The butcher, the brewer and the baker vs. the government

Rivals or partners?

Heads up – I’m about to drop some (attempted) philosophy here:

“He who believes in the infallibility of the free market is crazy; he who waits for the government to save him is a fool;
He who believes that both have their own domain is intelligent; he who believes they should share the same domains is wise”

Communism and Capitalism in their purest forms are just as bad as each other. Communism ignores individual incentives, and capitalism ignores important things that don’t generate profit (e.g. social equality, the environment). Consequently, most would agree that some tasks should be undertaken by the free market (with an eye to efficiency), and others by the government (with an eye to equity).

In Wealth of Nations, Adam Smith promotes the free-market with three simple activities:

“It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest”

This means that simple activities like this should be undertaken by the free-market. The butcher, brewer and baker don’t do these activities out of the goodness of their heart – they do it out of self-interest (to earn a wage). And yet this self-interest provides another family with their dinner, and the butcher, brewer and baker with the means to purchase their own dinner.

Conversely, the quintessential government intervention is healthcare – an industry that generates benefits far beyond the individual receiving the service, and far beyond the free-market’s ability to capture as profit. Consequently, to ensure healthcare that is affordable and adequately provided, government is needed.

One might therefore conclude that some things should be left to the free-market, and others to the government.

But I go one step further.

Even the most ardent free-market supporter would concede that the butcher, brewer and baker – the poster-boys of the free-market – should be subject to some form of occupational health and safety regulations. Similarly, while the government should assist in making basic healthcare affordable for everyone, the removal of all free-market incentives (e.g. patents and the ability to charge profitable prices) would discourage research and development into new medicines and treatments.

My point is that the free-market and the government are not each other’s alternatives – they are each other’s partners. Everything in society should be a mixture of both – from entire economies, to industries, companies, and even individual human beings. All our decisions should be based on private incentives and public concerns, not just one or the other.

CBA vs RBA continued

A side-thought for retirees and savers: can lower interest rates actually hurt the economy?

A previous blog entry, CBA vs RBA, discussed how the Commonwealth Bank of Australia (CBA) chose not to pass on a full Reserve Bank of Australia (RBA) interest rate cut, lest it unduly hurt its depositors/ savers. Consequently, an interesting side-thought occurred to me (beyond the conspiracy theory that I entertained in the previous blog).

During economic slumps when the RBA tries to revive the economy by lowering interest rates, this is intended to encourage borrowing and investment, thus spurring the economy. It is unsurprising that lowering interest rates may hurt savers and self-funded retirees but (I’m assuming) it has been correspondingly assumed that this is only a small section of the economy, so lower interest rates will overall be stimulatory.

However, with the ageing population in many Western countries, isn’t it possible that as this section of society gets bigger, the stimulatory impact of lowering interest rates will progressively get more and more undone/ reversed by this growing contractionary impact, and may even get outweighed by it?

In Japan, for example, decades of low interest rates have failed to bring their economy out of its slump. Could one not argue that this is because Japan is a net-saver (like Germany and China), so low interest rates may actually hinder their recovery?

My temptation is to say ‘probably not’ – the stimulatory impacts will probably continue to outweigh the contractionary impacts. Even in net-saver countries, low domestic interest rates should encourage savers (banks, superannuation funds, even individuals, etc.) to search for higher interest rates internationally. And if they are successful in finding such investments, this should offset (even outweigh) any contractionary effects of low domestic interest rates. Even today, the globally low interest rate environment is not a result of a lack of productive investment opportunities, especially for a government that was committed enough to infrastructure and fiscal stimulus. And the sooner the government picks up this slack, the sooner the economy will recover and interest rates can be increased again.

Consequently, to the extent that low interest rates hurt savers and retirees, there should continue be an even larger stimulatory impact on borrowers and investors (including savers and retirees). Japan’s problems specifically, are more structural than a reflection of the management of their macroeconomic cycles (though there are arguments suggesting the latter could have been better over recent decades, but let's leave that discussion for another time).

However, it did give me an interesting thought. What if the government – in addition to providing proper fiscal stimulus through infrastructure investment – also had an automatic mechanism which compensated savers and self-funded retirees to the extent that the interest rate is lower than some pre-determined ‘natural’ rate? This would mean that not only will lower interest rates spur borrowing and investment, but these benefits won’t be (even partially) offset by savers and self-funded retirees being squeezed.

