Australia versus chaos theory

According to Wikipaedia “chaos theory is a branch of mathematics that deals with complex systems whose behaviour is highly sensitive to slight changes in conditions, so that small alterations can give rise to strikingly great consequences”.

Australia exists in a state of blissful ignorance of this theory. How else to explain an economic model that relies upon the smooth running of just about every other economy on earth? Let me explain.

Back in 2009 when I co-wrote The Great Crash of 2008 with Professor Ross Garnaut, the book proved to be very influential in policy circles owing to one central observation. The book described the process through which the Australian economy had been transformed in the late nineties and millennium to a model highly vulnerable to external disruption:

The growing asset boom and falling savings rates meant that ANZ, NAB, CBA and Westpac found that the demand for loans outstripped deposits. Australian banks’ ratio of deposits to total liabilities was 59 per cent in December 1994. By 2000 the ratio had dropped to 46 per cent. It finally hit 43 per cent in late 2007.30 Competition for loans with the new shadow bank sector was also intense, which gave rise to the big four’s own shadow banking activities. They were cautious about securitisation, but their high (AA) ratings provided them with a different method for accessing funds to lend: the issue of bonds directly to international investors.

The banks’ foreign wholesale borrowings grew from A$30 billion in 1990 to A$100 billion in 2000. From there the borrowing escalated, reaching A$357 billion in 2008.31 The Australian housing and consumption boom of the early twenty-first century was funded by foreign borrowing by the banks on a scale far greater than had ever happened before.

Traditionally, banks had been cautious about this method of raising funds because it carried the added risks of managing currency and foreign interest-rate fluctuations. Consequently, according to Philip Bayley, former director of Capital Markets at Standard & Poor’s Australia, ‘there was a direct correlation between the big four’s steady mastery of currency and interest rate swap derivatives and the rise of their borrowing in international wholesale markets’. These shadow instruments grew even more rapidly than the underlying borrowing. In 1990, Australian bank books showed a combined total of A$1.57 trillion notional derivative exposure. By 2000, the notional figure had grown to A$3.59 trillion, and in 2007 shot above A$13 trillion

The policy fallout from the GFC and the book was an acknowledgement that Australia had, in effect, developed a fragile economic model, one overly exposed to the flapping of far flung butterfly wings. There were three policy implications to this, all of them openly acknowledged by Australia’s key economic managers at the time:

  • Treasury recognised that in a world where major offshore financial centers could close overnight then its doctrine of allowing foreign borrowing to run riot because it was derived from the decisions of “mature adults”,   creating huge current account deficits in the process, was high risk and required serious mitigation. What followed was the largest fiscal consolidation since WWII;
  • the Reserve Bank of Australia deliberately raised interest rates to difficult levels for Australia’s east coast mortgage economies in 2010 driving historic levels of deposit growth and flat-lining offshore borrowing;
  • the Australian Prudential Regulation Authority (APRA) pursued a policy of dollar-for-dollar deposit-in, loan-out for banks, ensuring deposit competition and a push outwards in the maturity profiles of offshore borrowing.

All of this was enabled by the serendipity of the commodities boom and was handled well if not as aggressively as it needed to be. The result was an historic four year buffering of Australia’s fragile economic model as offshore borrowing stalled and its ratios to growth fell, what MB described at the time as the Great Disleveraging from 2008-2012:

ScreenHunter_10741 Dec. 03 15.46
ScreenHunter_10740 Dec. 03 15.45

However, what appeared to be a structural change in thinking proved ephemeral. The same commodities boom that had allowed the lessons to be learned with little pain, in time fed into the old way of thinking, that Australia was exceptional, that its adults were somehow more wise and all-seeing than those of other countries and, as the commodities boom ended so did the repair work on Australia’s fragile economic model.

Indeed, one could be forgiven since for concluding that no lesson was learned at all as offshore borrowing screamed higher after 2011, its maturity profile radically shortened and fragility poured back into the economy, made all the worse by a dramatic deterioration in public finances, funded again from offshore:


In the past two years we’ve seen two more countervailing policy waves by folks in the system that still grasp this fragility. The first was the Murray Financial System Inquiry which ruled in favour of higher capital for banks and lower leverage ratios for mortgages in particular. It was incremental rather than step change but defined the “fragility” problem very clearly. Alas it was too late and not radical enough to prevent the post 2011 borrowing binge, nor could it prevent the public debt splurge now underway.

