8 December 2008

Its the Debt, Stupid: ”It’s not inflation that did us in, it’s the borrowing“

WARNING: The following comment benefits from the wisdom of hindsight. It's an idea that's crossed my mind several times in the past decade but now I'm sure of it: for all that time the world's central bankers have been on the wrong tram, worrying about inflation when they should have been worrying about excessive borrowing.

It's the old case of generals still fighting the last war.

The aim of the game of macro-economic management is to keep the economy growing steadily so as to keep unemployment low. The trick is to work out what factor is the main threat to unemployment.

We were well into the Great Inflation of the 1970s and '80s before most economists accepted that inflation was the great threat and that the way to achieve strong employment growth was counter-intuitive: fight inflation first.

The developed economies' policy makers flirted with monetarism and money-supply targeting, then with a continuous bias in favour of restrictive settings, and finally settled on inflation targeting.

At the same time the fashion, in the English-speaking economies particularly, turned towards privatisation, deregulation and generally reduced government intervention in the economy. We did more of this than most.

Most of the developed economies managed to get on top of inflation during the '80s, though it wasn't clear Australia had "broken the stick of inflation" until the early '90s.

By then the central bankers of the world had reconsecrated themselves to eternal vigilance against inflation. This was their job above all others. No one else really cared about controlling inflation, so it was down to them.

What too few people noticed was that the success in keeping inflation low owed less to the central bankers' vigilance than to the way micro-economic reform had made markets more competitive and flexible, and thus less inflation-prone.

Reduced government intervention in markets had greatly diminished the role of cost-push inflation, leaving excessive demand as the only potential inflationary threat.

Many people identified China's emergence as a major exporter as a significant medium-term source of downward pressure on the world price of manufactures, but few noticed the demise of domestically based cost-push inflation pressure.

In particular, few are conscious that, whereas excessive wage growth was the bane of the Great Inflation, wages haven't misbehaved in any of the English-speaking economies for the best part of two decades.

The ultimate demonstration of that is right before our eyes: even with our economy travelling close to full employment for the past few years, wages growth stayed disciplined. Truly, the labour market has changed.

So in their pursuit of macro stability, the central bankers have spent the past decade or more focused on the wrong variable. (Which is not to say our Reserve Bank was wrong to hit the brakes when it saw our economy reaching full capacity. What else could it have done?)

Turns out the inflation they should have been worried about was in the prices of assets such as houses and shares, not goods and services.

You can't have bubbles in asset markets without the ready availability of credit. And it's been the long build-up in debt on the balance sheets of households, businesses (via the private equity craze) and financial institutions (hedge funds, investment banks and even commercial banks) that's at the heart of the global financial crisis and the global recession it's feeding.

It's not the advent of derivatives, wrongheaded as they may now be revealed (and though they facilitated the urge to borrow), it's that the institutions caught holding those derivatives were so highly geared.

And when mighty financial institutions rock on their foundations, the people whose confidence is knocked hardest are those business people and home owners with the guiltiest conscience about how much they've borrowed.

If Australia is really hit hard by the global troubles it will be because of what we bring to the party: a heavily indebted household sector.

If we have a severe recession it will mean that not since the early '80s have we had a recession caused by wage-driven inflation.

Rather, the two recessions we've experienced since then will have been caused by the collapse of credit-fuelled asset booms and the need to repair balance sheets: bank and business balance sheets in the early '90s, household balance sheets now.

This is the point that's yet to sink in: recessions come not from excessive braking to control inflation, but from excessive borrowing and the bursting of asset bubbles. These days we have balance sheet-driven recessions.

To give it its due, our Reserve Bank devoted its annual conference to the study of asset prices and monetary policy as long ago as 2003.

The perceived problem then was, what do you do when you see an asset bubble building but don't have a conventional inflation problem and so find it hard to justify raising interest rates?

This insight achieved nothing, however, because other central banks, particularly the Americans, weren't greatly troubled by the problem. They should have been and, no doubt, now are.

The difficulty then was in thinking of an instrument that could be used to discourage borrowing other than raising rates. Impose direct controls on lending? Oh no, not in an era of financial deregulation.

But now that their failure to act before has seen them giving blanket government guarantees of bank deposits, buying shonky bonds and taking shares in every financial institution that threatens to fall over, perhaps the world's central bankers are prepared to be a little less purist.

Perhaps governments should be setting ceilings on the proportion of share and property values that can be borrowed against. Perhaps that proportion should be adjustable by the authorities as we move through the cycle.

Perhaps we should reinstitute direct controls on bank lending. Certainly we should rework the Basel II rules on the capital adequacy of banks to stop them being pro-cyclical.

Whatever measures we come up with, this surely is the most important lesson to learn from the global financial crisis and its aftermath: we must find a way to prevent excessive borrowing.

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