This would be a simple example of fiscal policy automatically supporting monetary policy, rather than monetary policy doing all the heavy lifting – especially when different groups in society are differently-impacted by interest rate decisions, and government can't be trusted to actively support monetary policy through deliberate investments.

Bittersweet validation

Looks like someone agrees with me about Brexit. No body important - just Nobel Prize winning economist Paul Krugman!

In his recent New York Times column, Krugman adds weight to my fears that Britain losing access to the European common market will create an incentive for London's financial services to relocate to Europe. Even with a weaker British pound offsetting some of this incentive, and supporting the local manufacturing industry, this could be a serious loss for the world's most significant financial centre.

It's a shame this validation wasn't in relation to something more positive.

CBA vs RBA

CBA the Usurper

FYI, this is not a legitimate rant. More like a raging conspiracy theory. So polish off that old tin foil hat and enjoy.

A new Reserve Bank of Australia (RBA) Governor – a new interest rate decision. Congratulations to Philip Lowe on his appointment as the Governor of the RBA, and his first milestone – the monthly interest rate decision (unchanged at 1.5%).

Lowe inherits some interesting circumstances – record low interest rates and a struggling Australian and global economy. As interest rates approach the dreaded zero lower bound and become less and less effective at stimulating the economy (especially when the government is so deficit-obsessed and unwilling to support the economy with stimulus spending), Lowe may have to reach into the RBA’s bag of tricks and pull out some non-conventional tools – additional pressure on government to enact stimulus spending, forward guidance, negative interest rates, quantitative easing, long term interest rates, and even (as a last and hopefully unnecessary resort) ‘helicopter’ money transferred directly to the government.

But there’s a new challenge that may be emerging for him that I have never seen before (maybe I just haven’t been paying attention). When the RBA last lowered interest rates in August, Australia’s big 4 banks (unsurprisingly) didn’t pass on the full 0.25% cut to their customers. Consequently, the CEO of the Commonwealth Bank of Australia (CBA), Ian Narev, tried to justify this decision – in light of their record $9.4 billion profit – by saying that passing on the full rate cut would have hurt CBA’s depositors/ savers. This is true. It would have. However, he followed it up with (paraphrasing) “therefore, it would be better for the economy if we don’t pass on the full cut”.

Hang on! Did the CEO of CBA just admit that he not only disagrees with the RBA’s decision, but is actively trying to undermine it? True, the CBA has its own stakeholders to consider – lowering interest rates would help borrowers but hurt savers, so it is justifiable to balance these demands. But to suggest that their actions were driven by a desire to do what is better for the economy goes beyond CBA’s terms of reference. The CBA is not the RBA, and they do not get to make this call. This isn’t just arrogant. To think that you know more than the RBA and are therefore going to undermine their decision is scandalous. If this was just CBA’s attempt to balance the needs of conflicting stakeholders, then fine. But don’t say that it is for the good of the economy – because that is not your job. It’s the RBA’s job. And it undermines their credibility – something that is essential for a Central Bank – to suggest that you can and do try to undermine them.

Remember what I said at the beginning of this post? To be honest, I don’t actually think the CBA is trying to usurp the RBA’s authority. I’m sure it was just an off-the-cuff comment by the CEO of CBA to justify a huge profit and a piddly interest rate cut. It’s just fun to think about it in terms of economic and political sabotage. CBA actually used to be Australia’s central bank, while simultaneously being a commercial bank. Conflict of interest, much? Hence why the RBA was formed in 1960. How exciting/ terrifying if CBA suddenly decided they wanted that power back.

*cue evil laugh*

Western Australian Secession

Right for the wrong reasons?

I’ve started thinking recently about WA secession from the rest of Australia. Now, let me just say this – if I were to support secession, it wouldn’t be because of any nationalistic or patriotic reasons (or whatever is the state-equivalent of those words), or about WA’s identity and independence, yada yada yada. I’m not even particularly interested in the GST debate about how much to which WA should be entitled and how much WA should subsidise the rest of Australia with its GST revenue. As I understand it, GST revenue distributions are updated every year based on the needs of the specific state/ territory over the previous three years. So there is a three-year lag but after WA has been slumping for three years, GST should start flowing back to support its economy. Maybe WA can negotiate a better deal, maybe the methodology can be improved. All relevant debates to be had – not really what has peaked my interest recently.