The next wave of policy innovation came with APRA finally moving to dampen the borrowing binge via macroprudential policies, something that the Murray Inquiry had unfortunately failed to endorse. We are seeing the excellent results of that today with mortgage growth rates tumbling as lending standards trending higher despite rate cuts and offshore borrowing slow sharply. However, there is more work to be done to prevent this debt from taking off again and, in reality, if it is pursued with appropriate vigour will probably prove to be pro-cyclical because it came too late.

It is at this last point that come back to today. Since the GFC, good people have done good things to stabilise the fragility built into the Australian economic but the structure of the system has still pushed it towards greater risk. Australia is only marginally less exposed to external disruption today compared with 2007. Non banks have been washed out and major banks are better capitalised, as well as having 60% deposit funding funding versus 50% back then but any serious freeze in global finance will still render the major banks insolvent in a ridiculously short period given they will be unable to roll over their liabilities. They’ll be able to lean on the RBA for nearly free liquidity but even so credit ratings agencies explicitly build in a two notch upgrade to bank ratings based upon an implicit public guarantee of the bank’s liabilities and as the Budget deteriorates so too does that guarantee.

So, we haven’t entirely wasted the previous cycle in terms of an anti-fragility policy agenda but we’ve done an awful lot less that we should have. And we are about to discover the efficacy of those efforts as first Brexit then a whole series of butterflies flap their wings across the globe. Anatole Kaletsky sums it up pretty well at Project Syndicate:

The febrile behavior of financial markets ahead of the United Kingdom’s referendum on June 23 on whether to remain in the European Union shows that the outcome will influence economic and political conditions around the world far more profoundly than Britain’s roughly 2.4% share of global GDP might suggest. There are three reasons for this outsize impact.

First, the “Brexit” referendum is part of a global phenomenon: populist revolts against established political parties, predominantly by older, poorer, or less-educated voters angry enough to tear down existing institutions and defy “establishment” politicians and economic experts. Indeed, the demographic profile of potential Brexit voters is strikingly similar to that of American supporters of Donald Trump and French adherents of the National Front.

Opinion polls indicate that British voters back the “Leave”campaign by a wide margin, 65% to 35%, if they did not complete high school, are over 60, or have “D, E” blue-collar occupations. By contrast, university graduates, voters under 40, and members of the “A, B” professional classes plan to vote “Remain” by similar margins of 60% to 40% and higher.

In Britain, the United States, and Germany, the populist rebellions are not only fueled by similar perceived grievances and nationalist sentiments, but also are occurring in similar economic conditions. All three countries have returned to more or less full employment, with unemployment rates of around 5%. But many of the jobs created pay low wages, and immigrants have recently displaced bankers as scapegoats for all social ills.

The degree of mistrust of business leaders, mainstream politicians, and expert economists is evident in the extent to which voters are ignoring their warnings not to endanger the gradual restoration of prosperity by upending the status quo. In Britain, after three months of debate about Brexit, only 37% of voters agree that Britain would be worse off economically if it left the EU – down from 38% a year ago.

In other words, all the voluminous reports – by the International Monetary Fund, the OECD, the World Bank, and the British government and the Bank of England – unanimously warning of significant losses from Brexit have been disregarded. Rather than trying to rebut the experts’ warnings with detailed analyses, Boris Johnson, the leader of the Leave campaign, has responded with bluster and rhetoric identical to Trump’s anti-politics: “Who is remotely apprehensive about leaving? Oh believe me, it will be fine.” In other words, the so-called experts were wrong in the past, and they are wrong now.

This kind of frontal attack on political elites has been surprisingly successful in Britain, judging by the latest Brexit polling. But only after the votes are counted will we know whether opinions expressed to pollsters predicted actual voting behavior.

This is the second reason why the Brexit result will echo around the world. The referendum will be the first big test of whether it is the experts and markets, or the opinion polls, that have been closer to the truth about the strength of the populist upsurge.

For now, political pundits and financial markets on both sides of the Atlantic assume, perhaps complacently, that what angry voters tell pollsters does not reflect how they will actually vote. Analysts and investors have consistently assigned low odds to insurgent victories: in late May, betting markets and computerized models put the probabilities of Trump’s election and of Brexit at only around 25%, despite the fact that opinion polls showed almost 50% support for both.

