Chapter 17: Stocktake: The Economy
Chapter 17 Summary . . . / Stocktake:The Economy
Overview
Ø This chapter analyses the implications of financial deregulation for the Australian economy. It considers allocative efficiency, external adjustment, monetary policy, savings behaviour, growth and employment.
Key Findings
Ø The removal of exchange controls accelerated the integration of Australian capital markets with international capital markets. This applied a more global framework of opportunities to the investment both of Australian owned capital and of foreign owned capital in Australia. In both respects this is likely to have been beneficial to Australia.
Ø Many financial institutions and many borrowers took time to adjust to a deregulated financial system. The result was a rapid expansion of credit to the private sector, a sharp rise in asset prices, and a subsequent correction in the early 1990s with associated bad debts and bankruptcies. This transitional process probably involved costs to the real economy during both boom and correction.
Ø More recently, measures of productivity in the Australian economy suggest an upturn during the 1990s. This may be attributable in part to greater allocative efficiency resulting from financial deregulation. These gains are likely to predominate in the future.
Ø Exchange rate flexibility has been appropriate because Australia’s economy frequently needs to adjust to changes in the terms of trade and other economic fundamentals.
Ø Scrutiny of governments’ economic policies by financial markets may be viewed either as a constraint or as a discipline. However, such market scrutiny has not prevented the implementation of redistributive policies.
Ø Financial deregulation has allowed monetary policy to be focused on price stabilisation. During the 1990s, the Reserve Bank of Australia has succeeded in maintaining low and stable inflation.
Ø The weakness in national savings in the period since deregulation does not appear to have been strongly associated with deregulation. It is due mainly to low public sector savings, especially as a result of Commonwealth government budget deficits.
Ø Private sector net wealth has increased, at an accelerated rate, during the period since deregulation¾notwithstanding any increases in foreign ownership and foreign indebtedness.
Ø Longrun growth in the Australian economy is the result of increases in inputs of productive factors (notably capital and labour) and increases in productive efficiency. To the extent that financial deregulation has increased the Australian economy’s access to capital or its allocative efficiency, it has increased the economy’s growth potential.
Ø The impact of financial deregulation on longterm employment, if any, is likely to have been through its impact on economic growth rather than through any direct linkage.
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Chapter 17: Stocktake: The Economy
Chapter 17
Stocktake: The Economy
17.1 Introduction
This chapter deals with issues in the Inquiry’s Terms of Reference concerning the effects on the Australian economy of financial deregulation. These issues reflect the concerns of members of the public, including some presented in submissions to the Inquiry, and debates among economists in Australia and overseas. The Inquiry’s approach has been to examine and summarise the available evidence about these issues.[1]
The most relevant aspects of Australia’s financial deregulation for the functioning of the economy as a whole were:
Ø removal of interest rate and lending controls, where they applied;
Ø removal of restraints on capital inflows and outflows; and
Ø allowing the value of the Australian dollar to be determined by market forces, subject to occasional intervention by the Reserve Bank of Australia (RBA).
Taken together, these:
Ø accelerated the integration of Australian financial markets with other financial centres ¾ in effect, substituting a global frame of reference for a domestic one in the allocation of investible Australian capital, and enlarging the opportunities for foreign capital to be invested in Australia;
Ø implied a change in the method of adjusting the economy to cope with external imbalance ¾ relying more on exchange rate variations and correspondingly less on changes in monetary conditions and interest rates;
Ø enabled monetary policy (the authorities’ influence on domestic cash rates) to be focused on keeping inflation low and stable, without the added task of offsetting shortterm capital inflows and outflows; and
Ø made borrowing easier for both businesses and private individuals, with some implications for private saving.
Most of this chapter is organised around these four sets of implications¾ allocative efficiency, adjustment, monetary policy and saving.
Australia’s experience during the past 15 years has been disappointing to many people in two important respects ¾ unemployment has remained persistently high, as has the current account deficit. This experience has created a sense of disappointment or scepticism about the dual strategies of opening the Australian economy to international competition and deregulating markets. However, this chapter argues that neither high unemployment nor a high current account deficit can be attributed to financial deregulation.
