Glenn Stevens: Finance and economic development in Australia
Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Committee for
Economic Development of Australia (CEDA) Annual Dinner, Melbourne, 12 December 2006.
* * *
It is a great pleasure to be invited to address the Annual General Meeting of CEDA, continuing a long
tradition of such addresses by Governors of the Reserve Bank of Australia.
CEDA - the Committee for Economic Development of Australia - began in 1960, an initiative of
D.B. Copland. Copland, one of Australia's most remarkable economists of the Depression era, was a
member of 'Giblin's Platoon', whose history is recorded so nicely in the recent book of that name.1
CEDA has over the years made a substantial contribution to debate in a number of fields, from trade
policy to taxation policy, from indigenous affairs to infrastructure.
Interestingly enough, the list of publications on CEDA's website does not include any which are overtly
financial in their focus. I do not say this as a criticism - perhaps the reason you have invited central
bank governors to speak so regularly is to cover that very set of issues!
But it seems appropriate, given CEDA's core focus on economic development, to address the
questions: what is the role of finance in economic development and growth? How does the financial
system contribute? How can financial events sometimes be detrimental to economic growth? What
can be done to ameliorate those risks? What risks do we face at present?
History
The growth we take for granted in the modern world is actually a fairly recent phenomenon in human
history. Prior to the industrial revolution in western Europe, living standards rose, if at all, very slowly.
According to Angus Maddison's data, the real per capita GDP of the United Kingdom rose between
1500 and 1820 at an average rate of only 0.27 per cent per annum.2 At that pace, living standards
doubled about every 250 years. In other words, a person would not live all that much better than their
grandparents - assuming they could discern any difference.
From 1820 to 1913, the rate of increase rose to 1.15 per cent. That's a very big change. At that pace,
living standards doubled in about 60 years. In the 20th century - despite wars, the Great Depression,
the Great Inflation and various other problems - growth per head rose further. Australia's per capita
growth was 1.70 per cent in the 20th century, according to the same data set, for a doubling in living
standards about every 40 years. The difference between my living standards and those of my
grandparents in the mid 1940s when they were as old as I am now - a trebling - is remarkable.
There is a vast literature on what accounts for this growth, and there has been a long debate in
economics about whether the development of financial institutions and markets followed or led the
developments in the real economy. Some, such as Joseph Schumpeter, Sir John Hicks and
Walter Bagehot argued that financial development actively fostered innovation and entrepreneurship.
Others, including Joan Robinson, argued that finance passively followed in the wake of real-side
development.3
Surely both components were necessary, and neither alone would have been sufficient. Technological
advance provided the potential for a marked acceleration in productivity. In the early age of
industrialisation, the steam engine and electricity were two obvious examples. Without those
opportunities, such financial capital as was available for deployment would probably have struggled to
find a useful outlet.
But equally, the potential technological advance would have remained just that - potential, rather than
actual - had there not been a capacity to mobilise the financial resources needed to invest in the
equipment embodying the new technology. The capital required for an economy based on agriculture
and artisan-based manufacturing had been in the form of land, seed, basic tooling and the like.
Traders needed working capital in order to purchase goods in one place and move them to another for
sale, and various financial devices arose to assist this. The need to sink very big sums into large-scale
machinery, however, called for capital on a different scale, and financial development was key to
providing it.
The economic historians suggest that a number of innovations were important. The development of
the limited liability corporate structure allowed proprietors to take risk without facing complete personal
ruin if the venture failed. Banking corporations efficiently pooled the resources of a large number of
savers, the more so as they developed into joint-stock ownership structures, as opposed to purely
private ones. These organisations also provided, before central banks developed fully, circulating
monetary assets for the community, which facilitated exchange. Markets for the trading of claims
against future income flows - what today we know as stock and bond markets - allowed the providers
of capital to retain their wealth in a more liquid form, thus encouraging them to commit more capital to
long-term ventures. In other words, the development of financial markets and institutions was an
integral part of the industrial revolution. It remains a key facilitator of the growth we enjoy today.
Yet such progress was not without its occasional problems, in the form of periodic panics.
Commodities markets had a certain tendency towards occasional instability. Optimism and greed
could push prices to extreme levels, following which a loss of confidence typically precipitated a crash.
