Debtwatch No. 24 July 2008

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My Comment on the Green Paper

Sen­a­tor Nick Sher­ry, as Min­is­ter for Super­an­nu­a­tion and Cor­po­rate Law, has released a Green Paper Finan­cial Ser­vices and Cred­it Reform: Improv­ing, Sim­pli­fy­ing and Stan­dar­d­is­ing Finan­cial Ser­vices and Cred­it Reg­u­la­tion (June 2008)

This is a very apt time for such an enquiry. It is now over a decade since the Wal­lis Com­mit­tee sup­port­ed fur­ther dereg­u­la­tion of the finan­cial sys­tem, and the con­se­quences of that dereg­u­la­tion are now evi­dent.  I doubt that a com­plete rever­sal of pol­i­cy is polit­i­cal­ly fea­si­ble now, but this inquiry may set the high water mark in the belief that the less reg­u­lat­ed finan­cial mar­kets are, the bet­ter.

Below is my sub­mis­sion.

I rec­om­mend that the Com­mon­wealth reg­u­late all cred­it (Option 1.E.2), not on the grounds that Com­mon­wealth reg­u­la­tion would nec­es­sar­i­ly be supe­ri­or to State reg­u­la­tion, but on the basis that all lenders should be reg­u­lat­ed. The cur­rent regime only applies, in any sys­tem­at­ic sense, to deposit-tak­ers.

I make this rec­om­men­da­tion, not because I believe that reg­u­la­tion of the pre-Wal­lis Report ilk would pre­vent finan­cial crises of the sort we are expe­ri­enc­ing now, but because I believe that in the after­math to this cri­sis, sub­stan­tial informed reform of finance will be need­ed.

A essen­tial aspect of this will be mak­ing the reg­u­la­tion of lend­ing, rather than deposit-tak­ing, the cen­tre­piece of the reg­u­la­to­ry frame­work. Bring­ing all cred­it providers under nation­al super­vi­sion now would make it eas­i­er to imple­ment this inevitable sub­stan­tial informed reform at some future date.

The cur­rent arrange­ments pro­vide comprehensive—if not nec­es­sar­i­ly effective—regulation of Autho­rised Deposit Tak­ing Insti­tu­tions (ADIs), but less comprehensive—and far less effective—regulation of Non-Deposit Tak­ing Insti­tu­tions (non-ADIs). In par­tic­u­lar, Mon­ey mar­ket cor­po­ra­tions, finance com­pa­nies and Secu­ri­tis­ers, which in June 2007 account­ed for 20% of the assets of cred­it providers, are not reg­u­lat­ed (See Table 1).

This empha­sis upon reg­u­lat­ing deposits-tak­ers and not lenders reflects the avowed need to pro­tect depos­i­tors funds. How­ev­er, this direct approach under­states the indi­rect dan­gers to depos­i­tors posed by the exces­sive growth of debt. Non-ADIs have played a piv­otal and direct role in the recent explo­sion in debt lev­els, while even Finan­cial Insti­tu­tions that do not lend—such as super­an­nu­a­tion funds—have pro­vid­ed the impe­tus to increas­ing debt by the impact of their invest­ment strate­gies upon asset prices.

Con­ven­tion­al eco­nom­ic analy­sis implies that con­trol­ling ADIs is suf­fi­cient to con­trol the finan­cial sys­tem. In this view, banks cre­ate cred­it by re-lend­ing depos­i­tors funds under a frac­tion­al bank­ing sys­tem, in which banks keep a pro­por­tion of depos­i­tors funds as reserves, and lend the rest. With the gov­ern­ment cre­at­ing so-called “Base Mon­ey” (or M0), the banks’ capac­i­ty to cre­ate mon­ey is giv­en by divid­ing M0 by the reserve frac­tion.

Since non-ADIs by def­i­n­i­tion do not take deposits, they are not part of this cred­it-mon­ey-cre­ation process, and this large­ly explains why exist­ing leg­is­la­tion exempts them from reg­u­la­to­ry con­trol.

How­ev­er, this per­spec­tive is flawed in at least two respects that are rel­e­vant to this Green Paper.

