In return for an extra $1 billion in social housing investment, the Greens dropped their demand that the bill include a two-year rent freeze, although housing spokesperson Max Chandler-Mather says the party is still committed to rent control and clearly sees this as a winning strategy in inner-urban seats.

“For us this fight has just started,” he told ABC Radio National Breakfast. “Nine months ago, no one cared about renters in the media and political establishment. Now they are a national news story.” The Greens had forced national cabinet to meet and discuss national renters’ rights, he said, referring to an August agreement by the states and territories to move towards a nationally consistent policy on tenancy laws.

National cabinet’s agreed measures would prevent landlords from terminating a lease without reasonable grounds or from raising rents more than once a year. They would also “phase in” minimum standards for rental properties — though the limp language doesn’t inspire great confidence that the lives of tenants will materially improve, especially given that the examples of “minimum standards” cited in the national cabinet communiqué are “stovetop in good working order, hot and cold running water.”

As well as setting up the HAFF, other bills before the Senate will create an independent body to provide housing research and advice to the federal government. The National Housing Supply and Affordability Council will fill an important gap created when the Abbott government abolished a similar body a decade ago.

Community housing activists have told me the Greens shouldn’t get all the credit for the progress, since the sector has also been lobbying hard, as has Labor for Housing and other ALP ginger groups. Other members of the Senate crossbench have been influential too.

Still, if the Greens hadn’t blocked the HAFF bill it’s hard to imagine that the government would have found an extra $3 billion to build homes for low-income Australians — the June commitment of a $2 billion social housing accelerator, and the additional $1 billion just announced. This new money will bolster the National Housing Infrastructure Facility and can be used to build new social and affordable homes or to pay for critical infrastructure needed to support them. The facility is administered by NHFIC, the National Housing Finance and Investment Corporation, which will become Housing Australia.

Under the original HAFF bill, the government set an annual cap of $500 million on disbursements from the fund to finance new homes. The Greens and other crossbench senators convinced the government to convert this ceiling into a floor — $500 million is now the minimum spend from the HAFF each year, rather than the maximum.

And independent senator David Pocock was also instrumental in getting these annual payouts indexed, which means their real value will be maintained over time rather than eroded by inflation.

The breakthrough on the HAFF is welcome news to not-for-profit housing providers. According to Wendy Hayhurst, chief executive of the Community Housing Industry Association, it will give the sector confidence to plan and deliver new homes.

Despite its designation as a “future fund,” though, the HAFF only offers five years of certainty. After that, there is no guarantee that more public funds will be available.

This isn’t the impression the government wants to give. In its issues paper promoting discussion of a new National Housing and Homelessness Plan it says the HAFF will “build 30,000 new social and affordable houses in its first five years” (my emphasis). Together with the name, this gives the impression that another 30,000 houses could be built in each of the subsequent five-year periods.

Housing minister Julie Collins has allowed this misapprehension to take hold by saying, for example, that “we’re talking about… a fund that in perpetuity each and every year would be delivering at least $500 million into social and affordable rental homes in Australia.”

At first glance, you might think that $500 million will be spent on new homes in every year of the fund’s twenty-five-year life. But that’s not how it works. Proceeds from the fund won’t provide up-front capital to finance new construction but will instead cover providers’ recurrent costs after the housing is built.

This is sometimes referred to as an “availability payment.” It’s essentially a subsidy to not-for-profit housing providers to bridge the gap between the cost of building and operating new homes and the low rents paid by social housing tenants. As a guaranteed future income flow it enables community housing organisations to raise commercial finance to build new dwellings. After five years almost all proceeds from the HAFF will be fully committed to covering the gap between housing providers’ costs and their rental income (at least until 2050).

The benefit of the model is that the HAFF leverages a modest amount of public money into larger sums of private capital. And once the funds are committed, it will be hard for the scheme to be undone by an incoming Coalition government: abolishing the scheme would mean interfering with commercial contracts.

But the HAFF is a complex way to fund housing. As business journalist Michael West writes, the biggest winners could be whoever manages the government’s investment. There’s a simpler alternative: as an analysis for the Australian Housing and Urban Research Institute concluded, “the cheapest and most efficient way to fund new social housing is direct public investment.” That’s why the Greens are crowing about directing an extra $3 billion from the government — six times the amount the HAFF will generate annually — straight into building new homes.

It’s certainly a good time to get money out the door. With the volatile construction sector heading for a downturn, this counter-cyclical release of new investment will help keep workers employed and firms afloat.

But all the extra investment will barely make a dent in the lack of rental homes for households on very low incomes. What is still sorely needed is a bipartisan commitment to financing new social housing for decades into the future.

The chances of that happening are slim. Shadow housing minister Michael Sukkar accused the government of waving the white flag on the great Australian dream because the HAFF does nothing for Australians who want to buy a home. In refusing to countenance support for the government’s social housing initiatives or engage with the struggles of renters, the opposition has dealt itself out of any role in tackling one of the nation’s most urgent challenges.

This leaves the Greens with a powerful hand in negotiations over other looming housing bills, including federal and state legislation to underpin Labor’s Help to Buy shared equity scheme, which is designed to help people into home ownership with a 2 per cent deposit.

The Greens demonstrated a tough pragmatism in the HAFF negotiations. As Chandler-Mather says, the media, the community housing sector and their fellow crossbenchers pressured the Greens for months to pass the bill without seeking further concessions. “We were told when we started this, that we were absurd and crazy, for pushing for more funding for public housing,” he said. “And look how far the debate has shifted.”

But it’s hard to see the party’s demand for a “rent freeze” gaining traction. The phrase promotes a binary understanding of rent control as a switch that is either on or off, rather than a dial that can be calibrated. It mobilises well-founded opposition based on evidence that blunt controls of this kind have unintended consequences.

As a report from the Centre for Equitable Housing notes, “hard” rent freezes, or “first generation” rent controls, have had negative effects elsewhere, deterring new housing investment and discouraging landlords from spending on maintenance. The report adds that a national one-size-fits-all rent freeze doesn’t account for regional differences and could drive some investors to switch their properties out of long-term rental and into short stays instead.

A range of more nuanced measures — what the report calls “second and third generation rent stabilisation” — could be used to moderate rent increases. These approaches, widely used in Europe, are more focussed on limiting rapid spikes than on bringing rents down overall. They may allow landlords to increase rents between tenancies, for example, or offer allowances for spending on maintenance.

The centre concludes that it is possible to develop rent stabilisation policies that allow the market “to play the defining role in setting rent prices but in a moderated and predictable fashion.”

The next test for Labor and the Greens will be whether they can move beyond the rent-freeze stand-off and begin a nuanced discussion about how to develop a more stable and affordable private rental market. That will require compromise on both sides. •

The post Two cheers for the HAFF appeared first on Inside Story.

As well as rising mortgage costs, families on the fringes face steep increases in energy prices. Across most of Australia, the wholesale price of electricity has more than tripled in the past two years; retail prices have followed, and are generally double or triple what they were two years ago.

A big contributor to those cost hikes is the price of gas, which has risen sharply as a result of Russia’s invasion of Ukraine. As one of the world’s largest gas exporters, Australia had been immune to such risks because of its plentiful local supplies. But we lost that immunity after 2015 when large-scale exports from the east coast led to domestic scarcity and the imposition of global pricing. The looming rundown of Victoria’s big Bass Strait gas fields poses a further risk to supply and prices.

High commuting costs, like energy market failings, result from poor planning. But they have another thing in common: transport and energy infrastructure are often financed by pension funds rather than governments. The people who administer these funds are the subject of political economist Brett Christophers’s new book, Our Lives in Their Portfolios: Why Asset Managers Own the World. These asset managers, he writes, “increasingly own and control our most essential physical systems and frameworks,” and their financial priorities are not aligned with social priorities unless governments impose that requirement.

While his style is somewhat dry and a little didactic, Christophers highlights three tendencies that raise big questions about how we finance infrastructure: the investment priorities of pension funds often determine which infrastructure projects go ahead; governments often take on risks that should belong to investors; and the conditions imposed by one infrastructure project can corrupt the process of providing public services or assets.

Christophers probes these interactions of public and private interests in detail. But I’m not sure he has stepped back to see the bigger picture. For starters, these investments aren’t big enough to justify the suggestion that asset managers rule society. Assets under management might total as much as US$1 trillion, he says, but that’s less than a third of the infrastructure investment undertaken last year by the fifty or so largest economies in the world.

The pension funds need reliable, predictable income to meet their obligation to pay regular returns, and the fees charged by proven asset managers are correspondingly generous. It’s no coincidence that the pioneering firm, Macquarie Bank, is called the “millionaires factory.” Macquarie, adept and innovative, has found new ways to skim earnings from unlikely places.

Asset management took off after the global financial crisis, partly because some assets — housing in the United States being the prime example — became relatively cheap and yet still offered good rental income. In the aftermath of the crisis the world was seemingly awash in savings; as interest rates fell, infrastructure assets became much more attractive to big investor organisations.

Christophers is inclined to focus on the incidental pitfalls of the asset managers’ investment in essential infrastructure rather than look at the design of the system that encourages this kind of asset. In many cases, these managers are standing in for governments. They raise money, just as governments do. Once an investment in a road or a tunnel or a power generator has been made, they generally manage the asset just as a statutory authority or government department would — or they outsource that function.

This form of asset management is created by government. Because the assets are often singular — a freeway or tunnel required to meet social needs — governments own the project from the start and set the terms. Asset managers often, perhaps always, get near-monopoly rights, and the primary tension between them and government is usually price.

What is this monopoly worth? If governments get that wrong, they miss out on some, or even a lot of, cash. If investors get it wrong, they don’t make much money — or sometimes go broke.

Interestingly, Christophers doesn’t examine two other fundamental questions: why roads are financed using tolls, and how better government might deliver more equitable and efficient results. And though politics can be  heavily influenced by real estate interests, he leaves property-sector influence in Western economies largely unexamined.

Our Treasury officials carry on quite a bit about rent-seeking by industry, but rarely do you see much pushback when developers demand taxpayer support as they convert broad acres into housing, often kilometres from schools or hospitals or even shopping centres. Looking back on the recent history of urban expansion, it’s fair to ask whether urban planning is extinct.

Poor planning exaggerates demand for some assets, like outer-urban freeways, that neatly fit the economic interests of asset managers. But you can’t blame asset managers for that. They might, however, have contributed to the illusions that have led governments down hazardous paths.

How did we get here? Australia’s economic debate has evolved over many years. In the decades after Federation an accord between capital and labour manifested in the Harvester judgement — our first national minimum wage — and relatively high levels of industry protection. During the 1970s and especially the 1980s a more laissez-faire consensus emerged, opening Australia up to trade, among other things, and sharply increasing the role of finance.

Once-passive pension funds, closely aligned with employers, became active investors largely driven by arithmetic. Asset trading became a big driver of Australian economic activity. And politicians became unused to thinking about public investment in any sector where business might have a role, even when the involvement of business depends on government.

One example Christophers highlights is renewable energy. He notes that asset managers haven’t much interest in large-scale traditional power stations, which are too complex and risky. He suggests that the set-and-forget nature of solar cells and wind turbines has attracted very big players to the energy transition. Government-backed purchase agreements are undoubtedly a factor, too, providing taxpayer assurance of investment returns.

One challenge of the energy transition derives from the fact that the energy itself is only part of the price consumers pay for electricity or gas. A cursory look at a typical electricity bill reveals that the supply charge is large relative to the price of the energy consumed. This charge is largely made up of the cost of wires, poles and maintenance, a monopoly activity delivered by privately owned companies largely in the hands of asset managers.

Less transparently, energy is only partly priced by markets. Australia’s National Electricity Market is good at pricing the least-cost source of power at any time of day, effectively delivering a competitive outcome. But consumers expect power when they flick a switch, and that level of reliability depends on investment in generation that isn’t needed all the time. This raises a challenge for the energy transition, and it cannot be resolved by the NEM.

The electricity supply Australians have today was built almost exclusively by state governments. Over time, New South Wales and Victoria sold power stations and other elements of their state energy authorities to private owners. In general, much of the money raised has been redirected to other infrastructure. Only Queensland and Western Australia still have a public power utility — though Victoria intends to resurrect the State Electricity Commission and the new NSW government has indicated it might have similar plans.

So far, though, state governments have been unwilling to deal in any concrete way with the reliability part of electricity supply. Yet the crucial question, occasionally hinted at by the national regulator, AEMO, but only raised in blunt terms by people like former Snowy Hydro chief executive Paul Broad, is this: will we have seriously unreliable power during the transition?

Without going into the specifics, the key point is that our power supply is a basic service that we experience in a certain way because of choices made decades ago, mostly by state governments. Today’s governments don’t appear to accept that part of their role is to ensure the next system is at least as effective as the old one.

While asset managers are certainly investing in the energy transition in a big way, they are not utilities. In fact, most of them behave more like property speculators, acquiring a right and setting up renewable generation before flipping the asset to a fund.

What seems to have happened since the 1970s is that Australia’s public management has retreated from any activity that has commercial potential, assuming instead that “the market” will deliver the right outcome as long as the “settings” are right.

In the case of power, a debate actually took place about the need for a publicly funded “capacity” payment to ensure that backup power was available for times when the system was not adequately supplied. But the states couldn’t agree. Instead, it was assumed that the very high prices that arise when normal supply is interrupted will encourage private investors to build storage capacity or “peak” gas plants that can be brought on quickly. For a variety of reasons, that latter outcome now seems less likely.

Meanwhile, we are getting good at bringing forward the dates on which the big, concentrated coal-fired plants will close, but less adept at rapidly rolling out the transmission and other investments needed to make sure those closures don’t bring serious problems.

Christophers’s exploration of the remarkable global reach of private asset managers into social assets is interesting and informative. But the other side of the asset management trend is a passivity among governments at a time when demands for active management of public assets are intense and have the potential to rise to unprecedented heights. •

Our Lives in Their Portfolios: Why Asset Managers Own the World
By Brett Christophers | Verso | $39.99 | 320 pages

The post Global reach appeared first on Inside Story.

Under spider socialism, some arachnids are more equal than others. Dominant spiders control large parts of the web but the subordinate spiders do most of the work: building and cleaning, organising and subduing the prey. Crucially, though, no one spider has full knowledge or control of the whole structure. Each works with some degree of independence in its own small section or subsection. There is no middle, beginning or end, no single locus of power and responsibility.

I know what you’re thinking: this sounds just like foreign capital investment in frontier markets under twenty-first-century financial capitalism. And you’d be right. Every few years, when some Cayman Islands middle manager discovers his or her conscience and shares a new tranche of incriminating files with the Guardian and the New York Times, we are reminded that out there, somewhere, the world’s super-rich and their vast network of highly remunerated accountants, lawyers, investment managers and “fixers” have built an elaborate parallel financial system that hides and protects their wealth.

The key to this system is its opacity. The wealthiest people on the planet benefit from the work of their most far-flung subordinates, but most of the time it is nearly impossible to establish precisely where and how they are connected. Capital doesn’t flow directly from Country A to Country B, but circuitously, through an invisible network of tax havens and offshore financial centres, an economic black hole that allows multinationals and the super-rich to exist in a permanent elsewhere.

When stories about tax havens and the offshore economy appear in the press — if they appear at all — they often tend towards the sensational: the laundering of an astronomical sum of money here, the implication of a highly recognisable name there. In 2015, for example, it emerged that a businessman named Jho Low had used a system of offshore shell companies to siphon more than US$4.5 billion out of the Malaysian government’s sovereign wealth fund, 1MDB. In 2017, Shakira, Bono and the Queen were among those named in the Paradise Papers, a huge leak of offshore data from a law firm operating in ten different jurisdictions.

In Spiderweb Capitalism: How Global Elites Exploit Frontier Markets, University of Chicago sociologist Kimberly Kay Hoang argues that the real story is not to be found in these headline cases but rather in the many thousands of low-key, everyday transactions that take place outside the purview of journalists, state officials and the public. Jho Low was unrepresentative: he was too big, too flashy, too public. If you really want to understand the system, she writes, you have to look at the people who operate without anyone noticing, the “stealth spiders.”

In 2016 and 2017, Hoang set herself the task of understanding precisely how this offshore economy functioned, especially in risky underdeveloped markets like Vietnam and Myanmar. For nearly eighteen months she “embedded” herself in the Southeast Asian corner of the spiderweb, first as an assistant in a Vietnamese asset management firm then as a kind of intrepid journalist-professor, pursuing and interviewing more than 300 fund managers, state officials, “C-suite executives,” consultants, lawyers, accountants and financiers, from the Cayman Islands to Hong Kong, and San Francisco to Myanmar.

In style and presentation, Spiderweb Capitalism is sometimes stultifyingly academic, but the material is pure Michael Lewis. Take, for example, Will, a forty-two-year-old Vietnamese-German investor and former Lehman Brothers banker who spoke to Hoang at length about his business operations in Southeast Asia. After losing his job in the 2008 meltdown, he says, he cashed out his savings and moved to Singapore to look for new investment opportunities. Despite earning up to US$1 million a year in his former career, he testified to a feeling of precarity. He wanted to become, in his own words, “an owner of capital rather than a worker for capital.”

Making direct equity investments in large companies required considerable staff support, however, so Will joined a “family office” (Wall Street shorthand for a private wealth management company that looks after the pooled wealth of one or more ultra-high-net-worth individuals). His company manages over US$100 million in assets and generally takes on individual investments in the five to ten million dollar range: serious money, but not serious enough to attract significant attention from the press or the top levels of government.

Will admitted to Hoang that he has lost count of how many offshore structures he controls. The main fund in this carefully constructed maze is domiciled in Guernsey, in the British Channel Islands, which has no income, state, corporation or capital gains taxes. That company has a number of tax-exempt subsidiaries in the Cayman Islands and Singapore, from which it manages its “onshore operations” in Vietnam, Cambodia and Myanmar. Each investment is registered as its own separate company or “special purpose vehicle” (a paper company that allows the parent business to insulate its various investments from each other). Will’s company only moves funds onshore for operations. With a bit of creative accounting, they are able to book all their profits in low-tax Singapore.

Creating such structures is remarkably easy. In Hong Kong, Hoang accompanied a wealth manager to the dingy offices of a company specialising in the establishment of offshore subsidiaries, a kind of H&R Block for tax havens. In a bland, windowless room, crammed floor-to-ceiling with stacks of paper, they were presented with a menu of wealth-concealment options.

The “privacy package,” they were told, included a company secretary service, an office address, a certificate of incorporation, the appointment of directors, share certificates and a company seal. They were regaled with the relative benefits of registering their company in Samoa versus the Seychelles. They were even provided with a list of preapproved company names, such as “Lucky Star 7” and “Happymoon4.” And the price was just US$900.

These structures are useful for tax evasion, but the reasons for using them, Hoang explains, are usually more complex. For foreign investors, they are often the only viable way to manage the culture of bribery in Southeast Asian business relations. Few show many qualms about this practice. Among her interviewees, there is a basic consensus that payments to government officials are part of the cost of doing business in this corner of the world.

The most common form of bribery in Vietnamese business culture, for example, is what is known as “speed money,” an unofficial payment to a minor government official that serves as a necessary supplement to their meagre salary. These payments can be as little as $25 and up to several thousand dollars. If a person refuses to pay speed money, paperwork will simply sit on government desks until they change their mind. Those who do attempt to stay clean must accept long delays and, by extension, much lower rates of return on their investments.

Larger, more overt forms of bribery and corruption are common, too, though Hoang’s interviewees are understandably coy about discussing them in any great detail. Even so, Will, the former Lehmann Brothers banker, admitted to owning an entire company — heavily insulated from the rest of his businesses — whose exclusive function it is to distribute bribes. For large projects, this can involve paying college tuition fees for the child of a significant government official or making a gift of high-end luxury products like Rolex watches and Hermès handbags, which function as stores of value that can be traded for cash.

Given the complexity and ambiguity of this informal economy, local knowledge is at a premium. In most cases, it is close to impossible for a foreign investor to operate in Vietnam without a local co-investor. The entire enterprise thus comes down to the cultivation of relationships: between foreign investors and their local partners, and between local partners and government officials. If one of these relationships breaks down, an investment can fall apart. They must be carefully managed, or — in Hoang’s words — “lubricated.”

Some of the most eye-opening passages of Spiderweb Capitalism involve the explanation of exactly how this lubrication takes place. In this highly masculine environment, it can typically involve drinking games and dance shows. On some occasions, though, it extends to “orgy parties,” organised encounters between investors, government officials and sex workers designed to establish a relationship of “mutual hostage.” “We have to literally get into bed with each other,” said one investor. “If one goes down, we both go down.”

The investors Hoang interviews for Spiderweb Capitalism are remarkably open about their business practices, many of which are at best ethically dubious. Some speak with pride of the elaborate offshore structures they have built, or the cleverness with which they have managed their relationships with state officials. Others speak of their activities in terms of sacrifice or duty, something difficult, sometimes unsavoury but ultimately necessary. One man even confessed — with full knowledge that Hoang was an American university professor working on a book — that a lot of what went on with sex workers at Vietnamese “orgy parties” was non-consensual.

This openness likely derives from the fact that — in a legal sense — they are all pretty much in the clear. If you are smart and you know the right lawyers and accountants, you don’t need to break the law: you “finesse” it. The key to doing business in this part of the world, Hoang writes, is this ability to work comfortably in the space between the legal and the corrupt, in the areas where the rules can be massaged in your favour. She calls it “playing in the grey,” the kind of cowboy mentality that has always prevailed in places where the law is ambiguous and inconsistently enforced.

Are those further up the capital chain implicated in these dilemmas? It is a complicated question, and one that the spiderweb is deliberately built to obfuscate. The legal firewalls that separate ethically questionable business dealings in Southeast Asia from their financial beneficiaries in other parts of the world are there by design. The big spiders, safe in their airconditioned boardrooms and private airport lounges, have plausible deniability on moral questions and impunity on legal ones.

What makes the system work are the small spiders, the white-collar strivers who do the bidding of the ultrarich. They build and maintain these elaborate capital networks, and they do so willingly, taking on pretty much all of the risk in the hope that one day they too might find themselves sipping pina coladas in a safer part of the web. As with the South American spiders, it isn’t clear who is the exploiter and who is the exploited, where the web starts and finishes.

Spiderweb Capitalism doesn’t give a systematic account of the offshore system. It is a study not so much of the spiderweb itself but of the individuals who work to create and maintain it. In the spirit of C. Wright Mills’s 1956 classic, The Power Elite, it attempts to “give global capital a face.” Markets don’t simply exist, writes Hoang. They are made. Each new section of the web is always built by humans. The novelty of this book is that she has gone out and talked to them. •

Spiderweb Capitalism: How Global Elites Exploit Frontier Markets
By Kimberly Kay Hoang | Princeton University Press | $49.99 | 288 pages

The post Playing in the grey appeared first on Inside Story.

It takes twenty-five minutes in an overpriced taxi, and longer in a free shuttle bus, to get from either end of the coastal strip to the UN COP27 venue, which has been specially constructed in temporary buildings around the international convention centre. When the conference palls, the bright lights, loud music and traditional Egyptian belly dancers of the Naama Bay strip inevitably have their appeal. “It’s like Las Vegas,” one delegate said, “only not as highbrow.”

Nevertheless, this is where COP27 is taking place, and it’s the scene of plenty of serious negotiation and debate. The Leaders’ Summit in the first two days was notable mainly for the traffic jams caused by presidential convoys and tight security. Although the speeches didn’t generally rise very far to the occasion, they served their allotted purpose: forcing heads of government to declare in front of their domestic TV audiences that climate change is an urgent priority and they are committed to stronger action to combat it.

The two most eagerly awaited speeches were not actually scheduled for the summit itself. Fresh from his unexpected triumph in the US midterm elections, Joe Biden arrived in the largest convoy of all a couple of days after the other leaders had left. In his usual inimitable monotone, he declared that the American Inflation Reduction Act — his administration’s unprecedented package of climate change measures, which finally got through Congress in August — would enable the United States to meet its 2030 emissions targets, driven by investment in new technologies and American enterprise.

The president also declared the United States would provide more help to developing nations to combat a climate crisis that concerned “human security, economic security, environmental security, national security and the very life of the planet.” Climate wonks poring over the text could find little new support that had not already been announced, but the general uplift from Biden’s presence was evident. A grateful audience gave him a standing ovation, not something hard-bitten COP delegates are wont to do.

The other eagerly awaited leader has only just arrived. President Luiz Inácio Lula da Silva of Brazil, fresh from his even more momentous election victory, will make his speech today, and his ovation will be even longer. Under the far-right, Trump-imitating Jair Bolsonaro, Brazil has gone from climate leader to renegade destroyer of the Amazon, and the relief among the climate community to have Lula back in power is palpable.

Without control of Brazil’s Congress, the returning president may struggle to pass the environmental legislation he wants, but he will beef up security protection for forest lands and indigenous peoples, and commit to “net zero deforestation” in the future. He has already made clear that he will be a regional and global champion for climate action, and in a geopolitical world riven by tension between the big Northern hemisphere states — the United States, China, the European Union, Russia and India — there are high hopes for his Southern leadership.

If the big countries inevitably take up the largest space in UN climate conferences — commensurate with their outsized emissions pouring into the atmosphere — there is nevertheless always room at COPs for the small nations to make a mark. It is one of the more remarkable features of the thirty-year-old UN climate regime that decisions have to be reached by consensus, which gives otherwise internationally invisible and powerless countries a crucial role. Coupled with the fact that the poorest countries most vulnerable to climate change — the small islands of the Pacific and Caribbean, low-lying nations such as Bangladesh and glacier-melting ones like Nepal — are the evident victims of a climate crisis they didn’t cause, this creates a rather remarkable dynamic.

At the Paris COP in 2015, it was the tiny Marshall Islands that led the High Ambition Coalition with the European Union and the United States that drove the final treaty negotiations to an unexpectedly radical conclusion. And in Sharm el-Sheikh it is Vanuatu and Tuvalu that have made the early headlines. They have been reiterating their request for an International Court of Justice ruling on the legal liability of rich countries and companies for the historical emissions that threaten their island existence. The two countries have demanded that the world agree a “Fossil Fuel Non-Proliferation Treaty” to manage the global phase-out of coal, oil and gas.

The most powerful speech at the Leaders’ Summit also came from a small island. The prime minister of Barbados, Mia Mottley, was the standout speaker at last year’s COP26, and retained her top spot in the unofficial charts with another remarkable and insightful contribution here.

Mottley’s rhetoric transfixed the hall. “We have the collective capacity to transform,” she told the heads of government sitting in the rows of seats in front of her. “We’re in the country that built pyramids. We know what it is to remove slavery from our civilisation… to find a vaccine within two years when a pandemic hits us… to put a man on the moon. And now we’re putting a rover on Mars. We know what it is. But the simple political will that is necessary, not just to come here and make promises, but to deliver on them and to make a definable difference in the lives of the people whom we have a responsibility to serve — this seems to be still not capable of being produced.”

Mottley’s core argument was that the international financial system isn’t working for poor and middle-income countries, like Barbados, that want to move to net zero emissions and cope with the devastating climate change they are already experiencing. They cannot access the finance or the technology to do so. She laid the blame squarely on the World Bank, the IMF and their developed country shareholders. “This world,” she said, “looks still too much like it did when it was part of an imperialistic empire.”

Mottley is not, however, content with rhetoric. Over the last few months she has been promoting a new plan for financial reform dubbed the Bridgetown Initiative after the Barbados capital in which it was hatched with her adviser, economist and former investment banker Avinash Persaud. And it has been getting increasing traction at COP27.

At the core of the plan are three innovative reforms that between them could galvanise more than US$1 trillion of new finance for climate-compatible development, including emergency help to countries hit by extreme weather events, and low-cost lending for emissions reduction investments.

The first is to get the World Bank, along with the other multilateral development banks, or MDBs, in Africa, Latin America and Asia, to use their capital base more expansively. These banks are all funded by the richer countries to provide concessional lending to developing ones. But the World Bank in particular has become deeply risk-averse. Highly protective of the triple-A rated status of its bonds, it has refused to use its healthy balance sheet to increase its lending capacity.

A recent expert report commissioned by the G20 group of nations found that between them the MDBs could lend an extra US$500 billion or more if they slightly relaxed their risk appetite and capital accounting procedures and better utilised government guarantees.

Second, Barbados has been pioneering “disaster clauses” in its debt contracts. These are stipulations that if a country borrowing money from private or public creditors experiences a predefined extreme weather event, all its debt repayments will be postponed for two or more years. Given how much many developing countries are forking out in debt repayments, such clauses immediately release millions of dollars of liquid funds for disaster relief and reconstruction and public service budgets. The creditors get repaid on a later schedule, but with the interest they have lost made up, removing any financial loss. Barbados is proposing that such clauses should become standard practice in all sovereign debt contracts.

Third, Mottley has called for a new issuance of Special Drawing Rights, or SDRs, the reserve currency the IMF is empowered to release to support the global financial system. She proposes that these SDRs be put into a trust fund that can then back new lending for emissions reduction investments such as renewable energy, methane control and forest and land management. For most developing countries, the cost of capital is simply too high to enable them to borrow for such priorities.

Where developed countries with strong currencies can borrow on international markets at 3 to 5 per cent, most developing countries — including relatively stable, growing ones such as India and South Africa — face interest costs at least three times higher. Barbados proposes that the new fund should auction its lending capacity to the projects, wherever they are located, that can achieve the highest and fastest emissions reductions.

These reform ideas are not the only ones circulating at COP27. The V20 group of climate-vulnerable nations has produced its own suggestions for new financing mechanisms, and innovative ideas are being produced by academics and civil society organisations, including a plan for the cancellation of developing country debt in return for commitments to verifiable climate action plans.

Mottley used her short stay in Sharm el-Sheikh to discuss her ideas with other leaders. French president Emmanuel Macron duly called for an expert group to look at the Bridgetown Initiative and other proposals and make rapid recommendations on their implementation to the international financial institutions and their shareholder nations next year.

And in the negotiating sessions that have followed, ministers from other countries have gone further. Several have called for a review, not just of individual funding mechanisms, but of the entire international financial system. Many countries are today experiencing once again the problem of the dominance of the US dollar. As American interest rates rise, their own currencies are depreciating, making imported energy, food and manufactured goods more expensive and raising the cost of dollar-denominated borrowing. Another global debt crisis looms, with more than forty countries in or at risk of debt distress, according to the IMF. When the United States catches a cold, one delegate noted, the rest of us get flu.

So an even bigger agenda is beginning to make its way into COP speeches and debates. The present international financial system and its institutions were designed in 1944, in a very different economic and political world. Nearly eighty years on, they could do with a refresh.

No one is yet claiming Sharm el-Sheikh will one day be as famous a venue for international financial reform as Bretton Woods. But the seeds are being planted. •

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Menand’s account of contemporary central banking is not entirely convincing, and his remedies for its problems are specific to the United States and unlikely to be adopted. But in focusing on the change wrought in central banking by the global financial crisis and the pandemic he identifies the most important issue in central banking.

Compared with the implications and consequences of this change, many of the monetary policy issues we are debating today in Australia — issues now the subject of a government-initiated inquiry — are interesting but not fundamental. Should the Reserve Bank of Australia be charged with targeting a certain band of consumer price inflation, or some other band, or even a different measure of economic activity? Should more professional economists sit on the Reserve Bank board? Should interest rates have been even lower in the years before the pandemic? Should Reserve Bank governor Philip Lowe have been more ambiguous in his “forward guidance” on interest rates during the pandemic? All these are worthy questions, but no longer the main point.

For Menand — and his argument applies equally outside the United States — the main point is that in 2008 and (to a vastly greater extent) in 2020 central banks busted conventional expectations of what they could do, with consequences as yet unknown.

Menand, a former Fed official and a senior Treasury official in the Obama administration, brings to his task an understanding of financial structure and economics, law and history, as well as a clear and logical mind. He reminds us that the pandemic’s first economic effect was a global financial crunch. That crunch was so quickly quelled by the Fed and other central banks (including Australia’s) that we have almost forgotten the grave danger of financial collapse in March 2020. This was what triggered central bank intervention, though that support was soon extended much more widely during the pandemic.

Startled by the unknown consequences of the emerging pandemic, financial markets sold off assets. In just six weeks, US shares fell by nearly a third from their peak at the end of January 2020. Investors who had borrowed money to buy shares were forced to sell bonds and other financial assets to meet demands for cash repayments. Bond prices fell and interest rates rose, spooking markets that had expected to see the opposite happen. Suddenly everyone, remembering 2008, wanted cash rather than securities.