If Brexit wins on June 23, the low odds accorded by experts and financial markets to successful populist revolts in America and Europe will immediately look suspect, while the higher probabilities suggested by opinion polls will gain greater credibility. This is not because US voters will be influenced by Britain; of course they will not be. But, in addition to all the economic, demographic, and social similarities, opinion polling in the US and Britain now face very similar challenges and uncertainties, owing to the breakdown of traditional political allegiances and dominant two-party systems.

Statistical theory even allows us to quantify how expectations about the US presidential election should shift if Brexit wins in Britain. Suppose, for the sake of simplicity, that we start by giving equal credibility to opinion polls showing Brexit and Trump with almost 50% support and expert opinions, which gave them only a 25% chance. Now suppose that Brexit wins. A statistical formula called Bayes’ theorem then shows that belief in opinion polls would increase from 50% to 67%, while the credibility of expert opinion would fall from 50% to 33%.

This leads to the third, and most worrying, implication of the British vote. If Brexit wins in a country as stable and politically phlegmatic as Britain, financial markets and businesses around the world will be shaken out of their complacency about populist insurgencies in the rest of Europe and the US. These heightened market concerns will, in turn, change economic reality. As in 2008, financial markets will amplify economic anxiety, breeding more anti-establishment anger and fueling still-higher expectations of political revolt.

The threat of such contagion means a Brexit vote could be the catalyst for another global crisis. This time, however, the workers who lose their jobs, the pensioners who lose their savings, and the homeowners who are trapped in negative equity will not be able to blame “the bankers.” Those who vote for populist upheavals will have no one but themselves to blame when their revolutions go wrong.

Quite right, except for the last paragraph. We are only here because people blame the bankers and their policy buddies and even an elective unraveling of the system will make that worse not better. After all, the globalists built the system that folks want out of. If anything Kaletsky is, I think, underestimating the psychological shift against globalisation underway and there are a series of lightening rods ahead:

  • taken at face value, a Trump Administration will be anti-China, pro-protection and nationalist with all kinds of economic struggle likely to turn hot across the Pacific;
  • Fraxit looms as a real possibility in 2017 as National Front leads national polling which is the end of the euro as we know it;
  • China’s debt mountain appears manageable until the Sixth Plenary of the Chinese Communist Party in mid-2017. After that, the reformist Xi Jinping should have complete control of the Politburo and be able to renew his economic transformation to much slower growth.

Chaos is coming in one form or many and Australia is not ready for it.

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  1. Very good summary of the state of play.

    As massive cracks have been developing in the globalist vision splendid of unregulated flows of capital, goods, services and people, Australias political class and policy makers have either not been paying attention or yet again, in an act of loyalty by a financial system colony, decided to plunge on regardless.

    Just as high volume and unimpeded capital flows and deregulated banking have been critical to the globalist project any retreat from the globalist objectives is likely to have significant implications on the current model of banking and finance.

    People are starting to draw the dots connecting deregulated banking and finance, “independent” central banks and credit regulation AND the globalist project.

    They are starting to understand that the globalist project is NOT really about improved trade in goods and services and bringing people together – even it does that in the process. They are starting to notice it is really about inequality, wealth extraction and concentration and financial colonisation by means of capital flows and the increasing privatisation of the monetary system and money supply.

    Naturally those at the bottom can see the problem most clearly as they are at the pointy end of the process. The politics is being noticed now simply because the disaffection is spreading upwards through the ranks.

    Those higher in the economic pile – the secure middle classes – left and right – still think that it is just about cheaper flights to exotic locations are watching their assets rise in price on a torrent of cheap private bank created fiat.

    For the time being they remain ‘shareholders’ in the global project and are still receiving dividends. Which is why they are keen to dismiss the disaffection as being the ignorant howls of the ill bred and uninformed.

    Some of them are confused when they find their own children supporting politicians who are offering a retreat from a globalist project they have assumed is just about delivering a superior consumption lifestyle.

    Hopefully the democratic process still has some life in it and we can retreat from the worst excesses of the radical experiment of the last 40 years without losing everything.

