Glenn Stevens: The director's cut - four important long-run themes
Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Australian
Institute of Company Directors Luncheon, Sydney, 17 September 2008.
* * *
Thank you for the invitation to speak to you today.
We are living through challenging times for decision-makers in both private and public roles.
The past year has seen a major change in international economic and financial conditions.
Global economic growth, having been well above average for a string of years, has slowed
noticeably, especially in the major industrial countries - yet inflation rates remain a concern.
Large losses have been incurred by major international financial institutions. Several
household names in global investment banking have disappeared. Appetite for risk - which
had been strong to the point of recklessness in some areas - has given way to risk aversion.
Credit is harder to obtain, and more expensive. Australia has been affected by these forces,
but much less than the countries at the epicentre. Our financial system is weathering the
storm well.
Amid all that excitement, it is useful occasionally to step back from the high-frequency detail
to focus on the bigger picture. Today, I propose to talk about four low-frequency, big-picture
themes - all of which are nonetheless amply demonstrated in the course of events over the
past year or two.
The themes are:
• the emergence of China;
•
the economics of a fully employed economy;
•
the end - perhaps? - of the long period of households leveraging up their finances;
and
•
shifting perspectives about the regulation of the financial sector in the economy.
China
I am not talking here about the notion of "de-coupling" and so on. That term is actually
unhelpful - nothing is ever really de-coupled; everything is connected. But the connections
are complex, various forces are at work and reasonable people will have differing opinions
about how things will play out over a year or two. At present, China is slowing, partly as a
result of the slowdown in the United States and Europe, but partly by design of domestic
policy. The Chinese policy-makers have been seeking some slowing because of evident
overheating, and are now in the position to be removing some of that restraint.
But the emergence of China as an industrialised economy is a fundamental long-term
change to the economic, financial and political landscape whose full consequences I suspect
we can barely appreciate as yet. This has been happening for a couple of decades now, but
the nature of its impact is gradually changing. For some years, it was too small to notice -
even a country with a lot of people is small economically if their per capita incomes and
productivity are very low. Then, some time in the 1990s, China became quantitatively
important enough for the rest of the world to enjoy the disinflationary effects of added
Chinese production capacity, as millions of low-cost workers turned out manufactures, in the
process lowering global prices.
More recently, we have been experiencing a new effect of that growth, namely the effect of
higher Chinese living standards on the price of energy and natural resources. f course, this is
not confined to China - it is happening around the developing world to a greater or lesser
extent. But China is the biggest example.
Commodity prices are coming off their peaks at present, though key prices for Australia are
still very high. Even if this marks a cyclical turn for such prices, in the longer term this new
claim on energy and other resources will not go away. Other countries are having to adapt to
that. The rise in prices for energy and raw materials has made it harder for those countries to
combine the steady growth and low inflation that had characterised the period from the early
1990s until about the middle of this decade.
At the same time, this extraordinary increase in the demand for natural resources and energy
has raised Australia's terms of trade by close to two-thirds in the space of five years - the
largest shock of its kind for five decades. So the economics of this for Australia are therefore
a bit different from those for the "average" industrial country. Like others, in the energy-using
parts of the economy, we find it more difficult to combine steady growth and low inflation. But
in addition, we have had to absorb a massive income boost.1 Of course, there are worse
problems to have! Nonetheless, significant adjustments are occurring - to the structure of the
economy, to where the population lives and how the national income is earned and
distributed. Unless resource prices reverse a long way, these trends will continue.
China's emergence is surely far from complete. China, like all economies, will have cycles.
But its average growth rate is likely to be pretty high for years ahead, even if not as high as it
has been recently. This is an opportunity and a challenge for Australian business and
policymakers, and not just in the resource sector.
Economics of full employment
Over recent years, the Australian labour market has been as tight as at any time seen in a
generation. The rate of unemployment in the past 12 months, at about 4 per cent, has been
as low as at any time since 1974. In surveys and our discussions with firms, difficulty
securing labour has been a common problem. The term "capacity constraint" has been a part
of the Australian economic lexicon over recent years in a way not seen for a long time.
Survey measures of capacity utilisation have been very high, and fixed investment to
increase capacity is running strongly.
Let's be clear that full employment is a good thing. It is one of the statutory objectives given
to the Reserve Bank in our Charter (though interestingly the authors of the Act never
quantified what they meant by full employment, nor for that matter, by "stability of the
currency").