US primary dealers, who borrow cash to buy bonds, using the bonds as security, discovered lenders wanted their cash back. Already falling, bond prices fell more as dealers sold bonds to meet those cash calls. The panic spread rapidly through other financial markets in the United States and elsewhere.

Taught by the experience of 2008, the Fed responded by providing cash to the market and accepting bonds and other financial assets in return. Even compared with 2008, the Fed spent big: between September 2008 and the end of that year it acquired assets of US$1.3 trillion; from February to May 2020 it acquired US$2.9 trillion.

The central banks’ response to the pandemic came in two major phases, both of them extending the usual perimeter of their activity. The first phase aimed to stop an immediate financial panic by sharply lowering interest rates and lending cheap money to financial businesses that needed it. The second phase aimed to support household and business demand through the long pandemic in two ways: directly, by keeping interest rates very low and freely lending money to banks and then to a wider category of businesses that needed it; indirectly, by buying government bonds issued to finance deficit spending.

Whereas the cash splurge from the Fed peaked at not much more than US$1.3 trillion during the global financial crisis, by February 2022 it had spent close to another $2 trillion. Its assets were now nearly four times bigger than at their peak in 2008.

In Australia, where shares fell just as sharply (and by a little more) in early 2020, the Reserve Bank spent much more as a share of GDP. In the second week of March 2020 it held $89 billion in Australian dollar assets. By the fourth week of May that amount had more than doubled to A$200 billion as the bank grappled with similar issues of financial instability and also began supporting fiscal policy by purchasing Australian government bonds. At the peak, in March 2022, the Reserve Bank would own more than six times the value of Australian dollar assets it held at the beginning of the pandemic, a total of well over half a trillion dollars.

This enlargement of the role of central banks matters to Menand for reasons that don’t necessarily matter to us in Australia. He is bothered because the US Federal Reserve is doing things Congress didn’t intend when it set up the federal reserve system. In this respect, he is taking an “originalist” approach. Congress is supposed to control tax and spending, yet the Fed is commanding resources by issuing money without congressional authorisation.

Menand wants Congress to be more active in responding to crises. That would be more democratic, he says, and also more egalitarian. Interest rate cuts stimulate increases in asset prices, helping rich people. Government spending, by contrast, can be targeted in a fairer way to support demand.

All of that is true, but a financial crisis doesn’t wait around while parliaments debate the proper response. Nor is the role of central banks in creating money to buy bonds during downturns necessarily inegalitarian. In principle, bond purchases facilitate government spending, with the character of that spending determining its distributive effect.

The legal remit of the central bank concerns us less in Australia because the federal government has the authority (never used, but there) to instruct the Reserve Bank to pursue, or not pursue, specified policies. Moreover, the Treasury secretary sits on the bank’s board and could convey a government view if he or she chose to do so, and by convention the governor of the bank and the treasurer of the day make a point of staying in close touch. Legally, the Reserve Bank is closer to being the monetary policy arm of government than its US counterpart. Its independence is conferred upon it, not required.

Had the Reserve Bank refused to buy bonds during the pandemic in the same way its predecessor, the then Commonwealth Bank, refused to finance deficit spending by the Scullin government beyond a certain point during the Great Depression, the consequences would have been fascinating. Central bank thinking has moved on and the issue didn’t arise. So has the legislative framework for central banking, partly reflecting Labor treasurer Ben Chifley’s determination in 1945 to prevent the central bank acting as it did during the Depression.

Menand rightly blames the shadow banking sector for the US financial crises of 2007–08 and early 2020. These institutions borrow cash to buy higher-yielding securities, or lend money with limited supervision and without a government guarantee for depositors. In the run-up to the 2007–08 crisis, investment banks like Bear Stearns and Lehman Brothers were borrowing in the overnight money market to buy home mortgage securities and other higher-yielding assets. When the crisis made the value of these home mortgage securities difficult to determine and hard to sell, overnight lenders wanted their money repaid rather than allowing it be rolled over. The Fed was forced to support these shadow banks by lending them cash and acquiring mortgage securities, but not before Lehman went down and plunged American and European financial markets into years of grief.

Australia’s financial crises in 2008 and 2020 were quite different. Shadow banks play a much smaller role in the bank-dominated Australian financial market (though in 2009 the Reserve Bank and the government found they had to support the market for bundled or securitised home mortgages and prop up lenders in the car loan market).

The Reserve Bank’s big job in 2008–09 was to protect Australian banks when, at the height of the crisis, they were no longer able to roll over their substantial US dollar-denominated loans from offshore institutions. The bank provided liquidity, including in US dollars. When other central banks guaranteed domestic bank deposits and other borrowing, the Reserve Bank was obliged to follow suit.

Though the circumstances were different in each country, the 2008 crisis greatly extended the scope of central bank actions. When a similar flight to cash began in February 2020, central banks knew what to do.

The central bank’s response to these two crises has left us with questions we are yet to work through. For example: the Reserve Bank of Australia now owns more than a third of the net debt of the Australian government. It is paid interest on that debt, amounting to something in the order $3 billion a year. As it retires its Australian government debt holding, the federal government will need to sell additional bonds to the private market (or increase taxes — not a live option) to finance its repayments.

Over time, the government will need to repay more than $200 billion (by redeeming bonds) to return the bank’s balance sheet holding of official debt to its pre-Covid size. That will mean higher interest rates than otherwise, higher taxes than otherwise, and less spending than otherwise on other things like nuclear submarines or disability support. How much of that $3 billion or so in interest payments should the Reserve Bank return to the government as profit on central banking operations? Even at the most ordinary of times, that question opens up a tense conversation.

And given that the bank bought those bonds with cash it created out of nothing but expects to be repaid out of taxpayers’ pockets or by the issuing of additional bonds to the private market, will governments begin to find the obligation inconvenient and seek to negotiate their way out of it? Will they ask why the bank needs — and what it will do with — all the cash it gets from government in return for its bonds? Treasury might find itself discouraging the bank from running down its bond inventory, or even encouraging the bank to add to it.

In tough times, these possibilities will all come to mind. The Reserve Bank is, after all, another arm of government, another agency of the Crown. Central banks can destroy as well as create money so the Reserve Bank could choose to extinguish payments from Treasury, at the same time extinguishing the corresponding accounting liability. But to extinguish payment from taxpayers looks odd.

The bank might well argue that it will need the cash from the redeemed bonds to buy bonds during the next downturn. Cash would then move from the Treasury to the Reserve Bank in good times, and from the Reserve Bank back to Treasury in bad times, confirming the bank’s new role as a participant in fiscal policy.

If the next downturn is far enough away, that might be a useful and workable reimagining of fiscal and monetary policy. The bank would assume a responsibility for fiscal stabilisation while the Treasury assumes a responsibility for economic stabilisation, the opposite of their declaratory roles in past decades. If it was to work, however, it would need to be discussed and agreed and publicly known, all of which is unlikely.

That issue is one aspect of the changed relationship between fiscal and monetary policy consequent on the changed role of the central bank. For decades, economic policy in Australia has been run on the official understanding that the Reserve Bank would smooth the ups and downs of the economy using interest rates while the government’s budget would be designed to achieve balance “in the medium term.”

During the pandemic Treasury secretary Steven Kennedy pointed out that the Reserve Bank cash rate was near zero, the effective limit of what the bank could do to stimulate demand using interest rates. While the government had spent a vast amount in pandemic support, Kennedy suggested, it could certainly spend a great deal more if necessary. The implication is that fiscal policy could become the active arm of economic stabilisation while the Reserve Bank slowly recovered its interest rate flexibility.

In the event, recovery from the pandemic was stronger than expected, and fiscal and monetary policy have been tightening at the same time. Whether or not fiscal policy emerges as the preferred stabilisation tool, a transfer of the focus of day-to-day economic policy from the Reserve Bank in Sydney back to the Treasury in Canberra waits on the character and timing of the next big downturn. •

The Fed Unbound: Central Banking in a Time of Crisis
By Lev Menand | Columbia Global Reports | US$16 | 176 pages

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But before we look at the criticisms of the RBA, it’s worth considering a few points about what has happened since I left.

Whatever might be alleged about the RBA’s caution in the decade to 2020, it has undoubtedly been very bold since then. At the end of last month it held almost $251 billion in Australian government bonds — a little under a third of their entire value, and eighteen times the value of those it held just before the coronavirus struck. In the first sixteen months of the pandemic, the RBA bought bonds equal to 70 per cent of the vast federal government deficit created by the pandemic. Among other actions, it also set the overnight cash rate at practically zero.

The Reserve Bank’s boldness was matched by that of the federal government. Even now, emerging from the pandemic, the federal budget deficit is the second-highest on record, exceeded only by last year’s. Before the pandemic Treasury expected the budget to be in surplus by now; on its latest projections, we will still be in deficit forty years hence.

But the revolutionary expansions, fiscal and monetary, are over now. Year by year the federal budget deficit will be reduced as a share of GDP. Year by year interest rates will go up. Tightening will be the backdrop of the economy and the political contest.

The tightening has already begun. The Reserve Bank has rightly given up on its attempt to hold the three-year bond rate steady. At its February meeting the board is likely to agree to phase out bond buying. When it comes, the next interest rate move will be up. This year’s projected budget deficit, meanwhile, is less than last year’s, and the figure is projected to fall each year over the next three financial years. By 2023–24, with spending cut by 1.4 per cent of GDP and taxes rising by a bit over 1 per cent of GDP, the deficit is projected to be half the share of GDP it is today.

But the vast household savings accumulated over the pandemic — savings we are now spending — mean we probably won’t feel the tightening for quite a while. Borrowing rates are so low compared with what we became used to before the pandemic that it will be a while before the contraction bites.

During the pandemic monetary and fiscal policy became far more closely connected. When both monetary policy and fiscal policy are tightened over a long period, there is a serious risk of miscalculation. The Reserve Bank needs to know what fiscal moves the government plans, and the government needs to know what the RBA plans.

If monetary and fiscal policy will be contractionary for some time, we need to think about other ways of lifting living standards. Increases in productivity — in output per hour of work — ultimately determine most of that rise, and on this measure Australia was already slowing, as were most wealthy economies. The big question is what we can do to speed it up.

But what of the years 2011–16, when I was a participant, like all other members of the board, in the RBA’s decisions on monetary policy? This was a period when the unemployment rate rose, and inflation — while mostly within the target band of 2 to 3 per cent — was generally closer to the bottom of the band than the top. An inquiry might well conclude that interest rates could have been lower without risk of serious inflation, and employment and GDP accordingly higher.

But critics sometimes overlook the fact that we were cutting interest rates throughout that period from 2011 to 2016, and quite vigorously. The cash rate was 4.75 per cent in June 2011. By July 2016 it was 1.75 per cent. That’s a pretty big cut. At 1.75 per cent, the cash rate in the middle of 2016 was lower than it had ever been.

Most of the time those rate cut decisions were sharply criticised. The Australian Financial Review was usually unhappy, arguing that tax and industrial relations changes were needed instead. The cuts generally went against the public advice of a “shadow” board of academics and others claiming expertise in monetary policy. The RBA cut a lot faster and deeper than most outside commentators expected, or preferred.

Nor were the cuts without effect. Mining investment was falling dramatically as projects were completed, and interest rate cuts in Australia couldn’t change the plans of global mining businesses. But what monetary policy could do, it did. The Australian dollar’s exchange value tumbled. Exports did well. Housing construction boomed. Household consumption growth remained firm. Overall, GDP growth averaged only a little under 3 per cent.

It is true there were no further rate cuts between August 2016 and May 2019, a nearly three-year period. But it is also true that the cash rate, by then 1.5 per cent, was the lowest on record. When output growth slowed into 2019 the RBA resumed cutting rates. By the end of 2019 the cash rate was just 0.75 per cent.

With perfect foresight the RBA might have cut a bit faster. But surely the main point is that in the circumstances of those years monetary policy could never be quite as effective as some of the bank’s critics — internal and external — believed.

An inquiry could be interesting. But it is hardly relevant to where we are now. What does deserve examining is what is happening to productivity. This is an issue about which we don’t know enough — not the RBA, not Treasury and not the Productivity Commission. A conference of local and international experts would be a good place to start. Productivity is the most important question for our future, not the pace of interest rate cuts before the pandemic. •

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The case for pessimism was made eloquently — if perhaps unintentionally — by Sir David Attenborough in a powerful address to the Leaders’ Summit that opened the conference on Monday. Tracing the precipitous rise in the concentration of carbon in the atmosphere over the past hundred years, the ninety-five-year-old naturalist reached a simple conclusion: “We are already in trouble.”

The prime minister of Barbados, Mia Mottley, was even more brutal in her speech in response. The developed world had failed to meet its promises to cut emissions and provide financial assistance to the poorest countries. The cost, she said, would be measured in lives, and in livelihoods. “It is immoral, and it is unjust.”

Both Attenborough and Mottley insisted humanity can still turn things around. But listening to the rhetoric of the 119 leaders whose speeches filled the next two days — all of them stressing how much their countries were doing, despite most of the facts showing otherwise — it was hard for the rational brain not to feel overwhelmed by pessimism.

The facts are pretty simple. To have a reasonable chance of limiting global heating to the UN goal of 1.5°C above pre-industrial times, global emissions need to be cut by 45 per cent by 2030. On current trends they will rise by 16 per cent.

And yet COP26 is strangely a place of extraordinary optimism. This is mainly a function of its structure. Most of the 25,000 attendees aren’t country negotiators here for the UN climate talks, who probably number around 2500. The rest are people who work professionally on climate change, for businesses, charities and activist groups, universities, city and regional governments, and myriad others. They are here not to negotiate but to sell their wares, meet their international colleagues and network tirelessly.

For a COP is never just — or even mainly — a UN negotiating meeting. It is the world’s annual global climate expo and conference. And almost everyone who comes has a positive story to tell about how they are tackling climate change in some way. For some reason the climate sceptics and the opponents of climate action don’t seem to regard themselves as welcome, and they don’t show up.

So walk among the country and business “pavilions” in the middle of the conference centre — a slightly grandiose name for a series of pop-up stalls and exhibits — and the good news is relentless. Every country is doing so much to tackle the problem, from renewable energy to flood defences, sustainable transport to overseas aid. Every business is committed to “net zero,” engaging its eager workforce in meeting the goal. Every technology company has a world-leading solution, from green hydrogen to drought-resistant crops.

And every hour of the day all the side rooms are full, hosting hundreds of fringe meetings on every possible aspect of climate change. And here too the mood is powerfully feel-good. Of course most of them start with speakers recounting how dire the climate situation is. But they quickly move on to what can be done to tackle it; indeed what their organisation is already doing, in partnership with local communities and local businesses, supported by benevolent financiers and researched by concerned academics. The poorest people in the world may be suffering from severe climate impacts, but a lot of people claim to be helping them.

Observing all this it is easy to be cynical. But it’s also hard not to be affected. It can only be a good thing that a global climate industry of this scale and variety exists. There will surely be no solutions without it. And it has contributed to the remarkably upbeat mood of the official COP proceedings in the first few days.

The negotiations themselves have barely started. An agenda was agreed on the first day — you might think that this would be routine, but plenty of seasoned negotiators saw it as something of a triumph — and the committees and working groups on key issues have held their opening sessions. But most of the attention has been taken up by a series of side agreements carefully choreographed by the British hosts. And the extent and ambition of these have taken many by surprise.

The first was on deforestation. A new pact was announced between more than a hundred governments, representing over 85 per cent of the world’s forests and including Brazil, Indonesia and the Democratic Republic of Congo, pledging to halt and then reverse deforestation and land degradation by 2030. Donor countries would give US$12 billion for forest protection and restoration; many of the countries, companies and financial institutions most involved in trading forest products, including timber, pulp and palm oil, would eliminate deforested areas from their supply chains.

After forests, methane. US president Joe Biden announced that ninety countries had agreed together to cut methane emissions by 30 per cent by the end of the decade. Methane, produced from agriculture, oil and gas, and landfill sites, is a much more potent greenhouse gas than carbon dioxide: if fully implemented, the pledge could limit global heating by about 0.2°C by 2050.

Green technologies were next in the spotlight. Forty countries, including the United States, China, India, the European Union, Britain and Australia, signed up to a “Breakthrough Agenda” to coordinate the global introduction of clean technologies, starting with zero-carbon electricity, electric vehicles, green steel, hydrogen and sustainable farming. The governments said they would align standards and coordinate investments to scale and speed up production. The aim is to bring forward the tipping point at which green technologies are more affordable and available than fossil-fuelled alternatives.

Then it was the turn of finance. Mark Carney, former governor of the Bank of England and Britain’s climate finance envoy, announced that financial institutions holding US$130 trillion of assets under management had committed to hitting net zero emissions targets by 2050. Including more than 450 banks, insurers and asset managers across forty-five countries, the Glasgow Financial Alliance for Net Zero said it could deliver as much as US$100 trillion of financing to help economies decarbonise over the next three decades.

Not everyone applauded all this. Observers noted that a very similar agreement on forests had been announced at the UN Climate Summit in 2014. Nothing much had happened since then; would this time really be any different? It was pointed out that China, one of the world’s largest sources of methane, had not joined the new agreement. Several other green technology initiatives over the last ten years, including a “Mission 2020” platform announced with great fanfare in Paris six years ago, had proved disappointing.

The finance announcements attracted the most criticism. Non-government organisations quickly pointed out that the financial institutions were not promising that all the financing would be focused on environmentally friendly companies. Many of the banks and pension funds would only be greening a small proportion of their portfolios while happily continuing to invest in fossil fuels. The “net zero” commitments of the firms whose shares they owned were in many cases pretty dubious, resting on “offsetting” mechanisms (such as buying trees in developing countries) that can’t be guaranteed to have any effect.

And yet these agreements can’t be wholly dismissed. Many involved a large number of countries that had not previously signed up to such pledges; and most came with a lot more money — both public and private — than previous attempts. A specific agreement between South Africa, the United States and several European countries to help South Africa move away from coal particularly impressed observers: it included both significant policy reform and serious financial support.

These side agreements have a slightly strange relationship to the main negotiations. Formally, they have nothing to do with them: they do not involve the universal participation of the 197 parties to the UNFCCC (the Framework Convention that governs the talks) but rather are “coalitions of the willing.” Most of them involve private sector partners that have no formal place in the UNFCCC.

Yet in another sense they are clearly part of the process of cutting global emissions and increasing climate-related finance, which are the two main goals of COP26. Indeed, they are rather more concrete manifestations of this than anything negotiated in the conference hall. So the British government is trying to find a way of bringing them into the final COP agreement. In particular it wants to show how these agreements will help close the emissions gap between the 1.5°C trajectory demanded by the science and the current total of country pledges. Initial analysis has been uncertain: it’s possible that these sector-specific emissions reductions will be the means by which the “nationally determined contributions” of the participating countries will be achieved. Or it could be that they will enable those contributions to be exceeded.

And the nationally determined contributions themselves have also received a welcome boost in the first few days. China and India were the only two major countries who came to the COP without having announced new commitments for 2030. When it did come, China’s statement added nothing to what it had already pledged. Coupled with president Xi Jinping’s non-appearance at the Leaders’ Summit, it has made many observers question China’s current stance: a country that once prided itself on being the champion of the developing world is appearing to absent itself from this crucial moment.

India, by contrast, announced a much more ambitious contribution than anticipated. Speaking in his leader’s slot, prime minister Narendra Modi declared that India would commit to net zero emissions by 2070, and half of its electricity production from renewables by 2030. The former — a later date than China (which has committed to net zero by 2060) and apparently too late to be compatible with the 1.5°C goal — seemed disappointing to some. But scientific observers noted that this was not necessarily the case: it was indeed too late if Modi meant net zero carbon dioxide, but not if he meant net zero from all greenhouse gases. And the renewables pledge was truly ambitious: with India’s proportion of renewable electricity currently under 20 per cent, a more than doubling in less than ten years is a startlingly radical goal.

And so the early feeling in Glasgow is considerably happier than many had feared. More side agreements are still to be announced, including on phasing out coal and electrifying cars. No one will admit to expecting that COP26 will be a raging success. But some are allowing themselves a small boost of optimism. •

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But a property crash in China would be vastly different from one in any other part of the world, and that’s because of the enormous amount of control the Chinese government has over the economy, the financial system, cross-border capital flows, labour markets, the media and the Chinese people.

Many believe that this level of control makes a systemic crisis less likely. This is true, but the optimism is misplaced. For China to achieve strong, sustainable and inclusive growth it needs an economy that sources its growth from productivity and innovation. History shows that these depend on well-designed free markets and a government that limits its interventions to delivering public goods and dealing with market failures. While government intervention is often required in crises, flexible markets are also much better at minimising their social and financial cost.

The Chinese government’s capacity to manage every facet of a property crisis — from the companies involved and the banks that lent to them through to cross-border capital flows, and what people do with their shares, savings and labour — reveals just how far China needs to go in liberalising its economy. It’s also a reminder of just how far backwards the country has gone under Xi Jinping.

A collapse of Evergrande is unlikely to significantly affect the rest of the world. China’s capital controls have limited the financial links between China’s property market and the global economy. While some foreign investors own bonds linked to Chinese property developers, most of the impact of the crisis so far has centred on specific Chinese firms within the property sector. Capital controls are preventing Chinese savers and investors from moving much of their money offshore, which would help limit falls in asset prices and relieve pressure to depreciate the exchange rate (which is also heavily managed by the Chinese government).

Property crises often spread through the banking sector. But a recent stress test of Chinese banks suggested the country’s banks are relatively stable. Although some smaller banks could get into trouble, the financial buffers across the system would be reduced by only 2.1 per cent in an extreme scenario. Evergrande is a big firm, but its debt amounts to just 0.5 per cent of total Chinese bank loans. And even if problems did emerge among banks, regulators have wide powers to clean up their balance sheets through forced mergers with other banks, forced reductions in the debt repayments being demanded by creditors, and forced “bail-ins” by shareholders, as well as direct bailouts and increased nationalisation.

The “shadow banking sector” is perhaps the biggest area of concern. These are the non-bank financial intermediaries that sit outside banking regulations. Almost half of Evergrande’s interest-bearing liabilities came from trusts and other shadow lenders in the first half of 2020. The opacity and lack of regulatory oversight, even by China’s standards, make it difficult to judge these risks. The offshore bond market is a similar concern given that Evergrande is the largest single issuer of dollar-denominated bonds through Hong Kong.

The direct financial implications for the rest of the world might be relatively muted, but that doesn’t mean there are no indirect effects. If the Chinese government pushed the economy away from property construction then China’s demand for other countries’ exports will change. With the price of iron ore already falling sharply, this is a particular risk for Australia.

Domestically, the Chinese government’s control over its economy has major drawbacks.

Its control of the country’s financial system stops savings from being directed to the entrepreneurs, startups and businesses that need them. That stops new businesses from forming, hurts job creation, reduces productivity, and results in a build-up of risk and speculation in asset markets.

Its control of labour markets prevents businesses from accessing the right workers, and stops workers from pursuing the jobs they most desire, reducing their productivity and efficiency.

Its control over the exchange rate has similar drawbacks. Its interventions have historically reduced the purchasing power of Chinese citizens, who then go without cheap goods and services so rich people in rich countries can have more.

And its control over cross-border capital flows stops citizens from getting the best possible return on their savings, crucial to funding their retirement given China’s weak social safety net. Foreigners can buy Chinese stocks 31 per cent cheaper than locals can. Why? Because foreigners have options and locals do not.

Nor is it correct to think that a trade-off exists between long-term growth and effective crisis management. Flexible economies are better for growth and better at preventing and managing crises. If people are free and able to leave industries, towns and cities to find new jobs, the effect of a crisis on employment will be smaller and the government won’t need to spend as much on stimulus. If businesses can easily close and redirect their capital elsewhere, the hit to GDP, incomes and savings will be smaller. If households are free to shift their assets, and prices, wages and the exchange rate are allowed to adjust, the economy recovers more quickly.

A liberalised Chinese economy is good for growth, and even better for crisis management. Sadly, China appears to be going firmly in the wrong direction under President Xi Jinping.

Xi’s campaign to rein in perceived capitalist excesses is increasing the government’s control over the economy. It is undermining the economic liberalisation China desperately needs. The government’s blocking of Ant Group (one of China’s biggest companies) from issuing shares, its punishment of Didi (a ride-sharing company) for listing its shares on American stock markets, its efforts to punish Evergrande, its banning of cryptocurrency trading, even its limitations on computer gaming are just recent examples of a steady increase in government controls.

China has achieved remarkable growth by combining modern technologies with an enormous population and an export-oriented growth strategy. But this is an old trick. It’s a model that only works for so long. Without sustained productivity and innovation, China risks getting old before it gets rich. •

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Turnbull’s words sum up why many people avoid trying to understand what’s going on in the Murray–Darling Basin — its ecology, productivity and politics. So it’s good we now have a mini genre of engagingly written Murray–Darling books, including Richard Beasley’s Dead in the Water — which is mainly a forcefully expressed version of the conclusions of the South Australian royal commission into the Murray–Darling, for which he was the counsel assisting — and Quentin Beresford’s forthcoming Wounded Country.

The focus of Sold Down the River is water trading, and what the authors believe has happened since water markets were created in the 1990s by separating water rights from the ownership of land. But the book oversells itself. The subtitle claims it shows “how robber barons and Wall Street traders cornered Australia’s water market.” The book doesn’t do this. That’s not to say water markets don’t have their problems, and the authors detail some of them — but they overstate their central case.

Earlier this year, the Australian Competition and Consumer Commission released the final report of its inquiry into water markets, which uncovered flawed market data, inequalities in access to information, and inadequate or non-existent regulation. What is needed, the ACCC declared, is “decisive and comprehensive reform.”

Water minister Keith Pitt announced he would set up an expert panel to devise the government’s response to the report, and $3.5 million was set aside for this purpose. But earlier this month the minister’s office confirmed the panel had not yet been appointed, nor its terms of reference set.

Why? Doubtless, part of the reason is that it rained, which always takes the political heat out of water policy. Meanwhile, Barnaby Joyce’s return as leader of the National Party saw the water portfolio shoved out of cabinet. There are many cynics in the world of water policy, and it isn’t hard to see why.

This means that Hamilton and Kells, while they don’t cover these recent events, aren’t wrong to smell many rats. But I’m not sure they are chasing the right ones.

They write from a position of profound scepticism about free markets, and in particular the Hawke–Keating government’s policies of deregulation, including opening Australia up to foreign banks. But before they get to the politics, they give us an elegantly written, sometimes lyrical, summary of the Murray–Darling Basin and its history. Those trying to get their heads around the issues could do worse than read it.

Even here, though, there are some notable omissions. Crucially, Hamilton and Kells don’t deal in detail with the big buybacks of water conducted under the Rudd government. Yet they claim that “emphatic social, economic and environmental evidence” shows “the process of buying environmental water from farmers [has] failed.” That isn’t the case, or at the very least is disputed. Buybacks certainly affect rural communities, but as several inquiries have found it is hard to separate their impact from all the other reasons for rural decline.

Indeed, the SA royal commission — referred to approvingly by the authors elsewhere — agreed with the Productivity Commission and several academic studies that buybacks were probably the cheapest, most efficient and to date most successful way of dealing with water over-allocation. The current government is wrong — and politically craven — to rule them out.

Here, Hamilton and Kells reflect the bias of their sources. They make much of the many interviews they have done with irrigators, but the sources identified by name mostly come from a vocal and highly politically involved group of Riverina irrigators. These people have long been hostile to buybacks, and more broadly to the idea that more water needs to be allocated to the environment.

Riverina irrigator Chris Brooks, for example, is quoted at length. A former chief executive of commodity trader Glencore, Brooks has backed Shooters, Fishers and Farmers Party candidates in New South Wales, and more recently announced he will support four independent or minor party candidates in government-held seats at the next federal election. He is considering running for the Albury-based seat of Farrer, currently held by Liberal Sussan Ley.

Brooks was also the main figure behind the “can the plan” protests of December 2019, in which irrigators blockaded federal parliament. He and people with similar views may balance the outsized influence of northern basin cotton farmers on federal politics and the National Party in particular, but they have not yet done more than represent their own sectional interests. Most are populists, offering simple “solutions” to complex problems.

From that perspective, the central narrative of Hamilton and Kells’s book — the argument that robber barons and overseas traders are manipulating the water market — is convenient and appealing.

But what about the evidence? Hamilton and Kells identify some of the problems with water markets, but the evidence for their central allegation of widespread market manipulation doesn’t get beyond the anecdotal and the presumptive. Their “central finding,” they say, is that policymakers made the “critical assumption” that the best economic use of water would also provide the highest financial return.

Whether the free market can be relied on to deliver good outcomes in water management is open to debate, of course, as is the question of whether financial returns are the only kind of “value” that should be considered. If we went purely on profitability, for example, we would accept the decline of small family farms, and rice growing and dairy, in favour of big corporately owned almond plantations and cotton farms. We would ignore the social value in a diverse farming sector and put to one side issues of national sovereignty and food security.

We are not doing those things, or not completely. River managers are universally worried about the proliferation of almond plantations on both sides of the South Australian border, all planted on newly irrigated land thanks to the owners being able to buy water on the open market.

Almonds are a thirsty crop. Delivering water to them already places a big strain on the capacity of the system, and the trees are mostly not yet mature. Victoria has imposed an embargo on new plantations, and South Australia and New South Wales are under pressure to do the same.

In other words, governments are not prepared to simply let the market rip. But nor, it seems, are they prepared or able to tackle the hard water-policy questions in a systemic way. And things drift, meanwhile, in disastrous directions.

But what of the authors’ central assertion — that big institutional investors are manipulating the market, hoarding water and creating artificial scarcity to maximise their profits? “If governments don’t act quickly,” they say, “basin agriculture will become a kind of irrigated Ponzi scheme, with over-investment in unsustainable crops and megafarms.”

They go on: “We are more than confident that, if and when a future audit or inquiry looks at this aspect of Australia’s water market experiment… regulators will have a lot of explaining to do… If you listen very carefully right now, you can hear the haptic hum and crackle of traders and agribusinesses shredding documents, deleting files and destroying USB sticks that contain evidence of their coordination and partnering.”

This last allegation is not supported by a reference — not even, as with some of their other assertions, to an unidentified interviewee.

The best evidence on whether institutional investors are manipulating the market is the ACCC’s water markets report. It certainly identified serious problems, but it found no evidence of market manipulation, despite extensive analysis and investigation, and despite using the ACCC’s powers to force data out of the big traders. This is the best information we have, and there is nothing in this book to force a reassessment.

Nor is the idea that the institutions have “cornered Australia’s water market” supported. In 2018–19, according to the ACCC, institutional investors accounted for an estimated 11 per cent of water allocation volumes purchased and 21 per cent of water allocation volumes sold. While the influence of institutional investors is growing, the main traders in water are those who use it — irrigators, agribusinesses and government environmental water holders. And, just this month, the Productivity Commission issued data showing that foreign entities own only 11 per cent of water entitlements in Australia (not only from the basin).

Hamilton and Kells refer to the ACCC report, describing its criticism of the market as a backflip on previous work. But they don’t deal with these conclusions, which undermine their central thesis. (They also describe the report as being published in 2020, when in fact it was 2021. Perhaps their publishers’ deadlines forced them to rely mainly on the interim report.)

So what do Hamilton and Kells think should be done? They suggest a “citizens assembly” drawn from across the basin to “make the high-level decisions about how to allocate water in the Basin.” They think that limited local trading should be allowed between farmers as a means of water management rather than for profit. Market players who are not connected to land should be forced out. Finally, they suggest “bipartisan agreements” between governments and a role for “a reconvened national cabinet” to oversee Murray–Darling reforms, including a cross-party, cross-jurisdiction standing committee reporting to the national cabinet. Well, that would be nice, wouldn’t it?

But it isn’t clear why those arrangements are either achievable or would lead to better outcomes than the endless negotiations of the Council of Australian Governments or the Murray–Darling Basin Authority, which after years of top-down autocracy is now showing signs of fostering genuine community involvement.

As Malcolm Turnbull’s comment indicates, it is a fantasy to think you can take the politics out of water. Rather, we need better politics. As the ACCC reported, the “robber baron” narrative combined with poor market design and flawed data has undoubtedly fed a lack of confidence in water markets. This book — more a polemic than an exposé — together with the current government’s culpable lack of action, will add to that lack of confidence. •

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They promised they would take “action” on all seventy-six of commissioner Kenneth Hayne’s recommendations to government. They would do everything necessary to empower regulators to hold to account “those who abuse our trust,” thereby demonstrating the government’s commitment to “ensuring a financial system that is working for all Australians.” (My emphasis.)