No, what I’m more interested in is the notion of the optimal currency area. For an area to successfully share a currency, resources need to be able to flow around the area freely and rapidly, so that if there are imbalances in one area (e.g. recession in WA and boom in the East), these resources will leave WA for the East, thus correcting the imbalance. These resources include money AND people.

In the case of WA, money flows easily between the east and west, but people don’t – even with a common culture and language (things that the Euro didn’t have), most of WA’s labour shortfalls during the mining and resources boom were met with international labour, not labour from other states. Furthermore, over the last 25 years, Perth’s inflation rate has, on average, deviated from that of Melbourne and Sydney by more than any other capital city, except Darwin (maybe NT wants to secede too, with WA or on its own). In other words, it seems the West doesn’t boom/ slump at the same time or with the same magnitude as the East.

And yet, the whole country operates under a common currency and common Central Bank interest rate policy. A recent news report after the August 2016 interest rate cut said that if WA were its own country, its interest rate would be zero or negative right now! And NSW would be over 4%. As it is, all states have to make do with a national interest rate of 1.5% – not optimal. And it was exactly the reverse problem during the mining and resources boom – WA needed a higher interest rate to curb inflationary pressures, and the East needed a lower one to combat their slump.

WA secession could be good be everyone – WA would get its own currency and Central Bank interest rate policy that it could tailor to its own circumstances, and the East wouldn’t have to worry directly about WA’s circumstances when deciding upon their own interest rate policy. Nor would their currency be influenced by WA’s activity to the extent that it is now. Even if WA was no better off from a tax perspective (they probably would still want to pay for the use of Australia’s military), even if NOTHING else changed – wouldn’t these gains be enough to justify secession? Australia could still be a whole country for national and international sporting events. There need not be animosity between East and West. Couldn’t this be beneficial for all concerned?

And the finance activity needed to support a Central Bank in Perth could fill up the looming vacant offices around the City, maybe even include the Central Bank with the already-internationally-famous Perth Mint. Imagine the boom! I admit, I am a bit biased here – I dream of working for the Central Bank in Sydney, so a Central Bank in Perth would be a great start!

I have not made up my mind about WA secession yet. But is this not something to think about? It need not be about East vs. West and who gets what. It need not be about State identities and ‘sticking it to the bureaucrats’. It really could just be about the economic realities, which are beneficial to both sides – exchange rates and interest rate policy.

Alternatively, if GST shares are improved, maybe that will improve the fiscal policy aspect of economic management, thus helping to correct any interstate imbalances without the need for separate currencies and separate interest rate policies. But I’d be less tempted to trust politicians with effective fiscal policy than I am to trust effective monetary policy to Central Banks that are at least quasi-independent. Just look at all the heavy-lifting monetary policy has had to do around the world to compensate for governments’ ineptitude and irrational debt-fears (something about which I am planning to go into great detail in subsequent blogs).

One possible problem with WA secession I do foresee is volatility – WA has only two million people and a GDP (or GSP when it applies to individual States) of around $150b (about 10% of Australia on both counts). To be its own country with its own exchange rate would possibly imply a lot of volatility, especially given WA’s export/ international exposure. Mining and agriculture would have an even bigger impact on the state’s business cycle swings, which may offset the smoothing-benefits of having its own currency and interest rate policy. Furthermore, trade deals may need to be renegotiated, given that Australia’s trade partners would now be dealing with two Australia’s, not one. And there would be the inconvenience of changing currencies during East-West travels. But would this be a deal-breaker?

But again – something to think about. I’m sure there’s an abundance of research/ case studies that could be/ have been done that actually puts real numbers on these impacts.

Now, before anyone says that my flirtation with WA secession is inconsistent with my criticism of the Brexit decision, it’s not. It is actually consistent. What I’m suggesting is that WA become like a PRE-Brexit Britain – independent interest rates and currency, but still part of the larger market. In fact, WA could remain even closer to the rest of Australia than Britain USED TO BE to the EU. So while I’m suggesting WA move in a similar DIRECTION to Britain, it would still be far more consistent with globalisation and integration than the Brexit decision. So there!

