian, not the RBA, well, the RBA cut rates three times, credit card rates went up. They actually went up. Business lending rates did not change at all and they're about seven or 8% and that's even when they're secured. So that's not zero interest rates. Even mortgages are still three and something, so I mean I think in practise we are not in a zero interest rate world, so I think it's important to keep that in mind.
Adam Creighton: Finally, shifting the inflation target from say two to three to one to three, I mean I do find these debates somewhat comical because I think so few people in Australia would even know what the inflation target is. So I mean, try asking your mom, you know, "What's the inflation target?" I bet she doesn't know. This huge drama about whether it's one to three or two to three, I think is rather comical, because I don't think the central banks have anywhere near as much control over the rate of inflation as they like to think they do.
Adam Creighton: I mean, there is in fact zero empirical evidence or systematic empirical evidence that there's any relationship between these short term cash rate and the rate of inflation. In fact, there's probably negative, if you just did a straight correlation, so I'm very kind of hesitant of that getting too involved in the inflation [inaudible 00:49:02] debate, because I think it's all somewhat of a Wizard of Oz effect if you like. There's just a lot of talk, a lot of discussion, a lot of theory, but certainly if you ask people, in the street what they think the rate of inflation is, they're going to say three and a half percent, 4%, that's what surveys say. They don't think it's between two and three. They certainly don't think it's 1.4.
Adam Creighton: Look, I just think because of that, we don't need to obsess so much about inflation. I think that's probably taken up my time.
Tony Morris: Thanks for the invitation to come and speak. I'm going to try and add a little bit of an international perspective on some of the points that Warren and the panel have made around this. I looked at this as sort of two questions that we've got to answer. One is monetary policy gone beyond its effective means and I think, I don't know if you've heard this term, this race to the bottom. I think we're there already.
Tony Morris: In terms of Australia, it looks like monetary policy's done. If you think about that race to the bottom and all of that dynamic was competitive currency devaluation, and some of the studies that we've done now, is that relative interest rate, differential some central banks is just having zero impact on currencies at this point. We've got there and we're dealing with the consequence of it, so I think that kind of point has been made.
Tony Morris: In terms of this issue of central banks destroying capitalism, I'll go into that a little bit more. I'm not really ... I know you're up there for hyperbole a little bit there, Warren, but I think that's not entirely the question that we should be asking so I want to talk about that a little bit. Now going to your charts and how did we get here, I think that they were really interesting in bringing two periods into sharp focus.
Tony Morris: One was the outbreak of inflation through to the 1970s and '80s and that was causing a lot of economic and political distress at that time. Volcker, you were right to point it out, when you look at the chart of US bond yields, for example, that was the peak and all the process since then, since Volcker and then our own inflation targeting in the '90s has been successful in bringing that inflation ... It's a 30 year process and I think a lot of us who ... I'm unfortunately old enough to remember most of that period. They've been successful.
Tony Morris: Now the next phase is this unhinging or this paradigm shift that you highlight as well, this breakdown between interest rates and the rate of inflation. I think this is a really interesting phase and I think is what mostly what we're talking about here and I'd like to talk about those countries, particularly Europe and then we'll go on and talk about Japan, but what's happened in Europe, so if you remember the response to the GFC, massive QE, the expanse of balance sheets, for example, but not negative interest rates.
Tony Morris: It was only after Mario Draghi made a speech in London, 2012, it was at a breakfast at the Olympic games in London. Some reports that he was actually drunk at this thing, but he said, "We'll do whatever it takes to save the euro," and two years later, the European Central Bank after having gone into bought QE, which is where you buy bonds and anchor that long term debt, they moved into negative interest rates in June 2014. There's a tick on Bloomberg series, so you can follow the amount of negative yielding debt around the world and at that date ... Because I remember the year, the Reserve Bank target interest rate at that time was 2.5, our 10 year bond yield was three and a half. There was zero.
Tony Morris: Now in August at this year, that reached 17 trillion. My favourite sort of stat there in terms of Europe going to negative interest rate, minus 60, for example, there's $13 billion of junk debt in Europe that yields negatively. That is junk debt, that is a likelihood of defaulting. It's just crazy. Actually, there has been a change, I think, and only recently, I think, this recognition that negative interest rates should only be there for an emergency, separate from QE, for example, but that damage has been done.