Over the two and a half years since then, those avowals have become increasingly hollow, even allowing for the unforeseeable six-month delay caused by the pandemic. While the treasurer’s media releases suggest all is well, it is only when you descend into the undergrowth of the reform process that the real state of progress becomes clear.

The government claims, for instance, to have enacted more than 80 per cent of Hayne’s recommendations. Yet more than half have been abandoned or watered down significantly, or are yet to be fully implemented.

The chart below gives a snapshot of the government’s reform progress across five fields of financial activity: banking, mortgage broking, financial advice, insurance, superannuation, and sector-wide financial services. Only reforms that are the direct responsibility of the government are included; excluded are those that require action by regulators or industry bodies.

Green shading on the chart indicates where the government has enacted laws in line with its February 2019 commitment. Blue signifies reforms in progress but not yet completed; typically they are either in draft form or delayed by an uncompleted inquiry.

Orange signifies reforms the government originally committed to fully implement but later changed its mind about and offered something different. These reforms are weaker than Hayne’s recommendations, yet the government’s press releases imply they give effect to the commissioner’s wishes.

Red signifies the government has made no progress; and those with no colour have been put off well into the future.

If the government’s claims were correct, 80 per cent of the boxes in the chart would be green.

One group of recommendations in particular caught my eye: those marked in orange — the ones that the government has modified since its original press conference. Despite their different subject matter (responsible lending, mortgage broker remuneration, anti-hawking and a new disciplinary system for financial advisers) they all have the potential to fundamentally disrupt the business models of financial services firms.

Keeping that in mind, it’s no surprise to find that lobby groups have played a crucial role in the government’s evolving response to Hayne. Lobbyists for banks, mortgage brokers and financial advisers leapt into the void caused by the pandemic, taking advantage of delays in drafting legislation to convince the government to rethink its promised “actions.” The banks argued that the flow of credit to households and businesses needed to be free of impediment. Mortgage brokers pointed to the alleged risk of their own small businesses being destroyed, pushing unemployment higher. Financial advisers argued against any new regulations that could damage their businesses.

First cab off the rank were the mortgage brokers, who mobilised well in advance of Hayne’s final report. The government capitulations began on day one, when Josh Frydenberg revealed that, at least in the short term, the government wouldn’t be giving full effect to Hayne’s recommendations for that industry. This early lobbying success spurred on the bankers and the financial advisers.

Interestingly, the insurance and superannuation lobbies were either much slower off the mark or less successful in their campaigns. It is in relation to those two sectors that the government has passed reforms giving full effect to Hayne’s recommendations.

Governments capitulating to big lobby groups should be of real concern to those seeking to restore trust and confidence in our financial system. After all, as Hayne observed in the opening pages of his final report, “the primary responsibility for misconduct in the financial services industry lies with the entities concerned and those who managed and controlled those entities: their boards and senior management.”

In keeping with that central message, Hayne stressed the need to carefully monitor the culture, governance and remuneration practices of financial services entities. He recommended that the Banking Executive Accountability Regime, which has applied to senior executives and directors of banks since 2018, be extended to senior executives in all financial institutions within the scope of the Australian Prudential Regulation Authority, or APRA. The system, known as the BEAR, closely regulates the behaviour not only of banks’ senior executives and board members but also of banks themselves, and can result in large penalties.

The government has now made two attempts to develop Hayne’s proposed Financial Accountability Regime, the first in January 2020 and the second just last month. In the first version, senior executives of all regulated financial institutions would face the same obligations as set out in the BEAR. Importantly, the 2020 model also specified that individual executives and directors would be personally liable for their breaches of the act and could be subject to fines of up to $1.5 million. After public consultation, the 2020 model was withdrawn.

The July 2021 draft has one significant difference: it no longer provides for individual liability for senior executives and board members who breach their duties. The financial entities themselves can still be liable for civil penalties, and APRA can still disqualify people from holding the position of an “accountable person” within regulated entities, but this version has been stripped of individual penalties.

It is hard to see this as anything other than a major concession by the government to the banking lobby. Given Hayne’s core message, it stands to reason that the increased duties under the proposed Financial Accountability Regime would be accompanied by penalties. The banking lobby clearly saw this as a bridge too far and convinced the government to give way.

Abandoning individual liability also calls into question the sincerity of the government’s promise to restore confidence in the financial system. Ordinary Australians rely on regulators to monitor the large financial institutions and to act if significant misconduct is detected. If this misconduct tracks its way up to senior executives and boards, it follows that regulators should be able to take robust action against them.

The Financial Accountability Regime is not yet law, but the government anticipates the parliamentary process to be completed during spring this year and the laws to take effect in 2022. Of course, whether executives and directors of financial institutions have liability under the new regime or not, they remain exposed to penalties under the Corporations Act. But the Financial Accountability Regime is tailored to financial services institutions, and strong notions of responsibility and accountability — which seem likely to be watered down for those at the top of these organisations — should be integral to its effectiveness.

The government’s backsliding has also undermined responsible lending laws, which potentially affect every Australian who takes out a home loan. Existing legislation requires banks to lend responsibly to consumers — essentially to help people avoid over-committing themselves — and sets out how they should do that. Despite the importance of responsible lending laws, and despite calls from consumer groups to strengthen them, Hayne declined to recommend changes. Instead, he said, these laws should continue to operate exactly as they have since they were introduced in 2009.

The government initially agreed, only to backslide in September last year. Treasurer Frydenberg announced that the laws would be rolled back to apply only to a small number of credit contracts and consumer leases. He justified the backflip by referring to the recession caused by the pandemic, arguing that the repeal would remove “unnecessary barriers to the flow of credit to households and small businesses.” Yet Treasury, in its own submissions to Hayne, had conceded that these “barriers” had no material effect on the overall availability of credit and were likely to enhance rather than detract from Australia’s economic performance.

The treasurer’s justification echoed a lobbying campaign by banks and government backbenchers, and some wider criticism of what was described as the “academic” and “uncommercial” administration of the responsible lending laws by the Australian Securities and Investment Commission. The rollback legislation has been blocked by the Senate, however, so ordinary Australians might yet win this day.

And so to the less monolithic end of the industry. Australia’s 15,000 mortgage brokers are a critical intermediary between customers and banks, responsible for settling 59 per cent of household mortgages. Commissioner Hayne concluded that the industry is hopelessly conflicted, largely because of how its members are remunerated. Mortgage brokers purport to act for retail clients yet they accept upfront payments and trailing commissions from lending institutions. The only clear beneficiary of their services appears to be the mortgage broking industry itself.

To resolve that conflict, Hayne made four key recommendations. He proposed that brokers have a legally enforceable “best interests” duty to act in the interests of borrowers rather than lenders; that borrowers, not the lending banks, pay fees to mortgage brokers for their services; that all mortgage brokers eventually be regulated by the same laws that apply to financial advisers; and that a Treasury-led working group monitors and adjusts fees paid to mortgage brokers.

The government enacted the best interests duty, but the other three recommendations have been abandoned or reversed, or can’t proceed at least until after a working group reports in the second half of next year, almost four years after Hayne delivered his report. Until then, the much-criticised trailing commissions paid by lenders to mortgage brokers will continue, despite Hayne’s recommendation that they be banned. Also despite Hayne’s recommendations, mortgage brokers are unlikely to be regulated by the same laws applying to financial advisers.

The mortgage brokers’ swift and successful lobbying was all too evident at Josh Frydenberg’s press conference on 12 March 2019, where he exclaimed that “the government stands side by side with mortgage brokers.” Just a month prior, he and the prime minister had claimed kinship with “all Australians.” The government’s press releases brightly claim that the government has acted on Hayne’s mortgage broker recommendations. In fairness, it has — just not the action Hayne had in mind when he wrote three of his four recommendations.

Industry lobbyists argue that mortgage brokers’ conflicts of interest are now well regulated by the best interests duty and the government’s new ban on mortgage brokers accepting “conflicted remuneration.” The definition of what constitutes “conflicted remuneration” is complicated, but as the law currently stands, it doesn’t necessarily rule out brokers being paid the very commissions that Commissioner Hayne wanted prohibited. Unless things change following a review scheduled for late 2022, mortgage brokers will continue to operate with the same conflicts.

Finally, what of financial advisers? Their campaign for change has really only just begun. Much of what follows for that industry depends on the outcome of a 2022 review of the effectiveness of existing measures to lift the quality of financial advice. But signs already suggest that the government is bowing to pressure to water down the new disciplinary system for financial advisers.

Hayne expressed concern that the current system is top-heavy with penalties that are really only appropriate for the most serious cases of misconduct, which means that less serious misconduct escapes sanction. He proposed a new disciplinary system quite separate from the Australian Securities and Investment Commission’s power to ban financial advisers. The government initially proposed that this function be taken up by the regulator, the Financial Adviser Standards and Ethics Authority. But in December last year that proposal fell victim to lobbying from the industry, which sees ASIC as more accommodating of the industry’s commercial concerns. The government’s subsequent announcement that the disciplinary role would be taken up by ASIC’s Financial Services and Credit Panel was hardly consistent with the spirit of Hayne’s recommendation.

Signs suggest that the backsliding won’t end there. Members of the government have recently begun expressing broader doubts about Hayne’s reforms. Last month Tim Wilson MP, chair of the House of Representatives economics committee, publicly questioned the thinking underpinning Hayne’s final report and complained that the government felt obliged to accept the commissioner’s approach. Treasurer Frydenberg has pressed ASIC to prioritise supporting Australia’s economic recovery from the pandemic, leaving open the question of how it goes about that task while enforcing the law in the manner recommended by Hayne.

The upshot of all these commitments, capitulations, delays and obfuscating press releases is that the fate of Hayne’s reform agenda is unclear. The commissioner’s final report expressed concern about the connections between misconduct and financial reward, the effect of conflicts of duty and interest, and the need to hold entities to account. The treasurer has reported on the government’s success in “taking action” on these issues while quietly modifying reforms to reduce their impact on bankers, mortgage brokers and financial advisers. Ordinary Australians, meanwhile, lack virtually any influence over the process. •

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One of Tett’s colleagues once queried the relevance of her doctorate on marriage rituals in Soviet Tajikistan to her work at the FT. Using this as her starting point, she demonstrates how anthropology provided the training and intellectual framework she needed to scrutinise banking, business corporations, factories, international industrial collaboration and technological change.

It’s important to bear in mind that Tett is famous for being one of the few people to predict the global financial crisis — several years before it occurred, in fact, after she became alarmed by the peculiarities of capital markets, derivatives and securitisation. Following her instincts, she began exploring the culture of banking and finance using standard ethnographic methods.

First she learned the language. Banking jargon is replete with terminology that is almost impenetrable to outsiders. CDO (collateralised debt obligation) and CDS (credit default swap) mean little to a person taking out a mortgage, as does the fact that their debts might be “bundled” with others and “sold on” to investors. In her efforts to discern the patterns created by these exchanges of risk and debt, she discovered a clash between what these innovations were meant to achieve for banks — reduced debt — and what appeared to be happening — increased debt. The predicted “market correction” was simply not happening. “Risks,” she wrote, “were building inside this strange, shadowy world.”

Although she was accused of scaremongering and her characterisations of the financial world were heavily criticised, Tett was undeterred. Her methods required the ingenuity that is essential when studying powerful people and their institutions. She attended conferences, interviewed people, read a great deal, and generally immersed herself in the culture. All the while she was maintaining a critical eye, looking out for gaps in the narrative, for contradictions between what people said and how they behaved.

Describing her fieldwork in Anthro-Vision, Tett questions widely held assumptions about the “natural” functioning of market forces and exposes the fanciful reification of money and its exchange. She reveals how bankers and financiers can effect economic change in complex ways, and how and why impending financial disasters can sit comfortably in their blind spots.

To show another way of working within large organisations, Tett describes how Genevieve Bell, now the distinguished professor in ANU’s School of Cybernetics, broke new ground after she joined Intel’s research division in 1998. Bell began by launching a cross-cultural study of consumers in India, Australia and Malaysia, where her band of researchers discovered that people used their technological devices very differently from how their designers envisaged.

Other comparative research into facial recognition and artificial intelligence applications has found striking differences between attitudes, behaviour and use in the United States and China. Americans tend to see them as a form of invasive surveillance that threatens their privacy and personal freedom; Chinese people are generally more comfortable with scrutiny, viewing it as a form of state-endorsed security.

On the urgent topic of how best to manage contagious diseases, Tett argues for cultural sensitivity by telling the story of how Ebola was eventually contained in Sierra Leone, Guinea and Liberia. The early assumption was that people’s behaviour would change if they understood how Ebola is transmitted, and attended medical facilities immediately symptoms developed. Quite apart from the difficulty of getting treatment within an underdeveloped healthcare system, Ebola continued to spread because people could not abandon their customs surrounding death and burial. Family gatherings, at which the deceased’s body would be embraced, were a major factor that simple prohibition failed to stop.

Tett describes how Paul Farmer, a medical anthropologist at Harvard who heads Partners in Health, had for decades advocated community-based treatment that respects local cultures and social context. The advice he and other anthropologists provided to hospitals and health centres had a dramatic impact on the spread of the disease.

To date, Tett observes, anthropologists have had little influence over how Covid-19 has been managed. Attitudes towards face masks, and ideas about family gatherings and religious rituals vary greatly, yet policies have generally been top-down, informed almost entirely by medical scientists. Technical solutions, such as contact-tracing applications for mobile phones, haven’t prevented people from transmitting infection (although the use of QR codes to track people’s movement, at least in Australia, provides the means for isolating contacts after the event).

Rational measures derived entirely from medical science might seem simple, but cultural understandings of certain practices are constructed within “webs of meaning” that privilege some human actions over others. Thus, kissing the corpse and sitting in a small room with other mourners are intrinsic to West African ideas of honouring the dead. Failure to do so invites opprobrium and disaster. Thus, too, British prime minister Boris Johnson initially refused to don a face mask, even while exhorting other citizens to do so, because masking has negative connotations and is “foreign,” and controlling what British people wear infringes their individual rights. In London or Sydney, refusing to wear a mask can be considered an act that demonstrates individual autonomy and freedom — cultural ideals that not only are seen as natural in a liberal democracy but are also more highly valued than responsibility to others.

Anthropological techniques are obviously useful in market research, and many of Tett’s examples illustrate the complex interweaving of cultural assumptions, social values and consumer choice. She shows how widely anthropological research is used in the United States and how different ethnography is from surveys that simply collect factual data and make correlations based on categories such as age, gender and political allegiance.

Anthropologists investigate why people make choices, and much of the complexity they identify derives from the fact that social values change. Tett offers the case of a childcare company that asked anthropologist Meg Kinney to find out why enrolments were so much lower than rates of website searches — what was deterring interested parents from enrolling? Conventional data showed how parents were using the website, but didn’t explain why they failed to pursue the matter. Using video ethnography, Kinney observed parents in their home discussing the services offered. She found that the people designing childcare programs, mostly born before 1975, placed far more emphasis on education and reassurance than did “millennial” parents, who wanted their children to be adaptive and resilient.

Tett also explores how environmental sustainability and the challenge of climate change have transformed corporate notions of moral responsibility. She discusses the strategies of ESG (environment, sustainability, governance) that BP and other corporations have embraced in response to criticism, but points out that the persistence of the profit motive means that many changes are made with an eye to the market advantage that derives from being “green.” This is hardly a novel anthropological interpretation —many activists have been alert to “greenwashing” for decades — but Tett moves the argument along by bringing in her earlier work on financial organisations, which prompts the insight that “the words around ESG are changing the money flow” in positive ways.

Anthro-vision is written for a general readership and aims to convince people in the worlds of business and industry of the value of anthropological research. Tett does acknowledge that the information and insights an anthropologist can offer are not always the ones hard-headed business figures might want to hear. Anthropological advice to mining companies can certainly fall on deaf ears in Australia, where disasters such as the destruction of the cave at Juukan Gorge in Western Australia testify to the fact that anthropological knowledge continues to be seen as either irrelevant or obstructive to modern business practice.

In a postscript to anthropologists, Tett concedes that many anthropologists would rather not engage in research that enhances business operations, perhaps enabling them to increase profits and power in a profoundly unequal world. But she also emphasises the advantages of influencing policies that can promote change based on the recognition of both common humanity and cultural diversity. At a time when the social sciences and humanities are in the firing line in universities across Australia, her conclusions about the value of anthropology are particularly germane. •

Anthro-Vision: How Anthropology Can Explain Business and Life
By Gillian Tett | Random House Business | $35 | 282 pages

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Most notably, the US Congress is now considering massive infrastructure programs that could costs trillions of dollars. Some, but not all, of this spending will be funded by extra taxation.

Governments have funded these massive budget deficits by selling enormous quantities of government bonds, most of them purchased by central banks. In the process, they have completely repudiated the previously unchallengeable assumptions that budgets should be balanced and public debt is always undesirable.

Those assumptions rested on the belief that a dramatic increase in public expenditure and debt will invariably produce sharp increases in interest rates. Nothing of the kind has happened. Although inflation has spiked in the United States, driven by shortages arising from the pandemic, long-term interest rates remain near all-time lows.

Even more striking are the interest rates being paid on a type of bond called an “inflation-protected security,” which offer investors a return calculated according to the rate of inflation. If the inflation rate is 2 per cent, for example, and these bonds guarantee a real return of 1 per cent, then the return would be 3 per cent.

Until recently, most market rates of interest were higher than the rate of inflation, so buyers of inflation-protected bonds expected to receive a guaranteed positive rate. But since the pandemic, this is no longer the case. The Australian Treasury’s ten-year inflation-indexed rate is now negative, at –0.75 per cent. And, while there has been a modest uptick in the expected rate of inflation in recent months, massive growth in government debt has had hardly any effect on inflation-indexed interest rates.

This is consistent with experience elsewhere. In the wake of the economic crisis of the 1990s, the Japanese government issued bonds in huge quantities, reaching more than 200 per cent of GDP. Although most of the funds raised were misused on large-scale construction projects with modest benefits, economic growth wasn’t adversely affected in any obvious way. Japan’s GDP per person has grown at a rate of 0.8 per cent since 2000, unimpressive by historical standards but similar to that of other OECD countries. Despite these high levels of debt, Japanese five-year government bonds yield negative returns, just as government bonds do elsewhere. Even bonds with a term of thirty years offer interest rates below 1 per cent, less than the current rate of inflation.

Experience in the aftermath of the GFC has also underlined the dangers of austerity. In Europe, far from stimulating growth, austerity policies led to a decade of severe depression. In the United States, where the swing to austerity was more limited, the recovery from the GFC was sluggish and still incomplete when it was ended by the pandemic.

What does this imply for Australia? Even after the massive expenditure needed to deal with Covid-19, Commonwealth gross public debt amounts to only 40 per cent of GDP. And with ultra-low interest rates, the cost of servicing this debt is minuscule.

Of course, interest rates may not remain this low forever. That’s why the government should seek to lock in as much long-term debt as possible, as long as investors are willing to buy bonds. But how long is long-term? The upper limit at the moment has been set by Austria, which has issued one-hundred-year bonds with a rate of 0.88 per cent.

In reality, though, government bonds needn’t be limited to a fixed period. Rather, as the American economist John Cochrane suggests, we should follow the example of British governments in the eighteenth and nineteenth centuries and issue perpetual bonds. In their case, the funds were often used to fight wars; post-Covid, the necessary spending is just as great but much more peaceable.

For Australia, the most appealing form of perpetual bond would be an inflation-protected bond. Investors would receive a periodic return sufficient to maintain the real value of the sum invested, along with a specified rate of interest, if any. In view of the continuing fear that expansionary fiscal policies will ultimately generate inflation, such securities should be attractive to many investors, even at very low rates of interest.

As Cochrane observes, the great advantage of a perpetual bond is that, whenever issued, the bonds would trade in the same market, creating a deeper market with more liquidity. Long-dated bonds with different maturities don’t have that advantage. This is particularly important for a small country, like Australia, seeking to offset the tendency of international investors to favour their home countries. The more liquid our market, the more attractive it will be to international investors.

Inflation indexing would also help reduce the premium currently observed on Australian dollar bonds. Although exchange rates fluctuate over time, in the long run they are determined primarily by differential rates of inflation. If an upsurge in Australian inflation produces a depreciation of the dollar, foreigners holding ordinary bonds will lose money. But if they are holding inflation-protected bonds their returns will rise, offsetting the depreciation effect.

How much could be raised in this way? A recent offering of $15 billion in thirty-year bonds received $37 billion of bids despite the fact that they would return less than 2 per cent a year. Assuming that the Reserve Bank succeeds in holding inflation between 2 and 3 per cent, that implies a negative real rate of return.

It seems reasonable to hope that Australia could market between $25 billion and $50 billion in inflation-protected perpetual bonds a year, at very low interest rates. Over five to ten years this would be enough to take up all the additional debt taken on as a result of the pandemic.

And what if investors were unwilling to buy these bonds? That would, at least, suggest that they expect real interest rates to rise at some point in the future. At this stage, though, it is hard to see any evidence supporting this view. Despite historically low interest rates, private business investment in productive assets has remained weak. Lacking any other outlet, money is flowing into absurd speculative assets like cryptocurrencies and non-fungible tokens.

What is needed now is a massive expansion of public investment in both physical and social infrastructure. The returns will be sufficient to service perpetual bonds indefinitely. •

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Combating climate change will require one thing in particular, and a lot of it: investment. The Economist estimates that the annual production of electric vehicles will need to increase ten-fold if we are to achieve net zero emissions by 2030. The number of charging stations will need to increase thirty-one-fold. Up to 2 per cent of America may need to be covered in solar panels and wind farms, according to one estimate. Mining companies will need to expand their production of the minerals that go into these technologies by more than 500 per cent.

All up, more than US$35 trillion of new investment will be required if we are to avoid dangerous climate change. Investment by governments will be part of the answer, but only a small part. Despite the best intentions of those who advocate policies like a Green New Deal, the reality is that most of the world’s governments have nowhere near the budgetary capacity required to undertake such investments. Any attempt to do so could have dangerous consequences for financial stability.

This is especially the case in developing countries. They often have large stocks of foreign-denominated debt, underdeveloped financial systems and weak monetary policy frameworks that heavily constrain what their governments can invest in green initiatives. And Europe has its own problems: its lack of an independent monetary policy, its common exchange rate, and its EU-wide fiscal rules mean most European countries will struggle to invest even a fraction of what is required.

The maths of climate change means that investment by the private sector will be critical. This, in turn, hinges on the ability of financial systems to direct sufficient finance to where it is needed.

Other than provide us with the mechanisms for making day-to-day purchases, the financial system has two key objectives. It connects savers to investors — by directing retirees’ savings to fund new projects, for instance. And it ensures that risk is properly priced and allocated to those who can best bear it — such as when insurance companies take on households’ risk and spread it across their balance sheets.

When it comes to climate change, the financial system is struggling on both counts. Not only is it having trouble directing enough finance towards the sustainable investments we need to reduce carbon emissions, it is also struggling to price and allocate risk, with potentially dangerous consequences for financial stability.

The reason goes to the heart of how we regulate our financial systems. Banks borrow money short-term (primarily by taking deposits from households) and lend that money long-term (for mortgages, personal loans and business loans). In the absence of safeguards, this leaves them open to the classic “bank run,” in which many people try to withdraw their money at the same time and a bank can’t unwind its investments fast enough, causing it to collapse.

One way governments manage this risk is to require banks to hold cash and assets that can quickly be turned into cash, such as government bonds. It’s for this reason that governments regulate not only the size of the assets banks need to hold but also the quality of those assets — the stability of their value and the speed at which they can be turned into cash.

This is where climate change comes in. A growing body of research shows that borrowers who have strong environmental credentials are less likely to default on their loans. Borrowers who don’t damage the environment are also less likely to get slogged with a big clean-up bill, and borrowers who take more of an interest in how their business interacts with society and the environment tend — unsurprisingly — to be better businesspeople in general.

It follows that lending money to people and businesses with strong environmental credentials is more profitable and also less risky than lending money to environmental vandals. And when these individual loans are securitised (packaged into assets that can then be bought and sold onto secondary markets) those securities are, in turn, more profitable and less risky.

The problem is that our financial regulations aren’t taking this into account. The global capital rules agreed by the world’s regulators don’t recognise the growing evidence that green loans are safer and more profitable than “brown” loans. As a result, banks and other financial institutions provide fewer green loans and buy fewer green assets than they should. This reduces the amount of finance provided to green projects and green initiatives, and it also makes bank balance sheets much riskier than commonly thought by loading them up with too many environmental sinners and not enough environmental saints.

How can we fix this problem? In short, both the global rules and Australia’s domestic regulations need to change. They need to recognise that green borrowers are safer borrowers, giving banks the incentive to make more green loans, hold more green debt on their balance sheets, direct more private finance to combating climate change, and bolster financial stability across the economy.

A more foundational problem, however, is that we can’t agree on how to measure whether a borrower, investment or security is “green” in the first place. Plenty of metrics and indicators exist, but they rarely align. The free-flowing nature of financial capital means these indicators need to be consistent and agreed at the global level. More and more countries — from Canada to Singapore — are developing their own indicators, but consistency will be critical if global markets are to function effectively.

The G7, G20, Bank for International Settlements and other institutions are exploring these issues. Australia not only needs to be participating in these conversations, it also needs to be actively shaping them. Australia’s carbon-intensive economy could suffer depending on the taxonomies and regulations that get agreed abroad.

While the global financial system is perhaps an unlikely ally in the fight against climate change, the sheer size of the investment required to decarbonise our economies means little can be done without it. Our success in fighting climate change will hinge on whether our financial system is up to the task. Without reform, it won’t be. •

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Not surprisingly, the government’s recent decision to make the change permanent has generated much political heat, a certain amount of debate in the business pages, and competing claims from those who stand to win or lose from the proposed changes, including class-action lawyers and third-party litigation funders. The new disclosure laws certainly deserve close attention: timely and accurate corporate information helps investors settle on fair prices and allocate capital as efficiently as possible. These disclosures also reduce the risk of insider trading and other forms of market abuse that indirectly affect us all.

In his second reading speech, assistant treasurer Michael Sukkar argued that the new legislation will reduce “opportunistic class actions,” the threat of which “makes it considerably more difficult for companies to release reliable forward-looking guidance to the market.” Without the proposed protection, “companies may choose to withhold forecasts of future earnings or other forward-looking estimates, thereby limiting the amount of information available to investors.”

Others take a different view, arguing that the direct and indirect costs of class actions, and their potential to discourage forward-looking disclosure, are generally justified by their significant deterrence impact. The market generally, and small investors in particular, benefit from rigorous continuous disclosure, according to supporters of the tougher rules; the proposed changes would reduce the incentives for corporations and their officers to keep the market fully informed.

That view has attracted some judicial support. As one judge put it, securities class actions serve “a role in not only providing for significant amounts to be paid to investors for claimed losses occasioned by allegations of corporate malefaction… but they also have occasioned a private regulatory discipline on the conduct of listed companies and their dealings with the market of investors in their securities.”

It’s important to note that the proposed reforms don’t alter the basic obligation of ASX-listed companies and their officers to disclose relevant information. Instead, they reduce the penalties for failing to share relevant information in a timely way or making inaccurate or incomplete disclosures.

Australia’s continuous disclosure laws date back to 1996. For ASX-listed companies, the basic obligation is contained in ASX Listing Rules 3.1. Once a company becomes aware of information that a reasonable person would expect to have a material effect on the price or value of its securities then it must immediately make an announcement to the market. Exceptions applied made in certain defined circumstances.

As the law currently stands, breaches can have four main consequences: criminal prosecution (brought by the Commonwealth Director of Public Prosecutions); civil penalty prosecution or the issue of an infringement notice (by the Australian Securities and Investments Commission); or a civil damages claim (usually via a securities class action brought by a plaintiff law firm, often with the support of a third-party litigation funder). If the failure amounts to misleading or deceptive conduct, then a person who believes they have suffered loss or damage can make a damages claim (again, via a securities class action) against the company and an officer involved in the contravention.

Over recent decades, legislative changes designed to facilitate class actions and access to third-party litigation funding have expanded the circumstances in which investors can claim damages without having to establish that the failure to disclose affected their individual trading decisions. At the same time, the maximum civil penalties have risen considerably and may now exceed $11 million for companies, with the possibility in some cases of up to 10 per cent of annual turnover, capped at $555 million.

The new legislation is intended to change the circumstances in which a civil penalty prosecution or private securities class action can be brought against the corporation. It doesn’t alter the criminal consequences (which apply when a disclosure breach is deliberate) or the infringement notice regime (which doesn’t require the Australian Securities and Investment Commission to prove any fault if the company accepts the fact of the breach and pays a fine).

For the listed company itself, the new legislation introduces a fault element for civil penalty prosecutions and civil proceedings. The key difference is that civil penalty and civil liability only applies if “the company knows, or is reckless or negligent with respect to whether, the information would, if it were generally available, have a material effect on the price or value” of its securities.

Having to establish that the listed company knew, or recklessly or negligently failed to recognise, that the information was price sensitive raises the bar for ASIC in pursuing civil penalties against the company, and for private class action litigants in establishing liability. But it brings the regime closer to the United States and Britain, where private actions require proof of a fault element, including knowledge or intention, on the part of the corporation.

The legislation also alters the position for corporate officers. Under the existing law, a corporate officer who is involved in contravention can be personally liable for the breach; under the new law they have a defence if they can prove that they took all steps (if any) that were reasonable in the circumstances to ensure that the disclosing company complied with its obligations and after doing so, believed on reasonable grounds that the disclosing company was complying with its obligations under that subsection. It seems likely that this change will eventually flow through to the general duty of care under the Corporations Act, which has been the basis of several civil penalty proceedings brought by ASIC.

So, do the reforms weaken Australia’s continuous disclosure regime? Or do they strike a better balance by no longer punishing (through the civil penalty regime) or no longer allocating loss to the company rather than the investors (through private litigation) in circumstances where a failure to disclose was inadvertent?

Probably the latter, but the jury will be out for a while and much will depend on how the reforms interact with other parts of the Corporations Act and the ASIC Act. Either way, though, it is hard to avoid the conclusion that Covid-19 gave a government already inclined to restrict securities class actions the opportunity to do so without conducting the full review urged by the Australian Law Reform Commission back in 2018. It also leaves open the disagreements that remained in the parliamentary joint committee’s findings on the question in December last year. •

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At its heart, a short squeeze is a simple play. A trader — say, a Wall Street hedge fund — decides that the value of a listed security is likely to fall in future. They “short” the security — that is, they borrow securities and sell them at the current market price. The plan bets on the fact that the price will fall before the borrowed shares must be returned and the trader can buy enough at the lower price to settle the trades. The risk is that the trader will be unable to find sufficient securities in the market or that the price will rise rather than fall. The squeeze comes on when other traders — say, retail day traders communicating through Reddit and other social media sites — decide to take the price of the security up instead, squeezing the shorts into significant loss.

In that sense the GameStop squeeze is nothing new. But it occurred at a time when securities regulators globally are increasingly concerned about the effect of new technology and new patterns of retail investor involvement in securities markets amid the turmoil of Covid-19.

The GameStop squeeze has three notable features. The first is the involvement of a new generation of retail investors in securities markets during the pandemic, whose trading motivations are mixed. The second is the power of social media to instigate and coordinate trading strategies among otherwise unconnected traders. The third is the democratisation and gamification of trading applications that allow orders for shares to be executed at low or no cost to the investor.

Events like GameStop raise two basic concerns for regulators. The first is that the economic functions of financial markets — to facilitate the efficient allocation of capital and distribution of risk between those with capital available to invest and businesses that require it — will be compromised by too many participants trading for reasons other than investment fundamentals. The second is that inexperienced retail investors will be exposed to financial losses they didn’t foresee and can’t readily absorb, which harms both the individuals involved and broader trust in markets.

A new taskforce, put together last year by the International Organization of Securities Commissions, or IOSCO, has been working to understand the impact of Covid-19 on retail investor behaviour. Co-chaired by the Australian Securities and Investments Commission and the Central Bank of Ireland, the taskforce considered the “potential impacts of the pandemic on the value of investment products, retail investor trends, and whether there will be an indelible effect on the regulation of the securities market going forward and the way in which supervision is undertaken by regulators.” Its final report, published in December 2020, found a significant increase in online general share trading and a notable “surge of retail investor interest in the share market during periods of lockdown.” This could be explained, it said, by a combination of “pre-existing trends, such as trading becoming more accessible (e.g., through apps offering no-fee trading, fractional shares, etc.), together with some pandemic-specific factors.”