First­ly, it focus­es upon the cre­ation of mon­ey, but ignores the cre­ation of debt—and as explained below, non-ADIs can cre­ate debt, even though they can’t take deposits. As is now becom­ing obvi­ous, the lev­el and rate of growth of debt have cru­cial effects upon the econ­o­my.

Sec­ond­ly, there is ample empir­i­cal evi­dence that the direc­tion of cau­sa­tion in the actu­al finan­cial sys­tem is the reverse of that giv­en by eco­nom­ic text­books: rather than “Deposits cre­ate Loans via the mon­ey mul­ti­pli­er”, it appears that “Loans cre­ate Deposits”. There­fore, laws that attempt to man­age the finan­cial sys­tem by reg­u­lat­ing only deposit-tak­ing institutions—and thus the deposit half of the finan­cial equation—are bound to fail, if lend­ing remains large­ly uncon­trolled. This is dou­bly so in the mod­ern era of dereg­u­lat­ed finance, when secu­ri­tis­ers and oth­er non-deposit-tak­ing insti­tu­tions are allowed to cre­ate debt via sell­ing secu­ri­tised finan­cial prod­ucts to the pub­lic.

Fig­ure 1 shows just how much debt has risen com­pared to the mon­ey sup­ply in the last half cen­tu­ry. The ratio of debt to M3 has risen from 0.5 in the ear­ly 1960s to almost 2 now (a sim­i­lar trend applies when debt is com­pared to Broad Money).2 Peaks and declines in the ratio bear a strong rela­tion to asset booms and sub­se­quent reces­sions in the ear­ly 1960s, 1974–5 and the mid-1980s-1990s, and the fact that this ratio is once again trend­ing down is could be an omi­nous fore­warn­ing of eco­nom­ic con­di­tions in the near future. Pri­vate debt has cer­tain­ly reached unsus­tain­able lev­els com­pared to income. This ratio must fall to restore the econ­o­my to even­tu­al finan­cial health, but its unwind­ing will be asso­ci­at­ed with a sig­nif­i­cant drop in aggre­gate demand.

Fig­ure 2, which shows the ratio of the rates of growth of debt and M3, indi­cates how lit­tle con­trol is exer­cised over debt by con­trol­ling the mon­ey sup­ply. Attempt­ing to con­trol the finan­cial sys­tem sole­ly by con­trol­ling deposits (M3) is rather like try­ing to con­trol a tiger by hold­ing its tail.

Dur­ing the peri­od of mon­e­tary tar­get­ting (as opposed to inter­est rate tar­get­ting), debt grew between as much as 250 per­cent faster than M3,3 and 30 per­cent slow­er. Explo­sions in the ratio of the rates of growth are also clear­ly coin­ci­dent with spec­u­la­tive booms (from the days of Cam­bridge Cred­it through to the Inter­net Bub­ble), while col­laps­es coin­cide with busts.

The empha­sis upon con­trol­ling deposits rather than loans allowed the blowout in debt to occur even when bank lenders dom­i­nat­ed the sys­tem. How­ev­er, this lend­ing could have exhaust­ed itself in the 1990s. Non-bank lenders, who were allowed to under­take a much larg­er role in the Aus­tralian scheme by the Wal­lis Com­mit­tee’s back­ing for secu­ri­tised lending,4 have played a piv­otal role in the con­tin­u­ing growth of debt after the 1990s reces­sion.

That non-bank lenders can cre­ate debt should be obvi­ous, but “text­book” eco­nom­ic treat­ments of mon­ey cre­ation don’t per­ceive this, because they focus sole­ly upon the “mon­ey mul­ti­pli­er” route to cre­at­ing debt.
A non-bank lender effec­tive­ly bor­rows mon­ey from a bank,5 and on-lends that mon­ey to bor­row­ers. When it does so, the non-ADI’s account at the bank falls, while the bor­row­er’s account rises—thus no deposits are cre­at­ed. But the bor­row­er now has a debt to the non-ADI. Thus debt has been cre­at­ed, with­out a bal­anc­ing cre­ation of deposits.6 This growth of debt has both pro­pelled eco­nom­ic activ­i­ty in Aus­tralia, and now imper­ils its future.