17.2 Allocative Efficiency
This section addresses the contributions of financial deregulation to the improvement of allocative efficiency, identifying them in a roughly chronological sequence.
The main points are as follows.
Ø The removal of exchange controls accelerated the integration of Australian capital markets with international capital markets. This brought the investment of Australian owned capital into a more global environment and encouraged the investment of foreign owned capital in Australia. Both developments are likely to have been beneficial to Australia.
Ø The removal of interest rate controls contributed to the restoration of interest rates to positive real levels. This provided more appropriate incentives for investing and saving.
Ø Many financial institutions and many borrowers took time to adjust to a deregulated financial system. The result was a rapid expansion of credit to the private sector, a sharp rise in asset prices, and a subsequent correction in the early 1990s with associated bad debts and bankruptcies. This pattern was common to other countries which deregulated around the same time, although Australia’s economy did not undergo as dramatic a boom nor as severe a correction as some others.[2] The process probably involved costs to the real economy during both boom and correction.
Ø Measures of productivity in the Australian economy suggest an upturn during the 1990s. This may be attributable in part to greater allocative efficiency resulting from financial deregulation.
17.2.1 Exchange Controls
Prior to deregulation, capital flows were subject to a wide range of controls. In particular, there were restrictions on holdings by Australian residents of foreign currency balances (apart from minimum working balances held by banks), and on holdings by nonresidents of Australian currency balances. Restrictions were also imposed on overseas investment and borrowing by Australian residents, and on nonresident borrowing in Australia.
There is evidence that, by the late 1970s, banks and market participants generally had become adept at circumventing these controls, reducing the inefficiency associated with them.[3]
The dismantling of these exchange controls at the end of 1983 (when the exchange rate was floated) accelerated the integration of Australian financial markets with international capital markets.
This involved two concurrent aspects. First, flows of capital across the exchanges were greatly magnified: this is reflected in the large (on average) inflows of foreign investment to Australia since deregulation and the sharp rise in overseas investment by Australians, shown in Figure17.1.
NonOfficial Capital Flows
Grew after Deregulation . . .
Figure 17.1: Annual Net Flows of NonOfficial Capital
Note: In any comparison with Figure 4.4, it should be noted that this figure shows annual net flows rather than endofyear levels, and excludes official capital flows, which were sizeable in some years.
Source: RBA 1996, Reserve Bank of Australia Bulletin, various editions; ABS 1996, Cat. no. 5302.0.
Secondly, interest rates in Australia, both shortterm and longterm, became more closely correlated with those in the world’s main financial centres, especially the United States.[4]
In the domestic economy, adjustment of financial institutions’ deposit and loan rates to internationally transmitted changes in money market rates has become more complete and more rapid since financial deregulation.[5]
In principle, this accelerated integration of Australia’s financial system with global capital markets should have improved allocative efficiency by:
Ø offering domestic investors a greater range of investment opportunities, including greater scope for diversification;
Ø offering overseas investors greater access to Australian productive opportunities; and
Ø applying through the financial system a structure of interest rates determined in a global economic framework.
17.2.2 Interest Rate and Lending Controls
Throughout the post1945 period until deregulation, Commonwealth governments imposed ceilings on the interest rates payable on bank deposits and loans, controls on the maturities of interest bearing deposits at banks, and restrictions on lending by banks and life companies.
These measures can be presumed to have inhibited the allocative efficiency of the Australian financial system, although their effect could not be and still cannot be measured directly. Because other financial institutions coexisted with banks (and in some cases, thrived) in the regulated era, the probable effect of interest rate controls was to impose some additional cost on obtaining similar services elsewhere, while depressing the returns available from depositing funds with banks.[6]
When interest rate and lending controls were removed in the early 1980s, the necessary conditions were established for resources to flow to their highestvalue uses.
Removal of these constraints probably also contributed to the return of interest rates, both shortterm and longterm, to levels which were positive in real (inflationadjusted) terms.[7] During the inflation of the 1970s, market interest rates in Australia had not risen commensurately. This happened only at the beginning of the 1980s, as shown in Figure 17.2.