The Dutch tulip bubble of the 1630s occurred without the aid of the highly developed set of financial
intermediaries that came later, though it did achieve considerable added fizz via a futures market for
tulip bulbs - derivatives allow leverage, which is almost always a key element of the latter stages of
speculative manias.4
But the growth of a modern banking system in England by the late 18th century, whose liabilities were
effectively financial claims against assets that could not be quickly realised if suddenly called, brought
heightened risks. Banking is, after all, a business that involves leverage and liquidity and credit risks.
There was always the possibility of a financial panic that could, if unchecked, threaten not only the
financial institutions but also the course of the real economy. The question facing public policy, then,
was how to find a set of arrangements that would allow the necessary credit extension to support
capital investment in pursuit of new technological opportunities, yet provide a stable monetary
standard and a financial system in which the public could have confidence.
We should record that in the same era, questions of a qualitatively similar nature arose in the fledgling
colonies of the Antipodes, even if they were, to begin with, at a lower level of sophistication. The
Colonies needed both a system of mobilising capital and a means of making payments other than
circulating paper claims over goods - be it rum or something else. We are all aware of
Governor Macquarie's ingenious attempt in 1813 at keeping metallic money in the colony of New
South Wales, by making two coins out of each Spanish dollar, thus rendering them at once more
useful in New South Wales and much less useful elsewhere.
But Macquarie's initiatives in granting a charter to the Bank of New South Wales in 1817, and those of
Governor Darling in rescuing it from disaster in 1826, were perhaps more important milestones in the
early financial development in this country. According to Trevor Sykes' account,5 both of these actions
were contrary to the policy of the British Government. These appear to have been occasions when the
lags in implementation of official policy - measured by the time taken for a request for instructions to
reach London by sailing ship, be considered and then answered by return ship, too late to influence
the decision - helped to produce a superior outcome!
Around the world, governments groped towards a sustainable solution for combining the benefits of
financial intermediation with stability. Progress was not necessarily always steadily in the right
direction,6 but one of the key developments was the gradual evolution of the institution we would today
recognise as the central bank. In a number of countries, these institutions had begun life as a means
to finance military expeditions by governments of not altogether unquestioned creditworthiness,7 but
they gradually became central players in the efforts to foster stability in normal times, and to restore it
after something went wrong. Bagehot's classic, Lombard Street,8 remains one of the best accounts of
this in the case of the Bank of England. The notion of the lender of last resort, and the idea that the
central bank should look to the interests of the system rather than any commercial interest of its own,
were slowly developing.
It was, of course, to be some time before the central bank had fully evolved into the current form, even
in the most advanced economies. In our own case, the central bank did not really have a fully
developed public policy mandate until after the 1930s, and arguably was not a purely policy institution
until the separation of the Reserve Bank from the Commonwealth Bank in 1960.
Through the 20th century, of course, views about the appropriate role of a central bank changed a
good deal, as did views about the appropriate extent of official intervention in financial markets and
institutions generally. The Great Depression of the 1930s occasioned new ideas about
macroeconomic policy, which envisaged more official intervention in economic matters. This was
followed by a very large increase in the government sector's command over economic and financial
resources, of necessity, to conduct the Second World War. Hence by the end of the 1940s, the
landscape had changed a great deal in comparison with 1930. The financial systems of many
countries found themselves subject to much more regulation, and central banks with more regulatory
powers and more explicit mandates for macroeconomic stabilisation, than had previously been the
case.
Initially, this arrangement held great promise. The instability of the 1930s had apparently been
banished. But as time went by, other problems emerged. As explained eloquently by Ian Macfarlane's
recent Boyer Lectures, macroeconomic policies became overly ambitious, and neither the policy
frameworks nor the governance arrangements under which they were implemented were up to the
challenges posed by the shocks of the 1970s.
Nor, we might add, was the structure of financial regulation, with its emphasis on governments or
central banks setting most financial prices and even seeking to decide who should and should not
receive credit. Many of us here will recall the debates at the time of the Campbell Inquiry in the late
1970s. By then, the problems of the extensive regulatory regime had become all too clear. It was
ineffective (or even counterproductive) at a macroeconomic level, it distorted resource allocation at a
microeconomic level and it fostered the rapid development of a more dynamic financial sector
operating beyond the regulatory net.
This wasn't sustainable, and something had to give. There was large-scale liberalisation of the
financial sector through the 1980s, winding back many of the post-Depression, World War II era
restrictions. Efforts at prudential supervision were beefed up, but these progressively became focused
on ensuring adequate risk management in individual financial institutions rather than the more direct
controls of the earlier era.
