Inside Story

Hear that ticking?

Finance’s share of the Australian economy is higher than ever, leaving us vulnerable to a growing global liquidity bubble

Michael Gill 22 March 2018 1596 words

Risky business: prime minister Malcolm Turnbull arrives at a media conference after the announcement of the banking royal commission in late November last year. Mick Tsikas/AAP Image

The sound you hear might possibly be a countdown in Pyongyang. But if you treat economics as a guide to global insecurity, the bomb you probably worry most about is debt.

Whether it’s the European Central Bank’s persistence in buying bonds, the US government’s persistence in growing budget deficits, the high levels of household debt in countries like Australia and Canada or the unmanaged appetites for debt among China’s enormous state-owned enterprises, the hazard lights are flashing globally.

The lessons of history are plain enough: long periods of cheap money and easy credit invariably lead to big trouble. There was a time when financial regulators like William McChesney Martin and Paul Volcker, both former heads of the US Federal Reserve, would hide the punch bowl — as they liked to say — before the party got out of hand. Today, only Jens Weidmann of Germany’s Bundesbank and officials at the Bank for International Settlements are firm restraining hands.

At the core of the problem is the too-big-to-fail status of a group of hugely influential enterprises. In the United States and Europe, as in Australia, these institutions are typically banks and related lending entities, which have bloated the size of the finance sector to unprecedented levels. In China, the politically and economically powerful state-owned enterprises, or SOEs, seem to have gained even more power under the regime of president Xi Jinping.

A characteristic of the too-big-to-fail enterprise is that it is immune to the usual consequences of its own bad decisions. Whether it’s a Chinese industrial company that borrows to speculate in real estate, a “zombie” European bank that has yet to recover from the last global financial collapse or a global asset trader that takes big risks — and big fees — for doubtful “performance” value, size and political power have delivered immunity.

In China’s case, president Xi and his allies have reversed reforms introduced by Deng Xiaoping designed to remove private enterprises from Communist Party influence. Strong words of encouragement for economic liberalisation and tighter financial discipline have been replaced by saccharine pronouncements, such as a recent assertion that SOEs are “deleveraging,” which looks a lot like a directive to swap debt for equity. (Converting bank debt into equity in a firm might shift the numbers on the balance sheet but it does nothing to lift the performance of the firm or improve the behaviour of the bank. In fact, higher equity might encourage new loans if the cosmetic is embraced as reality.) Meanwhile, the party has tightened its control over the largest SOEs, appointing chief executives from among its own cadres on a similar rotation system to that of party officials.

China’s reforming econocrats had their day in the years after Deng’s last big policy play in 1992. A long boom followed, only braking in 2008. The disruption wrought by the global financial crisis coincided with Xi’s appointment to the Politburo, and was followed by a slackening of controls over SOE borrowing that aimed to mitigate the impact of weak international trade. Since then, Xi’s administration has tightened the relationship between the party and the SOE managers to the point where the old privatisation campaign is called “wrongheaded” thinking. It’s a defensive move, but it’s not clear that the risk inherent in a politically managed corporate sector has been reduced.

On the one hand, Xi’s regime has tightened the screws, forcing conglomerates like CEFC China Energy, Dalian Wanda and Anbang to unwind what had become a speculative aggregation of assets. But on the other hand, companies like Fosun and Geely (which has recently taken a very large stake in Mercedes Benz) appear immune. And the heaviest debt loads are in the party’s steel, aluminium and related mining and metals businesses, which don’t appear to be under pressure — not in public, anyway, even though one steelmaker, Dongbei, has defaulted on more than ten bond payments.

Over in the United States, Donald Trump was elected president on the basis of rhetoric that — so far as it talked about “draining the swamp” — might well have been targeting Wall Street. There’s no doubt that recent administrations, and especially Bill Clinton’s, encouraged risky behaviour by banks and other financiers leading up to the 2008 crisis. There’s also no doubt that Wall Street is heavily invested in Washington and vice versa.