But the economics of full employment are different from the economics of trying to get to full
employment. This is a simple point, but an important one. When the economy has too much
spare capacity - say, in the aftermath of a business cycle downturn - the aim of
macroeconomic policies is to push up demand so that it catches up to supply potential. There
may be several years in which demand growth exceeds the normal pace as it eats into the
spare capacity.
Once the spare capacity has been wound in, however, actual growth in demand and output
has to slow, to match the growth rate of potential supply. That growth in potential supply is
given by the growth in the labour force, the capital stock and the productivity of those factors
of production. Typically we think of "potential GDP" in Australia rising by something like 3 per
cent a year, give or take a bit.
This, as my predecessor Ian Macfarlane remarked a few years ago, means that once the
reserves of spare capacity are pretty much used up, we should expect to be accustomed to
growth rates for GDP starting with a 2 or a 3. There will not be many with 4s or 5s, as we had
for some years through the 1990s and earlier this decade. Periods of growth noticeably
above about 3 per cent will be roughly matched in frequency and duration by periods below -
as we are having now. If we set our aspirations higher than that - if we try for above-average
performance all the time - we will just get inflation. That is the economics of full employment.
Now you may feel that a growth rate for real GDP of something like 3 per cent on average is
not that high. Is that the best we can do? Can't we lift it?
The only way the potential growth rate can be lifted is by adding more factors of production -
more labour and capital - or raising the growth rate of productivity. Over the long term, the
key is productivity. On that front, productivity growth does seem over the past several years
to have settled at a lower average rate than we had seen since the early 1990s. This may
have several causes, and the experts debate them. But over the years ahead, as a
community we must be sure not to let up on our efforts to keep productivity growing. I have
no specific policy prescriptions here - only general ones - trying to sustain competition, to
keep markets open, to maintain flexibility and so on. But those general values are worth
recounting from time to time.
Household balance sheets
A feature of the economic landscape of the past decade and a half has been the long
gearing up of households. In the early 1990s, household gross debt in Australia was equal to
about 50 per cent of average annual household disposable income. This year, it reached
about 160 per cent. Households' assets rose generally in parallel, though not quite as fast,
with total assets rising from about 460 per cent of income in 1990 to over 800 per cent at the
end of 2007. (Assets have fallen somewhat since then, with the decline in the share market
and some softening in housing prices.) The ratio of debt to assets rose from under 10 per
cent in 1990 to about 18 per cent in 2008. The ratio of housing debt to housing assets
reached about 27 per cent.
Very similar trends have been seen in a number of comparable countries around the world,
so in thinking about the causes, we should not look exclusively for domestic causes. But in
summary, the main factors behind this big increase in the size of the household sector's
balance sheet were:
•
the general tendency for financial activity and wealth to grow faster than income,
which has been a feature of most economies since at least as far back as the
1950s;
•
an increased pace of financial innovation - and, in particular, a lot more credit has
been available, particularly over the period since the mid 1990s, to households. In
recent years around the world, anyone who was creditworthy - and some who were
not - have been able to access ample amounts of credit;
•
the big decline in inflation. This lowered nominal interest rates dramatically.2 This
happened in all countries, though the timing differed. In Australia it was a big factor
after 1992;
•
a period of pretty low long-term interest rates globally, which encouraged borrowing
around the world, though this was a bigger factor in the United States than here.
This had a lot to do with the build-up of savings relative to investment in Asia;
•
a desire to devote a higher share of a rising income to acquiring housing services.
As people's income increases, certain goods and services will take a declining share
of total spending - food, for example, or products, such as electrical goods or
clothing, which have large falls in their relative prices over time. But other types of
products take an increasing share of income. Housing has tended to be in that
category. As we have become wealthier, our aspirations for housing in terms of
position, quality and size have naturally enough increased. But for various reasons
the supply is not very elastic - there is only so much well-located land, and other
factors have affected the supply price of dwellings more generally. In the end, a lot
more of our income is devoted to housing, acquired by servicing mortgages, than
was once the case.
The question is whether this long period of gearing up by households might now be
approaching an end. Certainly household credit growth is much slower at present than it has
been for some years, running roughly in line with income growth. Might we see this
conservative approach to debt among households persist?
It is hard to know the answer to this question. There is much more of the household balance
sheet that could, in principle, be turned into collateral, so gearing up might resume once the
current turmoil has passed.
But there is also a good chance that households will for some time seek to contain and
consolidate their debt, grow their consumption spending at a pace closer to income, and
perhaps look to save more of their current income than in the recent past. It is possible that
we are witnessing the early part of a new phase where the household spending and
borrowing dynamic is different from the past decade and a half.