In more recent times, financial system stability - as distinct from the solvency of individual
institutions - has become more prominent as an explicit focus of central banks, many of which publish
regular detailed assessments of system stability.9 This is a natural response to the circumstances, but
it is really a refocusing on one of the key original purposes of the central bank.
All of that history is a backdrop to the financial trends of the past decade, to which I now turn.
Financial and economic trends in Australia in the past decade
The most prominent financial development of the past decade has, of course, been the change in the
structure of the balance sheets of households. Much has been said about this and so any description
here can be brief.
The essence of the story is that in the early 1990s, two decades of chronically high inflation in
Australia ended. Interest rates declined as a result. In fact, they returned to levels last seen in the
low-inflation period in the 1960s. But in the intervening period, of course, the Australian financial
system had changed out of all recognition, a result of liberalisation, competition and innovation. No
longer was the potential borrower for housing on bended knee to a stern-faced bank manager, the
way they had been in earlier periods of low rates. Now, lenders were under more competitive pressure
to grow their balance sheets. Having pursued the corporate borrowers in the 1980s, with rather mixed
success, they were now looking to households as a source of growth. We can all recall the
advertisement for one major bank in which the formerly stern manager practises saying 'yes' in the
mirror each morning.
So by the mid 1990s, we had a household sector more able and more inclined to demand housing
finance, and financial institutions more willing to supply it. It is hardly surprising that this should
ultimately result in households carrying much more debt, as well as higher levels of assets, than they
had before. It might have happened earlier had the course of inflation and interest rates been different.
Nor is it surprising that such an expansion in finance over a relatively short period of years should be
associated with higher prices for dwellings. I find persuasive the arguments that changes to planning
and development regulations have raised the cost of new building - that is, the cost of adding to the
dwelling stock. It is plausible that this, in turn, adds to the price of those existing dwellings that could
reasonably be substitutes for new dwellings. But if we are seeking an explanation for why the prices of
the 8 million existing dwellings across the country have increased so much, we surely have to give a
very prominent role to the halving of the cost of debt and its easier availability.
These trends also added to aggregate demand in the economy, via additional construction and
renovation spending, and the generally expansionary impact of rising asset values on broader
household spending. Whereas dwelling investment averaged around 5 per cent of GDP through the
1970s and 80s, it reached a peak of nearly 7 per cent of GDP in 2003/04. Households also expanded
their consumption faster than their income. For a time, these trends were helpful in periods when
adverse shocks from abroad were having their impact. Over the past two or three years, these effects
gently faded. We have seen some decline in spending on housing, and a slowing in the growth of
household borrowing and consumption spending, but these changes have been fairly modest
compared with earlier episodes, partly because there are regions of the country where the resources
boom has continued to boost house prices and household demand.
The run-up in household borrowing has also raised, on occasion, and quite naturally, questions about
how sustainable all this was, and whether there was a build-up of exposures in the household sector
and the financial system that could impair financial or macroeconomic stability at some future time.
Considerable attention has been given over recent years to this set of questions, both in the Reserve
Bank and elsewhere.
We did not believe that the rise in debt was, in itself, likely to trigger an economic downturn. That said,
higher leverage would, in the event of an economic downturn that occurred for some other reason,
probably make at least some households' spending behaviour more responsive to declines in income
than it would have been in the past.
Precisely this set of issues has recently been addressed as part of the IMF's Financial Sector
Assessment Program (FSAP). That program was a very wide-ranging exercise, as all FSAPs are, but
from our point of view a key component of it was a macroeconomic stress test. The Reserve Bank,
through our Financial Stability Department headed by Keith Hall, co-ordinated this exercise, which
involved the IMF team, APRA, the Australian Treasury and the risk-management areas of the five
largest banks - for whose co-operation we express our thanks.
The results were included in our September Financial Stability Review, and also released by the IMF
as part of the FSAP report in October. In brief, the test involved a scenario featuring: a very large fall in
house prices, a recession, a big rise in unemployment, a sharp depreciation of the exchange rate and
a rise in the funding costs of financial institutions. This was designed specifically to test the resilience
of the financial system when several of the key elements underpinning business strategies over the
past decade were removed.
In such a scenario, only some of the adverse effects would come directly through mortgage portfolios;
a good deal of it would come through business portfolios. Faced with a loss of income, indebted
households would be likely to cut back consumption sharply in order to keep up their mortgage
payments. Hence, businesses supplying into discretionary consumer markets would feel the effect
quite quickly.