The GameStop squeeze was apparently driven by younger investors, whose growing involvement in direct share trading was already evident to IOSCO by the middle of 2020. Across the world, the taskforce found, there has been “a massive growth in online platforms and apps for share trading, and the fractionalisation of shares which allows people to trade in smaller dollar amounts than previously. This appears to have driven a lot of young people into equity markets who previously would not have easily been able to trade.” The result has been “a rush among younger investors into the stock market particularly during March/April 2020 with the lock-down and commensurate rise of online trading applications targeting certain demographics with simpler, game-like features.”

Part of the broader interest in the GameStop squeeze was the question of what motivated these investors’ trading behaviour. While many may have piled in hoping to take advantage of the security’s skyrocketing price, the Reddit thread suggests a more complicated agenda. The chance to inflict pain on hedge funds and other Wall Street insiders was clearly part of the narrative. More than a decade on from the global financial crisis, there is the sense of a reckoning still to come. In the same way that social media has changed political activism, it has the potential to change financial activism too.

Of course, in financial markets, money is not lost — it just changes hands. Retail investors will likely be left holding the bag when the music stops on GameStop, whose bricks-and-mortar video game retail business is not likely to come roaring back anytime soon. Someone who paid US$350 for a security with a real value closer to nil has handed over their money to someone else — likely a Wall Street insider going long with the benefit of data about market trends sold to them by the retail trading apps. Being prepared to wear that loss to feel like a rebel with a cause may be attractive in the short term, but has its limits for most retail investors.

So where does this leave regulation? Securities regulators like ASIC straddle two complicated and sometimes conflicting mandates. The first is to allow for the free functioning of financial markets, to allow them to fulfil their economic function of allocating and pricing capital and risk. If markets stray too far from valuing securities based on fundamentals, though, that function will be impaired. The second is to protect vulnerable investors from exploitation, predatory behaviour and market manipulation. This includes by the businesses — like product promoters, social media sites and trading apps — that profit from the growth in the number of retail investors using their services, not just by other traders.

As to market function, plays like GameStop are unlikely to prompt a significant rethink. The sheer size of global markets and the weight of long-term institutional money means that coordinated action at a retail level — even action motivated by a desire to disrupt rather than profit — is unlikely to disrupt markets significantly over the medium term. What will matter is how it affects the trading patterns of those institutions, including hedge funds. Knowing that a strategy such as a short can be disrupted by a backlash from retail investors is unlikely to deter institutions but will require them to find new ways of managing the risk.

Protecting retail investors is more complicated. Markets run on information, but information is impossible to control on social media. While Australian law prohibits misleading and deceptive conduct in trade or commerce and seeks to license and control investment advice, statements made on social media by individual traders about their own intentions are open slather. In the absence of overt market manipulation, individual traders are expected to take both the upside and the downside risk.

The GameStop squeeze shows that retail investors want to be involved directly in markets and, from time to time, want to use their collective trading muscle to make a point not just a profit. But, as the IOSCO taskforce identified, their inexperience may make them vulnerable, particularly when they are trading in leveraged or complex products. This vulnerability can be exacerbated when, as occurred with GameStop, their access to the market is limited by trading suspensions like those imposed by a number of trading apps at the height of the squeeze.

The ready access to markets and the sense of community that new technologies have enabled have attracted a new generation of investors to markets, whose decision-making may be influenced by a range of behavioural biases different from institutional or traditional private investors. The challenge for regulators like ASIC is to ensure that predatory and illegal behaviour by those who seek to profit from those biases is identified and disrupted. But ultimately, investors need to understand and evaluate the risks they are taking. This requires a new kind of regulatory engagement that emphasises the social, not just financial, considerations at play. •

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This is the thinking that motivates a procession of Labor luminaries, from Paul Keating down, to call for the government to lift compulsory superannuation contributions to 12 or even 15 per cent of wages. It also drives assertions by the super lobby that you can’t have a “dignified” retirement unless you are self-funded. And it fuels the argument of Coalition backbenchers that super has failed because most younger Australians can still expect to receive at least some of the age pension in retirement.

The retirement income review, released last week, challenges all these assumptions. It shows that the age pension today, far from simply being a safety net, will remain an important source of retirement income for all but the wealthiest Australians, even if compulsory super rises. In other words, raising compulsory super to make most Australians “self-sufficient” in retirement is not just misguided, it is also destined to fail.

The review shows that most of today’s retirees rely on the age pension for the bulk of their income. It’s a big reason why most of them have more income in real terms now than they did twenty years ago, when they were of working age. And rather than living on the breadline, the review points out, these retirees have higher levels of financial satisfaction and are much less likely to suffer severe financial stress or poverty than younger Australians.

The pension’s role is unlikely to diminish much in coming years. The review expects nearly half of younger Australians today to receive half or more of their income from the age pension when they retire in three decades’ time, and a bit more than half if compulsory super doesn’t rise beyond 9.5 per cent. Either way, they’ll typically enjoy a better living standard in retirement than across their working lives.

Many supporters of super see this as a sign of failure. But the enduring importance of the age pension to the incomes of middle-income retirees is a sign of a healthy retirement system. This means-tested payment plays a crucial role in insuring Australians against many risks they face that might hurt their retirement.

Take the 1.3 million Australians currently out of work and therefore without an employer contributing to their super. What they forego in super contributions today is largely offset by a higher age pension in retirement. That’s also why workers who dipped into their super during the Covid-19 crisis will suffer a smaller hit to their overall retirement incomes — super plus pension — than is commonly portrayed. The review’s modelling shows that median workers who withdrew $20,000 in super when they were thirty, then remained out of the workforce for two years and underemployed for another five, will see their retirement income fall from 87 per cent of their pre-retirement earnings to 82 per cent — still well above the 65 to 75 per cent “replacement rate” adopted by the review.

There’s endless talk about the need for superannuation products that better manage the risk that retirees will live longer than expected and exhaust their private savings. And super funds could certainly help retirees manage these risks better. But what’s often overlooked is that the age pension is already providing substantial “longevity risk” insurance for most Australians.

The pension also protects many (but not all) retirees from the risks of lower investment returns, since they will qualify for a larger part-pension if they have fewer assets. If investment returns are 0.5 per cent lower than we expect over the next sixty years, the review’s modelling shows the median worker aged thirty today will enjoy 85 per cent of his or her pre-retirement wage in retirement, rather than 88 per cent if returns don’t fall.

Together with the broader tax–transfer system, the age pension’s means test redistributes income towards low- and middle-income retirees, reducing income inequality in old age. Without it, income inequality among retirees would be far higher than among working Australians.

The age pension is also the one part of our retirement income system that is closing the gender gap in retirement incomes, since it redistributes income to women who, on average, have fewer retirement savings than men.

These features of our retirement income system should be celebrated. But it’s the age pension, rather than superannuation, that’s delivering them.

Ever since the FitzGerald inquiry into national savings in 1993, super has been seen as a way of replacing the age pension for many, if not most, retirees by helping them to become “self-sufficient.” But a closer look at the structure of the pension shows it’s unlikely to disappear anytime soon, no matter what happens to compulsory superannuation. And nor should we want it to.

The age pension needs to be adequate to help people with few other assets or little other income to avoid living in poverty. (At the current rate it achieves this for homeowners but not for renters.) Its means test should be set at a level that does not excessively discourage saving.

Given these realities, it’s inevitable that middle-income Australians will continue to receive at least some, and in many cases much, of the age pension over the course of their retirement. The only alternative would be to raise the compulsory super rate to such a level that the vast majority of Australians would save far more than necessary and be poorer during their working years.

The retirement income review makes this clear when it says that a key objective of the system is “to balance living standards across a person’s working life and retirement.” The review’s benchmark for an adequate retirement income is 65 to 75 per cent of pre-retirement earnings. Anything more gets the balance wrong, especially since it’s hard for workers to save less than the compulsory rate.

Our research at Grattan Institute suggests that lifting compulsory super to 15 per cent or even 18 per cent — the level required to push many more people off the age pension — would mean that a retiree who had earned the median income would receive 92 or 94 per cent of his or her pre-retirement earnings. The bottom 30 to 40 per cent of workers would be forced to save for a retirement income that exceeded their wage pre-retirement.

Whatever the benefits of super in reducing pension costs, higher compulsory super would hurt rather than help the federal budget for decades to come. Why? Because super comes with extraordinarily generous tax breaks.

The FitzGerald inquiry believed that the revenue lost because of compulsory super would never exceed 0.2 per cent of GDP and that the pension savings from compulsory super would outweigh super tax breaks by the early 2020s. Two decades later, though, Treasury estimated that the revenue forgone from tax breaks for compulsory super,  once contributions were lifted from 9 per cent to 12 per cent (as was legislated to occur by 2018), would exceed the budget savings on the pension by 0.4 per cent of GDP a year.

Modelling for the recent review shows that lifting compulsory super from today’s 9.5 per cent to 12 per cent would cost taxpayers more in super tax breaks than they would save from spending on the age pension through until 2055. And even then, thirty-five years of accumulated debt — more than 2 per cent of GDP — would need to be paid back before taxpayers ended up ahead.

Of course, this arithmetic could change if the government curbed Australia’s overly generous superannuation tax breaks. But they would need to be cut dramatically — perhaps by $10 billion a year out of about $30 billion — before the budget would save real money much sooner than 2055. Given that the Turnbull government’s 2016 reforms to super tax breaks saved less than $1 billion a year, the prospect of any government making such drastic changes to super tax breaks appears remote.

One last myth the retirement incomes review challenges is the belief that the age pension is financially unsustainable. As the review’s projections show, the government’s spending on the pension — stable over the past twenty years — is likely to fall a little, as a share of the economy, over the next forty years.

In 2001, the age pension cost 2.2 per cent of GDP. It’s now about 2.5 per cent, and the review projects a fall to 2.3 per cent by 2060. If compulsory super stays at its current level of 9.5 per cent rather than rising to 12 per cent, the review projects that the pension will cost 2.4 per cent of GDP in 2060.

There’s no doubt that compulsory super has cut pension costs, but arguably the bigger reason why Australia’s age pension is fiscally sustainable is its unique design. It’s more tightly means-tested than pensions elsewhere, and the maximum rate is the same for everyone, set just above the poverty line, rather than a proportion of workers’ pre-retirement earnings.

And there’s little chance of any political constituency calling for wholesale cuts to the pension. A growing proportion of Australia’s voters are aged fifty-five and older, and between 1995 and 2015, the proportion of eligible voters in that group grew from 27 per cent to 34 per cent. But they wield even more power than that figure suggests: because younger Australians are less likely to enrol to vote, people aged fifty-five or more now make up 38 per cent of enrolled voters. Cuts to the pension would be an incredibly tough sell for any party.

The biggest risk to the pension comes from thinking that superannuation should replace it. It distracts us from fixing the big holes in the retirement system that reflect shortcomings in the publicly funded social safety net rather than in the superannuation system.

Most Australians are comfortable in retirement, but the system is failing too many poorer people, especially in three groups: low-income women, those forced into early retirement, and retirees who rent. The best predictor of poverty in retirement today is whether retirees own their own homes. And that problem will only get worse, because young Australians on lower incomes are less likely to own homes than in the past. Rates of homelessness are already on the rise among older Australians.

Raising Commonwealth Rent Assistance by at least 40 per cent should be the number one priority to reduce poverty in retirement, although the review shows that a much bigger increase may be needed. Other parts of the social safety net also desperately need repair. The permanent rate of JobSeeker should be substantially increased. And access to the disability support pension, which was tightened in 2012, should be reviewed.

These are the real challenges in ensuring our retirement income system lives up to its promises to all Australians. But fixing them starts with acknowledging that the age pension is here to stay — and that’s a good thing. • 

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If property values fall and then stay low, Australia’s economic downturn could be deepened by the lack of consumer confidence that comes with subdued house prices. Some borrowers, particularly those who bought recently using low-deposit loans, could find themselves owing more to the banks than their house is worth — and with Australian banks more heavily exposed to residential property than most of their OECD counterparts, the financial impact could be wide.

Master Builders Australia predicts that residential construction will fall by 27 per cent next financial year, which means 43,000 fewer homes will be built in an already slowing industry. Construction — Australia’s third-largest employer — sheds labour quickly in a downturn but picks up much more slowly because of the time taken getting planning approval, running marketing campaigns, booking up pre-sales and securing finance. The impact of a construction downturn also ripples through sectors like building supplies and real estate services.

Perhaps it’s no surprise that Master Builders Australia has joined with its traditional rival, the construction union CFMMEU, in calling for the federal government to stump up $10 billion for 30,000 new social housing dwellings. Community agencies agree: the Community Housing Industry Association has combined with National Shelter and Homelessness Australia to propose a Social Housing Acceleration and Renovation Program, or SHARP, to spend $7.7 billion to build 30,000 new homes and repair thousands more, and ACOSS wants something similar.

This might sound like special pleading by vested interests and the usual bleeding hearts, but these proposals are a far more practical and immediate response to Australia’s recession than grandiose plans like a fast train between Melbourne and Sydney.

How do we know that? At a cost of less than $6 billion over three years, Kevin Rudd’s post–global financial crisis social housing initiative created 14,000 jobs. Every dollar spent generated $1.30 in economic activity. Almost 20,000 new dwellings were built and another 12,000 — some uninhabitable, others likely to become so — were repaired. Along the way the initiative helped to build the capacity and asset base of Australia’s nascent not-for-profit community housing sector.

But Rudd’s initiative was a one-off response to a crisis, and once it was over much of the momentum was lost.

State-based social housing packages — like the one announced this month in Victoria — will help to counter the immediate downturn. But they won’t tackle structural problems in the housing industry, including the way that Australia’s near-total reliance on the private sector generates boom–bust cycles. Despite Rudd’s initiative, real estate prices rocketed in most capital cities after the GFC, boosting household debt, inequality, rental stress, housing insecurity and homelessness.

Any stimulus program needs to fit into a national housing strategy linking all three levels of government. It should build at least 15,000 new units of social housing every year for decades into the future — about five times what gets built now, but no more than the construction levels regularly achieved in the decades after the second world war.

With the need for a national strategy more urgent than ever, the timing of Housing Policy in Australia: A Case for System Reform couldn’t be better. Experienced researchers Hal Pawson, Vivienne Milligan and Judith Yates pull together years of work — not only their own but also that of colleagues working through the Australian Housing and Urban Research Institute — and draw on overseas experience to make a persuasive case for change.

In a sense, the aim of housing policy is simple: everyone should have access to safe, decent, affordable shelter, whether rented or owned, house or apartment, city or country, shared, single or family. But if there is an underlying thesis to this book, it’s that the basic aim has been confused by the different and in many ways conflicting role housing has come to play. Increasingly, it is a vehicle for building and transferring wealth.

As housing researcher Bill Randolph writes in the foreword to this book, we’ve moved from housing policy as “a ‘fourth pillar’ of the postwar political settlement, alongside wages growth, social security and trade protection” to a position where, in effect, “the market became the policy.” But, as the authors make clear, the housing market is profoundly shaped by government action, primarily through iniquitous tax settings and subsidies that benefit some (existing homeowners and property investors) and harm others (low-income renters in the private market).

Successive government policies have led to the “financialisation of housing,” a term that I had found rather opaque until I read this book. As the authors explain, the term refers to how dwellings are “increasingly viewed as tradeable assets with capital value rather than homes with utility value.” It is a process supported by the deregulation of the financial system since the 1980s.

One local manifestation of financialisation is the way it encourages homeowners to view their house as a bank from which they can withdraw funds, often in order to buy more property. Financialisation also means that investors buy “stash pads” as a kind of “safe-deposit box” for excess capital, often in markets where the purchaser has little or no connection to the local community or its urban fabric. Foreign investors buying high-rise apartments in Sydney and Melbourne are a good example, but so are Australian investment funds buying cheap rental properties in the American Midwest.

In a more developed form, financialisation encourages the emergence of private equity firms, trusts and other corporate entities as mass landlords focused on driving up rents and driving down costs. The firm Kushner, in which Donald Trump’s son-in-law and preferred fix-it man Jared Kushner is a major shareholder, owns 23,000 apartments across five American states. It stands accused of systematically harassing low-income tenants to force them to move so that it can raise rents, and then of pursuing those same tenants through the courts for unpaid fees.

Australia’s 2.1 million landlords are mostly small-scale property investors. But if Covid-19 produces a major property slump and distressed owners are forced to sell in a falling market, then we face the possibility of the same kind of property empires that emerged in the United States and Ireland after the GFC. Even during the boom, the number of Australian investors with multiple properties was growing faster than the number who owned just one.

Pawson, Milligan and Yates build their case for system reform by revealing the many shortcomings of a narrowly conceived market approach. For a start, current arrangements increase risk — most obviously for households, with 1.3 million people pushed into poverty by excessive housing costs. But it’s also evident in the apartment boom, where a lightly regulated industry has produced defective buildings clad in highly flammable materials or vulnerable to flooding.

And then there is the risk that property-fuelled household debt poses for the financial system and the wider economy. Periodic “price corrections” in the housing sector depress demand and consumption throughout the economy, and threaten the stability of the banking system. As the authors write, “This latter issue is of particular salience for Australia since, as reportedly demonstrated by IMF loan book profile data, Australian banks’ exposure to residential property is the highest in the developed world.”

Second, our approach to housing increases inequality. In theory, an era of low interest rates and deregulated lending should make home ownership more affordable. But, by enabling higher-income earners to take out bigger loans “to purchase more expensive housing than they might otherwise be able to afford,” it fuels price rises and puts home ownership “further out of reach for low-income earners.”

Rising prices widen the “deposit gap” between the price of a dwelling and the maximum amount a bank will lend, so while a household’s income might be high enough to comfortably service a mortgage, it is almost impossible to save the required down payment. In March, just before the pandemic hit, Melbourne’s median house price reached a record high of $918,000. That makes the standard 20 per cent deposit $184,000, or more than a decade of saving on the gross median income of $88,000 — assuming, heroically, that the household is able to save a fifth of its earnings.

Over the past two decades, as a result, “wealth rather than income has presented the major stumbling block to home ownership entry for low-to-moderate-income households.” The best advice to aspiring first homebuyers is not “get a good job,” as former treasurer Joe Hockey once claimed, but choose wealthy parents.

As home ownership moves increasingly out of reach, the pressure on low-income tenants increases. They are crowded out of the declining number of affordable properties by renters who earn more and are trying to keep their housing costs low while they save for that elusive deposit.

Another way of thinking about housing and inequality is to think about housing as an essential cost that everyone has to pay. True income inequality is not revealed by comparing raw data on household incomes but by comparing those incomes after housing costs have been covered. Using this measure, the gradient of income inequality in Australia is much steeper.

During the housing boom, incomes for the top ten per cent of households rose 85 per cent before housing costs, and 81 per cent after. Incomes for the poorest ten per cent of households, by contrast, rose about 50 per cent overall but only 30 per cent after accounting for housing costs. As a proportion of income, housing costs had risen sharply for the poor — who are mostly renters — but barely changed at all for the wealthy — who generally own their own homes.

At the time of the Henderson poverty inquiry in 1975, as the authors note, “before-housing” poverty was higher than “after-housing” poverty. Now it’s the opposite. In other words, our housing system helped to pull people out of poverty in the postwar decades but now pushes them deeper in.

The role of housing in inequality also manifests spatially, write Pawson, Milligan and Yates, not only in the “coincidence of rising homelessness with growing numbers of grossly under-occupied homes” but also in the fact that residential property close to city centres (and to jobs and services) appreciates more rapidly than dwellings on the urban fringe.

Housing-related tax concessions — like exempting the family home from capital gains tax — drive this inequality. Households in the top income quintile receive “an average benefit more than sevenfold that received by households in the lowest income quintile.” It’s well established that wealthy households also capture the bulk of gains from investment breaks like negative gearing and the capital gains tax discount. Yet these tax concessions do nothing to increase the overall supply of rental housing (let alone affordable rental housing). As the authors document, in the ten years to 2018 only 7 per cent of investment property finance was used to build new dwellings.

These tax concessions don’t just increase inequality, they also reduce productivity by encouraging Australians to overinvest in housing using money that could be spent in sectors that might generate more wealth. By treating housing as a protected asset, tax arrangements encourage inefficient use — large houses with unoccupied bedrooms, for example, or second homes that are rarely used. And housing inequality is itself a drag on productivity: insecure private rental housing is likely to result in frequent moves, which damage children’s schooling, and congestion is worsened by the long commutes of workers forced to the “‘affordable edge” of Australia’s cities.

The market approach has also sent Australia’s public housing system into long-term decline. Under the first ten-year Commonwealth State Housing Agreement, struck in 1945, state housing authorities built about 96,000 homes for rent. Although Menzies shifted the bias towards home ownership under the second agreement in 1955, state construction continued to deliver a significant proportion of all residential building activity through the 1960s, accounting for about one in every six houses built between 1945 and 1970.

Since the mid 1990s, government’s average contribution to building has been about one in every thirty-three houses. Amounting to fewer than 4000 dwellings per year, this is barely enough to keep pace with sales and demolitions of existing social housing stock, let alone the growth in Australia’s population. With many dwellings occupied by long-term tenants, the availability of social housing to people in need has fallen precipitously, from 52,000 new social housing lettings in 1991 to just 35,000 in 2017.

Other processes have also had an impact on public housing. In the 1980s, the deinstitutionalisation movement shifted people with disabilities, especially mental illness, into community care. With no government investment in alternative housing to provide this care, “public housing became the default tenure for many of those affected by the closure of the institutions,” despite the fact that existing stock was not well suited to this purpose. Once a way of increasing the supply of housing, public housing became a safety net and then, increasingly, an “ambulance service.”

Symptomatic of this trend, state and territory governments have progressively transferred responsibility for their housing portfolios from public works agencies to human services departments. “Perhaps the single word that best captures post 1970s change as characterised here is residualisation,” write Pawson, Milligan and Yates:

This describes a process of socioeconomic change whereby the tenant population of social housing has become increasingly confined to those unable to compete effectively for market housing. This change is starkly highlighted by official statistics revealing that the proportion of NSW public housing tenants for whom wages are the main source of household income fell from 85 per cent in 1960 to just 5 per cent by 2013.

The history of public housing in Australia is one in which governments have been “reluctant landlords,” with the period from 1945 to 1956 “a partial exception to this general trend.”

Other nations have taken a different path. About a third of all Dutch households live in secure, rent-moderated social housing. In the face of UK-wide austerity measures, the Scottish government has continued to develop social housing at a high rate. Even in the United States, a longstanding low-income housing tax credit facilitated the private-sector development of almost three million affordable rental dwellings by 2017. US housing financed in this way must retain its affordable status for at least thirty years, whereas under Kevin Rudd’s short-lived National Rental Affordability Scheme, housing only had to be priced affordably for ten years. The US tax credit leveraged around US$100 billion in private investment; in the absence of a similar mechanism here, the holy grail of superannuation funds investing in social and affordable housing will never be realised.

Many other countries also make much greater use of planning measures like inclusionary zoning to generate social and affordable housing, recognising that the market alone won’t deliver an adequate range of dwellings.

While there are differences of detail between the major parties in Australia, write Pawson, Milligan and Yates, “it would be difficult to identify any distinct ideologically inspired policy difference between governments of Labor and Liberal/National hue at either federal or state/territory level.” Instead, governments engage in “busy work” — measures that give the impression of activity but fail to strike at core issues. Partly this failure reflects a shared view that home ownership “is inherently the most superior form of tenure” — a myth the authors debunk — and the linked ideal of “a property-owning democracy.” And partly it’s electoral maths: voters who own their own homes, and who have an interest in seeing the value of that property increase, vastly outnumber aspiring homeowners who have an interest in greater affordability and renters who would benefit from more social housing.

But governments can only ignore the failures of housing policy for so long. Australia’s low age pension rate is predicated on widespread home ownership keeping housing costs low in old age, but this is now the “crumbling pillar” of Australia’s retirement income system. With forecasts that home ownership rates among the over-sixty-fives could fall below 60 per cent around the middle of the century, spending on Commonwealth rent assistance will cost much more than the current annual $4.4 billion, which is more than three times the funding the federal government provides to the states under the National Housing and Homelessness Agreement.

As the authors make clear, pandemic or no pandemic, this is a long-term problem with long-term implications:

Firstly, Australia’s current housing policies and housing system are further compounding existing income and wealth inequalities. Secondly, current forms of housing assistance will become fiscally unsustainable if current trends persist. Thirdly, Australia’s housing system underperformance is increasingly compromising broader public policy objectives.

This is an academically oriented book using careful language and detailed referencing. Retailing at more than $100, it isn’t destined to be a bestseller. But it is a landmark achievement that puts a peg in the ground, a reference point for where housing policy should go next at this moment of crisis and opportunity. Politicians, public servants and industry players who are thinking about how Australia rebuilds after the Covid-19 pandemic would do well to read it. •

Peter Mares’s four-part radio series, “Housing the Australian Nation,” will be broadcast on ABC Radio National’s Earshot on  from Saturday 30 May.

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This mutually beneficial arrangement between the United States and the rest of the world comes with well-understood trade-offs. For the Americans, the trade-off means dominance of the global financial system, something they’re happy to use for geopolitical purposes. The appreciated dollar means US consumers and businesses can buy cheap goods from the rest of the world; the safe-haven status of American debt means that its governments, households and companies can borrow and spend with impunity, allowing huge unfunded tax cuts and unfunded spending promises other countries can only dream of. The flipside of the appreciated dollar, however, is that the United States runs a trade deficit.

The rest of the world faces the reverse trade-off. These countries get the global reserve currency they need for international trade, finance and commerce, and a big US market into which they can sell their goods and services and invest their money. But they are exposed to the turbulence of the US economy and a sometimes-unpredictable government that can, and regularly does, twist the financial knife to get the political results it wants.

This arrangement is far from perfect, but it gets the job done. Of course, some countries like it more than others. The undisputed winner from the arrangement is America, which receives spectacular economic and political benefits that far outweigh any perceived costs. The undisputed losers are America’s enemies — Russia, China, Iran, North Korea and others — who regularly find themselves on the receiving end of US financial power.

The losers have been keen to see the arrangement replaced for quite some time. This is easier said than done. Trying to get the world off the US dollar is like trying to get Australians voluntarily to stop driving on the left. Having everyone using the same currency vastly reduces international transaction costs, just as having everyone drive on the left in Australia reduces other kinds of transactions (some of them fatal).

Getting the world off the US dollar would require agreement from all countries, most of which are happy with the current arrangement. The even bigger challenge is coming up with a replacement.

The candidate most commonly put forward is China’s currency, the renminbi. Given the size of the Chinese economy, it makes a certain kind of sense, but China’s currency is not freely convertible, meaning that when foreigners want more of it, they can’t necessarily get it, and that instantly disqualifies it as a realistic contender. China has been working to change this, but progress is slow. And even if countries could access the renminbi freely, China’s markets, like other non-US currency markets, are woefully inadequate in terms of depth and access to compete with the United States.

Another option would be a new global reserve currency. This wouldn’t spell the end of national currencies — the euro area shows the problems of having a common currency without fiscal and political union. It would just mean an international currency sitting alongside national currencies. But creating such a currency, much like changing which side of the road we drive on, would require global agreement. The closest contender is the IMF’s Special Drawing Rights facility — a global reserve asset underpinned by the currencies of IMF members. Some have grand plans for SDRs to become this new global currency, but the vision is not shared by the IMF membership.

Others argue that the best candidate is digital. Former Bank of England governor Mark Carney called for a new virtual reserve currency, not dissimilar to Facebook’s Libra, whose value is based on a basket of global currencies. It’s a neat idea, but it suffers the same challenges as both other candidates. Existing crypto currencies, such as Bitcoin, are too shallow to be a global reserve currency. Its limited supply means that its value would skyrocket if countries demanded it to the same extent they demand US dollars, making it more like gold than a currency. Although Carney’s proposal would solve this problem by adjusting the currency’s supply, it faces the same challenge as the global-SDR idea: the global community isn’t interested.

So the US dollar wins the “least ugly contest,” as economist Adam Posen puts it. But that’s not to say the other candidates couldn’t be contenders in the future. If enough countries become fed up with the US dollar then these alternative futures could become the present quicker than you think. Strangely, Trump and the US Federal Reserve are making these alternative arrangements look increasingly appealing.

President Trump wants to have his cake and eat it too. He wants to keep the geopolitical benefits, cheap borrowing and cheap goods and services that come from being the world’s financial boss, but he doesn’t want the “cost” of the US trade deficit. This is a bit like wanting to be tall and short at the same time: you can’t have it both ways. The reason the United States runs a trade deficit is that its governments, households and companies spend and invest more than they save. The shortfall is borrowed from overseas, pushing up the exchange rate and resulting in a trade deficit. The ANU’s Warwick McKibbin and I modelled what would happen if Trump got his wish of a reduced trade deficit. It’s simply the reserve situation: higher borrowing costs, more expensive imports and less geopolitical pull.

Undeterred by reality, Trump has imposed trade tariffs and quotas in a pointless endeavour to reduce the trade deficit. Reports suggest he wants to cancel debts to China. Like his predecessors, he has used the US dollar as a weapon against his enemies — applying or threatening sanctions and asset seizures to cause pain for geopolitical rivals — and he has also repeatedly pressured the US Federal Reserve to weaken the value of the dollar. None of this will change the trade deficit. But all of it makes alternatives to the dollar-based global system much more appealing.

The Fed’s actions are having the same effect. Covid-19 has created unprecedented financial challenges for emerging economies that desperately need US dollars to finance their dollar-denominated debts. They normally get their dollars from exports, tourists and investors. But once these dried up, they turned to the United States for help. Amazingly, the Federal Reserve turned them away, only providing currency swap lines to countries that don’t need them (other than Brazil and Mexico).

Five decades ago, US treasury secretary John Connally warned countries that “the dollar is our currency, but your problem.” Things have not improved. The more the United States pushes countries away from the US dollar, the faster the alternatives will be embraced. The demise of American dominance won’t be Made in China, it will be Made in the USA. •

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This leaves Australia (and almost every other country) in the early stages of what is likely to be a serious economic slump — more serious (in Australia’s case) than the one prompted by the global financial crisis, and possibly the most serious since the Great Depression of the 1930s. By last week, according to an ABS survey published yesterday, 49 per cent of businesses had already been adversely affected by falling demand — and in some cases by shortages of staff — and 86 per cent expected to be adversely affected in coming months.

It is difficult to judge just how severe — how deep and how long — this downturn will be. It depends on how comprehensive the shutdown turns out to be, and how long it lasts. And that depends partly on the advice governments receive from medical experts — advice that can differ, as we are now learning, from one expert to the next. It also depends partly on how quickly an effective tracking-and-testing regime (similar to those developed in China, South Korea, Taiwan and Singapore) can be implemented that would allow mandatory social-distancing requirements to be eased before a vaccine can be developed, tested and made widely available. Finally, the depth of the downturn, if not its duration, will also be affected by the success of government and central bank efforts to support businesses and individuals.

With almost no reliable or useful history to draw on, economists can only construct scenarios based on assumptions about all these factors.

By way of illustration, consider a scenario in which current restrictions are extended to include schools in every state and territory, and parts (though not all) of the manufacturing and construction sectors. Assume exemptions for agriculture, mining, utilities, some other parts of manufacturing (especially food and beverages), food and beverage retailing, some business services (such as accounting and legal practices) and of course health services, as well as most government operations (though many public servants would be working remotely).

Under that scenario, the economy could contract by almost 10 per cent in the June quarter — an unprecedented decline — followed by a much smaller decline in the September quarter. With negative growth likely to have occurred in the March quarter as well, this would constitute Australia’s first recession (by the most commonly used definition) in almost thirty years. It would also be the most severe, with a cumulative decline in real GDP of more than 10 per cent. By comparison, real GDP declined by 1.4 per cent in the 1990–91 recession, and by 3.4 per cent in the recession of 1982–83.

Some sectors would experience much more significant contractions — around 70 per cent in accommodation and food services, for example, more than 50 per cent in art and recreation services and in other personal services, more than 40 per cent in retail trade and in transport, 25 per cent in wholesale trade and in construction, and at least 20 per cent in manufacturing.