    • moderate mouse

      “For the time being they remain ‘shareholders’ in the global project and are still receiving dividends. Which is why they are keen to dismiss the disaffection as being the ignorant howls of the ill bred and uninformed.”

      Nicely put PFH. I wonder how much longer they would remain supporters of the ‘project’ once their houses stop going up? I can see a rapid conversion from calm, ‘astute’ investors to frothing radicals calling for blood…

    • Jumping jack flash

      “They are starting to understand that the globalist project is NOT really about improved trade in goods and services and bringing people together – even it does that in the process. They are starting to notice it is really about inequality, wealth extraction and concentration and financial colonisation by means of capital flows and the increasing privatisation of the monetary system and money supply.”

      Indeed. Slavery-but-not-slavery.

      However without the oppression, the diligent slaves generally overtake the complacent masters.

  2. Never did trust the Second Law of Thermodynamics. Much prefer the Universal Law of Career Politicians Fuck Everything

    • Politicians are just servants for their betters… your a few steps removed from the rot…

      • St JacquesMEMBER

        Yes skip, I think we all understand they are just paid clowns doing the bidding of their corporate masters who intelligently stay behind the scenes. Probably explains why they like their military toys so much, it gives these clowns a sense of importance.

  3. Fourth Turning ? The Millenials will have to handle the crisis.

    This describes the Millenials in our family very well. They will rise to the challenge as past generations have when they have no choices left.

    Invest in Virtual Reality, we have failed the internet and it will be used by people mainly to confirm their own world view. This will be possible full time in the future.

    • Fourth Turning – ?????

      Academic response to the theory has been mixed—some applauding Strauss and Howe for their “bold and imaginative thesis,” and others criticizing the theory.[5][6] Criticism has focused on the lack of rigorous empirical evidence for their claims,[7] and a perception that aspects of the argument gloss over real differences within the population.[6]

      The theory has been influential in the fields of generational studies, marketing, and business management literature. However, it has been criticized, by several historians, and a few political scientists and journalists, as being overly-deterministic, “non-falsifiable,” and unsupported by rigorous evidence.[46][47][48]

      One criticism of Strauss and Howe’s theory, and the field of “generational studies” in general, is that conclusions are overly broad and do not reflect the reality of every person in each generation regardless of their race, color, national origin, religion, sex, age, disability, or genetic information[67] For example, Hoover cited the case of Millennials by writing that “commentators have tended to slap the Millennial label on white, affluent teenagers who accomplish great things as they grow up in the suburbs, who confront anxiety when applying to super-selective colleges, and who multitask with ease as their helicopter parents hover reassuringly above them. The label tends not to appear in renderings of teenagers who happen to be minorities, or poor, or who have never won a spelling bee. Nor does the term often refer to students from big cities and small towns that are nothing like Fairfax County, Va. Or who lack technological know-how. Or who struggle to complete high school. Or who never even consider college. Or who commit crimes. Or who suffer from too little parental support. Or who drop out of college. Aren’t they Millennials, too?”[6]

      Skip here…. nice big compartmentalization project based on a wonky base line…. but hay… marketing, and business management bloody love it – !!!!! – Neil Howe in 1988 coauthored On Borrowed Time with Peter G. Peterson – too….

      Disheveled Marsupial…. Ummm free market sociology is so religious… oops… meant rigorous…. no wonder all the boomer ™ and generational finger pointers all take their cues from [neo]libertarian F’wits like Peterson and assorted Cato – Heritage like think tanks…

      • ” do not reflect the reality of every person in each generation” wow! That’s the criticism? And name one theory of anything that accounts for each person?

      • mig…

        “However, it has been criticized, by several historians, and a few political scientists and journalists, as being overly-deterministic, “non-falsifiable,” and unsupported by rigorous evidence.”

        In the past I already unpacked the histrionics behind the term boomer and how some deemed it a workable methodological framework to engage in sociological observations. The term is loaded as referenced in the down the tread unpacking.

        Again I find your ideological bias intellectually crippling which precludes you from observing our species outside of the optics you have come to embrace as truth… if I may suggest….

        Is economics always self-corrective? Do erroneous theorems permanently disappear from the market of economic ideas? Intellectual Path Dependence in Economics argues that errors in economics are not always corrected. Although economists are often critical and open-minded, unfit explanations are nonetheless able to reproduce themselves. The problem is that theorems sometimes survive the intellectual challenges in the market of economic ideas even when they are falsified or invalidated by criticism and an abundance of counter-evidence.