Of course, debt of itself is not a bad thing—any more than car­bon diox­ide is of itself “bad”. With­out car­bon diox­ide, the plan­et’s tem­per­a­ture would be below zero, and life would not be pos­si­ble. Equal­ly, with­out debt, the eco­nom­ic sys­tem could not func­tion. Debt is nec­es­sary to enable con­sumers to pur­chase hous­ing and sev­er­al oth­er long-lived con­sumer prod­ucts, and to pro­vide busi­ness with both work­ing cap­i­tal and finance for new invest­ments.

The prob­lem comes when that debt is used, not for con­sump­tion smooth­ing (pur­chas­ing an abode, car, etc.) or busi­ness turnover or invest­ment pur­pos­es, but to finance spec­u­la­tion on asset prices. The for­mer uses are akin to the gen­er­a­tion of car­bon diox­ide by the plan­et’s endoge­nous car­bon cycle; the last is rather like human­i­ty’s unin­ten­tion­al addi­tion to CO2 lev­els by the burn­ing of fos­sil fuels.

Just as we are now learn­ing, via Glob­al Warm­ing, that we have to lim­it our pro­duc­tion of CO2, we must learn that we have to con­trol the finan­cial sys­tem’s pro­cliv­i­ty to pro­duce debt. If that can be lim­it­ed to the debt demand­ed for con­sump­tion smooth­ing and busi­ness invest­ment, then the finan­cial sys­tem will func­tion well. If that debt is instead dri­ven by spec­u­la­tion on asset prices, we will face the equiv­a­lent of Glob­al Warm­ing in our finan­cial sys­tem.

That, unfor­tu­nate­ly, is how the recent explo­sion in debt has been used, both domes­ti­cal­ly, in the USA, and across most of the OECD. Dri­ven by debt-financed spec­u­la­tion, the ratio of asset price to com­mod­i­ty prices has reached lev­els that have nev­er been seen before. This ratio is the best guide as to whether we are in a bub­ble or not, and accord­ing to it, the cur­rent finan­cial bub­ble is the biggest in human his­to­ry, dwarf­ing the Roar­ing Twen­ties and even the 1987 Stock Mar­ket bub­ble (See Fig­ure 3).

Also, in con­tra­dic­tion to Alan Greenspan’s oft-expressed view that a bub­ble could only be iden­ti­fied in its after­math, the USA Stock Mar­ket Bub­ble obvi­ous­ly began in 1995—note the accel­er­a­tion in the rate of growth of the CPI-deflat­ed index. By the end of that year it had already over­tak­en all pre­vi­ous stock mar­ket bub­bles in scale.

The pre­vi­ous record bub­ble in the US stock mar­ket in 1966 was not accom­pa­nied by a bub­ble in real estate, while the 1920s were in fact a time of below aver­age house prices. There­fore the cur­rent bub­ble, unlike all pre­vi­ous ones, embraces the hous­ing mar­ket as well as the stock mar­ket. In Amer­i­ca, it has dri­ven the hous­ing mar­ket from just above its long term aver­age to more than twice this lev­el in a peri­od of under ten years (See Fig­ure 4; 1997 can also be iden­ti­fied, by the accel­er­a­tion in the CPI-deflat­ed index, as the start of this hous­ing bub­ble).

The Aus­tralian data I have does not go back as far as the Amer­i­can, but even with this more lim­it­ed data it is obvi­ous that the cur­rent stock mar­ket bub­ble dwarfs the 1980s. Even after the recent fall in the index, the ASX is still more over­val­ued than it was before the crash in Octo­ber 1987 (See Fig­ure 5).

The Aus­tralian hous­ing mar­ket is over­val­ued even with ref­er­ence to the peri­od since 1986, when prices were already high on a his­tor­i­cal basis. Nigel Sta­ple­don’s PhD thesis7 implies that house prices in Aus­tralia are of the order of three times the long term aver­age. Even leav­ing that long term per­spec­tive out of the equa­tion, it is obvi­ous that house prices have dou­bled in real terms in the past decade (See Fig­ure 6).

This has all been on the basis of spec­u­la­tive, debt-financed purchasing—effectively, a Ponzi Scheme. Debt-financed pur­chasers of hous­ing lose mon­ey on the cash flow from their investments—indeed, the pecu­liar­ly Aus­tralian insti­tu­tion of neg­a­tive gear­ing pro­motes loss-mak­ing invest­ments in real estate.