Tony Morris: You look at the other countries now that got a negative ... I think Japan's a little bit different, but you've got Denmark at minus 75, so you can get negative mortgage rates in Denmark, if you can get your head around that. Sweden's really, interesting, Denmark and Switzerland, just because so much money was going out of Europe into Switzerland. They've got minus 75. Sweden only this month announced that it was downgrading its growth forecast. It was downgrading its expectation for inflation, but it was about to start raising interest rates, because they're at minus 25 and they've realised this is screwing up the system for all the reasons that you've highlighted there, Warren.
Tony Morris: I think that's a really big change and we've got a new head of the European Central Bank, Christine Lagarde, very capable politician, so there's one [inaudible 00:53:21] expectation she can navigate Europe. For Germany, which runs a current account surplus, an 8% of GDP to expand its fiscal balance, if you will, to get Europe working again, but the damage in terms of the banking system has been done, as far as I can see. We'll see if she's successful in terms of changing that around. What I did hear is that she might change the voting on the European Central Bank.
Tony Morris: I mean, this has just got crazy in Europe. When we evaluate what the European Central Bank does at a policy meeting, there are five different criteria by which we work out whether they're easier or not. That's guidance, that's tiering, for example. It's just absolutely bonkers, so it'll be really interesting to see if she has some success there, so they're at minus 60.
Tony Morris: Now if you plot, from these charts as well, it was really interesting, German bond yields through this period as well, and you overlay Australian bond yields. They're almost correlated one for one at a different level, until this year, until the Reserve Bank of Australia basically Phil Lowe said, "We can't ignore what's happening in the rest of the world. If we did, it's basically our currency would go through the roof." As a small open trading commodity country, it will be just uncomfortably high, so we followed that but that's almost one for one, so I think when we look about what actually changed, we've got to be looking at Europe. I think that's a really important point.
Tony Morris: I do want to say, a few positive words about the Reserve Bank in terms of they're quite rightly coming under scrutiny in terms of communication and all the implications, for example, but Australia hasn't gone into recession for 27 years and you look at our GDP, for example, from 1986 through the 2006, GDP was 3.5 and since 2006, it's 2.6, so we're pretty close to trend. So we've got some special issues at the moment. They've made it quite clear they don't want to go negative but we are at 0.75 now. The next step might be quantitative, for example.
Tony Morris: My own view on the inflation target, we're the only central bank in a developed world with that midpoint of the inflation target above two. So I thought maybe if there was a change in government, or the new government, maybe we should review it, maybe bring it as you suggested. I think it's a good debate to have, one to three. I actually, think the effective target at the moment is two. Josh Frydenberg has given them some flexibility to meet that, so they're not going to bring rates down because the rest of the world's gone crazy, so you build up that imbalance in debt.
Tony Morris: I do have a few stats there in terms of what exactly that negative interest rate has done in terms of assets. Wages growth we all know is pretty flat, for all these reasons. So you look at the reasons why, for example, interest rates have got down here, so this is where I think the question should be: Are central banks destroying, not capitalism, but are they contributing to sort of the degradation of democracy? I think there's a lot of other issues there, but I think in terms of globalisation, those I think are more interesting questions as well.
Tony Morris: If you think what's driven inflation down, it's globalisation, it's China and India, tech disruption, ageing, and there's only so much the monetary policy can do there, so what these rate cuts have done on QE is driven up prices as Adam rightly pointed out. Some numbers around that just to put it in perspective from my point of view, when you've got bond deals that have got down below 1% so the ASX here is up 80% since 2011. The SMP in the US is up a 190%. House prices ... I know that you can take it in non-nominal terms so there's even enough to the correction last year in Australia 50% over that period, 80% here in wage in Sydney.
Tony Morris: RBA own assessment of financial assets for the households as a percent of income in 2000 it was 450% of income, it's now 750. Remember that wages here are growing at 2.2 so this gap, huge politically significant as well, and I did actually go out and check the GNE coefficient from Australia through this period as well. It's kind of interesting, so you have to rely on a combination of the United Nations and CIA to get a really good insight to GNE coefficient.
