Sam Birmingham runs a top quality networking site for young professionals called WeBe, which provides up-to-date information on financial matters, work-related issues, lifestyle news and reviews, and current affairs and opinion pieces. WeBe also provides a platform where members can have their voices heard, express opinions and share ideas with other like-minded Young Professionals.
Yesterday, Sam published an article on WeBe questioning if Australia has become too obsessed with interest rates and whether the RBA has the right tools at its disposal.
Sam’s article is reproduced below for your reading pleasure, followed by some suggestions of my own aimed at improving financial stability.
According to our central bank’s charter, the RBA must conduct monetary policy in such a manner as will best contribute to:
1. The stability of the currency of Australia;
2. The maintenance of full employment in Australia; and
3. The economic prosperity and welfare of the people of Australia.
Over time, the RBA’s focus has been on the inflation rate and keeping it within a target range, using their principal mechanism of monetary policy, the cash rate, which the Board of the Reserve Bank sets at their monthly meetings.
At the risk of oversimplifying, the cash rate is a liquidity tool: When the economic outlook is strong (ie. capacity constraints looming and the risk of inflation rising), the RBA raises its cash rate; lenders pass this cost on to borrowers, who must then pay more each month to service the higher interest rate; this leaves them with less money in their pockets, thereby pulling excess liquidity out of the economy… And vice versa.
On the face of it, this approach makes sense to me. However, I can’t help but feel that when millions of Australians are focused on interest rates and whether the RBA’s next move will be 25bp up or 25bp down, perhaps we’ve lost a sense of perspective.
As Deep Throat said on MacroBusiness earlier this week:
“If we hang off RBA minutes to glean anything of use or influence then we’re deluded.”
Whilst I don’t necessarily agree with DT’s calls to abolish the RBA, I do agree that there needs to be a new approach to monetary policy… Why? Because the current system is clearly out of whack:
- Prima facie, we should be celebrating rising rates, because it means the outlook (for jobs, investment and confidence) is strong. But our response is exactly the opposite, because Australians are now so highly geared that every little rate rise stretches the household budget even further.
- Consider the link between asset markets and rate changes over the past couple of decades: Rates bottom out, the upturn begins, the economy continues to grow, rates rise incrementally, the economy approaches the top of its cycle, markets get frothy, commentators get excited about new highs, average homeowners tighten their pursestrings, the bubble bursts, rates get slashed, the pressure come off household finances, we are encouraged to borrow and spend more in order to restore economic growth, and the cycle beings again.
- Looking abroad, Japan’s central bank has kept rates at or near zero for years, desperately trying to stimulate growth… Where to now? And then you’ve got the US Fed who, having taken their cash rate down as far as it can go, have now resorted to quantitative easing – pumping squillions of dollars into the economy, trying to stoke growth by forcing down long-term rates and monetising Government debt in the process.
A Blunt Instrument
In the RBA’s defence, the cash rate is a one-dimensional tool when it comes to dictating monetary policy and managing the country’s economy. As far as I’m concerned, it has three main flaws:
1. Impact at the Margins
Raising the cash rate helps to suck liquidity out of the economy, but the real impact is felt by the most vulnerable households, whose budgets are already stretched and who can least afford higher rates.
Sure, if an extra $50 on your monthly mortgage bill is enough to tip you over the edge then your problem isn’t interest rates – it’s that you’ve got too much debt.
But relying on a mechanism which hits the poorest households the hardest in order to change an entire country’s saving and consumption habits is oppressive, if not discriminatory. And then you can throw in issues of generational fairness, with our wealthy (debt-free) older generations cheering every interest rate rise, whilst (highly-leveraged) younger families bear the brunt of it.
2. The Role of Intermediaries
As I explained above, the RBA sucks liquidity out of the economy by increasing its cash rate, with retail lenders then left to pass this increased cost on to their borrowing customers.
But our banks only source a portion of their funds domestically, so what happens when their alternative funding sources are pushing funding costs in the opposite direction to the central bank? Even worse, what happens if international wholesale funding markets turn off the tap?
This problem was foreshadowed by Deep Throat:
“Due to our over reliance of offshore debt, setting the cash rate lower would certainly have a negative effect on attracting offshore lenders so whilst reducing rates to stimulate, the RBA would reduce the availability of credit. Of course the reciprocal is true as well, in which case the RBA’s monetary policy is currently all but useless at the moment.”
The bottom line is that the impact of RBA cash rate changes depends on intermediaries ability to pass it on… We shouldn’t take for granted that will always the case.
3. Without Debt…?
I appreciate that debt is, for better or worse, a fundamental driver of our capital-intensive economy and plays an important role in funding household and business sheets.
But to what extent should our central bank’s prime policy tool be driven by something which, when relied upon excessively, poses a grave risk to our economy?
An Alternative Path
I’m as pro-market as the next “neo-liberal”, but I’m not convinced that we should be abolishing the RBA and leaving monetary policy to the private banking sector. However, perhaps it’s time to revisit whether the RBA has the right tools at its disposal?
Two opportunities occur to me…
Rather than nipping and tucking the cash rate, what if the percentage of our overall remuneration which goes into compulsory superannuation were allowed to fluctuate?