The only way that an indi­vid­ual spec­u­la­tor prof­its from real estate spec­u­la­tion is by either sell­ing to some­one with a high­er income—who can there­fore afford a high­er pur­chase price—or by sell­ing to anoth­er indi­vid­ual with a sim­i­lar income, who takes on suf­fi­cient debt to buy the prop­er­ty at a price that exceeds the spec­u­la­tor’s pur­chase price plus accu­mu­lat­ed net loss­es from debt ser­vic­ing. That is a recipe, not just for an asset price bub­ble, but for explod­ing debt lev­els com­pared to income. Lenders have unwit­ting­ly con­tributed to this Ponzi Scheme, and the focus of reg­u­la­tion upon deposit-tak­ing rather than lend­ing has equal­ly unwit­ting­ly allowed this to hap­pen.

Unfor­tu­nate­ly, while an indi­vid­ual can escape from an exces­sive debt ser­vic­ing bur­den by sell­ing a prop­er­ty for a prof­it, the coun­try as a whole can­not do that. The ulti­mate source of rev­enue for pay­ing off debt is the sale of com­modi­ties and the incomes this gen­er­ates, and the debt bub­ble that has built up under the cur­rent reg­u­la­to­ry regime pos­es an enor­mous chal­lenge for future eco­nom­ic pol­i­cy by dri­ving up the debt to GDP ratio (see Fig­ure 7).

The ratio of debt to GDP gives a sim­ple mea­sure of the debt bur­den, by show­ing how many years worth of nation­al income would be need­ed to elim­i­nate the debt. Though, as not­ed above, elim­i­nat­ing debt entire­ly is not desir­able, reduc­ing it to a lev­el where it reflects pre­dom­i­nant­ly pro­duc­tive uses of debt is desir­able. On the long term data, this implies a reduc­tion in debt from its cur­rent lev­el of 1.65 years of GDP, to of the order of half a year of GDP.

A sub­stan­tial reduc­tion of debt will occur (if not nec­es­sar­i­ly that absolute scale) because most of the debt accu­mu­lat­ed in the last twen­ty years financed waste­ful spec­u­la­tion on asset prices rather than real invest­ment. The vast major­i­ty of the increased debt tak­en on since 1990 was incurred by house­holds (see Fig­ure 8), and most of that bor­row­ing financed not the con­struc­tion of new hous­ing, but spec­u­la­tion on the price of exist­ing hous­es.

Since, by the ear­ly 2000s, less than 10% of mon­ey bor­rowed for hous­ing finance the con­struc­tion of new dwellings, 90% of that mon­ey was bor­rowed for the pur­pos­es of spec­u­la­tion rather than invest­ment (see Fig­ure 9).

We have now reached the end point of that spec­u­la­tion, when it is sim­ply not pos­si­ble for future buy­ers to take on more debt than cur­rent “investors” have done.

There­fore exist­ing spec­u­la­tors will start to lose mon­ey on their real estate posi­tions, lead­ing to a fall in Aus­tralian hous­ing prices and ulti­mate­ly a fall in the debt to GDP ratio. As that takes hold, spend­ing will also fall pre­cip­i­tous­ly, as the change in debt starts to detract from aggre­gate spend­ing, rather than sup­ple­ment­ing it.

There is evi­dence that this process has already begun. The growth in the pri­vate debt to GDP ratio has slowed notice­ably in the last two months, and as a result the con­tri­bu­tion that change in debt makes to aggre­gate demand8 has start­ed to fall (see Fig­ure 10).

This great de-lever­ag­ing will pose enor­mous dif­fi­cul­ties for eco­nom­ic pol­i­cy. It will also make obvi­ous that our cur­rent deposit-focused reg­u­la­to­ry regime for finance has failed. Clear­ly, reg­u­lat­ing deposit-tak­ing insti­tu­tions, but not reg­u­lat­ing lenders in gen­er­al, has con­tributed to the devel­op­ment of the great­est finan­cial cri­sis since World War II. The reg­u­la­to­ry phi­los­o­phy that large­ly relied upon lenders to self-reg­u­late has also failed.

