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