A harder shutdown would inevitably result in an even sharper and broader, but possibly shorter, downturn.

Among the principal objectives of the government and the Reserve Bank has been to reduce the impact on employment of the sharp downturn in output during the shutdown period, and to improve the prospects of a swift return to pre-crisis levels of employment by assisting businesses to survive through a period of shrivelled or completely dried-up revenue.

Those measures have been unable to prevent a significant number of employees being stood down or retrenched, although in many cases employers (particularly large businesses) have indicated that they will have jobs to go back to when restrictions have been lifted. Another of the government’s objectives has been to provide people who have lost their jobs, temporarily or permanently, with easier access to more generous income support than might otherwise be available. With the assistance of state governments and financial institutions, it is also providing some temporary relief from costs such as mortgage repayments and utility bills.

As but one illustration of the possible impact of some of these measures, suppose that, in each sector, employment falls by about half as much as output. In hospitality or retailing, for instance, where casual employment is more commonplace, employment losses may be larger than this; in some other areas, such as healthcare and supermarkets, there may be some net increase in employment.

Under those assumptions, employment could fall by almost 1.4 million — equivalent to a decline of more than 10 per cent from the February level. That is a similar percentage to the decline in output, because labour-intensive sectors of the economy are likely to be affected more severely by the shutdown than sectors such as mining or agriculture.

The impact of job losses of this order on the unemployment rate will depend on how many of the people who lose their jobs meet the statistical definition of being unemployed, which includes a requirement that they are not only willing and able to work, but are also “actively looking” for a job. If all of them fit those criteria, then the unemployment rate could reach around 15 per cent — the highest since the early 1930s. But it seems more likely that many people who lose their jobs will see little point in “actively” looking for work — in which case the labour force surveys will record them as being “not in the labour force” rather than “unemployed.” If, say, two-thirds of people who lose their jobs are classified as “not in the labour force,” the unemployment rate would likely increase to almost 9 per cent.

A more realistic picture of what is happening in the labour market could be provided if the government were to publish a weekly total of the number of people receiving the new coronavirus supplement, similar to the Unemployment Insurance Weekly Claims series published every Thursday in the United States. Such information would also assist in judging whether governments need to do more to cushion the impact of the crisis.

The economy’s recovery can’t start until restrictions on the movement and gathering of people are eased, whenever that might be, and it is unlikely to be as swift as the downturn. Some pent-up demand will lift spending on meals out and various forms of entertainment, but many people’s capacity to spend will have been eroded, perhaps significantly, by an extended period of substantially reduced income (or none at all).

As occurred after the financial crisis, many people may also want to save more in order to offset the depletion of their superannuation balances by the falls in sharemarkets. Home-buyers and businesses who have taken up the repayment holidays offered by financial institutions will face higher repayments (because interest not paid during the shutdown will have been capitalised). And, inevitably, some businesses will not have survived the downturn, and their employees will not have jobs to return to. Businesses that have survived may not be able to return to pre-shutdown levels of employment.

The economic downturn will thus have lasting consequences, not least for government finances. But that’s a topic for another time. •

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Now comes the next dangerous phase: a financial shock. Violent shifts in financial markets mean that a wave of financial crises across several countries is all but inevitable unless urgent action is taken. Governments have been warned for years that the world’s financial institutions are dangerously inadequate to cope with a large-scale crisis. The cost of this neglect is about to become clear.

To illustrate what’s happening, imagine your income is paid in Australian dollars but your mortgage repayments are in US dollars. How have the last few weeks been for you? Stressful, to say the least. The US dollar has appreciated by more than 22 per cent against the Australian dollar since January, increasing the cost of your mortgage by the same amount. If you also had to refinance this debt every few months, your stress levels would be higher still.

This is the situation in which many emerging and developing countries find themselves. Years of historically low interest rates caused a sharp increase in borrowing by governments, banks, companies and state-owned enterprises in emerging economies, much of which was denominated in US dollars and borrowed short-term. It’s not small change, either. These economies hold $5.8 trillion of debt denominated in US dollars. Total external debt in emerging economies has increased from 100 per cent of exports to 160 per cent since 2008. These countries now face a perfect storm.

First, the value of the US dollar is rising rapidly as investors flee for safe-haven assets and currencies. With that rise, the size of the US dollar–denominated debt held by emerging and developing economies has increased substantially. Debts that were previously sustainable may now be unmanageably large.

Second, the cost of servicing debt is rising fast. Interest rates on ten-year government bonds have increased by 2.75 percentage points in South Africa, 2.5 percentage points in Brazil and more than 1 percentage point in Russia, Mexico and Indonesia.

Third, because much of it was borrowed short-term, this debt needs to be refinanced regularly. Brazil needs to roll over US$210 billion of government debt this year alone. For India and Mexico, the amounts are US$150 billion and US$120 billion respectively.

Fourth, although rolling over these debts is vital, it may no longer be possible. As investors scramble to get out, we are seeing the largest capital outflows from emerging economies in modern history. The Institute of International Finance has warned that many economies are already unable to borrow internationally. Capital outflows from these economies are double what we saw during the global financial crisis.

It gets worse. While these debts and the cost of servicing them are rising, income is falling. Many of these countries get their earnings — and the foreign currencies they use to pay for imports and debt servicing — from their exports, particularly exports of oil and other commodities, and tourism. The fall in their exchange rates and the global collapse in trade, commodity prices, oil prices and international tourism is substantially cutting the incomes of these countries, and thus their ability to obtain foreign exchange. Combined with the impact of closing shops and industries because of Covid-19 and the inability of these economies to borrow internationally, the fall in income puts these countries on a knife’s edge.

Some of these countries might be able to fend for themselves. Low inflation means some governments can increase spending or cut taxes to stimulate their economies, more so than was the case during the Asian financial crisis, for example. If countries are unable to roll over or repay their debts, their central banks can purchase the debt without the usual risk of spurring inflation, and their governments can increase spending and cut taxes to boost demand while their exchange rates help cushion the blow.

But this is not true for most of these countries. Argentina, Brazil, India, Indonesia, South Africa and many others have limited flexibility to deal with this mix of pressures. Italy faces special challenges: although it is a developed economy, its membership of the eurozone means it doesn’t have its own exchange rate to depreciate or its own central bank to purchase its debt. Fear of an Italian default could quickly become a self-fulfilling prophecy. It also has a substantial existing stock of debt that markets, and its euro partners, are already concerned about. This is especially worrying given Covid-19 is hitting Italy, a very large economy, very hard.

When these economies start falling into crisis, they will be seeking urgent support from the global and regional institutions dedicated to helping countries facing financial crises and preventing them from spreading — collectively referred to as the global financial safety net. And this safety net is dangerously inadequate.

Modelling of crisis scenarios shows that the safety net struggles to provide even the same level of financial support that has been required of it in the past. This is a huge problem given that the crises associated with Covid-19 — the combination of demand, supply and financial shocks — will be far worse than before.

The increase in the safety net’s resources since 2007 has come at the cost of increased fragmentation. Historically, the International Monetary Fund and the World Bank represented two-thirds of its resources. Today they represent only one-third. The rest is spread across untested regional institutions, unreliable development banks and opaque bilateral central bank support. These institutions are poor substitutes for the IMF, and coordinating them all during a crisis will be very difficult.

Urgent action is required. Currency swap lines, which allow the central bank of one country to exchange its currency with another, give countries immediate access to foreign exchange, which can be vital during a crisis. The US Federal Reserve has extended bilateral swap lines to a range of countries (including Australia), giving them access to US dollars as needed. But the Fed has excluded all emerging and developing economies other than Brazil and Mexico. This creates far greater hazards than any credit risk associated with extending swap lines more widely. The United States and other G20 countries, including Australia, should urgently extend bilateral swap lines to these emerging and developing countries while treasuries and finance ministries prepare to provide loans to those that are in trouble. Australia should assist our neighbours to minimise the damage to their economies, and ours.

The IMF needs to issue at least twice as many international monetary assets (called Special Drawing Rights) as it did in 2009 and provide precautionary financial support to countries before they get into trouble. G20 countries should commit to increasing bilateral loans to the IMF to make such lending possible and bolster its resources, much of which is due to expire in the next two years, and the IMF should hold immediate consultations with regional institutions and development banks to plan and coordinate their response.

All of this should have been done years ago. But as the old saying goes, if the best time to plant a tree is ten years ago, the next best time is today. The severity of the Covid-19 shock means financial crises are a question of when, not if. The world best prepare now. •

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Whether it is enough to turn greedy banks into good citizens, only time will tell. For reasons beyond Hayne’s control, one can’t be optimistic. Australia’s four major banks form a de facto cartel that is extremely powerful and without serious competition. By and large, businesses and households who need to borrow money have nowhere else to go.

It may be, as RMIT University’s Andrew Linden and Warren Staples argue, that we will need another royal commission in ten years’ time to open the way for more far-reaching structural changes. But it is not clear what those changes might be, whether there is strong demand for them, or whether an appetite exists on either side of politics for doing much more than Hayne proposes.

Hayne and his team have already taken us a long way. Remember that just two years ago, the Coalition and its media echo chamber routinely dismissed calls for a royal commission as “bank bashing.” John Howard was even sillier, calling it “rank socialism.” You don’t hear that anymore.

The first great achievement of the commission was to put the facts about the way banks have behaved out there before the public in a manner so stark that nobody could defend them. It showed us that these examples of exploitation were not accidents, or administrative errors, but the result of a system-wide culture of corporate greed in which responsibility to customers was brushed aside to maximise profit.

Thousands of victims of financial malpractice made submissions to the commission. Hayne has been criticised for inviting only twenty-seven of them to give evidence in public hearings, but he was surely right that they had got their message out, and it was time to move on to repairing the damage.

The short-term impact on the banks’ reputation has been devastating. In public, their dismissal of any criticism gave way to confession and apparent contrition. It has created a political environment in which reforms are possible at last.

One can argue that Hayne could have been bolder. Several of his seventy-six recommendations are to retain the status quo. He rejects calls to give small-business borrowers the same consumer protection as households. Rather than forbid banks to own financial advice firms, as many advocated, he proposes that advisers employed by banks be required to inform clients in writing of that fact.

While he is sharply critical of the way the banks calculate their executive and staff remuneration, he does not criticise the extraordinary level of that remuneration, which has been a pacesetter for the obese levels of executive remuneration throughout the economy.

Nothing in this report will threaten the four banks’ dominance of Australian finance. The surgery Hayne proposes is to be performed with a scalpel, not a chainsaw.

He certainly could have — in my view, should have — explored how the Abbott government’s deep cut in funding for the Australian Securities and Investments Commission in the 2014 budget affected its willingness (and ability) to launch legal actions against miscreant banks with unlimited resources to fight any charges.

An outgunned ASIC has had some bad experiences in the courts. Its record of inaction against the banks is easy to criticise, and Hayne does so, accusing it of seeing the banks as “clients” and punishing them with press releases rather than prosecutions. All true, but a realist must recognise that inadequate funding has limited its choices.

ASIC chief James Shipton told the commission that his organisation is “woefully underfunded.” Although the business environment it polices has grown enormously since 1991, its staff has grown by just 14 per cent. Yet, just last May, Scott Morrison’s final budget proposed cutting its funding by $41 million a year over the four years to 2021.

That has changed since Shipton gave evidence. And on Monday treasurer Josh Frydenberg announced that the former chair of the Australian Competition and Consumer Commission, Graeme Samuel, will carry out a capability review of the banks’ financial regulator, the Australian Prudential Regulation Authority, to ensure it has the resources to do its job.

The lesson is clear: if we want our corporate regulators to be tough cops on the beat, we have to resource them properly. Even Labor has been reluctant to do that. In opposition in 2007 it also proposed cutting ASIC’s funding. Unlike the Coalition, it dropped that idea once it got into office, but it did little to increase the regulator’s resources in its six years in power.

One thing that will decide if this royal commission makes a lasting change, or merely a transient one, will be whether our next government gives ASIC and APRA the resources they need to fight and win cases in the courts.

This is a conservative report, in the best sense of the word. Hayne has not set out to reinvent banking, or to do what the banks’ regulators should be doing, or to propose his own blueprints to solve every issue before him.

He has focused on the things he believes matters most — above all, changing the culture of the banks to give priority to serving customers’ needs as well as making money, and resolving the conflicted interests of mortgage brokers.

The last is the big change his report proposes. It is also the recommendation that now faces most resistance.

Back when the Gillard government tried to resolve the conflicts of financial advisers, mortgage brokers were left out of the reform. The legislation we ended up with was severely watered down by the Coalition, “grandfathering” the existing conflicts of interest of advisers who worked for the big banks, and exempting retailers such as car dealers who sell insurance to their clients.

Urged on by Treasury, Hayne has called for government — which will almost certainly be the government we elect in May — to sort out the mess by applying the same rules to financial advice across the board. And the key rules are that a mortgage broker or financial adviser must work in the best interests of the client, and be paid by the client, rather than (as now) by commissions from those whose products he/she sells.

Hayne put it trenchantly. “The interests of client, intermediary and provider of a product or service are not only different, they are opposed,” he wrote. “An intermediary who seeks to ‘stand in more than one canoe’ cannot. Duty (to client) and (self) interest pull in opposite directions.”

He dismissed the hope embodied in current legislation that such conflicts should be “managed.” “Experience shows that conflicts between duty and interest can seldom be managed,” he countered. “Self-interest will almost always trump duty.”

Hayne lines up with Treasury in arguing that by simplifying the law to impose the same rules on all those offering financial advice — including compulsory registration, as well as banning commissions — you make advisers focus on what the law expects them to do, rather than try to find ways around it.

The mortgage brokers are not taking that lightly. They are warning loudly that scrapping commissions would put them out of business — and that the ultimate impact of that would be to strengthen the oligopoly of the big four banks, reduce competition, and hence give the banks more room to raise interest rates.

The brokers and their supporters argue that if intending homebuyers have to pay $2000 or more for using a mortgage broker, they simply will not do it. Instead, they will just walk through the doorway of a bank and deal directly with it free of charge — even if that means they won’t know about alternatives that would cost them less in the long term. And the banks with doorways on the street are the big four.

It’s not a negligible argument, and it’s not a bad idea to have a public debate before resolving it. Treasurer Josh Frydenberg says the government will put off a decision on mortgage broker commissions until it has brought all the financial advisers under the one legislative roof.

Similar reforms were introduced in the Netherlands after the global financial crisis, without dire consequences. The Dutch government used the sweetener of making the brokers’ fees tax-deductible. But 60 per cent of our mortgages are now written through mortgage brokers. The politicians will need to go out and explain to homebuyers why in future they will have to pay for a service they now get for free.

That aside, Hayne’s report really does three things. First, it trenchantly criticises the boards and senior management of the banks. Second, it proposes to induce a new culture in the financial sector that might best be called “responsible.” And third, it recommends a number of changes to fix other problem areas.

Most of Hayne’s recommended reforms, each relatively minor in themselves, collectively aim to make the banks and other financial firms more responsible in the way they deal with their customers.

Farmers would not be harassed for interest payments when a drought has frozen their income. If you walk up to a bank teller to make a deposit, he or she would not be allowed to divert you into buying an insurance or superannuation policy. APRA would work with the banks to create a remuneration system in which sales would be only one component, with other indicators to measure the quality of service.

Importantly, what is now the banking code of practice would become law. You could sue your bank if it breaches it.

I would sum it up by saying that Hayne wants the banks to be more like Bunnings.

When you walk into a hardware store and you don’t know exactly what you need, in my experience the service staff will ask the right questions, tell you what you need, and show you where it is. If you walk into a bank and you don’t know exactly what you need, you can have no confidence that the staff will tell you to do what is in your best interest. They are trained to persuade you to do what’s in the interest of the bank.

That’s the culture that has to change. We have to lift the customer service levels of the banks and the financial sector generally to match those of our hardware stores. It won’t be easy, and Hayne makes it very clear that it won’t come without direction from the top.

“There can be no doubt that the primary responsibility for misconduct in the financial services industry lies with the entities concerned and those who managed and controlled those entities: their boards and senior management,” he writes. “Everything that is said in this report is to be understood in the light of that one undeniable fact.”

Media reporting has highlighted Hayne’s sharp criticism of evidence given by NAB chair Ken Henry (whom he quaintly calls Kenneth) and chief executive Andrew Thorburn. But one suspects that what really fired him up was a report in the Australian at that time, citing an email sent by NAB management to staff urging them “to sell at least five mortgages each before Christmas.” Whatever the NAB chiefs were saying publicly, the culture within clearly had not changed.

Several of the recommendations dealing with specific problem areas relate to how banks deal with farmers in financial trouble. Hayne wants the banks’ ruthless approach of seizing land and assets and selling them to clear the debts to give way to a revival of older-style banking, in which “experienced agricultural bankers” engage in mediation — to be required by law — with the farmers to work out “the best outcome for bank and borrower.”

It’s the only area of specific lending that Hayne explores in such detail, leading some to question why farmers were singled out for such a benevolent blueprint. Why isn’t there a similar mediation path proposed for urban borrowers who lose their jobs and, largely owing to their age, become long-term unemployed?

It’s a fair question. One answer might be that the blueprint Hayne laid out for dealing with farm debts is an example of the way his vision of responsible banking should be applied throughout society.

Another is that it might be Hayne’s way of recognising the political courage of John “Whacker” Williams, the retiring NSW National Party senator without whom this royal commission would never have taken place. Williams himself had experienced rough treatment from the banks when his farm got in trouble, and he was determined to use his time in politics to set up a full-scale inquiry to ensure that others were not treated the same way.

(The ABC’s Stephen Letts has written a fascinating backgrounder relating how in 2011 Williams introduced Commonwealth Bank whistleblower Jeff Morris to Adele Ferguson, financial columnist for the Age. It began Ferguson’s public exposure of the extraordinary wrongdoings of the banks, other financial firms, and now other firms generally. I can think of no other journalist in Australia who has done so much to shine a torch into the dark corners of business practice, above all in the financial sector.)

On some other issues Hayne, probably wisely, passed the buck to those in a better position to negotiate detailed blueprints for reform. For example, he gives firm support to the principle that each of us should have one superannuation account, rather than multiple small accounts that get eaten away by service fees. But how we get there is an issue he leaves to others.

Similarly, it is left to APRA to sort out new remuneration practices with the banks. And while Hayne proposes that charges be considered against financial entities over twenty-four matters, he refers them to APRA and ASIC instead of using the commissioner’s prerogative to go straight to the DPP.

This restraint is sensible; a commissioner, however clever, is not in a position to lay down blueprints in these areas. And if you feel, as he does, that the regulators need to develop an appetite for and a habit of taking firms to court when they break the law, what better examples to begin the process than those he has perused himself in the course of the royal commission?

Hayne is clearly not dewy-eyed about what will follow from his inquiry. At one point he writes that the aim of his recommendations is to “reduce the chance that conduct of the kinds identified will happen again,” then adds more warily, “or happen again with the same effect for consumers.”

The banking oligopoly will remain an oligopoly, powerfully positioned to overcharge and exploit its customers. If this royal commission is ultimately judged to be successful, its legacy will be to change the financial sector’s culture to one that sees serving the customer well as being as important as making sales and profits.

But that can only be temporary. That culture will change again, and change for the worse. Memories are too short, and the ability to exploit customers too strong, for poor behaviour to remain suppressed forever. Hayne has told the government how to close some egregious avenues of exploitation that financial firms used in the past decade. But new ones will be discovered. It’s to be hoped that future governments will be quicker to set up an inquiry like this to shut them down. •

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So begin commissioner Kenneth Hayne’s four key observations about financial services in Australia. “Rewarding misconduct is wrong,” he notes, yet employees have been rewarded “regardless of whether the person rewarded should have done what they did.”

It was therefore logical that the incentives and commissions paid by banks to mortgage brokers should be one of Hayne’s key targets. Brokers should be paid only by the borrower, says the commissioner. Yet when the federal treasurer, Josh Frydenberg, released the government’s response to the report, he neatly excised that specific. The government would “take action” on all seventy-six recommendations, he said, but defer for three years a “review” of the borrower-pays recommendation:

The government recognises the importance of competition in the home lending sector, and will proceed carefully and in stages, consistent with the recommendation, with reforms to ensure that the changes do not adversely impact consumers’ access to lenders and competition in the home lending market.

Hayne gives only two of his recommendations more prominence than the proposed ban on broker commissions paid by banks. The first aims to stiffen national consumer credit law to put greater onus on lenders to ensure that a borrower is suited to a loan. The second would impose tougher civil penalties for banks that failed to act in the best interests of a potential borrower. Together, these recommendations respond to Hayne’s next observation:

Entities and individuals acted in the ways they did because they could. Entities set the terms on which they would deal, consumers often had little detailed knowledge or understanding of the transaction and consumers had next to no power to negotiate the terms. At most, a consumer could choose from an array of products offered by an entity, or by that entity and others, and the consumer was often not able to make a well-informed choice between them. There was a marked imbalance of power and knowledge between those providing the product or service and those acquiring it.

Hayne could not be more plain in describing and highlighting a system in which the weight of a few very large institutions has been channelled into a brutally self-interested commercial environment in which borrowers were sitting ducks.

So what?

Answering that question means going back to the emergence of popular mortgage broking in Australia in the early 1990s, which is usually dated from the 1992 launch of Aussie Home Loans. That was also the year in which Westpac almost went broke. Looking back, domestic banks had been drawn into dramatic corporate debt adventures in the 1980s, culminating in the crash of 1987, only to roll into a bout of property lending that compounded their problems.

Aussie’s John Symonds and his imitators took advantage of the weakness in Australian traditional banks and the emergence of “securitisation” via financiers like Macquarie Bank. Essentially, mortgage “originators” like Aussie pitched loans to people and then bundled them up for a financier, who then sold the package to investors.

Between 1992 and 2007, this was a growth business for everyone involved — but notably for the consumer. In fact, Australia’s experience was almost identical to the experience of the United States during that period, with household debt up from about 12 per cent of net worth to more than 25 per cent. But when the global financial crisis — a direct consequence of mortgage-finance profligacy — hit the United States, the debt burden fell, and it’s now back to 1992 levels. Not so in Australia: our household debt-to-net-worth ratio has remained stuck above 25 per cent, and there are ample signs of strain.

What happened in Australia in 2007–08 was that the financiers folded their tents but the big banks joined the game. They took over the securitisation market, funding increasingly high numbers of mortgages with bundles of cash sourced largely from overseas. With low interest rates and strongly escalating house prices, they were on a roll, at least until the politics of housing costs and a sense of risk among regulators caused a change.

The bank regulator put a lid on the share of loans that were interest-only, and made other, less direct efforts to ensure banks lifted the credit-worthiness of lenders. Combined, these interventions — together with the pressures implied by rising overseas interest rates — tightened the supply of debt. But it’s now clear that the tightening was temporary.

Independent brokers have re-emerged with the backing of securitisation financiers. And judging from commentary by the Reserve Bank, they may have undone the disciplines that had only recently been imposed. The trend is being monitored, the RBA said, for “financial stability risk.”

Kenneth Hayne describes an environment in which banks have overwhelming influence and use it with no regard for the consumer. He treats the idea of broker objectivity as being like a person trying to have a foot in two canoes; a nice trick, but not the nub of the game. Consumers had choice but no power; brokers and bank staff had unqualified incentives and were paid commissions driven wholly by sales. These are the factors at the heart of the Hayne view.

The government says it will allow the commissions and incentives to remain because Hayne’s proposed change might affect competition. Hayne says that the commissions paid by banks to brokers distort banks’ judgements and promote irresponsible lending. On that basis, the only competition the government seems concerned about is brokers’ competition for commissions.

The “so what?” in this picture is in the growth and size of household debt in Australia since the early 1990s. While there are plenty of logical reasons for this to have happened, Hayne’s serious worry is about discipline and quality.

Simplified, it seems that consumers found themselves with the unusual experience of having people literally knocking on their doors to offer debt; lenders had new sources of funds that have proved to be virtually unlimited; and interest rates have been low. What could possibly go wrong? •

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Conduct by many entities… has taken place over many years causing substantial loss to many customers but yielding substantial profit to the entities concerned. Very often, the conduct has broken the law… [It] has fallen short of the kind of behaviour the community not only expects of financial entities but is also entitled to expect of them.

First, in almost every case, the conduct in issue was driven not only by the relevant entity’s pursuit of profit but also by individuals’ pursuit of gain, whether in the form of remuneration for the individual or profit for the individual’s business.

Providing a service to customers was relegated to second place. Sales became all-important. Those who dealt with customers became sellers. And the confusion of roles extended well beyond frontline service staff. Advisers became sellers and sellers became advisers.

Incentives have been offered, and rewards have been paid, regardless of whether the sale was made, or profit derived, in accordance with law. Rewards have been paid regardless of whether the person rewarded should have done what they did.

Second, entities and individuals acted in the ways they did because they could. Entities set the terms on which they would deal, consumers often had little detailed knowledge or understanding of the transaction and consumers had next to no power to negotiate the terms.

Third, consumers often dealt with a financial services entity through an intermediary. The client might assume [that the intermediary] acted for the client and in the client’s interests. But in many cases the intermediary is paid by, and may act in the interests of, the provider of the service or product.

The interests of client, intermediary and provider of a product or service are not only different, they are opposed. An intermediary who seeks to “stand in more than one canoe” cannot. Duty (to client) and (self) interest pull in opposite directions.

Experience shows that conflicts between duty and interest can seldom be managed; self-interest will almost always trump duty.

Fourth, too often financial services entities that broke the law were not properly held to account. Misconduct will be deterred only if entities believe that misconduct will be detected, denounced and justly punished.

Wrongdoing is not denounced by issuing a media release… The community also expects that financial services entities that break the law will be held to account.

There can be no doubt that the primary responsibility for misconduct in the financial services industry lies with the entities concerned and those who managed and controlled those entities: their boards and senior management… Everything that is said in this report is to be understood in the light of that one undeniable fact.

On the National Australia Bank

I am not as confident as I would wish to be that the lessons of the past have been learned. More particularly, I was not persuaded that NAB is willing to accept the necessary responsibility for deciding, for itself, what is the right thing to do, and then having its staff act accordingly.

I thought it telling that Dr Henry [Ken Henry, NAB chairman] seemed unwilling to accept any criticism of how the board had dealt with some issues. I thought it telling that Mr Thorburn [Andrew Thorburn, NAB chief executive] treated all issues of fees for no service as nothing more than carelessness combined with system deficiencies when the total amount to be repaid by NAB and NULIS [NAB’s superannuation arm] on this account is likely to be more than $100 million.

I thought it telling that in the very week that NAB’s CEO and chair were to give evidence before the commission, one of its staff should be emailing bankers urging them to sell at least five mortgages each before Christmas. Overall, my fear — that there may be a wide gap between the public face NAB seeks to show and what it does in practice — remains.

The six principles the financial services industry should follow

• Obey the law.
• Do not mislead or deceive.
• Act fairly.
• Provide services that are fit for purpose.
• Deliver services with reasonable care and skill.
• When acting for another, act in the best interests of that other.

The six norms of conduct support

• The law must be applied and its application enforced.
• Industry codes should be approved under statute and breach of key promises made to customers in the codes should be a breach of the statute.
• No financial product should be “hawked” to retail clients.
• Intermediaries should act only on behalf of, and in the interests of, the party who pays the intermediary.
• Exceptions to the ban on conflicted remuneration should be eliminated.
• Culture and governance practices (including remuneration arrangements), both in the industry generally and in individual entities, must focus on non-financial risk, as well as financial risk.

Recommendations: answering the key questions

1. Simplify the law so that its intent is met

As far as possible, exceptions and qualifications to generally applicable norms of conduct in legislation governing financial services entities should be eliminated.

The first, and essential, step is to reduce exceptions and carve-outs. The more complicated the law, the harder it is to see unifying and informing principles and purposes.

Several recommendations propose the removal of exceptions and limitations in the existing law and industry codes. They relate to the point of sale exemption for retail dealers (from consumer credit law); grandfathered commissions (for mortgage brokers); life risk and general insurance commissions; funeral expense policies; insurance claims handling and settlement; and the definition of “small business” in the Banking Code of Practice.

As far as possible, legislation governing financial services entities should identify expressly what fundamental norms of behaviour are being pursued when particular and detailed rules are made about a particular subject matter.

2. Conflicts

Where possible, conflicts of interest and conflicts between duty and interest should be removed. There must be recognition that conflicts of interests and conflicts between duty and interest should be eliminated rather than “managed” (as existing legislation now envisages).

Several recommendations deal with conflicts of interest or conflicts between duty and interest. They include the recommendations that mortgage brokers owe borrowers a best interests duty [and that] financial advisers disclose any lack of independence.

Enforced separation of [financial] product and advice would be a very large step to take. It would be both costly and disruptive. I cannot say that the benefits of requiring separation would outweigh the costs… I am not persuaded that it is necessary.

3. Regulators and compliance

The recommendations seek to improve the effectiveness of the regulators in deterring misconduct and ensuring that there are just and appropriate consequences for misconduct.

Some recommendations seek to increase the ways in which the regulators can enforce the law. Some recommendations relate to the governance and performance of APRA [the Australian Prudential Regulation Authority, responsible for ensuring the stability of the financial system] and ASIC [the Australian Securities and Investments Commission, responsible for ensuring trustworthy conduct within that system]… and re-adjust [their] roles.

A new oversight authority for APRA and ASIC, independent of government, should be established by legislation to assess the effectiveness of each regulator in discharging its functions and meeting its statutory objects.

4. Culture, governance and remuneration

Effective leadership, good governance and appropriate culture within the entities are fundamentally important. And culture, governance and remuneration are closely connected. It must now be accepted that regulators have an important role to play in supervision of these matters.

APRA should require APRA-regulated institutions to design their remuneration systems to encourage sound management of non-financial risks, and to reduce the risk of misconduct.

APRA should [focus] on building culture that will mitigate the risk of misconduct;… assess the cultural drivers of misconduct in entities; and encourage entities to give proper attention to sound management of conduct risk and improving entity governance.

5. Increasing protections

The commissioner outlines a range of recommendations in specific problem areas, such as enacting a national scheme for mediation between banks and farmers on “distressed agricultural loans,” requiring that clients specifically approve advisers’ fees each year, prohibiting hawking superannuation and insurance products, ensuring that each worker has just one default superannuation account, and establishing a “compensation scheme of last resort” for victims wronged by firms unable to repay them.

These recommendations seek to improve the law to protect consumers from the misconduct and conduct that fell below community standards and expectations identified by the commission.

They are recommendations for changes that will reduce the chance that conduct of the kinds identified will happen again, or happen again with the same effect for consumers.

Choices must now be made. The damage done to individuals and to the overall health and reputation of the financial services industry has been large. Saying sorry and promising not to do it again has not prevented recurrence.

The time has come to decide what is to be done in response to what has happened. The financial services industry is too important to the economy of the nation to allow what has happened in the past to continue or to happen again. •

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But perhaps the biggest surprise about the royal commission is that it got started at all. The big banks and investment funds know they’re on a pretty good wicket in Australia, with muted competition, a relatively stable, unobtrusive regulatory environment, and some of the biggest profits, proportionally, in the world. From their perspective, it’s a state of affairs worth defending, and that means keeping pesky reformers at bay. To that end, the big players poured tremendous resources into heading off exactly this kind of rolling inquiry.

Indeed, their regulation-hedging has been a long-term project. New research coming out of the Dollars & Democracy project at the University of Melbourne reveals that the nation’s financiers have been making a disproportionate contribution to Australian political parties over the past two decades. Between 1998–99 and 2015–16, according to the project’s calculations, the finance industry donated over $120 million (in 2015 dollars) to the parties.

That may not sound like all that much nowadays. And it’s certainly a drop in the ocean when you consider the fact that the big four banks alone have made a minimum of $10 billion in pre-tax profits every year since the late 1990s. But for the party apparatchiks opening the envelopes, these are significant sums indeed. In fact, finance industry contributions have made up a bigger share than any other industry (yes, including mining and developers) and come in just shy of the contribution made by all the country’s unions combined. If we just look at corporate donations going directly to parties, finance industry dollars make up more than a quarter.