Not surprisingly, Trump has done nothing to change this culture. He appointed not one but two Goldman Sachs alumni to the key policy positions of treasury secretary and director of the National Economic Council. Tax reduction heads his agenda.

Early this year, US government debt passed US$21 trillion, a level described by the director of national intelligence, Dan Coats, as both “unsustainable” and a risk to national security. Tax cuts introduced by Ronald Reagan in the 1980s; George W. Bush’s tax cuts and cripplingly expensive military ventures in Afghanistan and Iraq; the bank bailouts and huge deficits in the wake of the financial crisis; and now Trump’s military spending and tax cuts — all have contributed to a government debt inexorably heading for 100 per cent or more of annual GDP. If, as expected, US interest rates double fairly quickly, then the yearly budget cost of interest alone could hit US$800 billion.

Here in Australia, meanwhile, the main worry is household debt. Now equal to about 120 per cent of annual GDP, it has joined Switzerland, Canada and the Netherlands at the top of global rankings. Houses are the driver of Australia’s debt addiction, though it must be obvious by now that public policy decisions are a significant factor. House prices have jumped to astonishing levels — from about twice average annual disposable income in 1991 to about five times today. Average household debt in 1991 was roughly six months’ disposable income; today it is two years’ worth.

Overall, Australians have the comfort of strong growth in average nominal wealth, mostly because house prices have largely held up so far. Incomes have been stagnant, but the interest on outstanding mortgages has actually been falling for most of this decade. Unemployment is about where it was in 2008, but average hours worked have been falling. In short, many households are likely to be alarmed at the prospect of rising interest rates.

Banks account for about 40 per cent of the nominal value of all companies listed on the Australian stock exchange and about two-thirds of the assets of all financial institutions. Finance now accounts for roughly 13 per cent of Australian GDP, a very high share by international standards and a dramatic increase on historical levels. Banks in Australia are most certainly in the too-big-to-fail category, and it’s likely that any major defaulter would be bailed out by taxpayers. Not that this has been in doubt for many years; in fact, it is nonsense to suggest that Australian governments would allow the markets to punish bad management by driving banks and finance companies to the wall.

While public criticism of the growing power of finance has tended to focus on high fees and even higher incomes, the more fundamental issue is this immunity from failure. Regulation plays a very large part in determining how much of the economy accrues to finance. In Australia, regulation plays a central role: most obviously through the compulsory superannuation system, which taxes salaries and puts the money into a highly dispersed range of superannuation funds. For a variety of reasons, this fuels the growth of a large, well-endowed class of fee-takers.

Australians have been encouraged to accept that public debt should be minimised, and low public debt was certainly a great asset when things went pear-shaped in 2008. But we have not done much to discourage private debt and — as we are seeing in the evidence to the banking royal commission — the banks’ risk management has been inadequate, and perhaps even seriously degraded by the influence of mortgage-broker marketing. No one doubts that the residential property market is awash with debt; the only question is the extent. And the elevated level of household risk is a big headache when we are faced with significant rises in interest rates.

Globally, the finance bubble is also subject to another risk factor. Political leadership is unusually concentrated in two huge players. China’s Xi has accumulated power in ways that leave no doubt about his supremacy. At the same time, he seems committed to integrating China’s financial sector into the global system, though he may be going slow on the essential prerequisite: a clean-up of debt-ridden corporations and tiers of government. Potentially, this is a Chinese virus within a somewhat vulnerable global host.

Across the Pacific, President Trump has also been shedding shackles, though of course he has nothing like the reach of his Chinese counterpart. What Trump appears to have done is cut himself off from any of the usual sources of knowledge and caution that the US system relies on. If something goes seriously wrong in global finance, it’s fair to assume that the president would not have his finger on the pulse. More likely, he would withdraw US support and engagement.

Just recently, Australia’s former treasurer Peter Costello used a megaphone to warn of the risks of household debt. Yet it is just one part of a wider, international pattern he didn’t mention — a pattern of accumulated risk that has been disguised by the policies of central banks. As the world moves back to more normal interest rates, a few too many dials are showing red. It’s time for caution, at the very least. ●