Allocative efficiency requires that the level of real interest rates be broadly consistent with the marginal productivity of capital, which is fairly steady through time, while nominal interest rates should vary with changes in expected inflation. Unless nominal interest rates are able to reflect expected inflation in this way, increases in inflation result in transfers of real wealth from lenders to borrowers. In principle, removal of interest rate controls could only have improved the allocative efficiency of the financial system.
Real Interest Rates
Returned to Positive
Levels after Deregulation . . .
Figure 17.2: Nominal and Real Interest Rates
Note: Interest rate observations are quarterly averages. The conversions to real rates use increments in the GDP deflator over the four quarters to the interest rate observations ¾ that is, they assume extrapolative expectations of inflation.
Source: RBA 1996, Reserve Bank of Australia Bulletin, various editions.
17.2.3 Transitional Costs
In Australia as in other countries where financial systems were deregulated around the same time, several transitional factors detracted initially from the contribution which financial deregulation could make to allocative efficiency.
In the early years following deregulation, investment was probably attracted into inefficient areas as a result of preexisting distortions of investment incentives ¾ trade barriers, other industry assistance, tax preferences, and rigidity in wage rates. Many of these distortions were subsequently reduced.
Secondly, allocative efficiency was probably impaired by excessive expansion of credit to the private sector, a resulting boom in asset prices in the late 1980s, and a sudden correction in the early 1990s. Figure17.3 shows that real asset prices and private credit as a proportion of gross domestic product (GDP) grew together, unusually rapidly, from the mid-1980s until the early 1990s.
Asset Prices and Private Credit
Rose Together Rapidly after Deregulation . . .
Figure17.3: Real Aggregate Asset Prices and
Credit to the Private Sector as a Proportion of GDP
Source: RBA estimates. Quarterly figures for total private credit prior to 1977 are interpolated from annual data.
Financial deregulation contributed to this process by creating an atmosphere of intense rivalry for market share, and by enabling banks to expand in areas of business in which they had previously been constrained. The established banks’ competitive response to the prospect of competition from new foreign banks was in most cases to expand their business lending vigorously. Inthe process, they accepted lowerquality business which later gave rise to unusually high levels of bad debts.
According to staff of the Bank for International Settlements (BIS), the relaxation of credit constraints in the finance industry in a group of countries including Australia, when combined with preexisting tax provisions which encouraged indebtedness, ‘provided fertile ground for a selfreinforcing spiral of credit and asset prices, with faster credit expansion raising asset prices and higher asset prices in turn relaxing credit constraints further.’[8]
While the losses of financial institutions flowing from the correction of asset prices in the early 1990s were large, they should not be taken as measures of the costs of those losses to the economy as a whole. Some losses of financial institutions caused by transactions at artificial prices simply represented wealth transfers, with no necessary net effect on real investment and output.
The third notable impairment of allocative efficiency in the transition to financial deregulation occurred in the early 1990s when overexposed financial institutions tried to minimise their risk in new lending and to restore their capital through wider margins on existing and new loans. This approach was followed wherever competitive pressures permitted¾ notably for small and medium enterprise (SME) and household borrowers. Itreduced the availability of new loans and raised the interest cost of borrowing. This may have depressed aggregate investment, or caused suboptimal allocation of investments in the SME and household sectors.
Finally, it is sometimes argued that allocative efficiency in this period was further impaired by a reduction of time horizons, or ‘shorttermism’, on the part of institutional investors and financial markets. Some have argued that financial deregulation caused this change of attitudes, and that it diverted both private and public investment from some projects which would have been viable in the long term.[9]
General attitudes may indeed have been influenced by financial deregulation, but it is impossible to isolate one set of influences from others which operated at the same time. It should be remembered that financial deregulation was a policy response to external trends, and so should not be regarded as the cause of those trends.
In summary, Australia experienced a lengthy ¾ and possibly costly¾ transition to the different disciplines and dynamics of a deregulated system. During the 1990s, however, the more visible signs of transition including high levels of bad debt, asset price instability and poor risk management diminished. The length of the transition period appears to have been common to other countries which deregulated their financial systems in the 1980s.[10]