Inside Story

Keynesians of the first hour

Called on the eve of a revolution in economic thinking, the 1936–37 banking royal commission mattered in ways that the latest one probably won’t

Alex Millmow 6 December 2017 2160 words

Perfect timing: royal commissioner Ben Chifley, shown here in 1948. National Archives of Australia

Of the several inquiries into Australia’s financial and banking system, only two have borne the imprimatur “royal commission,” one of them held in 1936­–37, and the other announced last week. It’s likely, however, that only the first will continue to have enduring consequences, partly because of the times and partly because of its scope.

The royal commission to be headed by former High Court justice Kenneth Hayne will not, we are told, “put capitalism on trial.” But the 1936–37 Royal Commission into the Monetary and Banking Systems did just that, focusing on the role many people felt the banks had played in prolonging the 1930s depression. According to Labor Party folklore, the “money power” of big finance had made the depression worse by calling in loans and restricting credit — a view shared by many within the Country Party. Also under scrutiny was the question of whether Australia’s central bank could have done more to calm the economic blizzard.

The two commissions share some remarkable similarities. In both cases, a prime minister was reluctant to call for an inquiry. Joe Lyons didn’t want to antagonise the financial interests that had facilitated his rise as leader of a motley collection of conservative interests known as the United Australia Party. But he could only govern after the 1934 federal election in coalition with the Country Party, and one of its conditions was an inquiry into the behaviour of the banks. Malcolm Turnbull only announced his inquiry after a parliamentary challenge to his authority became inevitable. (It also helped that the big four banks thought an inquiry was a good idea after all. Unlike their predecessors in the thirties, they are armed with extra legal personnel to deal with the onslaught.)

In 1935, after a year or more of fruitless resistance, Lyons announced the terms of reference and the personnel to sit on the commission. The terms of reference, drawn up by his energetic treasurer Richard Casey without any input from the banks, were suitably broad:

To inquire into the monetary and banking systems at present in operation in Australia, and to report whether any, and if so what, alterations are desirable in the interests of the people of Australia as a whole, and the manner in which any such alterations should be effected.

Casey felt the inquiry would be useful even if it only showed how the present monetary system could be improved. In contrast, the Hayne inquiry has been told that it will not be required “to inquire into, and may not make recommendations in relation to macro-prudential policy, regulation or oversight.”

In 1935, the selection of the commissioners was closely scrutinised. Mellis Napier, a justice of the SA Supreme Court, was in the chair, supported by five other commissioners. As the opposition’s nominee, Labor leader John Curtin selected a future prime minister, Ben Chifley, who had an interest in economic matters. To strengthen the technical capacity of the panel, Casey chose Sydney University economics professor Richard Mills, who had expertise in monetary economics. H.A Pitt, a Victorian Treasury official, J.P. Abbott, a pastoralist, and E.V. Nixon, a Melbourne accountant, made up the team.

Mills had a considerable influence on the commission, including by drafting the final report. Later, his fellow commissioners would praise his diplomatic skills in getting six opinionated men to agree (mostly) on the path to take. Mills and Chifley were charged with drawing up a detailed questionnaire to be completed by all witnesses, a process that enabled them to influence the agenda. The two men were predisposed to strengthen central bank powers in the name of sober economic management, a view not initially shared by Napier, Nixon and Abbott.

After questioning one witness, Napier commented that, even after six months of taking evidence, it was not clear to him what the government could have done to deal with the depression beyond expanding the money supply, which it had done. That said, Napier was open to hearing whether there were other “measures that might have been adopted that would have had a more beneficial result.” One observer, Brian Reddaway, a young Cambridge economist on a two-year sojourn in Australia, was not impressed by the commissioners. Apart from Mills, he told a colleague, they were insipid; only Mills had “any pretensions to economic intelligence,” and consequently had to “clear matters for the other members, because they don’t even know enough to be able to frame their questions properly.”

The prospect of the inquiry — and the likely probing of their own handling of the depression — filled officials at Australia’s then central bank, the Commonwealth Bank, with dread. How ironic that eighty years later, the same bank, now privately owned, is likely to be the focus of evidence from many witnesses at the Haynes commission.

In the mid 1930s, with depression conditions lingering, the royal commission provided a forum for advocates of monetary reform. Among testimony amounting to some two and a half million words, the evidence from economists performed a valuable role in elucidating the art of central banking within a system of fixed exchange rates. They drew on the latest in contemporary economic thinking laid out in the book that would initiate the Keynesian revolution, John Maynard Keynes’s The General Theory of Employment, Interest and Money, which had been published just as the commission began sitting.

For the first time, macroeconomic goals were enunciated in a public forum. The economists’ evidence was more influential than that of any other group, especially the bankers, and revolved around how to balance the competing goals of exchange rate stability and economic activity. They argued for economic stability combined with measures to pursue full employment, with most of them following Keynes in advocating countercyclical monetary and, in some cases, fiscal policy. The mooted liquidity controls on banks sent a shudder through the ranks of private bankers.

The economists would therefore have welcomed the report’s key finding:

The Commonwealth Bank should make its chief consideration the reduction of fluctuations in general economic activity in Australia, thereby maintaining such stability of internal conditions as is consistent with the change which is necessary if economic progress is to take place.