Islamic banking is not "interest-free"

But it does present some challenges

One of Pauline Hanson’s (I know, *groan*) latest crusades is against Islamic Banking – something that she refers to as providing “interest-free” loans to Muslims while Australian families struggle to pay their mortgages. Sorry to burst your bubble Pauline, but that’s not how it works. Even though charging interest is technically forbidden under Islamic law (interestingly, the Christian Bible forbids it too, but this is conveniently overlooked in most ‘Christian’ countries), borrowers still have to pay an equivalent premium/ mark-up. It is simply that Islam does not consider money to be a commodity and therefore should not have additional charges on top of it, but the ASSET that the money is financing CAN have a premium/ mark-up attached to it. Consequently, in the case of a mortgage, whereas a conventional Western bank will lend someone money to buy a house and the money is paid back over time plus interest, an Islamic bank would buy the house FOR the person, then sell the house to the person for a mark-up/ premium, to be paid back in instalments over time – a semantic difference that allows compliance with Islamic law. It is NOT interest-free in the way Pauline Hanson is trying to suggest.

Furthermore, Islamic CORPORATE banking actually focuses more on a borrower’s investment intentions from an economic, social and environmental perspective before lending to them, rather than focusing on the borrower’s credit rating as is done in conventional Western banking. This is arguably a more efficient means of allocating financial resources to their most valued uses.

The government has already started adjusting the tax system so that Islamic banking is treated consistently with other banking and not given any unfair tax advantages. Nor do I see any reason why non-Muslims wouldn’t be able to use Islamic banking services too, if it suits their circumstances better than conventional Western banking. After a quick Google search, I couldn’t find any example of non-Muslims being refused access to such financial services. But even if there were such examples, I’m sure Australia could arrange it so that everyone is allowed access. And surely a bit more competition in Australia’s financial industry would be a good thing.

Islamic Banking is also a relatively ‘small’ ($1.4 trillion – yes, trillion – in global assets) but rapidly growing market internationally. Australia would be foolish not to accommodate such a market – think of the foreign investment we’d be able to attract, the major infrastructure that could be financed. I know, I know, I can already hear the people saying “what if it finances terrorism? … what about how Australia is selling off too much of itself to foreign powers … etc. etc. etc.”

First, money laundering and terrorist financing is actually a legitimate concern with Islamic banking (even the IMF recognises this) – not because Islam is associated with terrorism so often, but because so much of the international anti-money laundering and counter-terrorist financing standards are tailored to the structure of conventional Western banking systems, not Islamic banking systems. Consequently, there may be loopholes in Islamic Banking that can be exploited by money launderers and terrorists – Muslim and non-Muslim alike. Again, not because of any association between Islam and terrorism, but because Islamic banking is an emerging, less well-understood and less well-regulated (or rather, regulations haven’t been tailored to their unique features and arrangements) industry. There remains no evidence that money laundering and terrorist financing risks in Islamic banking are any higher than in conventional Western banking. Even so, for the above reasons, this is something that regulators in Australia and internationally would need to investigate further, and I have confidence that any loopholes in Islamic banking for money launderers and terrorists could be identified and mitigated.

Second, we have government institutions responsible for assessing foreign investment bids on the basis of security, competition, etc. Therefore, if you’re worried about Australia selling its soul to foreigners, your anger should be directed at these bodies, not Islamic Banking specifically. And if, like most people I believe, you are not opposed to any and all foreign investment in Australia, then you can’t treat Islamic investment any differently. And if you’re entirely opposed to foreign investment, full stop, then that’s a conversation for another time.

One possible interesting challenge I do foresee is for the RBA to accommodate Islamic Banking. At the moment, the RBA manages economic activity by (among other things) trading short term assets so as to adjust interest rates. The benefit of interest rates is that they, directly and indirectly, affect such a wide range of economic activity that they can be quite effective at managing economic activity. The challenge with Islamic Banking, especially if they become a significant component of the economy, is that they may not respond to interest rates if they don’t use interest explicitly.

