The cash rate isn't the RBA's only toy.

And it’s not even necessarily their best one.

Normally, I try to keep my blogs to 500-1,000 words – the sort of length one could read in under five minutes. But this one – at almost 4,000 words – got away from me a little … enjoy!



THE CURRENT SITUATION

The Australian Council of Financial Regulators (the Reserve Bank of Australia (RBA), the Australian Prudential Regulation Authority (APRA), the Australian Securities and Investments Commission (ASIC) and the Treasury) have recently started making big moves to reign in Australia’s eastern states property markets. But there are concerns that it might be too late.

Australia’s property markets are looking very much like a bubble – nationally, prices are accelerating at 12.9% per annum (the fastest rate since 2010), led by Sydney (18.9%) with an average dwelling price of $805,000, Melbourne (15.9%), Canberra and Hobart (both over 10%).

Lenders and mortgage brokers have been naughty, increasingly offering interest-only loans – loans where, for the first five or so years, you only pay interest on the loan without paying down any of the principle – to borrowers who are less and less able to afford them. Specifically, interest-only loans re-accelerated to 37.5% of lenders’ new residential mortgage lending in the last quarter of 2016, up from just 20% three years ago. That is high by both national and international standards. And in a $1.65 trillion mortgage market, that risk can have a widespread impact if realised.

The appeal of interest-only loans is their ability to reduce the borrower’s annual servicing costs and provide greater flexibility in their cash flows/ principle repayments via an almost uniquely Australian arrangement – mortgage offset accounts. But in order to be properly beneficial, these offset accounts need to be properly utilised. If they are not, and the principle is paid too slowly, the loan will take longer (and cost more in the end) to pay off. Consequently, investors need to be quite savvy (and ideally already quite wealthy) for interest-only loans to not cause problems for them – more savvy (and wealthy) than a lot of people who have been granted such loans recently.

This is very reminiscent of the US sub-prime mortgage boom that triggered the GFC – people being lent significant sums of money that they could only afford to pay back if property prices continued growing strongly. Comparisons have even been made to Australia’s great 1890s property collapse, which was deeper and more prolonged even than the Great Depression, rendering about half of Australia’s banks insolvent. And now – as it was then – even a small shock to the economy, or slight increase in interest rates, could result in a wave of defaults from these heavily-indebted investors and households, and consequent widespread economic turmoil. Even just the fear of such turmoil can result in a self-fulfilling prophecy if enough investors/ households start acting in response to the downside scenario.



WHAT’S BEING DONE TO HELP?

Here is a timeline of the measures the Australian Council of Financial Regulators have undertaken before and in response to Australia’s supposed property market bubble:

·         Just before the GFC, APRA allowed the Big Four banks, and Macquarie to calculate their own risk weightings for mortgages (the amount of capital they would have to hold as a buffer), which substantially reduced their capital requirements.

·         In 2015, in light of concerns that banks weren’t being disciplined enough regarding their capital buffers, APRA ordered a 25% floor under the risk weightings for residential mortgages (up from a 16% average at the time) which resulted in banks needing to raise an additional $20 billion of capital. They also imposed a 10% growth rate cap on investor loans. But these measures failed to reign in the system – banks remained highly leveraged. This isn’t shocking I suppose, given that 10% is still a $60 billion injection of new demand every year. But neither is it cause for alarm because, given the fragility of the market, undershooting on these measures is preferable to overshooting and risking crashing the market ourselves.

·         On Friday 31st March 2017, APRA instructed lenders to limit their interest-free loans to 30% of their new residential mortgage lending and remain “comfortably below” the 10% growth rate cap on investor loans that was imposed (but clearly not adhered to) in early 2015. This includes bank and non-bank financial institutions, which is important, given the significance of the latter in the US sub-prime mortgage crisis.

·         APRA is also targeting banks that conduct overly-generous borrower-serviceability assessments (another characteristic of pre-sub-prime crisis lending behaviour), assuming that borrowers can live more frugally than reasonable. Specifically, lenders should ensure that borrowers have more than a $200-a-month buffer after expenses and mortgage repayments if things go wrong.

·         ASIC announced a probe where it will use its compulsory information-gathering powers to gather data that will tell them more about the interest-only lending activities of large and small banks, mutual banks and non-bank lenders.