There­fore, as dif­fi­cult as these future times are like­ly to be, they should also be used to put in place a finan­cial sys­tem that dis­cour­ages spec­u­la­tive lend­ing and bor­row­ing.

Decades ago, Hyman Min­sky argued that the role of reg­u­la­tion should be to cre­ate “a ‘good finan­cial soci­ety’ in which the ten­den­cy by busi­ness­es and bankers to engage in spec­u­la­tive finance is con­strained” (Min­sky 1977, 1982: 69). The reform pro­posed in Option 1.E.2, by propos­ing that all lenders fall under Com­mon­wealth reg­u­la­tion, is a step in this direc­tion For that rea­son, I com­mend it to Par­lia­ment.

Appendix One: My supplementary remarks on securitised lending to the Wallis Committee

After an event like the sub­prime cri­sis, it is not uncom­mon to have peo­ple argue that it was some­thing that could not have been fore­seen. That is non­sense. It takes a par­tic­u­lar set of intel­lec­tu­al blink­ers not to see the poten­tial that “reforms” such as allow­ing secu­ri­tised lend­ing had to lead to an ulti­mate finan­cial cri­sis. Unfor­tu­nate­ly, con­ven­tion­al eco­nom­ic think­ing pro­vid­ed just that set of blink­ers,  and the Wal­lis Com­mit­tee fol­lowed con­ven­tion­al eco­nom­ic advice in its rec­om­men­da­tions.

I claim no spe­cial pow­ers of pre­science, but mere­ly the ben­e­fit of analysing finance from the point of view of Min­sky’s “Finan­cial Insta­bil­i­ty Hypothesis”—a mod­el of how the finance sec­tor oper­ates that I pre­sent­ed to the Wal­lis Com­mit­tee Inquiry in 1996. As a fol­low up to my ver­bal sub­mis­sion, I sent a let­ter to the Com­mit­tee on Decem­ber 7th 1996. My com­ments on secu­ri­tised lend­ing in that let­ter accu­rate­ly pre­dict­ed the Sub­prime Cri­sis (see under point 2 below):

“Mr Stan Wal­lis,
Chair­man,
Finan­cial Sys­tem Inquiry
Dear Mr Wal­lis,

Thank you for the oppor­tu­ni­ty to present my views per­son­al­ly to your Com­mit­tee yes­ter­day. There were two points on which I was not sat­is­fied with the qual­i­ty of answers I gave to ques­tions from the Com­mit­tee, and I am writ­ing this note to attempt to improve upon yes­ter­day’s per­for­mance…

(2) The impact of secu­ri­ti­sa­tion

The secu­ri­ti­sa­tion of debt doc­u­ments such as res­i­den­tial mort­gages does not alter the key issue, which is the abil­i­ty of bor­row­ers to com­mit them­selves to debt on the basis of “euphor­ic” expec­ta­tions dur­ing an asset price boom. The abil­i­ty of such bor­row­ers to repay their debt is depen­dent upon the main­te­nance of the boom, and as the share mar­ket reac­tions to yes­ter­day’s com­ments by Alan Greenspan remind­ed us, such con­di­tions can­not be main­tained indef­i­nite­ly.

Should a sub­stan­tial pro­por­tion of eli­gi­ble assets (e.g., res­i­den­tial hous­es dur­ing a real estate boom like that of 87–89) be financed by secu­ri­tised instru­ments, the inabil­i­ty of bor­row­ers to pay their debts on a large scale will not, of course, direct­ly affect liq­uid­i­ty in the same fash­ion that a fail­ure of bank debtors does. Instead, the impact will be felt by those who pur­chased the secu­ri­ties, or by insur­ance firms who under­wrote the repay­ment.