This $120 million captures only one sliver of the industry’s charm offensive. In all sorts of other ways, its members donate to or otherwise seek to shape the agenda for Australia’s parties of government and to steer them away from new regulations. Indeed, the channels of influence are so numerous and tangled that it can be hard to keep track of it all. We really need to focus on an example to have any hope of understanding the breadth and depth of these activities. As it happens, the biggest single finance industry donor over this eighteen-year period was Westpac, so it is as good as any to track. And what holds for Westpac is broadly true of most of the other banks, be it CBA, ANZ or NAB (though NAB has quit making direct political donations as of 2016).

For starters, Westpac donates directly to the major parties. Since 1999 it has donated $33,789,963 to Labor and $21,606,599 to the Coalition parties. Last election it was $2 million for Labor and $2.5 million for the government. Considering Labor’s bank bashing throughout 2016, it might be rather surprising that Westpac would give it almost as much as the other side. Certainly the bank’s strategy differs from the good old days: in the 1949 election, for instance, the banks pumped Robert Menzies’s Liberals full of campaign dollars in order to head off looming bank nationalisation by sweeping the Chifley government from power. They even had tellers handing out anti-Labor flyers to depositors. These days, Westpac opts not to pick a side — rather, it seeks to “support the democratic process” with a bet each way.

This “support” goes beyond direct donations to parties. Westpac funds also make their way more indirectly to the parties via its subsidiaries — Westpac’s BT Financial, for instance, is also a donor — and via industry associations. The Australian Bankers’ Association donated $10,000 to the NSW branch of the Labor Party in 2016–17; the Financial Services Council, of which BT Financial is a member, donated over $100,000 to the major parties last election. On top of this, Westpac also plays banker for, and makes out loans to, an array of party fundraising groups, investment vehicles, unions and associated entities, including the notorious Cormack Foundation, Labor Holdings Ltd, the Canberra Labor Club, the Australian Workers’ Union, the CFMEU and more, so it is intimately involved in many other political money trails.

But it’s not just polymer notes doing the talking. Westpac is also showing up in the halls of power, attending fundraisers and luncheons (sometimes party fundraisers are even held on the banks’ own premises), sending “business observers” to party conferences, and meeting with ministers. The banks send their own people to converse with political decision-makers, as well as their representatives in the Bankers’ Association and other groups.

It also hires corporate lobbyists to do this work for them. The Australian Register of Lobbyists shows that the Australian Finance Industry Association, of which Westpac is a member, retains the services of an outfit called Premier National to represent its interests in Canberra. This is the lobby firm owned by Michael Photios, moderate faction supremo in the NSW Liberal Party and key ally of Malcom Turnbull. Why hire Premier National? According to the firm’s website, one might do this because it helps its clients to “anticipate and influence complex legislative and regulatory changes, keeping them connected with key influencers and mitigating risks to their operations.”

The flow of people is not one way, either. We are familiar with the case of Anna Bligh, Queensland-premier-turned-Bankers’-Association-CEO, but the banks’ in-house government relations units are filled with former politicos too. Westpac’s head of government relations right up until the start of the royal commission, Brett Gale, worked in the Hawke, Keating and Carr governments, and most recently was chief of staff to Chris Bowen while he was assistant treasurer. Marcus James, also part of the unit, worked for Bowen’s successor, Nick Sherry.

These people don’t exactly put up a Chinese wall between themselves and their former comrades — rather, they are valued for their connections, remaining on Capital Hill to lobby their up-until-yesterday bosses and colleagues. And they sometimes return to the fold: Gale has now left Westpac to become executive director of a Labor think tank, the Chifley Research Centre (named after the Labor PM who wanted to nationalise the banks). So there is a revolving door between high-level politicos and the banks’ government relations units.

Taken in isolation, we might think that each of these measures is a little pushy, but basically ad hoc and not especially sinister. But these well-resourced, staffer-stuffed government relations units aren’t paid big bucks for ad hoc. And the notion that their activities extend only to innocent support for the democratic process seems a little less plausible when we put the full picture together: millions of dollars given directly and indirectly to the parties of government, so regularly that they come to depend on it, and all followed up by direct and indirect lobbying by carefully recruited party insiders.

This is less about supporting the democratic process than about inserting eyes and ears inside the parties of government, and indeed, about getting close to the ears of the agenda-setters in those parties. It is about protecting profits and hedging risk, about steering government away from reform or, failing that, getting ahead of the curve. Who knows how many reform pushes they’ve managed to squash over the years?

And yet, here we are, in the middle of a year-long royal commission into the finance industry. The moral seems to be that, even with all the resources in the world, the best one can do is hedge the risk of scrutiny and profit-eating reform. Money talks, but the fact that Labor pushed for the royal commission despite millions in donations from the banks, and despite party insiders-turned-bank-lobbyists urging against it, suggests something else is talking too.

Parties are responding to things other than dollars — public outrage, opportunities for political wedging, scapegoating, that sort of thing. We are not living in a dystopian corporatocracy just yet. Moneyed interests have influence, that’s for sure, but they remain part of a bigger political game in which other players, with other resources, can and do compete. The playing field may not be level, but the game is not totally rigged either — those seeking scrutiny, regulation and reform can and do, from time to time, come out on top. ●

Thanks to Joo-Cheong Tham and Malcolm Anderson at the Dollars & Democracy Project for providing donations data.

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Australia’s business culture, like its political culture, has acquired something of a production-line character. People who fit in easily and say the right things to the right people tend to get jobs they might not be well equipped to perform. Boards of directors and chief executives often appear more concerned to showcase the process of leadership than to practise it firmly and effectively. Processes are unguided by clear purposes, or are shaped by wilful ignorance. And the regulators have been slow to act.

Take the commission testimony of Louise Macaulay, a senior manager at the Australian Securities and Investments Commission. Ms Macaulay, who heads ASIC’s supervision of financial advisers, revealed that the subjects of the agency’s enforcement obligations — the financial services licensees themselves — decide which transgressions are important enough to investigate. Here’s her exchange with counsel assisting the royal commission, Rowena Orr, on 27 April:

Orr: Is there any obligation on financial services licensees to report misconduct by their employees or authorised representatives to ASIC?

Macaulay: Well, it depends on whether it fits within the provisions of the legislation. So it needs to be a significant breach, and whether or not a breach is significant will depend on the nature of the breach and also on the — the nature of the licensee. So if it’s one adviser within a small licensee and there has been a breach that’s affected a number of clients, the licensee may say that that is a significant breach. If it’s a large licensee and there is one adviser with a limited number of clients, the licensee may form a view that that is not significant, because a significant breach aspect relates to the conduct of the licensee’s business, not to the conduct of the individual adviser.

Once it does track down a miscreant and he or she is banned from practising, Ms Orr asked, does ASIC consider the benefits of a public denunciation, as occurs in criminal cases?

Macaulay: I think you can probably say that it doesn’t at the moment. There are constraints on what we can publicly say about bannings. It’s a — our investigations and surveillances, of course, are private, and then the banning process also takes place privately. And the only — the decision is also private, and so we can make a — and we do always put out media releases which record the order, and we do have some brief explanation of the misconduct. So those constraints apply as a result of procedural fairness.

No names are revealed in the ASIC media releases.

Later, Ms Macaulay was asked very directly whether the current regulatory structure meant that misconduct by a financial adviser is predominantly dealt with by the licensee. “Yes,” she answered, without qualification.

In her summing up, Rowena Orr offered a striking counterpoint, drawing on one of the case studies considered by the commission. “Despite attempts from more junior staff to convince senior management of AMP advice licensees to cease charging fees for no service, they continued to do so,” she said. “Mr Regan [Jack Regan, an AMP executive] admitted that this conduct showed that the culture at AMP was not as robust as it should be. He agreed that it showed a culture in which conscious decisions were made to protect the profitability of AMP and put the interests of shareholders first at the expense both of the interests of clients and of complying with the law.”

For Ms Orr, AMP’s approach raised an important question:

Why has it placed so much emphasis on the question of whether an employee or executive received legal advice explaining that it was unlawful to charge fees for no service? While the receipt of such advice might be an aggravating factor in the culpability of an individual, it is difficult to understand why so many employees and executives at AMP were unable to recognise something that was plain to Mr Regan, namely, that to charge fees for services that will not and cannot be provided is unlawful and ethically and morally wrong.

A few days later, the Australian Prudential Regulation Authority, or APRA, released a lengthy report on the culture within Australia’s largest financial institution, the Commonwealth Bank. APRA’s review panel — made up of former APRA head John Laker, former banker Jillian Broadbent and former competition commissioner Graeme Samuel — found that “CBA’s continued financial success dulled the institution’s senses to signals that might have otherwise alerted the board and senior executives to a deterioration in CBA’s risk profile. This dulling was particularly apparent in CBA’s management of non-financial risks, i.e. its operational, compliance and conduct risks.”

According to the report, “These risks were neither clearly understood nor owned, the frameworks for managing them were cumbersome and incomplete, and senior leadership was slow to recognise, and address, emerging threats to CBA’s reputation. The consequences of this slowness were not grasped.” The trio catalogued a series of extremely damaging shortcomings, including inadequate probing of emerging non-financial risks by the board and its committees, unclear accountabilities at senior levels, risk-management processes that didn’t work, and distorted incentives.

Aside from CBA’s extensive reach into the day-to-day activity of households and businesses, its sheer size means that it has a very large influence on the value of savings held by Australian superannuation funds such as AMP. CBA has also appeared at the Hayne royal commission, as have AMP and others. The evidence there so far suggests that the problems in the cultures of CBA and AMP are not confined to our largest and oldest institutions.

The most striking feature of ASIC’s evidence to the commission was the revelation of its distorted priorities. ASIC revealed that cases of serious misconduct are reported to it quite frequently by financial institutions. Yet it then pursues its inquiries in private and obtains private undertakings and relatively modest remediation — always relying on the institutions themselves to admit misconduct and never considering the social benefits of the publicity that would accompany criminal charges.

ASIC was created out of the National Companies and Securities Commission, which was a creature of the pioneering national corporations regulation developed by the states and the Commonwealth in the early 1980s. The NCSC had a rough introduction, running up against some remarkably aggressive corporate pirates in the 1980s. Perhaps bruised by the knuckling, the NCSC’s first chair, Henry Bosch, later confessed that he pined for the days when a miscreant might be guided back on track with a few words from the chaps at his club. The reality, at least in one case related to me, is that legal advisers were told, “Don’t tell me what’s illegal. Tell me what gets me into jail!”

The pirates have mainly gone now, and today’s corporate environment is different in important ways. Critical to this shift has been the influence of compulsory superannuation. In fact, a case could be made that superannuation policy has had a powerful negative impact on corporate culture. Citizens are compelled to put almost 10 per cent of their earnings into investments they often don’t understand. Despite this compulsion, governments have made no real effort to provide a simple, low-cost default fund for those who don’t feel confident to choose. Employers and unions offer a narrow choice of funds differentiated, at best, by banal tags.

Generally, the super funds don’t comply with the disclosure rules imposed (by them) on listed companies, so we don’t know much about the salaries and benefits they pay, or about the related-party transactions they may make, or about how their bonus schemes work. Many super fund board members have been there for a very long time, a practice they discourage when it comes to listed companies. And it’s not at all clear how they are chosen.

As big investors, super funds should be closely monitoring the performance of the companies they have stakes in. Generally, they focus almost exclusively on smooth (ideally smoothly rising) share prices and profits. Unless there has been an egregious and widely publicised event, it is extremely rare for a chief executive or board to be tipped out. Even when they sometimes are — as was the case with former AMP chair Simon McKeon — we now know that broader questions should have been asked about governance.

Superannuation has pumped a huge flow of cash into the Australian stock market. This has at least two serious effects, both of which reflect Warren Buffet’s aphorism: in the short term, the share market is a voting machine; in the long term, it is a weighing machine. In the short term, corporations are under enormous pressure to sell a story and to maintain a narrative, even if the real world is unpredictable, in order to keep their share prices high. Longer term, their aim is to market concentration, which is why we have ended up with a very large proportion of companies’ growth being driven by takeovers.

In a market heavily influenced by very large superannuation flows, conformity and predictability are extremely highly regarded corporate attributes, and strong-growth companies are not always favoured. CSL, for example, has an impeccable governance record and a remarkable growth history, but is not in the portfolio of some large funds. Its growth — frequently uprated — has attracted international interest to the point where super funds have turned down the chance of substantial gains because of what they think are exaggerated prices. Yet the same funds do nothing when BHP blows a few billion — for the umpteenth time — at the peak of a commodity cycle. In this cautious world, financiers and advisers become unnaturally influential and companies pursue a strategy of least risk and most certainty — not always succeeding even in those terms — rather than one that elevates value creation and community benefit.

It’s clear that the primacy of institutional interest is unquestioned at ASIC. Combine that with the apparent need for explicit legal advice about right and wrong — at AMP, anyway — and, like a small island lacking genetic diversity, we are breeding a dangerous culture.

Overlaying all this is a dubious leadership culture. Ever since Bill Clinton’s administration opened the way for equity-based incentive schemes, corporate salaries have inflated beyond imagining across the English-speaking world. Executives are very often rewarded for capital appreciation rather than operational performance, which effectively treats them like owners and elevates their interests above those of shareholders. The glamour of enormous salaries and status has seeped into the boardroom, which appears to be much more intrusive, politically charged and fickle than in the past.

The curative required is tension. Roles need to be clear and enforced. Purpose needs to be at the top of board members’ and executives’ minds. Outcomes must be the test of performance. ASIC ought to introduce serious tension into its relationship with companies. Superannuation funds ought to be clear that their job is husbanding savings and demonstrating they can increase their value. Corporate leaders ought to be absolutely clear about the need to create value.

Right now, a lot of emperors are poncing around naked. They need new clothes. •

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Already the commission has claimed a spectacular wicket with the departure of AMP’s chief executive, Craig Meller, and the position of other institutions’ executives could prove untenable as more revelations emerge. Latest indications suggest that the commission’s work will be extended by a year.

As of 13 April, the commission had received 3433 public submissions, an overwhelming 69 per cent of which relate to banks, with 8 per cent covering the super funds and 7 per cent financial advice. Though the commission doesn’t have the power to order compensation payments or resolve disputes, the financial institutions will find it hard not to recompense the victims of their misconduct, and the regulators — the Australian Securities and Investments Commission, or ASIC, and the Australian Prudential Regulation Authority — will be forced to act more firmly against erring banks.

Submissions on consumer lending were the subject of the first round of hearings. The case studies compiled by the commission revealed that all players, including the major banks, at least one foreign bank and a mortgage broker were involved in conduct harmful to consumers. The dodgy practices related mainly to residential mortgages, credit cards and vehicle finance.

In the case of the National Australia Bank, for example, an internal scheme offering incentives for new customers was abused by staff and potential “introducers” from 2013 to 2016. According to the commission, there was a “reliance on false documentation to support loan applications; use of incorrect income figures in loan serviceability assessments; dishonest application of customer signatures on Introducer consent forms; and/or the misstatement of loans in loan documentation.” The misconduct, it concluded, “potentially resulted in customers taking out loans which were unsuitable for them.” Conflicts of interest also came to light, and some bank staff were involved in an alleged multi-branch bribery ring involving forged documents, payslips and Medicare cards.

This case study echoes the reckless lending that was allowed to occur in the lead-up to the 2008 US subprime crisis. Fuelled by the pressure on loan officers to achieve targets and sweetened with bonuses and other incentives, so-called NINJA loans were provided to borrowers who had no income, no jobs and no assets. The NAB revelations highlight the care that needs to be taken in designing incentive schemes and putting checks and balances in place.

Another of the royal commission’s case studies concerned a car loan granted to a carer by Westpac despite the fact that she informed the bank she couldn’t afford the payments of $259 a fortnight. A car dealer, remunerated by the bank through a process called flex commissions, saddled her with a used car that she believed was new and then, astonishingly, set the rate of interest to be paid by the customer. (ASIC has since banned these commissions.)

In financial advice, too, glaring misconduct has come to light. A nurse whose dream was to start a bed-and-breakfast business was misled by Westpac financial advisers. They told her to sell her home, obtain $1 million in life insurance, and roll over her superannuation into a self-managed fund to be used to borrow up to $2 million. Those funds would be used to buy the desired business, where she would also live herself. She followed the advice but later found that the law didn’t permit the use of self-managed super funds to buy an owner-occupied home. She now lives in a rented property.

The current hearing culminated last week with the revelation that AMP had lied to ASIC for nearly a decade over allegations that customers had been charged fees for advice that was never provided.

What explains this state of affairs? After all, the industry has been the subject of a series of inquiries over the years, the most recent being the Financial System Inquiry, chaired by former banker David Murray in 2014. That inquiry, considered the biggest overhaul of the Australian financial system since 1997, made forty-four recommendations aimed at making the financial system efficient (to support growth), resilient (to withstand shocks) and fair to consumers. It argued that confidence and trust needed to be enhanced by “creating an environment in which financial firms treat their customers fairly.” Its recommended approach combined self-regulation with regulatory changes to strengthen financial firms’ accountability. A little over three years on, that mix hasn’t delivered the desired benefits.

My view, expressed in opinion pieces and interviews in recent years, is that the banks’ misbehaviour can only be checked if criminal provisions are introduced. Now, the shocking revelations at the commission appear to have forced the government to do just that. The treasurer has announced that executives who engage in corporate and financial misconduct will face up to ten years in jail and institutions fines of up to $210 million. The move, though belated, is in the right direction.

Incentives need to be designed to ensure that an institution’s interests and those of its clients are aligned to produce fair outcomes — the opposite of what was revealed to have happened at the NAB. In many cases, not just at the NAB, unreasonable sales targets force employees to resort to unethical methods, such as withholding critical information from clients, as happened in the bed-and-breakfast case. If top management places ethics at the centre of its expectations of staff, that attitude will filter down. Appropriate protections and incentives for whistleblowers will be crucial.

Among financial advisers, it seems that nothing has been learnt from the Storm Financial scandal. Many clients are unaware that financial advice must, by law, be provided in writing and that only such advice can be acted on. ASIC’s MoneySmart website provides useful consumer information, but the regulator should also mandate that financial advisers provide additional material to their clients about what they are entitled to expect.

In some ways, the latest revelations were a moment of shock and awe for the Australian people and the government. With an election due within little more than a year, both major political parties will be especially sensitive to what happens at the commission. Labor was quick to blame the government and has been calling for an apology; the treasurer responded with tougher penalties to demonstrate government’s seriousness.

Finally, the regulatory authorities need to use their powers more aggressively to ensure that the harmed party’s financial position is restored to where it was prior to the misleading advice. The deterrent effect, in combination with the other mooted changes, could be significant and lasting. ●

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Whether it’s the European Central Bank’s persistence in buying bonds, the US government’s persistence in growing budget deficits, the high levels of household debt in countries like Australia and Canada or the unmanaged appetites for debt among China’s enormous state-owned enterprises, the hazard lights are flashing globally.

The lessons of history are plain enough: long periods of cheap money and easy credit invariably lead to big trouble. There was a time when financial regulators like William McChesney Martin and Paul Volcker, both former heads of the US Federal Reserve, would hide the punch bowl — as they liked to say — before the party got out of hand. Today, only Jens Weidmann of Germany’s Bundesbank and officials at the Bank for International Settlements are firm restraining hands.

At the core of the problem is the too-big-to-fail status of a group of hugely influential enterprises. In the United States and Europe, as in Australia, these institutions are typically banks and related lending entities, which have bloated the size of the finance sector to unprecedented levels. In China, the politically and economically powerful state-owned enterprises, or SOEs, seem to have gained even more power under the regime of president Xi Jinping.

A characteristic of the too-big-to-fail enterprise is that it is immune to the usual consequences of its own bad decisions. Whether it’s a Chinese industrial company that borrows to speculate in real estate, a “zombie” European bank that has yet to recover from the last global financial collapse or a global asset trader that takes big risks — and big fees — for doubtful “performance” value, size and political power have delivered immunity.

In China’s case, president Xi and his allies have reversed reforms introduced by Deng Xiaoping designed to remove private enterprises from Communist Party influence. Strong words of encouragement for economic liberalisation and tighter financial discipline have been replaced by saccharine pronouncements, such as a recent assertion that SOEs are “deleveraging,” which looks a lot like a directive to swap debt for equity. (Converting bank debt into equity in a firm might shift the numbers on the balance sheet but it does nothing to lift the performance of the firm or improve the behaviour of the bank. In fact, higher equity might encourage new loans if the cosmetic is embraced as reality.) Meanwhile, the party has tightened its control over the largest SOEs, appointing chief executives from among its own cadres on a similar rotation system to that of party officials.

China’s reforming econocrats had their day in the years after Deng’s last big policy play in 1992. A long boom followed, only braking in 2008. The disruption wrought by the global financial crisis coincided with Xi’s appointment to the Politburo, and was followed by a slackening of controls over SOE borrowing that aimed to mitigate the impact of weak international trade. Since then, Xi’s administration has tightened the relationship between the party and the SOE managers to the point where the old privatisation campaign is called “wrongheaded” thinking. It’s a defensive move, but it’s not clear that the risk inherent in a politically managed corporate sector has been reduced.

On the one hand, Xi’s regime has tightened the screws, forcing conglomerates like CEFC China Energy, Dalian Wanda and Anbang to unwind what had become a speculative aggregation of assets. But on the other hand, companies like Fosun and Geely (which has recently taken a very large stake in Mercedes Benz) appear immune. And the heaviest debt loads are in the party’s steel, aluminium and related mining and metals businesses, which don’t appear to be under pressure — not in public, anyway, even though one steelmaker, Dongbei, has defaulted on more than ten bond payments.

Over in the United States, Donald Trump was elected president on the basis of rhetoric that — so far as it talked about “draining the swamp” — might well have been targeting Wall Street. There’s no doubt that recent administrations, and especially Bill Clinton’s, encouraged risky behaviour by banks and other financiers leading up to the 2008 crisis. There’s also no doubt that Wall Street is heavily invested in Washington and vice versa.

Not surprisingly, Trump has done nothing to change this culture. He appointed not one but two Goldman Sachs alumni to the key policy positions of treasury secretary and director of the National Economic Council. Tax reduction heads his agenda.

Early this year, US government debt passed US$21 trillion, a level described by the director of national intelligence, Dan Coats, as both “unsustainable” and a risk to national security. Tax cuts introduced by Ronald Reagan in the 1980s; George W. Bush’s tax cuts and cripplingly expensive military ventures in Afghanistan and Iraq; the bank bailouts and huge deficits in the wake of the financial crisis; and now Trump’s military spending and tax cuts — all have contributed to a government debt inexorably heading for 100 per cent or more of annual GDP. If, as expected, US interest rates double fairly quickly, then the yearly budget cost of interest alone could hit US$800 billion.

Here in Australia, meanwhile, the main worry is household debt. Now equal to about 120 per cent of annual GDP, it has joined Switzerland, Canada and the Netherlands at the top of global rankings. Houses are the driver of Australia’s debt addiction, though it must be obvious by now that public policy decisions are a significant factor. House prices have jumped to astonishing levels — from about twice average annual disposable income in 1991 to about five times today. Average household debt in 1991 was roughly six months’ disposable income; today it is two years’ worth.

Overall, Australians have the comfort of strong growth in average nominal wealth, mostly because house prices have largely held up so far. Incomes have been stagnant, but the interest on outstanding mortgages has actually been falling for most of this decade. Unemployment is about where it was in 2008, but average hours worked have been falling. In short, many households are likely to be alarmed at the prospect of rising interest rates.

Banks account for about 40 per cent of the nominal value of all companies listed on the Australian stock exchange and about two-thirds of the assets of all financial institutions. Finance now accounts for roughly 13 per cent of Australian GDP, a very high share by international standards and a dramatic increase on historical levels. Banks in Australia are most certainly in the too-big-to-fail category, and it’s likely that any major defaulter would be bailed out by taxpayers. Not that this has been in doubt for many years; in fact, it is nonsense to suggest that Australian governments would allow the markets to punish bad management by driving banks and finance companies to the wall.

While public criticism of the growing power of finance has tended to focus on high fees and even higher incomes, the more fundamental issue is this immunity from failure. Regulation plays a very large part in determining how much of the economy accrues to finance. In Australia, regulation plays a central role: most obviously through the compulsory superannuation system, which taxes salaries and puts the money into a highly dispersed range of superannuation funds. For a variety of reasons, this fuels the growth of a large, well-endowed class of fee-takers.

Australians have been encouraged to accept that public debt should be minimised, and low public debt was certainly a great asset when things went pear-shaped in 2008. But we have not done much to discourage private debt and — as we are seeing in the evidence to the banking royal commission — the banks’ risk management has been inadequate, and perhaps even seriously degraded by the influence of mortgage-broker marketing. No one doubts that the residential property market is awash with debt; the only question is the extent. And the elevated level of household risk is a big headache when we are faced with significant rises in interest rates.

Globally, the finance bubble is also subject to another risk factor. Political leadership is unusually concentrated in two huge players. China’s Xi has accumulated power in ways that leave no doubt about his supremacy. At the same time, he seems committed to integrating China’s financial sector into the global system, though he may be going slow on the essential prerequisite: a clean-up of debt-ridden corporations and tiers of government. Potentially, this is a Chinese virus within a somewhat vulnerable global host.

Across the Pacific, President Trump has also been shedding shackles, though of course he has nothing like the reach of his Chinese counterpart. What Trump appears to have done is cut himself off from any of the usual sources of knowledge and caution that the US system relies on. If something goes seriously wrong in global finance, it’s fair to assume that the president would not have his finger on the pulse. More likely, he would withdraw US support and engagement.

Just recently, Australia’s former treasurer Peter Costello used a megaphone to warn of the risks of household debt. Yet it is just one part of a wider, international pattern he didn’t mention — a pattern of accumulated risk that has been disguised by the policies of central banks. As the world moves back to more normal interest rates, a few too many dials are showing red. It’s time for caution, at the very least. ●

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I’m on record as having said, back in 2013, that bitcoin “will eventually attain its true value of zero, though no one can say when.” By contrast, its most optimistic backers foresee the value of each bitcoin reaching millions of dollars. Both estimates should concern financial regulators.

If the value of bitcoin and other cryptocurrencies falls to zero, lots of individual speculators will lose lots of money, adding up to billions of dollars. For regulators, that’s not too much of a concern: speculators should have known they were taking a risk that could turn out badly. More concerning is the prospect that a big crash will take down not just speculators but also the financial institutions that backed them. The longer the bubble continues to grow, the more serious this risk becomes. So, if bitcoin is truly worth zero, the best outcome for regulators is that it should reach this price as soon as possible.

If bitcoin increases in value a hundredfold, on the other hand, as it did between 2013 and 2017, it will become critical to the global financial system. Even modest fluctuations will mean the difference between prosperity and ruin for vast numbers of people.

Bitcoin’s original value proposition was that it would be superior, as a medium of exchange, to cash, credit cards and bank transfers. On that basis, people would prefer holding bitcoins, or financial assets denominated in bitcoins, in place of existing currencies, especially the US dollar. If this were to happen, the value of the total stock of bitcoins would be equal to the value of US currency now in circulation, a bit over US$1 trillion. Since the stock of Bitcoins is limited to twenty-one million, each coin would be worth around $50,000. At a current price of $10,000, this would be a bet worth taking at odds of five to one.

Unfortunately for bitcoin fans, the chances of this happening are a lot less than that. In the time since bitcoin was launched in 2009, it has become evident that design flaws make it useless as a medium of exchange. A design feature called the block size limit means that bitcoin can only handle around seven transactions per second. Under current rules, those who want their transactions handled rapidly (mostly speculative traders) must pay a premium to have this happen.

As a result, anyone wanting to use bitcoin for buying and selling faces lengthy delays and, currently, a cost of around US$20 per transaction. Obviously, no one will pay such a charge for day-to-day transactions. The handful of merchants who announced a willingness to accept bitcoin in the early days have since dropped it. Even a bitcoin conference was recently forced to announce that it would not accept bitcoin for registration fees.

For a while, bitcoin was favoured by users who wanted to transact anonymously, sometimes for legitimate reasons and sometimes illegally. But while bitcoin transactions are anonymous in the short run, they are anything but untraceable. The whole point of the bitcoin blockchain is that it is a complete ledger of all transactions. So, if someone else gains access to your bitcoins (for example, if a law enforcement agency compels you to hand over the keys), they have access to your entire transaction history.

Various means have been proposed for making cryptocurrencies untraceable. But all of them run up against the fact that the blockchain operates on the basis of contributions from a set of servers. If someone can get control of a majority of the servers, he or she controls the blockchain. Because the great majority of these servers are in China, the Chinese government is in a position to do this at any time it chooses. In fact, because mining is organised into relatively small “pools,” it would be sufficient to take control of four of them, something that could be done overnight.

Similarly, although various suggestions have been made for improving efficiency, there’s little to suggest that a decentralised blockchain can outperform a central intermediary like a bank or credit card company.

Even if blockchain technology turns out to be the basis of a new digital currency, it’s clear that bitcoin will not be that currency. What about the thousand or so other cryptocurrencies out there? The ease with which cryptocurrencies have proliferated supplies the answer.

Suppose that some government and its central bank decided to replace their existing currency with a digital system based on a blockchain. Adopting one of the existing currencies would involve a massive transfer of wealth to the owners of that currency. The obvious choice would be to start a new one and capture the value of issuing it (known as seigniorage).

Most people now understand that bitcoin is never going to work as a medium of exchange. Supporters now claim that it should be seen as a store of value, desirable because of its scarcity. It is this use that raises the question of its inherent value.

The bitcoin mining technology operates on what is called “proof of work.” To gain access to a bitcoin, miners must use specialised computers to solve a problem that has two characteristics. First, it must be hard to solve, and capable of being made harder as the competition to secure bitcoins intensifies. Second, the solution, once obtained, must be easily verifiable.

The crucial characteristic of most computation — the characteristic missing in bitcoin — is that it should serve some inherent purpose. Unlike a word-processing program or even the uploading of a cat video, the calculations used to mine a bitcoin are of no interest to anybody. (An initiative called Gridcoin works on complex calculations that are of use to scientists but, sadly, it has gone nowhere.)

Bitcoin fans argue that bitcoin is not unique in this respect. As they point out, most of the world’s stock of gold is held by central banks or investors simply as a store of value. That’s true. But the use of gold in this way is not an arbitrary convention. Gold has physical properties (attractive colour, malleability and ductility) that have always made it desirable for use in jewellery. More recently, these same properties have given gold industrial uses, for example in electronic circuitry. Using gold as a store of value certainly amplifies the demand and increases the price, but it rests, in the end, on a solid reality.

“Fiat money” (such as Australian dollars), which isn’t convertible into gold, might seem to be an example of an arbitrary convention. But fiat currencies are valuable because the governments that issue them have the power to levy taxes in those currencies. Anyone who has to pay tax to the Australian government needs Australian dollars — as actual currency, or as an asset convertible into currency on demand, such as money in a bank account.

Governments have long understood this. When Britain established colonial governments in Africa in the nineteenth century, its first act was to levy a “hut tax,” payable in cash. While the revenue from the tax helped to offset the cost of running the colony, the primary purpose was to force Africans out of the subsistence economy, in which they provided for themselves, and into the cash economy, where they had to produce goods for sale on the market or work for wages in the colonial plantation economy.

In any case, the argument for bitcoin based on scarcity is a form of bait and switch. The claimed uniqueness of bitcoin arises from the blockchain process, not from the fact that the supply is limited. Generating an item guaranteed to be in finite supply is far less difficult than creating a blockchain: all it requires is a reliable datestamp to ensure that no more of the item can be made.

Finite supply is a necessary condition for any kind of collectible to be valuable, but it is not sufficient. Items with William Shakespeare’s signature are worth millions, while equally rare items signed by his forgotten contemporaries can be had for a few dollars. To be a store of value, an item must be valued by somebody (and not necessarily the holder).

Since bitcoins are not useful as a medium of exchange, or desirable in themselves, their true value is zero. The highest price at which bitcoins have traded is around $20,000. At the time of writing, the market price is halfway between that level and zero. Pay your money (or not) and take your chances. ●

The post Bitcoin’s zero-sum game appeared first on Inside Story.

After a brief scene-setting summary of the ideas of the great classical economists Adam Smith, John Stuart Mill and Karl Marx, Bookstaber’s account starts in earnest with the rise of neoclassical economics and mathematical formalism in the late nineteenth century. The key player here is William Stanley Jevons, who sought to place economics on a firm mathematical foundation. For Jevons, among the key things economic theory needed to understand and predict were the crises that were already a well-established feature of the capitalist economy.