Tony Morris: So for Australia, in the '90s, it was 30.9, in 2000, it's 31.7. In the 2000s, it's gone up to 33.6, but we're still way below the UK at 36, China at 38.6, and the USA at 39. Even with this distribution, we're still doing okay, and on a really positive note, something that hasn't sort of come up, it's even picked up, you know the nations also do this human development index as well, and guess where Australia comes in? This is one life expectancy, years of schooling, and Gross National Income per capita, we are third in the world behind Norway and Switzerland, so negative rates there, don't ... we're doing too bad at all.
Tony Morris: I know I've spoken quite a long time, I did want to broaden it out a little bit in terms of saying what the implications are of all this. Our team in New York, our investment team put out note this week and it got picked up by the APCSE, so if you want more detail around this, but just very, very simply, considering we've gone through this decade of zero interest rates and assets going up, what happens next? They think that going into this period of quantitative failure, the consequences of which we're increasing protectionism, redistribution, reflation, and higher taxes ... so I think that's the next phase, we'll have the consequence of all this is we move away from monetarism much more back toward Keynesian as well, but I'll leave it there in purpose of time, but thank you very much.
Warren Hogan: Thank you. All right, I might just have a couple of quick comments, because I raced through my section, Tony you talked about the end game here, which I think is what everyone is really interested in. That there's a real political channel operating, whether it's the inner quality piece or through a less vibrant economy, people can rightly say, in my view, that, well, we're not getting the benefits of a free market or a capitalist society.
Warren Hogan: One of the key benefits is innovation, is rising living standards, is the shifting of capital. It's obviously a difficult process that we can get better at managing, but if we short circuit that and if we don't get the productivity and we don't get that increasing living standard, the political support for the system may come under pressure as well. That political channel's also an important one to think about, not necessarily in a few years, it might take a decade, what have you, but if you're not getting those benefits ...
Warren Hogan: Look, I'll leave my response at that.
Kylie Richards: We're going to move to audience Q&A or comments. I'll actually kick it off. I'll come over to you in a sec. I'm actually going to bring this back to the title about destroying or the Destruction of Capitalism. We talked about this having its roots in Caines interpretation of money. If we think about in the US, was the so called Greenspan put the catalyst or the nail in the coffin for the US and how does that play out for the Australian economy?
Tony Morris: Yeah, I just referred to the period where, that went in terms of collapsing on inflation, but the Greenspan era was when he went through that whole series after the great technology crash and he just raised, raised 25 base, 25 base points, you just go and see the big shore about what that sort of did to the US economy and I think then you go into the big crash, the GFC, for example, very different between Australia and the US where you had non-recourse mortgages over there and now the response.
Tony Morris: What kind of worries me now is, one, that the US has tried to "not so called normalise" after that experience, but because the rest of the world was negative and going even more negative, they've had to turn around and get rates lower. That sort of sullied US monetary policies as well. Trump is perceived as pressurising the Fed. "Look at those guys in Europe, they got negative rates. You guys are useless," that kind of thing.
Tony Morris: That's not helpful from anywhere at all and I also worry in terms of regulation, it goes back to banks, as well, so a lot of the regulators, rightly so, going back to the lessons of the GFC. But when you've got this increase in the monetary base, and yet the banks are not lending or as they're lending it against housing, for example, then maybe you could make the argument that maybe they're fighting the last war and not getting ready for this next challenge.
Kylie Richards: Yup. Okay.
Warren Hogan: Just on the Greenspan point, I think that concept that the central bank will bail out the markets is a really dangerous one and I do think it's part of this story and it's part of this idea that constantly worrying about the downside, of this idea that you shift from being a central bank who's primary role is to make sure the monetary stability of the economy is intact to then having a stabilisation role, because I actually think the monetary stability piece ... I mean I think separating the prudential piece out of central banks was a stupid thing to do, so I think ... but then gets the point where actually, no, it's just all about saving the day and it undermines risk appetite, which is fundamental to the great challenge of capital allocation, which is all about decision making and uncertainty and I think as Tony said at the beginning of that is ... I mean that's clearly an important foundation point for the GFC and all the problems that we saw there.