        A key question which often gets little or no attention is: why do economists not reject theories when they have been refuted by evidence and falsified by philosophical reasoning? This book explores the answer to this question by examining the phenomenon of intellectual path dependence in the history of economic thought. It argues that the key reason why economists do not reject refuted theories is the epistemic costs of starting to use new theories. Epistemic costs are primarily the costs of scarcity of the most valued element in academic production: time. Epistemic scarcity overwhelmingly dominates the evolution of scientific research in such a way that when researchers start off a new research project, they allocate time between replicable and un-replicable research.

        This book is essential reading for anyone interested in the methodology, philosophy and history of economics.

        Disheveled Marsupial…. I file it under … Science Mart –

        This trenchant study analyzes the rise and decline in the quality and format of science in America since World War II.

        During the Cold War, the U.S. government amply funded basic research in science and medicine. Starting in the 1980s, however, this support began to decline and for-profit corporations became the largest funders of research. Philip Mirowski argues that a powerful neoliberal ideology promoted a radically different view of knowledge and discovery: the fruits of scientific investigation are not a public good that should be freely available to all, but are commodities that could be monetized.

        Consequently, patent and intellectual property laws were greatly strengthened, universities demanded patents on the discoveries of their faculty, information sharing among researchers was impeded, and the line between universities and corporations began to blur. At the same time, corporations shed their in-house research laboratories, contracting with independent firms both in the States and abroad to supply new products. Among such firms were AT&T and IBM, whose outstanding research laboratories during much of the twentieth century produced Nobel Prize–winning work in chemistry and physics, ranging from the transistor to superconductivity.

        Science-Mart offers a provocative, learned, and timely critique, of interest to anyone concerned that American science—once the envy of the world—must be more than just another way to make money.

  4. Brexit is about the failure of democracy to protect institutions that preserve the essential balance that is the basis of the social contract between and among democracy’s stakeholders.

    The mere act of having to vote for tells of the unwinding of the EU project, and the winner is ……

    nobody !

    • See above unpacking of the meme you give life too… worst bit is it comes from the very ideologues that created the mess in the first place…. grok fail…

      Dishevels Marsupial…. with the cognitive skills you display it would be apparent their efforts are not unrewarded…

      • You’re writing jibberish skip. I was trying to be facetious, I guess it went…..over your….head.

      • I don’t pretend to read peoples minds… so without a sarc/ tag I treat is as it stands…

        Disheveled Marsupial…. gibberish – ???? – you might want to check your contribution….

      • Here’s some grok fail for you

        “orst bit is it comes from the very ideologues that created the mess in the first place…”

        Show me ONE Chicago school document that blames the boomers, just one, go ahead and prove me wrong. Or accept your full of it

      • Sorry mig the post was locked for a bit…. too whet your palette…

        Moving on….

        “The idea of generational warfare is almost as old as Social Security itself. Back in Eisenhower’s time the long knives were out for the program, prompting Ike to write to his brother:

        Should any political party attempt to abolish Social Security and eliminate labor laws and farm programs, you would not hear of that party again in our political history. There is a tiny splinter group, of course, that believes you can do these things. Their number is negligible and they are stupid.

        Those were the days before the Koch Brothers, Peter G. Peterson, and the vast sums they and others lavished on conservative think tanks to provide the intellectual ammo for propelling their ideas into the public’s thinking. In 1983, Stuart Butler, now director of the Policy Innovation Center at the Heritage Foundation, and a colleague crafted a plan for the Cato Institute called “Achieving a ‘Leninist’ Strategy,” which described in detail how to attack Social Security. It recommended an educational campaign “to gain support of key individuals in the media as well as to win over vital constituencies for political reform.” In the 30s, 40s, 50s, and 60s, opponents of Social Security had based their attacks on ideology—the value of limited government—but those arguments gained little traction. By the late 1970s they had fashioned a new argument: Social Security was not affordable and had to be radically changed, and it was all because of the boomers.”

        Now the flip side of that coin…

        “ADVOCACY AND VOLUNTEERISM: Much of Peterson’s work is focused on building grassroots organizations that can tackle problems from different angles.