The final report of the 1936–37 commission reflected the economists’ general view that domestic economic activity should come before any concerns about the exchange rate or the relationship between the Australian pound and sterling. “The general objective of an economic system for Australia should be to achieve the best use of our productive resources…” it said. “This means the fullest possible employment of people and resources under conditions that will provide the highest standard of living. It means, too, the reduction of fluctuations in the general level of economic activity.”

Achieving this required an intelligently managed central bank, working under government direction, which would regulate the volume of credit and currency in the light of the “general objective of the monetary and banking system.” The exchange rate and foreign reserves would need to be brought within the control of the central bank. By placing the central bank under government supervision, within the federal treasurer’s ambit, monetary policy would become better integrated with other arms of economic policy. (That reduction in independence was progressively reversed in the first half of the 1990s, with the independence of the Reserve Bank of Australia, the Commonwealth Bank’s successor, formalised in 1997.) The commission also conceded recourse to public works as an effective remedy for economic depression.

While the final report of the commission conceded that “reducing fluctuations in general economic activity” was not as precise a goal as exchange rate stability, it felt it was of “fundamentally greater importance.” Credit should be expanded when the economy was in need of stimulus and the reverse should happen when the economy was overheating, with the exchange rate generally kept stable.

One of its bolder recommendations was that the Commonwealth Bank should have the power to confiscate a percentage of each trading bank’s deposits, variable according to economic conditions. The commission felt that the central bank’s power to restrict credit was circumscribed and that regulating the level of credit was one way to prevent fluctuations in economic activity.

One bank chief thundered that the measure would fit a “communistic government.” A more sober bank executive had earlier raised the valid point that allowing the Commonwealth Bank to have more control over banks’ credit creation raised the question “Quis custodiet custodes?” (Who guards the guards?) given that the Commonwealth Bank, wearing two hats, also operated as a trading bank. The complication was only resolved when the Reserve Bank was created in 1959.

The evidence tendered by the trading banks was predictably antediluvian, focusing more on matters of banking practice and the allocation of capital than on concerns with national economic policy. The bank chiefs dismissed the notion that they had deliberately restricted advances during the depression or that they had reached a consensus to restrict credit during the depression. They rejected the idea that the Commonwealth Bank should have the power to set interest rates as well as imposing liquidity controls on them.

The arguing didn’t stop when the commission’s final report was handed down. The bank chiefs argued that the Commonwealth Bank didn’t have the competence or vision to use greater monetary powers wisely, but what they feared most was surrendering monetary policy to the whims of the treasurer. They were unhappy, too, that the Commonwealth Bank would have greater leverage over Australia’s foreign exchange reserves.

Chifley’s biographer, L.F. Crisp, wrote that Chifley became a “Keynesian of the first hour” after listening to the evidence at the commission. The two-year spectacle also reinforced his view that the interests of high finance had to be corralled. He signed the final report and also submitted a three-page addendum putting the case for bank nationalisation, which he wrote without reference to any of the evidence presented before the commission.

Chifley seemed simply to be giving voice to Labor Party policy, especially the new platform on monetary policy that had been released as the commission sat. But in 1948, as a sequel to the commission, Chifley set out to achieve the vision of nationalised banks, and learned first-hand how effectively the banking industry can marshal a public campaign against government interference. It’s a lesson that the Turnbull government is learning afresh. But the banks, faced with the Haynes commission, are taking a leaf out of the mining industry’s campaign against the mining tax. They are already running a media campaign to convince the public that all those excessive bank profits are distributed to the community. Expect more over the coming eighteen months.

The Lyons government prevaricated over the banking reforms. Casey was given the difficult task of winning over the private banks and implementing the commission’s findings. He later told his mentor, Stanley Bruce, how he had “sweated blood” to devise measures that “will do most good and least harm.” He had anticipated that the reforms would be greeted by alarm from bankers who were “really a most unintelligent crowd.”

Casey anticipated that the technical and political negotiations over the proposed legislation would be complicated and protracted. So they proved. Political and institutional resistance meant that the key powers only became operational with the outbreak of war.

Most commentators believed that the commission’s hearings and findings had been well worth the money and had contributed to the dissemination and improvement of modern central banking practices. Many of the commentaries on the commission’s findings suggested that an age of enlightened central banking had arrived.

In his review of the commission report, Syd Butlin of the University of Sydney welcomed the recommendation that the central bank should be brought under government control. This would allow economic policy to be integrated with other arms of policy, he felt, not least public expenditure — something that had been lacking in the past. Butlin also praised variable minimum liquidity controls, believing they would rein in lending during booms.

Butlin’s colleague, commissioner Richard Mills, later pointed out that the power to call up deposits from the banks — at a percentage rate that hadn’t been stipulated — was only likely to be used in periods of acute crisis or when trading banks were proving recalcitrant. Mills reminded his detractors that the whole spirit of the report was to allow the Commonwealth Bank to continue to regulate the monetary system by exercising its existing powers with the cooperation of the trading banks. The clause giving the federal parliament, and through it the government, ultimate responsibility for monetary policy would only be used if there were irreconcilable differences between the government and the Bank. In that event, the government would give an assurance to the Bank that it took responsibility for the policy and its implementation.

For all these reasons, the first royal commission into banking had a resonance across decades that its present-day equivalent is unlikely to have. ●