Some modest proposals to make the financial system even stronger

"Australia's financial institutions survived the GFC without much visible damage. Can we afford to rest on our laurels? Can we do better, not just in banking but insurance, capital markets and superannuation?"

The GFC and Australia

Australia is a modern 'miracle economy'. Culturally we are Anglo-American, geographically we are in the Asia-Pacific region and our exports go disproportionately north to Asia. With sensible monetary policy and not too much wasteful stimulus spending, the Australian economy sailed through the Global Financial Crisis of 2007-08 (GFC) with little disruption.

However, it was judged essential for the government to guarantee bank deposits and the overseas wholesale borrowing of Australia's banks, building societies and credit unions as well as locally incorporated subsidiaries of foreign banksat the height of the GFC, which says there was a perceived potential crisis of confidence in the financial system of our 'miracle economy'. I can attest to a conversation with a well-to-do friend who several days before the guarantee was put into place said he was withdrawing $2 million from his bank to put in a safe deposit box. This was a tactic used during the depression of the 1890s in Australia, and which led then to savage bank closures, in some cases outright failure.

On the global stage, the greater cause for concern was the failure of American, British and Icelandic banks and other financial institutions. In September of 2008, contagion was the big fear, and financial institutions were being bailed out with billions of dollars of taxpayer support. Curiously Lehman Brothers was not bailed out, an event that unleashed a 'torrent of mistrust' among bankers everywhere. The world's financial system trembled on the brink at that time, and the guarantee must have seemed to Australia's econocrats as an inexpensive safeguard.

Can we afford to rest on our laurels? Certainly not. The massive overseas borrowing by Australia's banks is directly related to spending in excess of income by business, households and governments. This spending is sometimes justified as Australia Inc 'gearing up' to finance growth. If all the overseas borrowing was going into productive investments, that would be fine, but too much of the borrowing goes, directly or indirectly, to finance consumption and/or investment in private dwellings.

Twice in Australia's history, excess borrowing has made for misery when the global markets decreed that Australians needed to stop borrowing and repay debt. Both in the 1880s and the 1920s Australians lived beyond their means and had to face serious disruption in the 1890s and 1930s when the lenders stopped lending and demanded their money back.

Unless and until Australians decide to live within their means, Australian banks and other financial institutions will be at risk of classic 'runs' at a time of global uncertainty. Maybe a government guarantee will be effective each time this happens, but who can be sure of this.

For many years, Australian households have fully shared other western nations' propensity to spend ahead of income, accumulating debt in the process. Encouraged by tax policy, Australian firms have geared up. There is clear evidence of higher saving by households and deleveraging by businesses in the wake of the GFC, but this move to more conservative behaviour cannot be relied upon. The Federal government is committed to return the budget to surplus, although the structural budget will remain in substantial deficit unless policy changes. The fundamental reform is to persuade Australian consumers to live more nearly within their means. How to achieve this is far from obvious. A move away from income tax and in favour of expenditure tax would help, but seems unlikely for the foreseeable future. So too would education about the perils of excessive borrowing. Have you ever wondered why ASIC does not prosecute retailers who offer 'interest free loans' of several years duration? This must be wrong, and just as misleading as a mining mogol claiming he has a firm contract when what he has is a memorandum of understanding.

Modern capitalist nations, it seems to me, have gone much too far along a consumerist road. The prevailing ideology of economists is 'maximisation of lifetime consumption', so the consumerist bias has some powerful backing. This capitalist bias is creating vast differences in saving patterns between 'developed' and 'developing' nations, and this is the source of great opportunity for swings in currency values (if exchange rates are flexible) or in ownership of assets in the high saving nations and growth of international debt owed by the low saving nations. Current imbalances among the family of nations seem unsustainable and it would be useful to develop a more coherent economic policy framework. To this writer, a modified ideology for developed nations with explicit weight on 'acquisition of knowledge' and away from simple consumerism would be a good start.

One specific change to present general tax arrangements would be for developed nations in particular to place greater weight on consumption taxes and less weight on income or wealth taxes. This would tend to limit consumption in the developed nations, and thus help to harmonise the fiscal imbalances which are causing so much global economic instability. It would also provide a tax that would help to even out the ebbs and flows of economic activity, as a semi-automatic increase in consumption taxes in booms and decreases in downturns would provide a more efficient economic moderating mechanism than current income and wealth taxes. I am not seeking a way to iron out fluctuations altogether, because of the benefit of times of economic boom or even euphoria. Rather I am proposing a more effective automatic stabiliser, one that would more strongly test the reality of booms and reduce the severity of busts.

Governments also have a legitimate role in devising and maintaining sensible rules about various features of the financial system. The first such feature should be doing whatever can be done to encourage prudent and ethical behaviour by financial institutions and financial salespeople. I do not go so far as simply advocating the old rule of caveat emptor – let the buyer beware – thought this approach is tempting to people, like me, of a libertarian inclination.