Kylie Richards: Okay. Great. I'll start over here and ... Oh.
Speaker 8: Thank you, Professor. You mentioned earlier in your modelling and forecasting, quite a bit of mathematics was used. Are you able to ... or would you mind elaborating on that? I studied mathematics myself, so ...
Warren Hogan: Did I mention that? I used a spreadsheet. No, I don't think I recall mentioning that, did I? No, but there's plenty of maths in economics so if you want to go and get a second degree, you can knock yourself out. In fact, there's a lot of people who think economics has been destroyed by over mathematization, if that's a word and I actually think there's a theme in this about really smart people, people in ... Well, in academia, but in these policy making institution to really all over the theory and a lot of it is highly mathematical or at least have mathematical frameworks and they're losing perspective of that thing out there called the real world.
Warren Hogan: Often, I've said it all my career, one of the things I love about economics is when something that seems like common sense an economist can go, "But, yeah, this is counterintuitive, but let me just explain this. It's a lot like free trade. A lot of people say an economist can explain why it works for everyone, so there's lots of examples of that, and I think ... What is that, the smartest ... Anyway, there's lots of examples. Right now, we're in a world where I think some of the really smart economists who have got such a strong foundation in theory and stuff need to take some advice from people with just a bit of plain old common sense.
Warren Hogan: It is a tricky one, but I do think there are moral boundaries around zero with interest rates, and I do think that in our banking system, an interest at this level or below is starting to muck around with its functioning, in terms of its profitability, its risk appetite, its ability to extend credit into the economy, and you've got to think about that.
Warren Hogan: Look, I think that's one of the problems, and this, same with a lot of technical things, is that getting that mix of the theory and the applied right is really important and is a lot of really just common sense practical stuff that needs to be thought about right now when it come to this issue. I think, I didn't even know that Sweden had decided to reverse negative interest rates, just because they realised it's not working in the system.
Warren Hogan: Because it's quite easy, a lot of things work theoretically. The interesting one on this is Ben Bernanke actually came out as a really silly comment from [inaudible 01:05:19] but he said in like 2014, "Actually QE doesn't work in theory." It's like ... "Well, as we now know, it probably doesn't work in practise either, Ben."
Kylie Richards: Okay, so over here.
Speaker 9: So in a parallel universe, the banks followed the RBA downwards with each and every interest rate reduction. Would any of the panel members care to comment? Perhaps, Tony, with your wonderful analogy around the 10 kilogrammes of gold per house ... Oh, sorry. 10Ks of gold per house, that was ...
Adam Creighton: Oh, sure, well, just in terms of how much the banks pass on the official rates, I think this is where the interesting issue is. I mean, both from a journalist point of view and from a political point of view is the power of the major banks to withhold their market power and I think as wages stagnate in the economy and in Australia, we're really seeing a battle over economic rent between ordinary consumers and large corporations and this is going to be a really tough battle, a really awkward fight.
Adam Creighton: In the old days, you could have heaps of rent and you could also have wages growing at 4% a year, so everyone was kind of happy, but that's now over, and so I think you're going to see a lot more confrontation, political confrontation between major banks and the government and that's why you're seeing this push for them to pass on more. I mean I think that they're just withholding it for, just as the Prime Minister said, profiteering reasons. I think this argument about zero rates is not relevant in Australia yet. It's just not a factor, and look, we've just seen all the banks report their profits in recent weeks, they're all doing really well, and they're making a fortune, like ROEs of 10% roughly, that's very good on a global level. It's just that they have the power to withhold that.
Adam Creighton: Do you want to make a comment?
Joseph Healy: Yeah, just to add, I mean, it's on the question of profitability. I mean, the banks make a lot of noise about declining levels of profitability. They point to ROEs having come from the high teens down to 11, 12, 10%. What they don't say is that the cost of capital has come down, as well, quite significantly, given the discussion that we're having and so they rent over and above cost of capital highlight an industry that is profiteering and an industry that lacks any real competition to address the power that the major banks have by virtue of public policy interventions in the past.