However, it may be a simple matter of the RBA just trading in Islamic securities in the exact same way, which will affect the size of the premium/ mark-up on Islamic debt in the same way as with interest rates on conventional debt. And Islamic financial institutions could arguably be subject to the same regulatory oversight and capital reserves requirements as other financial institutions. Again, potentially just semantic differences, but something the RBA would have to account for, lest a significant section of the economy grow beyond their influence and oversight, and risk endangering the whole country if it crashes (remember the US sub-prime mortgage market?).

Islamic banking holds great promise, but also presents challenges that must be addressed. But it should not be hindered by the misunderstandings of Pauline Hanson.

Donald Trump makes me a special kind of nervous

And he just won't go away

Most of us know how unreliable individual election polls can be. That’s why I prefer to look at what the polls are saying over an extended period of time (like the graphs here, here, here and here).

After Donald Trump first joined the presidential race in mid-2015, his popularity against Hillary Clinton in the polls rose quite rapidly. But despite this, and even though individual poll results fluctuated plenty, Clinton appeared to maintain a consistent general lead over Trump, even if it wasn’t enormous. However, in late July this year, after the Republican and Democratic Conventions, Donald Trump’s popularity in the polls took a big hit. And yes, I gave in to temptation and started believing that this represented a new solid underlying trend - that the Trump train had finally been derailed. But he quickly recovered in the polls again. Woops!

A lot of politicians have made me nervous before, but it’s usually relating to social issues – their attitude towards women (e.g. abortion, contraception, or just general snide remarks), the influence of religion in public policy, LGBTQ and other minority rights, etc. And while it’s easy to note the times Donald Trump has met this criterion, my quickness to grasp on to anything that suggests the Trump phenomenon is over is because he is the first ‘politician’ to truly make me nervous from an economic perspective.

Let us review:

• He has sympathised with the idea of the US returning to the Gold Standard – the Creationism of economics (more to come on this in subsequent blogs)
• He plans to reduce the top income tax rate from 39% to 33%, followed by just two other rates – 25% and 12% (see video here). This is a policy which will worsen the US’s debt situation by incredible magnitude. Seriously, it is delusional to think that cutting US tax rates like this (the US is already the 4^th lowest taxed country in the OECD), in a way that further benefits the rich, will give the necessary boost to economic activity and not cause government debt to balloon. This kind of ‘trickle down economics’ simply does not work
• He has threatened to walk away from the North American Free Trade Agreement (NAFTA) if he doesn’t get it re-written the way he wants, and criticises Mexico and China for taking American jobs – and one has to consider whether this is just an objection to specific aspects of specific agreements, or part of a wider anti-globalisation push that will make the US more insular
• He has threatened to partially default on the US’s debt obligations, or as he puts it (in my best Trump accent), “make a deal” with the US’s creditors – I don’t even know how to begin explaining why America defaulting, even partially, on its debt obligations is a very very very bad thing
• And if this fails, they can just “print the money” – that’s right, Trump actually suggested instructing the Federal Reserve to just print money to pay off government debt. That is called ‘helicopter money’ – and not even the ‘good’ kind that is transferred from the Federal Reserve to the government and spent on good productive things like infrastructure. Even the Federal Reserve, during the height of their unprecedented quantitative easing measures, weren’t bold enough to go as far as helicopter money
• He has had a go at NATO and threatened to stop supporting the US’s allies unless they meet their financial obligations – who does he think he is, the mafia, charging the local shopkeeper for protection money? Such hostility to one’s own allies could not only violate international treaties and seriously mess with global stability, but also sour current and future trade and investment relations
• And then, of course, there’s the deportation of about 11 million illegal immigrants, on whose labour a significant amount of economic activity is dependent – hundreds of billions of dollars potentially (a significant chunk in agriculture, construction and service occupations), not including the additional hundreds of billions needed to deport them (immigration agents, lawyers, support staff)

And what’s worse is that he’s dropping these comments as the potential leader of the wealthiest and most powerful country in the world. An economic stuff-up (or several) in the US has far greater implications that one in, say, Bhutan. America, you may be disenchanted with the current political establishment and desperate for a ‘new kind of politician’. Just remember how many other lives would be affected by this ‘change’.