As Bookstaber points out, contemporary economics might fully reflects Jevons’s mathematical approach but it has largely abandoned his search for a model of the business cycle. It’s only fair to mention, though, that the failure to develop such a theory wasn’t for want of trying. Throughout the twentieth century, mainstream and heterodox economists alike produced a profusion of attempts, none of which was entirely satisfactory.

Bookstaber argues, correctly in my view, that the standard approach of neoclassical economics, embodied in Dynamic Stochastic General Equilibrium, or DSGE, models, can never account for financial crises. In these models’ archetypal versions, macroeconomic outcomes arise from the decisions of a “representative agent,” a single participant in the economy exhibiting typical preferences.

This agent is uncertain about the future (the “dynamic” in DSGE means “over time” and “stochastic” means “uncertain”) but can nevertheless make perfectly rational choices about what to consume and produce along every possible path the economy might traverse in the future. These choices determine, and are determined by, market prices (this is where the “general equilibrium” part of DSGE comes in).

DSGE models failed spectacularly in the lead-up to the global financial crisis, and were equally useless in the developing responses. The core approach of DSGE modelling starts with conditions conducive to the emergence of a stable equilibrium, and so it effectively rules out the possibility of crises.

DSGE modellers are aware of this problem. Indeed, the typical DSGE paper focuses on a particular deviation from the canonical model, and shows what happens when it is adjusted to allow for it. After the GFC, these adjustments commonly involved acknowledging that “frictions” in the financial sector could be tweaked to simulate a crisis.

Writing just before the GFC, the French economist Olivier Blanchard summarised the standard DSGE approach using the following, literally poetic, metaphor:

A macroeconomic article today often follows strict, haiku-like, rules: It starts from a general equilibrium structure, in which individuals maximise the expected present value of utility, firms maximise their value, and markets clear. Then, it introduces a twist, be it an imperfection or the closing of a particular set of markets, and works out the general equilibrium implications. It then performs a numerical simulation, based on calibration, showing that the model performs well. It ends with a welfare assessment.

Staying within a step or two of the standard general equilibrium solution has obvious benefits. The properties of general equilibrium solutions have been analysed in detail for decades, and this means that modelling “general equilibrium with a twist” has exactly the right degree of difficulty for academic economists. It’s hard enough to require, and exhibit, the skills valued by the profession, but not so hard as to make the problem insoluble, or soluble only by abandoning the underlying framework of individual maximisation.

Bookstaber’s argument is that DSGE can’t work in the face of what he calls the “four horsemen”:

• Emergent phenomena: “When system-wide dynamics arise unexpectedly out the activities of individuals in a way that is not simply an aggregation of that behaviour.”

• Non-ergodicity: “Where the dynamics themselves change over time.”

• Radical uncertainty: “Our unanticipatable future experiences, on the one hand, and the complexity of our social interactions on the other.”

• Computational irreducibility: “Our interactions are so profound that there is no mathematical shortcut for determining how they will evolve. The only way to know what the result of these interactions is to trace out their path over time… The world cannot be solved; it has to be lived.”

All of this is spot on, and Bookstaber develops these ideas in some insightful chapters. The problems start when he proposes his solution: agent-based modelling.

The key goal of agent-based modelling is to simulate the behaviour of a system populated with individual “agents,” each of whom follows a simple rule. The best-known example, discussed by Bookstaber, is John Conway’s Game of Life, in which the “agents” are represented by squares that turn on and off according to simple rules. Depending on the starting configuration, an amazing variety of patterns can be produced, but there is no general way of predicting the behaviour of the system.

Bookstaber presents his own agent-based model of a financial system subject to crises. He hopes that the widespread use of a model of this kind would become a kind of self-refuting prophecy. Sovereign wealth funds and other asset owners would intervene in the early stages of a crisis, buying up assets that had fallen below their long-term value, and would thereby prevent a market retreat from turning into a rout.

This sounds appealing, and Bookstaber backs it up with a convincing retelling of the story of the global financial crisis, which his model describes very well. So why did I become more and more unhappy as I approached the end of the book?

The big problem with Bookstaber’s approach is that it is vulnerable to the same criticisms he makes of mainstream economics. His agent-based model works well in describing the 2008 crisis, but he has the benefit of hindsight. With that same benefit, mainstream DSGE modellers have tweaked their models so that they can also represent the crisis.

More importantly, agent-based models share the same starting point with DSGE: the behaviour of individuals, which is then combined to model the market as a whole. This is based on a misunderstanding of the crucial idea of emergent phenomena. Precisely because the behaviour of complex dynamic systems can’t be predicted from individual components, models need to work at the aggregate level. Just as we can’t model human behaviour by looking at the sub-atomic particles of which we are composed, neither can we capture all aspects of an economic system by looking at individual agents, whether these are the “rational maximisers” of neoclassical orthodoxy or the rule-followers of agent-based modelling.

The history of agent-based modelling in economics supports these concerns. The general idea has been around since the 1970s, and produced some notable early successes, such as Thomas Schelling’s model of racial segregation and Anatol Rapoport’s Tit for Tat strategy for Prisoner’s Dilemma games. But subsequent advances have been few and far between. In economics itself, agent-based modelling has been used extensively for two decades but has yet to produce any widely accepted results, let alone a program sufficiently powerful to challenge the dominant DSGE.

By contrast, while DSGE models reign supreme in the journals, they have been displaced in policy discussions by much simpler models working at the level of the economy as a whole. The most successful, in terms of predicting the behaviour of the economy, have been modified versions of textbook Keynesian models, focusing on aggregate investment, saving and demand for liquidity. The main opposition to Keynesianism has come from advocates of “austerity,” who focus on abstract notions like “confidence” that can’t easily be reduced to the beliefs of any particular agent or individual.

A focus on the properties of the financial system as a whole, rather than the agents within it, suggests a very different approach to policy. It may be well be impossible to model a system in which agents seek to profit from marginal misalignments between the prices of alternative asset portfolios, with aggregate values in the hundreds of trillions of dollars and daily transaction volumes in the tens of billions. But it is not hard to see that such a system must be fragile, and that bailing it out in the event of failure is going to be hugely expensive. The primary lesson we should have learned from the GFC is not that we need better models but that we need a better system: more robust, more risk-averse and correspondingly smaller and less profitable.

Whatever the merits of his proposed solution, however, Bookstaber has done a great job of exposing the flaws in dominant economic theories. For anyone concerned with these issues, his book is well worth reading. •

The post The four horsemen of the global financial crisis appeared first on Inside Story.

The guard, about their own age but with the confidence of uniformed authority, delivers a crisp lecture. “The greatest privilege of socialism is freedom. Freedom from greed. The kind of greed that made you two break our laws to get a better deal. Ever thought about that? Next time you decide to take East German laws into your own hands, ask yourselves, who will win? You greedy capitalists, or we socialists who work together for the collective good?” He dismisses them, but blocks their attempt to pick up the books. “The Shakespeare stays.”

It’s a good scene. From here, the ironies pan out to form the shape of a cold war spy story, as the young guard, Martin Rauch, is selected to work undercover in West Germany and finds himself steering between irreconcilable yet strangely equivalent frames of value. Deutschland 83, the hit German series currently showing on SBS, had a slow start with German-language audiences but was the highest-rating foreign language drama series shown in Britain last year.

Rauch’s rhetorical challenge is juxtaposed with a clip from Reagan’s “Evil Empire” speech, with its declaration that there would be no nuclear freeze. Quoting a passage from C.S. Lewis, Reagan declared that evil has its genesis “in clear, carpeted, warmed and well-lighted offices” where “quiet men with white collars and cut fingernails” sow the seeds of totalitarian darkness.

As the series progresses, the contest for the moral high ground becomes increasingly confused. Rauch assumes the identity of Moritz Stamm, a West German army officer shot by Stasi agents as he is on his way to take up the position of aide de camp to General Edel (Ulrich Noethen). Rauch/Stamm’s duties involve observing NATO meetings, where Edel is involved in the dangerous game of nuclear brinkmanship that leads up to the simulated missile attack known as Able Archer.

When it comes to the battle for hearts and minds, Edel isn’t doing too well on the home front. His daughter goes off to join the Rajneesh cult and his son, also an army officer, reads left-wing political philosophy and gets drawn into the anti-nuclear student protest movement in Bonn. Rauch/Stamm, played by Jonas Nay as a youth whose coming of age involves constant negotiations between sincerity and deceit, is by no means immune to the seductions of the new world in which he finds himself. His contempt for the black market is soon overcome when he discovers some of the technological wonders on offer: the Walkman, and a miniature recording device perfect for use in the office.

It’s Nay’s performance that gives Deutschland 83 its psychological depths and the layer of suspense underlying the conventional lures of the thriller plot. And Rauch’s aunt Lenora (Maria Schrader), the Stasi agent who recruits him, makes the perfect dramatic foil for the ingenuous Rauch; as a hardcore spy, her merely personal responses have long ago atrophied. Yet the other characters, however much they are drawn into the complex storylines, are curiously unmemorable. In this respect, the series doesn’t match its rivals from the Scandinavian production teams. The Killing and The Bridge set new standards in ensemble playing, giving every actor a distinctive presence and subtext to prepare the ground for the classic double helix move, in which apparent motivations are inverted.

Deutschland 83’s compensatory strengths are in the authenticity of the storyline and nuanced evocation of milieu. The 1980s is an easy decade to laugh at for its absurd pretensions in fashion and style, but here the humour is more subtly tuned. Lenora keeps a secret jar of Nescafé Gold in her desk drawer. A group of Stasi operators in the coding centre, confronted for the first time with two floppy disks, are seen staring down at them like visitors in a sideshow.

Writers Anna and Jörg Winger have done their research assiduously, accessing material on Able Archer newly released by the US National Security Archives and consulting a range of specialists in military and diplomatic intelligence. The seeds of the story came from Jörg Winger’s awareness, as a radio signaller for the West German military in the early 1980s, that a mole at his own base was monitoring his interceptions of transmissions from Russia.

It’s refreshing to have a spy story in which the espionage is frequently bungled or misconceived. Of course, Rauch’s few days of intensive briefing are insufficient to equip him with the advanced skills required for bugging the office of a senior NATO official, or for seducing a staffer and keeping the relationship on an even keel. In terms of plotting, the thriller and the farce are closely allied, and the Stasi team operates much of the time on the Basil Fawlty principle: a stuff-up is only a pretext for a more elaborate way of constructing the situation. This operational realism brings a strong command of dramatic timing. The action, when it occurs, is sudden and unpredictable, and the consequences may be drastic or inconsequential. You never know which way the pendulum of events will swing.

If there’s one thing the future learned from this critical period of Western history, it’s that there’s no such thing as a stable hold on the moral high ground. Margaret Thatcher claimed it with aplomb when she famously took a copy of Friedrich Hayek’s The Constitution of Liberty from her handbag and pronounced, “This is what we believe.” Hayek, drawing on his experience in Austria following the first world war, wrote from a conviction that totalitarianism was the direct and inevitable outcome of socialism. Free markets and small government, its antithesis, meant freedom. In Thatcher’s words, Hayek’s analysis “gave us the feeling that the other side simply could not win in the end.” On this, she and Reagan were in fierce agreement.

Comment threads on reviews of Deutschland 83 here, in Germany and in Britain are fraught with tensions over the ideological legacy of the East/West division. Was the socialist regime in East Berlin really so bad? And if it was, has the capitalist model that won out delivered anything better in the long run? Those who still think Thatcher was right might take the road to Wigan Pier, as British journalist Ros Wynne-Jones did recently, to demonstrate that conditions in the towns of northern England now replicate those described by George Orwell in the 1930s.

At the other end of the spectrum, it’s not so far-fetched to see the political culture of Wall Street as the postmodern equivalent of East Germany under the Stasi. In his book Flash Boys (2014), Michael Lewis, the supreme chronicler of this hyper-real environment, tells the story of Sergey Aleynikov, a Russian computer programmer who worked for Goldman Sachs. Aleynikov, who grew up with a deep sense of loyalty to the Soviet Union, left Russia in 1990, soon after the fall of the Berlin Wall, lured by the opportunities to develop his expertise in New York.

In Lewis’s account, Aleynikov remained a man of modest tastes, unable to relate to the excesses of the world of finance to which he’d migrated and somehow become a linchpin. By 2008, when the global financial crisis hit, he was known to corporate recruiters as the best programmer at Goldman Sachs, and in 2009 he accepted an offer to work for a rival company. In preparation for his departure, he sent himself the codes he had worked on and, in accord with routine, deleted the “bash history” (the keyboard sequence used to upload them).

Aleynikov never made it to his next destination. He was arrested at the airport, driven to the FBI building in lower Manhattan and charged with violating the Economic Espionage Act and the National Stolen Property Act. The rationale for the charges was technical, so much so that the prosecuting officers didn’t understand it themselves, but it had to do with a claim from Goldman Sachs that the uploaded files were company property. Unaware of the gravity of the situation, he signed a confession that led to an eight-year jail sentence without parole.

The power plays and corruption of this arcane world are the backdrop for Billions, a Showtime creation entering its second series on Stan. The series pits super-trader Bobby Axelrod and prosecuting attorney Chuck Rhoades against each other in an increasingly tangled battle for, yes, the moral high ground.

“Axe” Axelrod (Damian Lewis) is portrayed as something of a hero because he diverted profits made after 9/11 to support the families of colleagues lost in the tragedy. He’s loyal to his wife, generous to his staff and, with his liking for fast food and preference for jeans and T-shirts as workwear, comes across as a pretty regular guy much of the time. But he also has a yearning for a multimillion-dollar beach house and a family trip around the Galapagos on his private yacht.

Anyone who makes that much money can’t be that good, and Chuck Rhoades (Paul Giamatti), with an eye to his own prestige, is out to take one of the highest-profile scalps in the business. But Rhoades is himself an ugly customer, who has trained his glamorous wife to cater to his advanced sadomasochistic tastes, and is driven by a vindictive need to get the better of other alpha males who cross his path.

The script, a collaboration between New York Times reporter Andrew Ross Sorkin and screenwriters Brian Koppelman and David Levien, has grit and momentum. Perhaps it’s clever to explore the moral inversions of a situation in which the motivations of the prosecutor are more nefarious than those of the billionaire, but it gets pretty tedious watching the displays of stereotyped masculinity from both characters. Rhoades’s wife, Wendy (Maggie Siff), is a motivational coach employed by Axelrod, but just how much is there for her to explore in these men, whose motivation seems to boil down to nothing less obvious than sex, money and ego?

Watching Billions, I kept thinking of Adam McKay’s brilliant film The Big Short, based on the book by Michael Lewis, with its collection of oddball personalities so driven by their bizarre forms of expertise that they have no interest in being players in the world of human relationships. Billions has none of the psychological diversity Lewis finds in the rarefied world of stock trading. In dramatic terms, it’s banal. One look at the poster, showing Axe and Chuck fronting up to each other like a couple of primates while the supporting cast cluster around to restrain them, tells you everything you need to know. •

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Social impact bonds, or social benefit bonds as they are called in New South Wales, are generating enough excitement to make Malcolm Turnbull proud. Not only that, they fit right into his innovation agenda, holding out the promise of a new way to tackle some of our most intractable social problems. They also tap into a growing market for investments aimed at doing good as well as earning a return.

The idea is to harness the resources of private investors to fund social programs at a time when governments feel increasingly constrained. The investors get a return only if the programs are successful, meaning some of the risk is transferred from taxpayers to private individuals and payments are based on outcomes rather than what the program happens to cost.

Pioneered in Britain six years ago, social impact bonds have spread rapidly, with sixty launched in fifteen countries. In Australia, Barry O’Farrell’s Coalition government in New South Wales was the first to announce a trial of the bonds in 2011, when Mike Baird, as treasurer, acted on a report commissioned by the former Labor government. Now Baird’s government is running two bonds aimed at reducing the rate of foster and institutional care for children. In July, it announced a third designed to reduce reoffending rates among ex-prisoners.

Baird wants to introduce two new social impact investments each year. He has outlined three priority areas: increasing access to early childhood education, encouraging more permanent foster care (including through adoptions), and using a new Aboriginal Centre for Excellence to help Indigenous children in western Sydney make the post-school transition. And as a sign of how far it is prepared to go down this path, the government is exploring four other areas – homelessness among veterans, waste management, the road toll and domestic violence. The new projects won’t all necessarily involve bonds: the government is also looking at potentially less complex alternatives such as government or private grants paid on the basis of outcomes.

Labor governments may not be quite as gung-ho about the idea, but Victoria, Queensland and South Australia have all announced pilot programs, or have plans to do so, in areas including drug and alcohol treatment programs, homelessness, prisoner reoffending and out-of-home care for Indigenous children.

As a concept, social impact bonds require a leap of thinking. Since governments took over providing mainstream social services from churches and charities during the first half of the twentieth century, it’s been assumed that the best way to ensure people are not left behind is to maintain nationwide programs funded by taxpayers.

Beyond routine social security payments, though, governments have a generally poor record in delivering services. Take, for example, shortcomings in child fostering and adoption, prisoner rehabilitation, and dealing with homelessness and long-term unemployment. There are arguments for trying something different.

At the same time, governments, particularly conservative ones, are looking to spend less in these and other welfare areas. As social services minister, Morrison was unequivocal about what he saw as the trend. Governments, he said, would get smaller in proportion to the size of the social challenges of the future:

But the non-government sector, the community, the private sector, will have to get bigger when it comes to addressing these challenges. This must extend to… private capital investment in addressing social needs – not charity… What I am basically saying is that welfare must become a good deal for investors – for private investors. We have to make it a good deal – for the returns to be there, to attract the level of capital that will be necessary in addition to the significant injection of capital and resources that is already provided by the states and the Commonwealth.

In the same speech, he said he was “very keen” to explore social impact bonds because “they have great potential for helping improve people’s lives while increasing public sector accountability.” When I submitted questions about the government’s plans to Morrison’s successor in the portfolio, Christian Porter, a spokesperson told me that the Coalition is exploring ways to develop a social impact investment market in Australia. “The government is open to looking at where social impact bonds might be a good fit in delivering outcomes for Australian communities,” she added.

Federal Labor is on board, too, at least in principle. “I am really interested in how to encourage and support the not-for-profit sector as they try to think of new ways of doing things,” shadow families and social services minister Jenny Macklin told me. “The good thing about social impact bonds is that people are trying out a new idea. At the moment I think there is still a lot of work to be done to see whether or not they will be effective. We need proper evaluation and a strong evidence base.”

In a speech last year, Porter also sounded a note of caution. Referring to various initiatives to increase housing affordability, including the South Australian trials of social impact bonds directed at homelessness, he observed that success had been “mixed” and “few projects have been able to scale up to the level of supply needed to make a real difference…”

Last year’s McClure report on welfare reform recommended expanding outcomes-based social investment models, including social impact bonds, or SIBs:

To date, evaluations of SIBs trialled overseas and in Australia have been promising. The vested interests of the parties in ensuring success has led to innovation and performance. A key benefit of SIBs is the opportunity they provide to “test and try” a multitude of different approaches. Where these solutions prove effective they could be scaled on a larger level.

This year’s federal budget included $96 million for a Try, Test and Learn Fund, which will invite bids from inside and outside government for innovative solutions to the problem of long-term welfare dependency among working-age people. Under its “investment” approach to social security, based on the New Zealand model, the government has commissioned an actuarial analysis, similar to that used by the insurance industry, to identify groups of people at risk of long-term dependency. As a result, young carers, young parents and young students will be the initial priorities for funding. The idea is to focus on policies or programs that, through prevention or early intervention, make a return on their investment – that is, that they save more money than they cost.

The first social benefit bond in Australia, launched in New South Wales in 2013, was Newpin (the new parent and infant network), which aims to help fostered children aged five years or younger return home and also to prevent the removal of those at risk of entering out-of-home care. Families go to Newpin centres, where staff help them work through problems such as the legacy of abuse they experienced as children, drug or alcohol addiction, and domestic violence. Caseworkers, typically trained in social work and early childhood development, and sometimes in psychology, focus on building respectful relationships with participants, in turn helping them to build better relationships with their children. Families are expected to attend two to four times a week for an eighteen-month period.

The program is run by Uniting, the services and advocacy arm of the Uniting Church in New South Wales and the Australian Capital Territory, and is partly funded by $7 million raised from fifty-nine investors, including wealthy individuals, family foundations, superannuation funds and Uniting itself. Payments to investors are based on the number of children successfully restored to the care of their families for at least a year.

According to the NSW government, “the bond targets a financial return of 10–12 per cent per annum for investors over its seven-year term.” In the first year, on the basis of a “restoration” rate of 60 per cent, the return was 7.5 per cent. In the second year, the return rose to 8.9 per cent and in the third year to 12.2 per cent, with a restoration rate of 65.2 per cent. This compares with a base restoration rate of 25 per cent, which the NSW Department of Family and Community Services considers to be the business-as-usual level. The maximum annual return is 15 per cent if a restoration rate of 70 per cent or better is achieved.

These are handsome returns that would be envied by most commercial investors in the current financial environment. Newpin investors do face risks: if the restoration rate falls below 55 per cent, they can lose up to half their funds. But they also have protections. Investors are assured of a minimum 5 per cent return, regardless of the restoration rate. And the proportion of restorations that fail because children are returned to out-of-home care within twelve months is assumed to be a maximum of 10 per cent, although the actual figure to date is 12 per cent.

The pilot: Britain’s then justice secretary Kenneth Clarke talks to prisoners at Peterborough Jail at the launch of the first social impact bonds scheme in September 2010. Chris Radburn/PA Wire

The families chosen for the programs are those considered most likely to benefit. “If the state child protection service thought there was definitely no chance of reunification, they would not refer to us,” says Liz Sanders, the head of Newpin. As a government official confirmed, “the aim is to identify people for whom the service can make the most impact and achieve the best outcomes.” This means that most of the 43,399 children in out-of-home care in Australia in mid 2015 – a 15 per cent increase over four years – are unlikely to be reunited with their families, even where this might be the best outcome. That figure includes 16,843 in New South Wales, which is disproportionally high in terms of share of population.

Compared to the scale of the problem, the numbers helped by Newpin have been small: after three years it had returned 148 children to their families, with eighteen going back to out-of-home care within twelve months, making a net restoration of 130 children. Another forty-seven were prevented from going into care. But sixty-six children left the program.

Nor does this kind of intensive social work come cheap. Contrary to the impression created by the Baird government, the $7 million provided by investors covers less than 20 per cent of the estimated $41 million the program costs over seven years. Another $9 million is allocated to the expected return to investors, the expected performance payment to Uniting, and a set payment to Social Ventures Australia – $50,000 in the first year, rising by 3 per cent in subsequent years – for managing the bond. To help meet Uniting’s commitments, the NSW government helps with an estimated cash flow of $50 million, which is supposed to be more than covered by the savings to the government ultimately generated by reduced out-of-home placements.

KPMG modelling for NSW Treasury before the launch of Newpin suggested that the program could save the state about $80 million by 2030. In 2014, the NSW government was reported to be planning to retain half these savings and use the other half to pay Uniting and bond investors.

But the government is not prepared to endorse this figure or commit to a current one. When I pressed the office of the NSW treasurer, Gladys Berejiklian, for current estimates of savings, the best government officials could offer was that further data was needed before a full analysis of gross and net savings was conducted.

Also aiming to reunite families, though structured differently from Newpin, is the second NSW program, Resilient Families, run by the Benevolent Society. Westpac and the Commonwealth Bank raised $10 million from investors for a five-year program to which the Department of Family and Community Services refers families with at least one child under six (including unborn children) assessed as being at risk of significant harm.

Under the program, caseworkers aim to visit families in their homes at least twice a week during an initial period of intensive support that also includes a twenty-four-hour call line. Families receive help dealing with substance abuse, domestic violence and other problems, and staff act as advocates on issues such as inadequate housing and welfare benefits.

“The funding has a lot of flexibility and we also can adapt very quickly,” says Claudia Lennon, the program’s manager. She cites as an example “Baby Ray,” an infant simulator doll used to help teach expectant parents how to care for a child. Imported from the United States, the doll is programmed to cry in certain circumstances – when its nappy hasn’t been changed, for instance – and to collect data on routines such as feeding, burping and nappy changes, as well as whether it has been shaken or had its head bumped. “It is a fabulous practical learning tool for parents expecting their first baby,” says Lennon. “It brings up things that parents would not have thought about, such as babies crying and not stopping.”

Two groups have invested in Benevolent Society bonds: a capital-protected class, which provided $7.5 million and receives a maximum return of 10 per cent a year; and a capital-exposed class, which put in the remaining $2.5 million and risks losing its money, but can achieve annual returns as high as 30 per cent. The minimum investment is $50,000. For each of the first two years, the return to the investor classes was 5 per cent and 8 per cent respectively in each year.

The NSW government provided $5.75 million up front to help establish the program and reduce the risk to investors. Assuming the scheme’s continued success, that amount will be deducted from the government’s payments at the end of the five-year bond. Westpac and the Commonwealth Bank did not charge for their services as financial intermediaries.

As with Newpin, payments are based on outcomes, but in this case there are three different measures rather than one. Two of them – the number of safety and risk assessments conducted on participating families, and the number of reports to helplines – showed a deterioration in each of the two years, which the Benevolent Society attributes at least in part to the “increased visibility” of family interactions under the program.

Despite this, Resilient Families was still able to report positive outcomes because two-thirds of the weighting is given to a reduction in children going into out-of-home care. The latest investor report puts this reduction at 27 per cent in 2014–15. What it doesn’t make clear is that the 27 per cent represents three children – a fall from eighteen to fifteen.

These figures drive home the point that social benefit bonds are not only in their early stages but are also operating on a very small scale. The NSW government is still developing principles to guide exactly how risk will be shared between government and investors and to determine actual, as opposed to assumed, benchmark costs – that is, what it currently costs the government to deliver services.

Innovation is one of the political selling points of social impact bonds. New South Wales is now leading the nation “in the innovative area of social impact investment,” Berejiklian declared in August last year.

But while the method of financing the program may be new, at least in the case of Newpin, the program’s approach is not. It originated in Britain as long ago as the early 1980s and was run by non-government organisations and funded by local government, which traditionally delivers social services in Britain. It was an expensive program, though, and fell victim to funding cuts.

Sanders, Newpin’s head in Australia, worked on the program in Britain before Uniting recruited her in 2005 to run it here. “Governments have been trying to find short-term solutions to these problems, so they love ten-week parenting programs,” she says. “That works for some families but it doesn’t work for the families we see because of entrenched intergenerational issues that need to be addressed.” These often include abuse suffered by parents when they were children, and recent or current drug and alcohol addiction. It was when Uniting was looking to expand the program from four to ten centres that it successfully tendered for one of the first two social benefit bonds in NSW.

Underlying that history is the potential conflict between innovation and the need to draw on a solid base of evidence. As government officers told KPMG during an evaluation of the trials, “if there is good data and a solid evidence base then it is likely that there are already effective programs in an area and there may be little in the way of service innovation.” Investors are also more likely to be attracted to a proven program.

Nevertheless, those involved in Newpin and Resilient Families praise their flexibility compared to sometimes lumbering bureaucracies with hard-and-fast rules. Parents who leave Resilient Families can rejoin the scheme, for instance, without needing to go through another government referral process. But there is no inherent reason why this should not be the case for any program delivered by non-government organisations, whether or not it’s funded by outside investors.

Supporters are keen to scale up the programs, confident that there is sufficient investor appetite to fund expansion. But they agree that the inhibiting factor is a shortage of personnel and other resources. This is not just a government funding issue: social workers and others in the field are mostly poorly paid, meaning that non-government organisations have trouble recruiting them.

It’s also the case that creating the bonds has been complex and extraordinarily time-consuming. KPMG calculated that the average number of staff hours spent on planning and developing each of the two NSW bonds was 11,712. It’s true that this was the first time the bonds had been introduced in Australia, and further experience is likely to reduce this figure. You’d certainly hope so.

Adding to the complexity is the involvement of a third party – namely, investors – and financial intermediaries. A 2011 report by the University of NSW Centre for Social Impact, headed at the time by former prime minister’s department head Peter Shergold, argued that social investors wanted a simple structure for the bonds and recommended against the use of a financial intermediary for a NSW pilot. But officials now say that this kind of financial expertise has been essential in establishing the structure.

As a result of these and other factors, some proposed schemes – here and overseas – have failed to make it beyond the conceptual stage. Back in 2012, the NSW government announced plans for three bonds: the third, designed to reduce prisoner reoffending rates and to be run by Mission Australia, didn’t proceed. Mission Australia is coy about the reasons. According to the government’s Office of Social Impact Investment, the decision not to go ahead was based on risks and challenges that included “performance targets, funding required, reputational risks to the parties involved, investor profile and legal,” as well as ongoing changes in prison policy and administration.

Negotiations for New Zealand’s first social impact bond, to help people with mental illness find employment, collapsed in July this year after a year of talks and $1.6 million in government spending on four proposals. The reported reason was that investors were unable to obtain guarantees about the security of their investment.

And sometimes the bond is issued, and fails. In the United States, a bond targeted at juvenile prisoners in New York was scrapped when it failed to reduce reoffending rates. The main investor, Goldman Sachs, lost a notional US$7.2 million as a result, but the blow was cushioned by a Bloomberg Philanthropies guarantee over most of the capital, resulting in its paying Goldman Sachs US$6 million.

While the savings to government from social impact bonds have the potential to significantly outweigh the costs of investor returns, administrative complexity and failed programs, the evidence to date is unclear. For each child who avoids going into out-of-home care, the NSW government saves between $30,000 and $45,000 a year, according to one official calculation. And that amount doesn’t include the indirect costs of potential future welfare benefits, health costs and crime. But the calculations are difficult to make: restoring a child to a family doesn’t guarantee he or she will have better life outcomes.

The jury is still out: the OECD’s Antonella Noya. Agence Française de Développement

Overseas experience suggests that savings are not always as large as anticipated. The UK National Audit Office reported in 2015 that a £3 billion Work Programme contract cost just 2 per cent less than would otherwise be expected. While that program isn’t financed through a social impact bond, it operates on the same principle: the government contracts with service providers to pay on the basis of the results achieved in finding work for long-term unemployed or those in danger of entering their ranks.

An OECD working paper warns of the risk of manipulating programs focused on outcomes. “It may be possible to game the results by selecting clients that are easiest to reach,” it says, “…while leaving those that would be most expensive without service.” Indeed, this was the experience in Australia with the Job Network, created when the Howard government privatised the Commonwealth Employment Service.

As a result, some in the welfare sector are wary of social impact bonds. As one policy adviser put it to me, an organisation committed to assisting the most disadvantaged, though not necessarily in the cheapest way, could be driven out by operators who promise quick, cheap results. “In the early days of the Job Network people made a lot of money, both for-profits and not-for-profits,” says this adviser. “They funded huge expansions in their charitable services by creaming funds from the Job Network. Then the government got wise and cut back. Who lost out? It was the unemployed.” In this race to the bottom, “it is very hard to see what the countervailing forces are, especially in a market environment where you set people up as competitors.”

Perhaps it will be different with social impact bonds. Many investors are motivated not just by the prospect of a financial return but also by a desire to improve people’s lives. But in its enthusiasm, the NSW government in particular has a political stake in the success of the bonds, creating a potential bias towards unnecessarily attractive investment returns.

In Britain, which has gone furthest down the social investment path, only philanthropists have put money into social impact bonds, according to one of their architects. That raises the question of whether the same goals can be achieved without the considerable cost and complexity involved in incorporating an investment return.

The OECD working paper, though not endorsed by the organisation as a whole, is cautiously supportive of social impact bonds but concludes that it is too early to make a definitive judgement. It argues, for example, that “few public authorities currently have the skills required to draw up complex results based contracts that are required for SIBs.” And on the other side, “few investors have detailed understanding of the types of social outcomes that are needed to address complex social challenges or of the barriers that need to be overcome to achieve better results. People who look at the world through a financial lens may think that everything can be fixed through incentive structures.”

In a second OECD working paper released this year, researchers Antonella Noya and Stellina Galitopoulou are also cautious:

SIBs have been costly instruments so far. They have entailed significant transaction costs that stakeholders should consider before embarking on them. Policy makers should evaluate carefully what is the value added for implementing a SIB for a policy intervention compared to a more traditional approach. However, transaction costs are expected to drop as more SIBs develop and there is a streamlined process for establishing them… Overall, while SIBs have achieved interesting results in some policy areas and triggered debates that can help reflect on how social services are being financed and delivered, additional knowledge and sound evidence need to be generated in order to reduce controversies around SIBs. The jury is still out.