Joseph Healy: Mentions of ROE, which get a lot of focus are incomplete statements because you have to obviously look at the risk adjusted cost of capital that the banks have been, have seen progressively come down.
Kylie Richards: Just ...
Donnie MacLurcan: Thank you. Donnie MacLurcan from the US based Post Growth Institute. I want to pick up on Adam's great point about money creation. I talk to people about this all the time and the common thinking that comes from discussing how money's lent into existence is that then people think that debt and money match up but of course you have interest on debt and with the global debt aggregate at the moment at $247 trillion and liquid money at $90 trillion, there's a piece that gets missed, which is that the majority of the bond market when bonds are introduced into the market, don't increase the money supply because they're not bonds that are being purchased by way of central banks.
Donnie MacLurcan: My question here is are we actually heading with that kind of dilemma? Are we maybe missing something by not looking at the ratio of aggregate global debt or within country debt to money supply, when we're always looking at debt to GDP ratios and are we perhaps even on the way towards secular stagnation?
Adam Creighton: Well, that's really a hard question. I was just thinking, "Whoa, so deep, so deep," but, well, look, I think most central banks still do publish these aggregates, they do have all this information. That's how I got today the $1.9 trillion, $2.9 trillion was I looked up the ABA website, which has fantastic stuff on monetary aggregates and this sort of thing.
Adam Creighton: I think there's going to be a partial shift back to previous years when people looked at this stuff more. You know, comparing things to GDP all the time is actually really frustrating because it's ... No one even knows what it is for a start and it's extremely hard to measure. Everyone just says, "Income," well, it's actually not. I mean, it's actually a very technical thing and it's a flow. Stocks are far more interesting than flows. I think this is the great gift of Picketty's book. I mean it had flaws, of course, but it's a wonderful book, but he finally reminded everyone to talk about stocks. They're way more interesting than flows.
Adam Creighton: I think we're going to be looking more at stocks, going forward. Yeah, so look, I mean I can't add any more other than that. It's a difficult question.
Joseph Healy: I was just going to say that I think there's far too much weight put on the stock of debt. I mean it's an important headline figure but debt plays different roles as to where it's allocated in the economy and so what you need to understand is where is this debt being allocated. If you've got $1.7, $1.8 trillion of debt sitting in the household balance sheet, which has doubled in the last 10 years and 30 or 40% of that is tied up in buy to let or investment property, which is speculative investment, and then you've got X amount of debt in the SME, [inaudible 01:10:58] X amount of debt. I think that's the key analysis is where is this debt going and at the margin what is the economic contribution of that debt, that's more meaningful piece of analysis in my view.
Adam Creighton: Just one more very brief comment, I think that the debt will grow a lot more than it currently is. The $247 trillion, I reckon we can get to $350 trillion, I reckon before there's a real problem, because I just think this our economic model, right. I mean we've really hitched our waggon to more and more debt, I mean that's basically what central banks are trying to do to revive growth, get people to borrow more, even though debt was the problem in the first place with the financial crisis, but I think there's a good kind of decade to go before there's a real problem.
Tony Morris: You know, I just want, very quick, some numbers around this in terms of government bonds, for example, the largest government bond market in the world, US and Japan, Japan 60% of JGB, Japanese Government Bonds on issue is actually owned by Bank of Japan. Japan just recycles its own savings. Italy, the third largest bond market in the world, a lot of those bonds are owned by the ECB, so I'm not sure that looking at the bond market holdings and flows, relative to money supply.
Tony Morris: One bit of data I didn't cover actually, even in the US, for example, through this whole period of QE, US excess liquidity since 2009, amount of money that they've put out there has risen by 300%, and yet M4 credit growth has just been rising at 2.9% and Europe, with negative rates, that credit creation process has just been absolutely broken because they're penalised. They just don't want to lend, so I'm not sure about that relationship.
Tony Morris: When you look at the stock of debt, there's some very strange holdings out there, which might distort your analysis of bonds on issue.
Desiree Lucas: Yesterday, Swedish banks, [inaudible 01:12:41] Bank, basically divested from Australian carbon intensive bonds, so we have an economy strongly dependent on fossil fuels at a high risk of climate risk, so what do you think should the role of the RBA be ... low carbon transition?