In the tests conducted, the result was an estimated decline of around 40 per cent in the banks'
aggregate profits after around 18 months, and by the end of the three-year scenario, profitability
remained 25 per cent lower than its starting point. That said, the institutions remained not only well
and truly solvent but with capital positions above regulatory minima. In part, this reflected the strength
of business balance sheets. As the banks worked through the scenario, this strength meant that the
significant cutback in household spending did not cause widespread loan defaults in the business
sector.
Overall, the results are, within the limitations of this type of exercise, reassuring. Before we take too
much comfort from them, however, we need to enter a few caveats. For a start, while the scenario
seems a demanding one at first blush, it is predicated on a recession in Australia but not in the rest of
the world. That would be, if not unprecedented, at least very unusual, and a more realistic scenario in
which Australia suffered a downturn simultaneously with, and largely as a result of, an international
downturn could well be a more challenging environment than the one assumed for the tests.
A second factor is that everyone taking part in the simulation knew that the scenario involved an
economic recovery, by assumption. They could factor that into their modelling. But in a real recession,
there always comes a point at which many people are not confident of recovery, and that affects their
behaviour. It is not unknown for lenders to be sufficiently lacking in confidence that they are reluctant
to take on the risk of new borrowers. That would feed back to the economy, deepening the decline and
slowing the recovery.
Thirdly, there were quite large differences in results across banks. While these differences may be
partly explained by variations in the structure of individual bank balance sheets, they also appear to
reflect different approaches used by the banks to model their outcomes. There is nothing wrong with
that - it is not that one approach is definitely right and another wrong. But the fact that varying
techniques can produce significantly different results means that there must be a fair bit of uncertainty
around any individual estimate.
Hence, while the results provide some comfort, we can have only limited confidence that they would
be replicated in a real-world downturn. We are, however, confident that the exercise was worthwhile,
and would be worth doing again at some point. The Council of Financial Regulators, a body that brings
together APRA, ASIC, the Treasury and the Reserve Bank under the chairmanship of the RBA
Governor, is of the view that system-wide stress testing should be conducted on a regular basis,
though of course the scenario would need to change through time. This was also the view of the IMF
in its FSAP report. We have indicated to the CEOs of the participating banks that we would look to do
this type of stress test roughly once every two years, and I look forward to their support for this.
Looking ahead, the increasing prominence of private equity and leveraged buyout activity will be a
point of interest. To date, this trend has probably caused a bit more excitement than the straight
numbers would suggest is warranted, since LBOs accounted for a relatively small proportion of
corporate mergers and acquisitions of Australian companies in 2006.
But perhaps the reason for the attention is the feeling that the trend could continue for some time. In
essence, many of these transactions are based on two fundamental premises: the return on equity is
high, and has in recent years been unusually stable as well; and the cost of debt is low. Those offering
high prices for businesses are essentially betting that, over the next several years, they can enhance
returns by increasing leverage. To some extent, they may also feel that in a private-ownership
structure they can do some things to improve long-run performance of the company that current
shareholders would not tolerate because of short-term damage to earnings and share prices. But
mainly, the strategy is one of leverage. If this analysis is correct, then corporate leverage, and the
associated exposures around the financial system, could be rather more prominent as an issue over
the next five years or so than it has been for a couple of decades. Going back to the FSAP stress tests
for a moment, it is likely that the results would have been more worrying had the leverage of the
corporate sector been considerably higher.
But we shall have to leave a more detailed discussion of such issues to another occasion. For now, it
is time to conclude.
Conclusion
Finance and growth go together. It was no accident that the acceleration in growth in the industrial
revolution was associated with the development of modern banking and capital markets.
By the same token, disruption to the financial sector is costly to the real economy, as is only too clear
in history. The role of public policy is to respond to these disruptions forcefully if and when they occur
to preserve the stability of the system, but in the good times to work hard at fostering a climate of
careful risk assessment in the relevant institutions and markets.
For the past 15 years or so, the financial system in Australia has worked remarkably smoothly to assist
the economy. A very large change in the household sector's balance sheets has made households
more sensitive to changes in their circumstances, but financial institutions have continued to perform
strongly.
The challenge remains for these institutions, and all of us, to understand how risk is changing in this
new environment, and to remain aware that we may at some stage face less forgiving circumstances
than we have enjoyed over the past decade. We need also to be alert to the shift in the wind in the
area of corporate leverage that seems to be occurring. I suspect we will be talking about that for some
time to come.
In the interim, I wish all of you a merry Christmas and a happy, prosperous - and stable - new year.