        For example, he’s given about $2.3 million to America Speaks, which designs and facilitates large-scale town meetings on public policy issues, and $275,000 to to help with its mission of empowering Millennials to create and implement solutions to social problems.

        Organizations that bring people and causes together also speak to Peterson. America’s Promise Alliance, which focuses on volunteer action for children and youth, received a $2 million grant; Be the Change received a quarter million for its programs, such as ServiceNation; and the Clinton Global Initiative has received at least $1 million in recent years.” – inside philanthropy”

        See how memes travel….

        Disheveled Marsupial…. Another fine product of the Booth School imo… you think I’ve forgotten your volunteerism days mig….

  5. Chaotic systems have a bunch of interesting characteristics, but my personal favourite is their inherent unpredictability. It’s worth keeping in mind as you consider the seductive linearity of many economic narratives. Maybe the chaos that is coming will be great for Australia. What would be a bigger black swan than that?

  6. Jumping jack flash

    So.. basically an economy pegged on infinite debt constructed using our amazing, stupendous debt machine we have here?

    The reason we rely on so many other economies being awesome for our own awesomeness is because we have positioned ourselves that way.

    “We’ve got dirt, who needs anything else?”
    “Ooh look, cheap imports”
    “We’ve got houses, who needs anything else?”
    “Ooh look, cheap imports”

    “Pass me my equitymate, my funds are running a bit low… next door sold for 3m, that’s just a shack. Get the valuer in next week, love”

  7. trump will win in a landslide

    get used to it

    globalisation has done bugger all for the average working person..they have seen their jobs disappear to the third world

    hope brexit happens too

  8. Potentially chaotic systems can be controlled by governors (damping fluctuations); but do our regulators understand how to operate the controls?

  9. It is incredible that chaos theory has delivered year in year out continued price hyperinflation in a place to call home for 2 decades here.

  10. As I’ve said before most Aussies are streets ahead of their supposed financial betters, they saw this Chaos coming 15 years ago and started to transition their savings and investment strategy away for AUD denominated assets into what I call AHD denominated assets (yea the H stand for Housing).
    Our Aussie Housing Dollars are not nearly as susceptible to external disturbances because supply is strictly regulated and locally controlled (or used to be)
    Only a fool or their political puppets would even suggest that any thinking individual maintain their savings in AUD denominated asset classes. WHY do this when the AUD is so easily manipulated by global capital flows / political interference and so clearly inferior to the AHD?
    Just attend any Aussie BBQ you’ll hear variations on a theme that can be summarized as our Super is invested in useless AUD assets but our souls are invested exclusively in Housing….it’s the one true Aussie religion.

  11. If it all goes pear shape we can surrender our assets and sovereignty to international banks and become Bankstralia. Given the shareholding structure of the Big 4 they would become a collective governor general.

  12. Ok I see there is inevitable uncertainty ahead. You have all identified that in your own style but no-one has identified how us knowing masters prepare to survive whilst the wankers (what happened to my spellcheck?) deny the inevitable. Where do we place our $$$?

  13. adelaide_economist

    That Project Syndicate article is pretty funny. It’s busy slamming those po’ ignorant old and uneducated people for daring to not know their place. Get it straight, the ‘elites’ have stuffed up big time. They’ve actively pursued decades of increasing inequality, growing share of production to capital rather than labour, massive uncertainty introduced into people’s lives in jobs, housing, access to health and access to education and still they push – ever harder – for more of the same.

    And hey, pretending the ‘stay’ argument in Brexit is all rational and credible compared to the ‘exit’ (with reference to National Front etc) might make them feel good but does not reflect what I’m reading on a variety of sources. Both sides are making stupid arguments and the truth is no-one really knows for sure how things will work out. The real failure of the elites is that people are actively considering the greater unknowns of Brexit because the more familiar stay option looks so awful. Thinking about how innately conservative (with a small c) the British people are this is utterly damning.

  14. Garnaut. Wasn’t he the genius that compared the Tiger Economies in the eighties with Australia claiming how superior they were …….. um, until they collapsed under the weight of their own corruption? Oh how we forget and forgive. I wouldn’t ask him for an opinion on the weather.

  15. If the Poms have any sense they will vote to LEAVE ! Anything else is death by slow strangulation.
    A/holes in Brussels dictating your lifestyle – F%$K that.