The world’s first bond, designed to reduce reoffending rates among prisoners on short-term sentences at Peterborough Jail in Britain, operated for two years before the British government replaced it with a national rehabilitation scheme. While still based on payment by results, the new scheme will be implemented through a direct contract with the government.

This is despite the fact that the bond was judged by the government to have been a success, achieving an 11 per cent reduction in reoffending rates at a time when the national figure went up by 10 per cent. As with the Benevolent Society’s bond, the actual numbers don’t look as impressive: a reduction from 159 reconviction events for every 100 people released from prison to 141 – that is, from slightly more than one-and-a-half new offences per person to slightly less. Participation in the program was voluntary, presumably making it more likely to succeed, while the new program will be compulsory.

Victorian green bonds, issued by the state government in July at a coupon rate of 1.75 per cent, are an example of a less complex way of attracting private investment without a financial intermediary. Seventeen investors, including insurance and funds-management companies, contributed $300 million in a little over a day to finance LED traffic lights, mini-hydroelectric power stations, low-carbon buildings, a large-scale renewable energy power station and other projects.

All of this means that the question of whether social impact bonds can change the world, as Mike Baird believes, is still very much open. They may have a role in testing new approaches, but until there is much clearer evidence of net savings to taxpayers, it would be a courageous government that used them to run large programs. •

This article was jointly funded by Inside Story and Australian Policy Online.

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If the pursuit of the story sounds more than somewhat romantic, that’s because it is. This film invests in the perennial, still irresistible romance of journalism: the lure of getting in close to the action, fighting your way into the middle of the traffic. There’s a sequence in which one of the team, Mike Rezendes (Mark Ruffalo), dodges and dashes past people, along corridors, in and out of swinging doors, in a great rush to get to the files before library closing time. He makes it, only to find that crucial folders have been emptied. In this account, the Church has that kind of power. There is symbolic resonance; with all that frustration along the way, the journalistic pursuit is necessary, and necessarily obsessive. Go back, if you can, to the classic filmic versions; there aren’t so many – Howard Hawks’s His Girl Friday (1940), one which age has not withered for a moment; All the President’s Men (1976), brilliantly written as it was by the real-life protagonists, Woodward and Bernstein; Good Night, and Good Luck (2005), the Edward R. Murrow story, as retrieved by George Clooney and team, possibly to suggest that the ghost of Joe McCarthy could still be hanging around.

Spotlight is in many respects a completely conventional addition to that line-up; it’s a well-structured tale, with clearly interwoven plots and subplots, about the uncovering of evil. There’s the one girl on the team to three blokes, and she is a young and pretty blonde; but Rachel McAdams lifts Sacha’s professionalism, and her personal struggle, well above a decorative role. Like others in the account, she was schooled as a Catholic; as the investigation proceeds, she can’t hang on to her schoolgirl faith, and the process is costly, with her devotion to an unshakably devout grandmother. But “we’re going to tell the story, and we’re going to get it right,” she says, and is shown, briefly but eloquently, having trouble with a cranky dishwasher. Mike’s marriage is offscreen, but we know he’d rather be on the job than at home, and his conscience is under perpetual strain. They and their colleagues win the right to open the records – “the truth is out there” – if at cost all round; and they’re last seen pounding away on their laptops, never to be deterred.

Meanwhile, the technology that frames their professional lives is clearly in flux. We have seen the old-fashioned presses rolling, the streams of newsprint crossing and flowing furiously, the Globe’s huge trucks setting out through the city before dawn. At the same time, the script and fine-tuned, throwaway interchanges show again what time it is; the classified scores are dropping, the new editor – and he’s Jewish, not Catholic – just might shed staff even though the Globe’s figures are well ahead of the local competition. We glimpse the big desktop computers – remember them? The tale of evil uncovered unfolds in changing times, and it is sometimes proposed that the new times’ technologies could make deep-set hypocrisies harder to keep hidden – or could they? When the story begins, the Spotlight team has already been given a full year, in several cases, to carry out investigations and develop the results – for print.

See it twice, and make all the connections you want. They’re real. The end credits most usefully list countries and locations where the Boston story is replicated over and over. There are twenty-two references to priestly corruption in Australia, a country where mainstream journalism on the Globe’s level of courage gets always harder to pursue, and not only because it’s expensive. Spotlight’s director, Tom McCarthy, had a huge production team and a topline cast; but he, and they, also had exactly the kind of courage they attribute to the Globe journalists.

It’s a real question: why dress down a multimillion-dollar feature to make it look like a documentary? That’s the case with Adam McKay’s The Big Short, an essay on the global financial crisis of 2007–08. A group of young Wall Street traders are found cruising around ways to outsmart the system while also exposing its follies. They cross the line (that is, talk to the audience); they are plausible and easy with each other; Christian Bale plays drums in daggy T-shirt and bare feet, and after this nobody can read those elements as cinematic signs of integrity. An extremely sober, bearded Brad Pitt sees through the general fraudulence; but even a slightly older ex-trader, struggling to regain his integrity, isn’t going to save the houses and jobs of several million citizens. This film offers a macabre kind of fun; the problem is the special way in which it stakes a claim on truth. There’s no doubt that there were and are young operators like these; some of them, we’re told in the end-notes, solved things for themselves after the crash by retreating into simple lives in the country (there’s an old mythology there).

The big banks shook themselves, and recovered. The film is swift-moving, and we can enjoy its energy, but note that everywhere, those homeless millions are still floundering for survival. Briefly, we visit a garden where, all of a sudden, there’s an alligator in the swimming pool.

Charles Ferguson’s documentary Inside Job (2010) was a very much better film about the global financial crisis than this one. It probably cost about a quarter as much. •

The post The thrill of the chase appeared first on Inside Story.

Senior Yen Trader:
the whole HF [hedge fund] world will be kissing you instead of calling me if libor move lower

Yen Trader 1:
ok, i will move the curve down 1bp [1 basis point, or 1/100th of 1 per cent] maybe more if I can

Senior Yen Trader:
maybe after tomorrow fixing hehehe

Yen Trader 1:
fine will go with same as yesterday then

Senior Yen Trader:
cool

Yen Trader 1:
maybe a touch higher tomorrow

Both Zingales and Tanzer make the point that banks have paid enormous fines in recent years for their bad behaviour. According to Tanzer, British banks alone have paid fines and client repayments amounting to 60 per cent of their profits since 2011. Zingales raises the obvious question about the imbalances that drive these crimes: disproportionate financial incentives for bank executives and poor product knowledge among clients. “When I talk about poor outcomes for customers, this is a genteel way of saying people got fleeced,” says Tanzer. “And, sadly, those who get fleeced are usually everyday Australians, not wealthy people who can make a major loss and not blink. That is, those affected by poor culture are usually those who can least afford it.”

Tanzer’s speech was an appeal for leadership. He asks that banks improve their culture and says ASIC will be monitoring things like incentive schemes, training and complaint handling. That might very well be an admission that bank regulation has not been especially effective, even during this unhappy period.

Zingales clearly doesn’t think moral suasion is likely to achieve much. He’s fairly certain that bank regulation generally is ineffective and believes regulators quickly become captives of their industry. His approach is plain: use simple, obvious rules. “For example,” he says,

a simple way to deal with the problem of unsophisticated investors being duped is to put the liability on the sellers. Just like brokers have to prove that they sold options only to sophisticated buyers, the same should be true for other instruments like double short ETF [exchange traded funds, a superannuation savings product]. This shift in the liability rule (caveat venditor) risks shutting off ordinary people from access to financial services. For this reason, there should be an exemption for some very basic instruments – like fixed rate mortgages and a broad stockmarket index ETF.

His other solutions are similarly straightforward, involving improved transparency in reporting and clearer burdens of risk for those who create them. He also makes a great suggestion for dealing with the pass-the-parcel kind of madness that underpinned the financial crisis: make the financier liable for deals that rely on cheating regulations.

Zingales’s views are timely and relevant for Australians because we have a finance sector that is unusual by international standards. Like many others, Australians were aggressive in using debt in the lead-up to the financial crisis. Household debt is still high, but consumer debt has been flat for six years or so and overall household behaviour is focused on saving. In fact, recent private debt growth has been fuelled so heavily by investor mortgage borrowings – the so-called housing bubble – that regulators have been trying to cap lending, apparently with mixed success.

What we don’t know – possibly can’t know – is how much risk there is in the sheer size of Australia’s finance sector. As in many rich countries, ours has grown dramatically in recent decades, bloated in part by compulsory superannuation savings that drive around 10 per cent of everyone’s paypacket into (mostly) the sharemarket. The expansion of credit, meanwhile, has been fuelled by ready access to global credit at historically low prices. Australia might be an attractive market for lenders chasing security and good returns, but this is “hot” money, as the Asian financial crisis demonstrated in 1997. If the settings change, if the relative security or the returns come under doubt, then the illusion of easy liquidity and cheap money will evaporate.

Alongside the imbalance created by our appetite for foreign debt is the finance sector’s illusion of prosperity. This an industry styled after J. Wellington Wimpy, best known for his appeal to Popeye: “I shall gladly pay you Tuesday for a hamburger today!” Shareholders and clients of banks deal in assets and liabilities that rely on value sustained over time. When housing bubbles burst, borrowers – like those recently in the United States and thirty years ago in Britain – may have incentives to simply walk away from mortgages, incurring serious damage for themselves and their banks. But the bankers’ bonuses are paid in the years when loans are made.

Despite clear doubts about the efficacy of the policy, compulsory superannuation has created an enormous industry. Leaving aside that concern and the patent inefficiency of the scheme (which we shall come back to), there is also the question of whether it’s promoting risk. Through superannuation, most householders are forced to invest in the sharemarket, where investment cycles reflect a worrying volatility, even though they would prefer to pay off their mortgage. And it’s not as if the flood of compulsory super has engendered a large number of great new businesses. The privatisations of Telstra, the Commonwealth Bank, CSL and Qantas might have added sound investment options for households, but we’ve seen an overall lessening of competition in sectors consolidated by takeover, some growth for growth’s sake by companies like BHP and Rio and a massive increase in the price of banks. The question is, what happens later?

We know that Australia’s population is ageing, and that means many of those who benefited from the tax policies and asset inflation of recent years will begin to convert their savings to income streams. Sensible people might be wise to shift from shares to cash at that time, taking away the worry that the sharemarket might fall. But that sort of trend could fundamentally change the dynamics of the savings industry.

Then there’s the efficiency question. It’s safe to assume that Greg Tanzer’s views are shaped by revelations that banks and other institutions have been reckless in their method of selling superannuation products. As Zingales observes, this is a common problem: complexity is the friendly tool of the rent-seeker. The core problem is the policy design. Most people do not understand the sharemarket and would be best placed with a plain indexed product that can be had for a tiny management fee. Good options start at roughly 0.20 per cent of the investment. So-called active managers (taking more risk for the goal of more reward) often charge at least 1.30 per cent, and probably another 10 per cent if they manage to exceed a target rate of gain, but give none back when it fails to hit the target.

There’s little doubt that over the life of their compulsory saving most people would be better off with the plain product, for the simple reason that active managers rarely beat passive ones over the long haul. And then there’s the obvious fact that a household that has paid off the house will generally have a better savings result than one forced to divert 10 per cent of its salary income to equities.

A fundamental point that Zingales makes is that big finance is a powerful rent seeker. We know that from the American and British experience of recent years. In Australia, we’ve become used to the idea that our finance sector is safe – despite the evidence that compulsory super is converting household capital into super-earnings for some players in the finance industry; despite the regulators’ failure to crack down on the dubious techniques used to sell complex investment products; and despite Canberra’s evident fear of any suggestion of policy that might inhibit the flow of rents to financiers.

It might be that there’s more risk here than meets the eye. In this case it’s a community risk, just like the many instances going back to the US savings and loan debacle, the collapse of Victoria’s Tricontinental Bank, the Pyramid scandal, and many more recent catastrophes. In this case, don’t ask for whom the bell tolls… •

The post More risk than meets the eye appeared first on Inside Story.

But the notion that money is often irrelevant to economics is sometimes difficult to sell to non-economists. Try it out on your least favourite aunt this Easter. “Nonsense,” she will tell you irritably and quite understandably, “that’s exactly what economics is about. It’s the study of money!” Nonetheless, there are hundreds of economic models that exclude the stuff entirely.

Economists are often interested in monetary phenomena, of course: in the short run, and sometimes in the long, money can matter quite a lot. But in many economic situations, you might think of money as nothing more than the medium in which everything else is expressed, of little interest in and of itself: a pane of glass in a window, rather than the view beyond.

A bit like language, you might go on to think. After all, a shovel is exactly the same thing as une pelle or eine Schaufel: the actual sounds and penstrokes that distinguish the English word from the French or German aren’t of much intrinsic interest themselves. They’re just an easy convention that transforms the picture of a garden implement that’s in my head into roughly the same image in yours – just as, when you stand at the counter in Bunnings, a fifty dollar note might transform a shovel that belongs to the shareholders of a home utility store into a shovel that belongs to you.

But in times of financial crisis brought on by fraud and deception, money and words lose their right to the presumption of neutrality. Money and the language we use to describe its operations have become important of themselves, and the sometimes-forbidding dialect spoken by financial pedagogues, central bankers and pyramid schemers ought to be translated for the use of an average citizen. These, at least, are the underlying philosophy and the guiding motivation, respectively, of John Lanchester’s witty lexicon, How to Speak Money. “Imagine if plumbing became a national problem,” Lanchester invites us, “then, although we could all remember happier times when we didn’t have to speak plumbing, we would now have a reason to learn.”

A novelist, Lanchester became interested in financial diction through a desire to write “a big fat novel about London.” As the world toppled into recession, and one squalid pyramid scheme after another was exposed to the light, he discovered that the horrors that a writer can invent always pale in comparison to reality, as Balzac has one of his characters say. (You can’t help but think that Lanchester might have taken inspiration from that other novelist with a fascination for the darker side of the pecuniary arts.) Lanchester began to write pieces for the London Review of Books as a way of making sense of it all, firstly to himself and then to his readers. How to Speak Money is in some ways a compendium of everything he learnt along the way.

The book is actually three short ones: for the price of entry we get an introductory essay on “the language of money,” then the dictionary itself, and finally an afterword that touches a little more on questions of politics and economic ideology. The first and third portions are charming if a little too heavy on the polemic at times; the dictionary is witty and may be sampled, on and off, at the reader’s pleasure.

There, we are treated to intelligible and sometimes acerbic definitions of technical terms used in finance, the kind that will help you make sense of the business reports at the end of the nightly news. What is a “no-recourse loan”? Lanchester has the answer. What is a synthetic instrument, and how does it differ from a non-synthetic one? With Syriza now in power, how might the possible departure of Greece from the eurozone (or Grexit, see page 144) be affected by legal interpretations of the principle of lex monetae (page 166)? Our author can assist with an explanation, written in the kind of prose that usually manages to appear knowledgeable without coming across as smug, and entertaining and informal without sounding arch. His lexicographical coverage is broad but idiosyncratic: for example, we get both margin in the sense of profit margins and margin call but not marginal, which is something quite different and possibly the most ubiquitous word in economics.

Economics is not usually thought of as a promising repository of metaphor, but Lanchester is especially good at showing how pervasive it is. Metaphor exists not only in financial words that retain the original sense of the comparison, as with, say, bond, but also in words that have dropped anchor quite a distance from their original place of linguistic departure. As Lanchester shows, words like “securitisation” have come to mean something like the opposite of what their metaphoric garb might suggest, a process for which Lanchester has given us the useful neologism “reversification.”

In theory, there is nothing sinister about reversification, of course. Through sarcasm, understatement or hyperbole, words change their meanings all the time. But there are at least two good reasons why you might think it dangerous among twenty-first-century financiers.

The first is that when words change in meaning, the world of finance becomes increasingly less intelligible to anyone outside the clerisy who has been trained in its language. This is not necessarily because the financiers want to be obscure: as Lanchester puts it, “the language of money is complicated because the underlying realities are complicated.” A trade-off has to be made between universal intelligibility and precision of meaning. But there are real social consequences. If the only people who know what a “vanilla mezzanine RMBS synthetic CDO” is are the people who trade them (don’t worry, Lanchester explains it quite well), then people who take a more sceptical attitude towards the notion that commerce in exotic financial instruments is necessary for human prosperity may very well not get the chance to join the discussion at all.

The other potential problem with reversification and other phenomena in economic language is a little more subtle. Sometimes numbers-people tend to use words that resemble normal English ones, but whose meanings are slightly different from their common significations. Consider the phrase “statistically significant.” If I tell you that “there has been no statistically significant warming of the atmosphere in the past fifteen years,” you are liable to think that I have made a particularly strong positive statement about a climatological phenomenon. The adverb “statistically” is partly to blame: it gives off a sort of feeling of scientific rigour that is scarcely supported by the useful but utterly ad hoc notion denoted by the adjective it qualifies.

Far from pronouncing definitely on the state of the world, “no statistically significant warming” is a Scottish verdict, a “not proven” rather than a “not guilty”: a recognition, in other words, that we don’t have enough information to say either way, usually because the period under study is too short. But the delusion-mongers who try to convince you that climate change is a fraud don’t tend to tell you that. You have to rely on your inferences from the plain English meaning of the words, which don’t make for a very good guide at all.

In cases like these, reversification – consider Lanchester’s example of “Chinese wall,” a phrase that could easily have soothed unsuspecting investors unaware that it no longer meant what it once had – can have disastrous intellectual consequences. For anyone who thinks that civilian oversight of the economy is essential, as it is for the military, reversification ought to be worrying, and Lanchester does us a service in defining and exposing it.

Whether by temperament or merely by Stockholm syndrome, Lanchester is usually scrupulously fair to money-people. That said, he misses a trick here and there, describing as “magnificent,” for example, the “the dismal science” tag given to economics by Thomas Carlyle. When he minted that phrase, the grumpy old protofascist was actually regretting the tendency of economists to insist that market forces and individual choice govern the labour market in the West Indies, in marked contrast to Carlyle’s preferred method, which of course was slavery. Economists have more often than is commonly supposed been on the side of the angels.

All autodidacts tend to make the occasional false inference about the meaning of a word or unconsciously fill in the gaps in their knowledge with misapprehensions. (Your correspondent’s German has been the subject of universal criticism on this point.) As such, Lanchester is at times something of an unreliable interpreter and instructor. Deadweight loss, for example, is defined as the “costs that are the indirect consequences of tax”; in fact, deadweight losses are incurred as a result of any deviation from a socially efficient equilibrium, as with monopolies and unregulated carbon emissions. The G20 is not only “for finance ministers and central bankers”: since the global financial crisis, it has been notable for its Leaders’ Summits, a development for which you can to some extent thank Kevin Rudd. Nor is it uniquely focused “on the operation of the financial system.” Milton Friedman was not a proponent of the notion of “rational expectations,” which in any case is not really “the idea that people’s actions, when parsed correctly, can almost always be found to have an economically rational foundation.”

Lanchester is most liable to error when, as with his entry on Friedman, he abandons explanation for condemnation. Pithy characterisation is liable to degenerate into caricature, and caricature dissolves easily into confusion. After all, a true dissection requires a thorough acquaintance with anatomy. Lanchester’s waffly definition of “neoliberal economics” is so expansive that it might plausibly describe everything from the boring old mixed capitalism of Attlee and Chifley to John Galt’s speech in Atlas Shrugged. To be fair, the inexactness of the word “neoliberal” is not Lanchester’s alone, but the deficiency seems more problematic in a lexicon than it might have elsewhere.

“Disagreements in economics aren’t just about technicalities,” Lanchester points out, “they’re usually based on profound divergences in moral analysis.” He’s quite correct. Address your inquiries on this point to Adam Smith, whose chair at Glasgow University was in moral philosophy. But in his attack on “neoliberalism” (incidentally, Lanchester can’t seem to decide whether Smith was a subscriber or not) our author neglects to outline the moral or ethical basis of this ideological disposition he doesn’t like. Merely stating that neoliberalism is “the system which has been dominant in the English-speaking world” isn’t really sufficient; nor is the assertion that neoliberalism emphasises “the role and importance of the individual” or that “the individual is paramount as a moral entity.”

Is this the Mandevillean transmutation of private vices into public virtues? Or is it pure Benthamite utilitarianism: adding up individual pleasure and subtracting individual pain in a sort of moral arithmetic? Can the case for latter-day capitalism instead be made by appealing to the tradition of Aristotelian virtue ethics, as Deirdre McCloskey has done in her book Bourgeois Virtues? Lanchester doesn’t specify.

These flaws, though, are not fatal: they debase slightly the authorial currency – the value of which has been established by what is obviously long and serious reading on Lanchester’s part – but not to the point of hyperinflation (page 151). The strength of the book is its democratic temper and Lanchester’s obvious affection for and talent with the English language. The exposure of linguistic reversification in finance is a real public service and the phrase itself a useful coinage. Like a foreigner who has been living for a time in a land that is not his own, Lanchester is not entirely fluent in his second tongue, and he is not an infallible critic of the native population, but he is a charming and generous guide to tourists, for whom his book would be well worth the capital outlay. •

The post Money talks appeared first on Inside Story.

Two senior economists at the Bank for International Settlements, or BIS, have surveyed recent research about the impact of the finance sector on the rest of the economy. They draw two conclusions. First, higher growth in the finance sector reduces growth across the economy as a whole. “In other words,” they write, “financial booms are not, in general, growth-enhancing, likely because the financial sector competes with the rest of the economy for resources.” And, second, “credit booms harm what we normally think of as the engines for growth” – those sectors of the economy fuelled by research and development. Add in the experience of the financial crisis, the two economists say, and there is “a pressing need to reassess the relationship of finance and real growth in modern economic systems.”

The punchline was provided in the Economist’s coverage of the report. Serious trouble starts, it says, when private sector debt exceeds 100 per cent of GDP or when the finance sector accounts for more than 3.9 per cent of total employment. Australia is at or very near those benchmarks.

So what does that mean for our economy? Usually we think of financial excess in terms of the risks borrowers take. Borrow too much, go bust. Like John Elliott. Or Greece. The BIS researchers focus instead on the wider impact. Too much finance, they think, stifles innovation (or productivity, in econspeak) because finance is conservative. Investors and lenders like to bank bricks and mortar, or at least solid incomes. They tend not to like untried ideas, or intangible assets, like science or new technology.

When finance gets too big, the economy grows the equivalent of a beer belly. Good times attract smart people to work in hedge funds or big banks or investment banking. Fewer people and less money go into engineering or science or areas where research and innovation are central. The economy ends up without the diversity and healthy innovation that provide balance and vitality.

In Australia two factors seem to have contributed to a conspicuous increase in the finance sector’s share of the economy. First, the deregulation of banks fundamentally changed the supply of credit. Then compulsory superannuation inflated the supply of equity to share markets and, possibly more importantly, drove a huge amount of fee income into the hands of people who might otherwise chase careers in something productive.

Ignoring for a moment the consequences of exaggerated household debt and compulsory super, the BIS perspective points to another important issue. What’s happened to the economy?

There is no doubt that Australia has ridiculously over-invested in private housing. Most of it is existing housing, so the rising debt is largely a function of asset price inflation. Similarly, the bulk of the trillions forced into super is invested in existing businesses.

Two problems are immediately apparent. The first is obvious. We know that the global financial markets are volatile. We know that Australian markets have attracted very large swathes of foreign cash. And we know that in 1997 this sort of behaviour caused huge problems for the so-called “tiger” economies to our north. (Indeed, some observers are worried that the end of “quantatitive easing” by American authorities offers a hint of déjà vu.) When the tide goes out for us – and the collapse of commodity prices is certainly that – Australia doesn’t look quite so rock solid.

As the BIS demonstrates, there is a second area of risk. Australia already had an over-reliance on commodity exports. We have always known that demand for those exports is cyclical, and we are witnessing a cyclic downturn. But the muscled-up finance sector adds to the problem because it has detracted from diversity and added asset inflation to the mix.

We live in a world of technological change, of rapid innovation and market restructuring. Yet Australia has a big exposure to volatile capital markets and commodity markets, with finance secured largely against historical assets.

There are plenty of arguments for changing the tax and regulatory treatment of Australia’s finance sector. But possibly the best one is the need to shift away from risky overreliance on finance and debt and to promote diverse economic activity better suited to the world we live in.

What the BIS and others, like the Financial Times’s Martin Wolf, have demonstrated is that the cycles of financial trouble we have seen over the past couple of decades have grown into an entrenched malaise. The novelty of home loans in Port Macquarie made cheap by foreign debt were an early instruction. The US savings and loans debacle was another. We’ve now had a global crisis, the effects of which still resonate. Yet in Australia we have skipped along unchecked and evidently unheeding.

It is clear that Australia needs to reduce risk and promote economic diversity. Soon. That is not a matter only of dealing with budget deficits; it must also involve a serious go at the distortions we have allowed to entrench during a very comfortable few decades. •

The post Crowding out appeared first on Inside Story.

It’s a simple matter to reel off the remarkable features of Australia’s good life. The often irascible Institute of Public Affairs has even gone to the trouble of compiling evidence of how well our lives are lived. Too good to be true!

Wages and employment have been robust – so much so that Australia tops the Economist’s league table of wage gains since 2002. House prices have climbed to remarkable levels, a strong dollar has made imports cheap and our public finances are the envy of the world – so much so that Australian governments have developed a Magic Pudding offer for every poll: a turkey in every pot.

For more than two decades we have enjoyed strong economic growth, low inflation and rising prosperity. It has been a double boom in a country where booms are a cultural heritage. We have seen turmoil in the world’s finances of such force that it bears an acronym more tired than KFC, yet Australians have breezed on.

Lately, however, the nagging doubts that afflict those of a cautious mind have gathered momentum. The surrender of large parts of traditional manufacturing after a long attrition might well have been brought on by strong foreign exchange rates and domestic wages, but it woke a few people up. A slide in confidence is finally raising doubts about Australian economic exceptionalism.

Doubts about the efficacy of Australia’s housing market and the sustainability of related household debt are longstanding. Most commentary tends to the view that debt is concentrated in wealthy households and is therefore manageable. But while it is clear that household savings jumped sharply when the financial crisis hit, average household debt remains at about 150 per cent of average incomes – a level roughly double what it was at the turn of this century.

Lately, the worries have been sharpened by lower commodity prices and doubts about China’s ability or willingness to sustain the stimulus from which Australia has drawn comfort. And the rose-coloured glasses have gone missing.

On 14 October, RBA assistant governor Guy Debelle gave a speech on volatility in financial markets in which he noted that there wasn’t much. We should expect that to change, he said, possibly violently:

If I had told you that there were heightened tensions in the Middle East and Eastern Europe, uncertainty about the turning point in US monetary policy, a succession of strong US job numbers, uncertainty about the future direction of policy in Europe and Japan, as well as increased concern about the strength of the Chinese economy, you would not be expecting that to make for a benign time in financial markets. But that is what we have seen for much of this year.

Debelle went on to describe some of the conditions apparent in the markets, and their evident inertia in the face of what are otherwise volatile influences. He noted that markets had built-in rules and mandates that tended to bust any instinct to go against the flood when the dam of confidence breaks. “So there is a fair chance that volatility will feed on itself,” he said. “One should always be careful of looking for too much rationality in trying to understand market dynamics. Given the lack of rational arguments for the current state of affairs, trying to rationally explain how it will unwind is also going to be difficult.”

As if to underline the point, world markets immediately went into a funk, though it’s fair to say that Australian markets remain comfortably ensconced in their extended happy hour.

Debelle’s remarks highlight the unstable character of global economies revealed since 2007. They highlight the fundamental volatility, opacity and excess leverage of global financial markets. And they add immediacy to any doubts one might have about the efficacy of the systems that supposedly manage economic welfare and stability.

All of which makes this an ideal time to question where we are and what’s what, six years after the financial crisis set in. Many books have been written about the hows and the whys: racy Wall Street yarns about Federal Reserve governors, Wall Street honchos and American presidents wrangling in panelled rooms; finger-pointing morality tales; and some useful accounts of people who tried to head off trouble but were drowned out. But until recently I had not read a book that gave me a full understanding of what went wrong.

Martin Wolf’s The Shifts and the Shocks does that job with erudition and lucidity. The Financial Times’s highly regarded economics commentator elevates our view of this financial trauma, asking purposeful questions about what we all have been thinking. He makes it clear that it’s mostly the thinking that is a problem.

There’s no easy way to summarise Wolf’s nuanced argument, which starts and finishes with issues of imbalance. At the heart of things is an unresolved excess of savings, the result of rich nations growing too slowly to absorb their wealth and poorer nations growing without great resort to others’ capital. Because governments have been brainwashed into paring back their own role as investor, we have had a long period in which capital was very cheap and its effects were transmitted globally. End result: increasingly large volumes of one-way traffic in capital markets. A virus of debt in search of a host.

Despite ample evidence that this was a big problem, the regulators of global finance became increasingly complacent. This may have had something to do with the gigantic profits and salaries that flowed from rising leverage. Or it may have been the naivety of people like Federal Reserve governor Alan Greenspan, whose unwavering belief in the self-correcting discipline of capital markets evidently overrode otherwise plain signs of trouble. The party was out of control, but Greenspan kept filling the punchbowl.

President Bill Clinton’s decision to repeal key “affiliation” sections of the Glass–Steagall Act was in many ways a watershed. Glass–Steagall, a product of the Great Depression, was simple and effective. Its principal impact was to prevent commercial banks having affiliations with security-trading firms. And while that limitation had been watered down over the years by regulators’ interpretations, Clinton’s declaration that Glass–Steagall was “dead” came, sadly, at a time when a hearty application of its intent would have had huge practical value.

Wolf’s contribution to this plain formula (cheap money plus indiscipline = mayhem) is largely about ideology. He explains that economists, regulators and legislators have been corralled into thinking of the economy without thinking about finance. They ignore ample evidence of the natural tendency of finance markets toward excess and volatility. (Hence Greenspan’s infamous apologia to a US Congressional committee in 2008: “Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity, myself included, are in a state of shocked disbelief.”) So here we are.

Wolf isn’t alone in arguing that we need to be more realistic and less ideological in handling the issues of economics (no small order!), but he also makes it plain that the conditions that created the crisis persist.

What’s to be done? Wolf spends a lot of time on possible improvements in the regulation and management of financial markets. Australians might like to read those thoughts with the Murray inquiry into the financial system in mind, and especially the debate over capital adequacy. One of Wolf’s central concerns is that the role of creating money has moved from governments to commercial banks, and it’s certainly the case that Australian banks are not limited in their financing by domestic factors. I had the impression that Wolf would like to see the deposit-takers wound back through measures that might look like Australia’s old liquidity controls, applied by the central bank through adjustable statutory reserves and liquidity measures. This would be radical, but it would certainly bring us back from a situation in which any bank failure would automatically trigger a public finance crisis.

Wolf makes good points about public finance, which is at the heart of the savings glut. He thinks governments need to engage directly in managing excess savings so that the financial-market beast can’t gorge to excess. But that would require a very big shift in thinking because most of the relevant countries are committed to limiting public expenditure, regardless of the state of the economy. On which note, we should keep an eye on the global infrastructure initiative that is bouncing around in G20 talks.

I came away thinking about the futility of our domestic debate’s narrow focus on government finances. Wolf might as well have specified the fragility of Australia’s position, with a considerable private debt weight, household debt reflecting high property prices and a banking system with a heavy reliance on international savings. He didn’t, but his observations had immediate resonance for an Australian reader.

Essentially, we have a global financial system that promotes trade in assets and has developed the means to create money at will. It’s true that most wealthy or emerging countries are ageing, throwing off excess savings that exacerbate the financial system’s inherent flaws. Governments could do more, though, by directing excess savings to dealing with global infrastructure deficiencies or similar purposes, which would balance away the savings glut and avoid the risks of massive and unpredictable volatility. But that would require fundamentally different thinking.

The financial crisis struck without apparent warning, its epicentre in what is supposedly the most sophisticated financial centre in the world. The shock was such that people in New York who actually work in capital markets were parcelling their savings from bank to bank to obtain the protection of government deposit insurance. To put it mildly, this is not at all what’s supposed to happen. Greenspan admits “disbelief” and Guy Debelle has confirmed that opacity, irrationality and absence of certainty about large risks remain characteristic of financial markets today. Martin Wolf offers practical and relatively simple propositions for change. But he left me wondering whether it will need another depression before we get back to reality.

As Dorothy would say, we are a long way from Kansas. •

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