•   Where this is a gov­ern­ment, the impact on liq­uid­i­ty will again be slight, since pub­lic debt will replace pri­vate.
• Where this is a finan­cial insti­tu­tion, such as a bank, it will be in a very sim­i­lar sit­u­a­tion to the State Bank of Vic­to­ria (and many oth­ers) after the last real estate crash, with sim­i­lar con­se­quences.
• Where this is an insur­ance com­pa­ny, it could be dri­ven into bank­rupt­cy, with an impact on liq­uid­i­ty via its share­hold­ers and its own cred­i­tors. How­ev­er this would not be as seri­ous as the sec­ond instance above.
• Where the secu­ri­ties are trade­able, there would obvi­ous­ly be a col­lapse in the trade­able price, and, poten­tial­ly, the bank­rupt­ing of many of the investors—depending again on their own financ­ing arrange­ments.

Over­all I would agree that direct reg­u­la­tion of secu­ri­tis­ers is not war­rant­ed. What is need­ed instead is pru­den­tial overview of the extent to which banks, insur­ance firms and super­an­nu­a­tion insti­tu­tions invest in secu­ri­tis­ers and their prod­ucts. How­ev­er, I would object strong­ly to the pro­pos­al from Aussie Home Loans (p. 135, para­graph 5.94) that secu­ri­tis­ers should be able to call them­selves banks.”

As might be expect­ed, the Wal­lis Com­mit­tee was sub­stan­tial­ly more san­guine about the impact of secu­ri­ti­sa­tion than I was. Now that events have unfold­ed and it is obvi­ous the Com­mit­tee’s relaxed pos­ture towards finan­cial mar­ket dereg­u­la­tion was not jus­ti­fied, it is to be hoped that this and future enquiries will be more cog­nis­cant of the need to con­trol the growth of debt.

Appendix Two: The Wallis Committee’s Overview on Securisation

Secu­ri­ti­sa­tion

Secu­ri­ti­sa­tion refers to the process of issu­ing mar­ketable secu­ri­ties against an income stream derived from a pool of oth­er­wise illiq­uid assets. It involves sales of loans or oth­er assets into spe­cial­ly designed trusts which then issue secu­ri­ties direct­ly into the cap­i­tal mar­ket. In Aus­tralia, secu­ri­ti­sa­tion has become a force in home mort­gage finance.

It has also emerged in some oth­er retail mar­kets, such as cred­it card receiv­ables and motor vehi­cle loans, although at this stage only on a small scale.

Like dis­in­ter­me­di­a­tion, secu­ri­ti­sa­tion rep­re­sents the sub­sti­tu­tion of trade on finan­cial mar­kets for func­tions tra­di­tion­al­ly per­formed via the bal­ance sheet of finan­cial inter­me­di­aries. By orig­i­nat­ing loans and pro­vid­ing recourse to an insur­er in the event of default, finan­cial insti­tu­tions screen loans and enhance their cred­it­wor­thi­ness suf­fi­cient­ly for the loans to be trad­ed in open finan­cial mar­kets. The role of the insti­tu­tion is not dis­placed entire­ly by this process but it is sub­stan­tial­ly restrict­ed in scope. In many cas­es, it is the insti­tu­tions them­selves which are using secu­ri­ti­sa­tion as a means of bet­ter man­ag­ing their cap­i­tal.
The prospects for growth of secu­ri­ti­sa­tion will depend on its cost effec­tive­ness rel­a­tive to bal­ance sheet inter­me­di­a­tion. The ques­tion also aris­es as to pos­si­ble lim­its to secu­ri­ti­sa­tion. At present, secu­ri­ti­sa­tion is large­ly restrict­ed to assets which have very low, even neg­li­gi­ble, risk or which rep­re­sent a homo­ge­neous class on which risk can be sta­tis­ti­cal­ly esti­mat­ed and priced. Whether there will be a mar­ket for high­er risk or less homo­ge­neous assets is unclear. The test will come with assets like loans to small busi­ness­es (some mort­gage backed lend­ing has recent­ly emerged in this area).

Ref­er­ences

Hyman Min­sky (1977), “The Finan­cial Insta­bil­i­ty Hypoth­e­sis: an inter­pre­ta­tion of Keynes and an alter­na­tive to ‘stan­dard’ the­o­ry”, Nebras­ka Jour­nal of Eco­nom­ics and Busi­ness, reprint­ed in Min­sky 1982, 59–70.

Hyman Min­sky (1982), Infla­tion, Reces­sion and Eco­nom­ic Pol­i­cy, Wheat­sheaf, Sus­sex.