Tony Morris: I saw that story. So they also got out of Canadian provinces as well, it was I think British Columbia or Alberta. It was Western Australia and Queensland, Queensland on coal, kind of makes some sense, WA, I'm not sure the rational there in terms of the liquid natural gas, which is much cleaner energy is a major part of the growth of those WAs .... Anyway, I can see where they're coming from in terms of that.
Tony Morris: In terms of the RBA, I'm not going to comment on that, other than we are seeing a lot more states, for example, today I think the state of New South Wales issued a sustainability bond. You're going to see far more green bonds, it is a thematic around ESG investing going forward, and again, a bit of data I picked up from the US, this is the kind of view from our US investment team over the next 10 years. They think in terms of "moral capitalism" is one of the big things going for it. They expect $20 trillion of assets under management's going to go into the SG strategies over the next 20 years and that's equivalent to the market cap in the SMP, for example, so maybe that theme will continue.
Warren Hogan: I think the RBA has enough things on its plate without having to worry about that. We do have plenty of other potential policy failures on that front elsewhere, but let's not pin that one on the RBA.
Joseph Healy: Because it is an example, I think, it goes to your comments earlier on, because this is a role for the capital markets and if the capital markets are saying that we don't want to fund these business models, then you have the beginning of Jean Peter's creative destruction, which you said was absent from ... was not clearly evident in the capital markets. The more that the capital markets say that these are no longer businesses that are going to attract capital, then you start to see a change, if that happens widely, then you start to see a change of the level of investment in those industries and that's the market. That's how the market functions.
Warren Hogan: [inaudible 01:14:50]
Joseph Healy: Yes, yeah.
Speaker 13: Thank you. I'd like to come back to your presentation, Warren, on the costs of having extended periods of real policy rates will allow the real growth rates and you had the chart for Australia. I don't have any particular issues with most of the costs that you put up, but to me, the real question is what are the alternatives and what are the costs of the alternatives. If you're sitting in the RBA, you could just accept that the new norm is a lower rate of inflation, reduce your inflation target, that's not going to help inflation expectations. You can argue whether it would reduce it, I think it probably will but it's certainly not going to help it. You could raise policy rates in the environment where there's growth in the economy, but it's not that strong. That's probably going to reduce inflation and inflation expectations.
Speaker 13: Those alternatives, if you look at them, then the next presentation we'll be doing are what are the costs of deflation and the cost of deflation may be greater than the cost that you've delineated.
Warren Hogan: No, it's really a point and I certainly not saying that the RBA should take it's real rate back up to the, yeah, rate in growth of the economy because that would be madness and I'd never do that. I think it's about that this idea of an effective limit is maybe I'm sort of hitting it, I think, that we're somewhere near it. It's what is your real rate so far away and that might even not be the best measure but once you sort of sow stimulatory and have been for so long that you're not ... There's a whole debate going on out there whether any rate cuts do anything good. Like it's not about my long term cost, it's just whether or not they do any good and then if you throw on top of that, the costs and somehow quantify that, which of course is very difficult, then it's this idea that you just slow down.
Warren Hogan: I've seen partly this is my response to looking at the commentary out there, which is just cut, cut, cut, QE, QE, QE, and just keep going and I think that's ... and I don't think the RBAs at all thinking like that, but I think even entertaining QE at this stage of the game is insane.
Warren Hogan: In that frame, the counter factual frame, I would ask ... The only reason you do QE is the currency channel, as Tony alluded to and they're obviously talking about that quite a bit ... either stop the Aussie dollar going up, because everyone's doing it, so I'd ask, rather than do QE in May next year, if the economy does take a step down if something goes wrong, but it's not ... If it's a crisis, fine, we can look at it, but if it's just a further slowdown and unemployment's drifting up towards six or something, rather than do QEs is wait and see what the Aussie dollar does. If it means the Aussie dollar goes to 72 or 73 or up by three or 4% on a trade weighted index, that's where their judgment's going to have to come into it and that'll be is that appreciation worth these long term costs.