Time will tell. But if that is the trend of the next several years, the growth opportunities for
businesses and financial institutions will be different. And whereas the household balance
sheet has been the big financial story of the past 15 years, some other financial trend will
probably be the bigger story of the next decade. There are some developments that suggest
the balance sheets of governments might well be expected to expand a good deal. The need
for support of the finance sector in countries like the United States and the United Kingdom is
one. The build-up in public infrastructure in Australian cities and regions may point in the
same direction, though to a lesser extent. If the sudden aversion to these sorts of assets by
private investors continues for any length of time, governments may have to choose whether
to fund the projects themselves, or defer them. Fortunately, public balance sheets in this
country are in a very much stronger starting position than those in most other countries.
Financial stability and regulation
All the issues surrounding the use, or not, of the government's balance sheet to support the
financial system have been on prominent display over recent months. We have seen the
actions by the US Treasury to take over the running of the two large entities known as
"Fannie" and "Freddie". As Secretary Paulson commented, the ambiguity about who was
bearing risk in these entities has been a problem for a long time, and it needed to be
resolved. The US Government has shouldered the burden that investors always assumed it
would, but has, quite appropriately, done so in a way that minimises the extent of bail-out for
private shareholders who had been profiting from the risk-taking behaviour.
Facing up to these problems where the entities concerned were regarded as effectively
guaranteed by the government was one thing. The question of support has also arisen for
entities which have always been seen as purely private, and hitherto not, at least explicitly,
regarded as so central to systemic stability that failure could be costly. The events of the past
few days illustrate how difficult these issues have become.
In all these cases though, in the final analysis there was not enough capital behind the risks
that were being taken. The sophisticated financial system of the 21st century was supposed
to spread risk, but a lot of the risk ended up being concentrated on the books of highly
leveraged institutions. High risk and high leverage proved to be a fatal combination. It always
does.
Some significant questions arise from all this. The main one, put at its broadest and simplest,
is whether something can and should be done to dampen the profound cycles in financial
behaviour, with associated swings in asset prices and credit, given the damage they can
potentially do to an economy.
This debate has been going on for quite some years. There are several points of view.
One is that counter-cyclical regulatory measures using the power of the prudential regulator
should be taken to dampen the so called "financial accelerator". This is the process where
confidence boosts asset prices, which then provides additional collateral for further
borrowing, which then boosts asset prices further and so on - until at some point the whole
process goes into reverse and there is a fall in asset values and de-leveraging, as is
occurring now. Use of prudential tools to work against these tendencies would be a
departure from the way prudential supervision is conducted at present, where the goal is
soundness of individual institutions, rather than managing the dynamics of system stability
through time.
A counter view is that it is not feasible to do this, for various reasons. One is difficulties with
tax and accounting rules. Another is that some of the key players are outside the regulatory
net - hedge funds for example. This view holds that an effective response against the
financial cycles almost certainly involves monetary policy. This would mean raising interest
rates in times of booming asset and credit markets, even if goods and services price inflation
was contained, in order to provide a stabilising influence over the swings in financial
behaviour. Some argue that this could be reconciled with standard inflation targeting, though
only if the central bank had a very long time horizon or a great deal of flexibility.
A third view is that it is not possible, with policy-makers' current state of knowledge, to know
whether it is correct to lean against such booms, and that in fact it could turn out to be
destabilising to try. On this view, the only thing that can be done is to respond to asset and
credit collapses if and when they occur, protecting where possible the financial system and
the economy generally. That is, to clean up the mess afterwards, so to speak. This has
tended to be the US official view, at least up until now.
This debate was quite active in the period following the collapse of the dot-com boom in the
early 2000s. But those in favour of policy action aimed at moderating financial cycles did not
carry the day, I think mainly because the US economy recovered pretty quickly from what
was a quite mild downturn in 2001. I sense now, however, that among many thoughtful
people this question is once again up for discussion. It will be fascinating to watch how the
debate unfolds.
Conclusion
In the barrage of information with which we must all cope day by day, it is often hard to stand
back and see the big forces at work. But those forces - and our responses to them - will
ultimately do more to shape the course of our economy and financial system than the
shortterm news. Hopefully, we can still find some time for reflection about such matters, even in
the volatile conditions in which we all find ourselves at present. It is in that spirit that I offer
these remarks today.
Thank you.