This would have the same effect of increasing/decreasing the flow of money around the economy, but would spread the load across the entire workforce, rather than impacting most heavily on those who can least afford it. Also, the payment system is already well established, making it reasonably easy to administer.
On the downside, such an approach is pro-cyclical: Employees would be pumping more money into their super account when the economy is booming and markets are heading skywards – leaving their saving more exposed to the inevitable downturn.
2. Consumption Tax
Given that the Government has gutlessly excluded the GST from consideration when it comes to tax reform, I don’t hold much hope that they would allow the tax rate to be set by an independent body. However, as far as I can see, a variable rate GST is the most effective way to influence the flow of liquidity throughout our economy.
First and foremost, this approach is equitable: We all consume goods and services, hence this takes money out of everyone‘s pocket, rather than hammering the poorest and most-indebted.
Again, the payment/collection system already exists: Shops could simply mark items at their pre-GST price; the RBA would announce the GST rate at its regular meetings; and then the relevant percentage would be added to our bill at the checkout.
And finally, a fluctuating GST is counter-cyclical: It captures excess liquidity during the good times, which can then be used to fund stimulus measures in the bad times.
Thanks Sam. Your suggestions are certainly food for thought. I agree that the RBA needs more policy tools at its disposal; although I have different ideas on what these tools should be.
Given the major role that excessive credit has played in creating Australia’s housing bubble, and that the Australian banking sector faced insolvency requiring a Government bail-out during the GFC (via the bank funding and deposit guarantees), my personal view is that greater regulation of mortgage lending is required to prevent the excesses that lead to asset bubbles.
One possible option is to task the RBA with developing and implementing “macro-prudential” measures aimed at strengthening the resilience of Australia’s financial system by mitigating excessive credit and asset (house) price growth. Possible macro-prudential measures could include:
- Setting maximum loan-to-value ratios (LVRs) for all property lending (i.e. lending by both bank and non-bank institutions). This measure would assist in both limiting a lender’s exposure to a property market downturn as well as preventing highly-leveraged property purchases. Maximum LVRs could, for example, be set at 85% (requiring a minimum 15% deposit) when a cash deposit is used and 50% when non-cash collateral (e.g. another property) is used in place of a cash deposit.
- Placing limits on the ratio of debt service to income for housing lending. This measure would reduce the likelihood of borrower default and limits highly-leveraged property purchases. For example, a 30% limit would permit a household with a gross income of $100,000 to borrow a maximum of $380,000 at a 7% interest rate and 30-year loan term, whereas a 40% limit would permit the same household to borrow a maximum of $500,000 under the same terms.
- Placing limits on the amount of loans that banks can extend against short-term funding sources, such as at-call deposits, and term deposits and wholesale funding with less than 12 months term-to-maturity. These types of measures: reduce the tendency of lenders to rely on short-term or unstable funding markets to support rapid lending growth; reduces the likelihood of experiencing a liquidity crisis like Australia’s banks experienced during the GFC; and reduces the overall amount of leverage in the financial system.
Macro-prudential measures, such as those described above, offer a number of addition benefits beyond simply increasing financial system stability, reducing systemic risk, and improving housing affordability. First, they could improve the function of monetary policy, since using interest rates in response to an asset bubble/bust is a blunt instrument that can have unintended consequences in other parts of the economy. Second, fixed measures, such as maximum LVRs and debt service to income ratios, tend to be more binding during a credit boom, when banks seek to expand property lending, than in a bust, when heightened risk aversion reduces their propensity to extend loans with high LVRs or debt service ratios.
Had such macro-prudential measures been in place globally during the 2000s, it is possible that the credit excesses experienced in the lead-up to the GFC would have been much less severe, since the kinds of speculative housing lending undertaken in the United States and Europe would not have been possible. It is also likely that Australia’s house prices would never have surged like they did post-2000, since access to credit and the ability to undertake highly leveraged purchases would have been muted. Houses would likely be more affordable, even in the absence of much-needed reforms to the supply-side of the housing market.
That said, implementing such macro-prudential measures domestically in the current climate would be risky, since they could lead to an immediate contraction in housing lending, resulting in house price falls and a severe economic contraction. For this reason, it would be wise to implement such measures gradually with the goal of preventing future housing bubbles.
Realistically, the political climate would likely be most amenable to change after Australia’s housing prices have deflated somewhat, since attitudes towards housing speculation and leverage would likely become more conservative. The Reserve Bank of New Zealand, which is in the process of developing macro-prudential measures, provides a useful template of how reform could be approached by Australia’s authorities.
As argued many times before by MacroBusiness’ bloggers, the Australian Government should immediately undertake another Financial System Inquiry (FSI) to examine these financial stability issues. The previous Inquiry (the ‘Wallis’ Inquiry), completed in 1997, never envisaged systemic risk engulfing financial markets as well as intermediaries, as occurred during the GFC. Nor was the idea of macro-prudential regulation ever considered.
Furthermore, the Government’s October 2008 decision to guarantee bank funding and deposits completely ignored one of the original FSI’s key recommendations – that no government would ever guarantee any part of the financial system. The long-term implications of using the Government’s balance sheet as role of guarantor of last resort for the banks’ wholesale debts is also unclear and needs to be comprehensively examined by such an inquiry.
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