Warren Hogan: Now, of course, the bird in the hand is worth two in a bush and when it comes to forecasting, it's probably even more than that in the sense that, one of the reasons we're in this globally is because the central bank, can see the job losses that will come without cutting but they can't ... Well, some of them will debate whether or not any of these costs exist, they certainly it's impossible to quantify, so you've got, I think, psychologically, we know that there's a skew. They're going to underplay the long term costs, "Mm, climate change," and over play the short term, for the short term benefits.
Warren Hogan: "Ah, this will cost us this many jobs," well, will it actually and are these jobs that were going to go anyway, and et cetera, et cetera, et cetera? So I think you're totally right. I would not suggest the RBA should be hiking rates now or anything like that and the other thing I suppose I'm getting at here is it I don't that the RBAs done a bad job. I think they've done a great job to this point. This is almost just my last little plea that let's not step over the edge, because I think we're right on the edge and I'm hoping the governor since ... You know, we obviously thought about this topic months ago, I pretty much put it together in the last few weeks, but the governor's come out, he's going to speak to the ABA and he's going to speak about the experience of unconventional monetary policy overseas.
Warren Hogan: Now, I'm hoping what comes out there is, it works pretty good in a crisis. We did a bit of it back in 2008, but actually it's not clear that it did much, it had much benefit and actually there's surmounting evidence that can be counter productive, so in a crisis we may go there, but we're not doing QE. I really hope that's the tide of it, because I really don't think ... I think this is just a live experiment and too much is at stake. The political pressures on democracy, I mean we've gone from 1991, end of history in the last man Francis Fukiyama to this place is burning and monetary policy is seemingly the only active macro tool left and I think it's in territory that's not helping the cause of just ...
Warren Hogan: I mean if you believe in democracy, if you believe in stability, the sort of stuff, that's getting very dramatic now, but I think it's important that we tread carefully from here, because the situation's delicate and then, you know, Trump and the Trade War, I mean this is just basic reversal of what economists have been trying to talk about and the foundation of prosperity, not just for years, for generations, we we've got a tricky world out there and it's a really good time to tread carefully with a non policy actions, would be my advice.
Adam Creighton: Just on the hubris issue, I just think central banks have just kind of given the impression that they have far more control than they do. I mean they've been telling us for decades that they can micromanage the economy and then the financial crisis came along and it was extremely humiliating for the central banking and regulatory community, but the perception is still out there that they can say, "Reduce the unemployment rate to 4.5%," now. The Reserve Bank said recently that that's kind of the target rate.
Adam Creighton: We just saw today the unemployment rate went up to 5.3% almost on cue, just after they said that they're going to reduce it to 4.5 it started to go up. I mean the breakdown in the relationship between inflation and short term rates is almost comical. I mean it's almost the opposite of what their theory suggests should be the case, so I think what is needed is a great dose of modesty and just don't cut rates again, don't do QE. I mean the only lesson we have with QE from overseas is that once you're in it, you can't get out of it.
Adam Creighton: I mean Japan's been in it for 20 years and there's very little sign of the US or Europe getting out of it, I mean the US tried and it was hopeless. What was it? Nine months, a couple of rate increases and then, whoops, straight back again. I really think that we need to avoid it as much as possible and the central bank operates in a political context. I mean QE in Australia would be a disaster because Australians don't understand it. It's going to be written up by journalists like me as money printing, it's a great headline. It's going to happen over and over and over again and people are going to be very frustrated and scared and concerned about what it all means.
Adam Creighton: Look, at the end of the day, it is really weird. I mean, it is the creation of electronic money on a massive scale and the partial subsidisation of government, because of course, you're buying the debt with new money ultimately, so it lowers the budget constraint of governments, which is not necessarily a good thing. I just think we really need to avoid it.
David Langford: David Langford, just a couple of quick sort of points that haven't been covered so far, which are outside of the control of the central bank and the deflationary impacts of technology, first of all, and what that means and particularly from an importing deflation perspective. Then secondly, innovation and what the lack of innovation means for Australia and what low interest rates mean for the lack of innovation and what the government should potentially be doing about implementing tax policies which support us from being a very narrowly focused economy.
Warren Hogan: In terms of the policy piece, I think the whole idea here is other policy options need to be looked at. Way too much pressure is being put on central banks. Way too much pressure's being put on the RBA, and they feel a responsibility. They are genuinely good people who want to do the right thing by this society now and well into the future, but it's got to be handed off. They need some support. If anything, if the RBA was a little bit more holding back, there are other central banks who are holding back, that'd put more onus on the political class to do something, but they're letting them off the hook year after year, by being the ones who take care of it.
Warren Hogan: I mean you see it in this debate right now. I mean you get economists who say, "Oh, the right role for monetary policy is this and not this," and it's craziness. It's time for other policy leaders to take it up. Now I actually don't think the economy's in such bad shape that we need to panic and start throwing money at it, but this whole missing ingredient, the whole piece, if you want higher growth, if you want lower NAROOs and unemployment and all of this, you're not going to find the answer in monetary policy, you're not going to find it in fiscal stimulus. You're going to find it in structural economic reform, encouraging innovation, encouraging the flexibility of the economy. That's social judgement , that's up to us to decide.
Warren Hogan: We did an incredible job of structural economic reform in the 1980s and it came from the party who's main stakeholders paid the price. I mean don't let anyone kid themselves that the benefits that we're now getting in the last 20 years from the structure reform of the '80s and '90s did not come at a huge price in terms of jobs and human well being. We took those steps because the long term betterment for the whole community was there, so anyway, the emphasis has got to be there and the thing I'm worried about with monetary policy going too far is it actually short circuits the structural flexibility of the economy.
Warren Hogan: It actually, "Eh, let's not talk about structural reform because it ain't going to happen, because no one's going to go bankrupt, we're not going to free up any capital." This is another interesting point, this people who say there's capital everywhere, because, yeah, zero interest rates, QE, and there is this debt everywhere but there's no more equity capital. That's still scarce and that's what's getting trapped and, of course, there's also why the capital getting trapped in those firms as well.
Warren Hogan: We've got to look at that policy mix that focuses in on the structural and the other sad, sad thing about this is that the outcomes of it take years, so there's nothing that's going to fix anything in the next few years. We've got a number of years of somewhere between zero and two and a half percent growth facing us, I would imagine and that's the political dimension. Can we never get that without political system? Look, the policy of its there, the innovation, Australia's an innovative place. We don't need to go through the story, we've been innovating for years. We do need to capture it better, we need to encourage it. We need to commercialise it, that sort of thing. It's a global marketplace now, though, really, and we need to think in those terms.
Warren Hogan: I have no doubt that Australia's going to continue to innovate and so forth, we have a challenge about our currency but it's not all about RBA interest rates being too high. It's actually about how massive natural resource export base holding that currency higher than it otherwise would be but that starts again another story, but just the point of your question is exactly right. We need to look at other policy tools and they're tough, politically tough tools.
Kylie Richards: It's been absolutely fantastic discussions. Thank you very much Adam, Joseph, Tony, and Warren, and also thank you to the audience. The questions were great and certainly brought out the discussions further. Please join me in thanking our panellists.
On the evening of Thursday 14 November 2019 the UTS Finance Department hosted a Finance Masterclass on the topic:
“Has monetary policy gone beyond its effective limits, or are central banks destroying capitalism?”
This Masterclass led to a robust and provocative discussion. The policy debate was led by Industry Professor Warren Hogan, expert panelists Adam Creighton (Economics Editor, The Australian), Joseph Healy (CEO Judo Bank), Tony Morriss (Chief Economist, Bank of America Merrill Lynch) and master of ceremonies Kylie-Anne Richards, PhD.
Key takeaways from the discussion were:
- Effective limits to monetary policy are 1-2 years, at which point using this as an active long-term tool comes at some considerable cost to economic and political stability.
- Ultra easy monetary policy short circuits the bankruptcy mechanism for business, which is a critical part of the efficient allocation of capital.
- This contributes to the rise of the zombie firm and the impact of these firms on productivity, real wages, growth and inflation.
- Ultra easy monetary policy results in declining productivity and growth and results in calls for even more monetary stimulus.
- Central bank inflation targets may need adjusting due to changing circumstances.
- Rather than the high target of 2-3%, the RBA needs more flexibility to deal with structural uncertainty in the economy, with a recommended target of 1-3%.