·         ASIC’s 2015 investigation found that up to 30% of mortgages lent had not properly considered the borrowers’ circumstances and their ability to repay. Furthermore, they reported in March that brokers were being rewarded with commissions based on their volume of loans, not their quality – consequently, ASIC (and APRA) recommended these incentives be changed to encourage more responsible lending.

·         ASIC has also instructed eight major lenders (including three out of the Big Four banks) to compensate borrowers for their poor lending practices, and is even taking Westpac to court for supposed breaches of the National Consumer Credit Protection Act.

The new measures imposed so far by APRA have been ‘tactical’, rather than structural, which means APRA, beyond potentially reducing the 30% limit on interest-only loans even further, has the capacity to do more (i.e. a second leg to the strengthening of capital requirements) if required as conditions evolve, including the very real possibility that the risk-weighting floor will be raised to 30% (by some accounts, as high as 50% for investor loans). This will require lenders to raise another $12-15 billion in capital between them, making them (in APRA Chairman Wayne Byres’ own words) “unquestionably strong” and able to access credit markets in any possible crisis. And it remains cheap for lenders to raise more capital in current conditions. Indeed, rising profit levels may allow them to raise this additional capital naturally, without the need for a capital raising.

As can be seen, these new measures can be targeted solely at the areas of the housing market with particularly high risk characteristics (investor and interest-only mortgages) – the areas we want to slow down, not the whole economy. And due to the consequent higher cost of lending to these areas, banks would happily protect their returns by either lending less to these areas, or charging investors in these areas higher interest rates/ reduced discounts (or both) – consequently slowing down the area. And politicians are less likely to criticise such a move, given their increasing appreciation of the dangers of an unchecked property bubble.

Will these lenders cooperate? Recall my fevered conspiracy theory that the Commonwealth Bank of Australia wants to usurp the RBA’s authority and may therefore, not cooperate? More realistically though, banks may argue that their residential lending practices have actually been an attempt to help the RBA transition the Australian economy away from its dependence on the mining and resources sector in the face of the significant decline in associated investment and weak demand for business loans. Lenders may not appreciate being punished for this. Nor will they be happy to ignore their incentives to keep their lending standards low and maintain market shares – especially given the tendency of mortgage brokers to direct customers straight to the cheapest and least onerous borrowing conditions, and for public outrage every time the banks increase interest rates independently of the RBA.



SHOULDN’T THE RBA JUST INCREASE INTEREST RATES?

Now here's the big point of contention. There are many (including Judith Sloan, Economist at The Australian newspaper) who believe that the current property market bubble is actually the fault of the RBA for dropping interest rates (specifically its own cash rate) so low, and for so long, thereby spurring the property market to these dizzy heights.

But the RBA's cash rate is a crude tool for controlling property markets. It is designed to control inflation rates and unemployment in the real economy. In normal times, a booming property market would be associated with a booming real economy. Therefore, increasing the cash rate would be the right decision, because the real economy requires it too.

But if the real economy is moving in a different direction to the financial economy, the cash rate still needs to focus on the real economy. That is why the cash rate is so low in Australia – real inflation (or ‘core’ inflation, as the RBA calls it) is below the RBA’s target, unemployment is too high, and employment and wage growth are too low (and softening further[1]). Using a higher cash rate to combat a property bubble will further hinder the real economy, including consumption spending which accounts for about 60% of the economy. Furthermore, the property bubble may require a significant increase in the cash rate to deflate.

This was somewhat the situation during the sub-prime market boom leading up to the GFC. A massive cash rate increase would have been required to disincentivise those property investments. Even then-Federal Reserve Chairman Alan Greenspan’s era of low cash rates was a result of a low inflation rate. No doubt he further incentivised the sub-prime boom but he would have had to increase the cash rate monumentally to slow the sub-prime market – that’s how profitable it was (until it wasn’t). Using the cash rate to ‘lean against the wind’ of asset markets is not advisable, especially when the real economy (specifically, real inflation and employment) is sluggish.

And this is also the current situation in Australia – the RBA is stuck between wanting to stimulate the lagging real economy with a low cash rate, and not wanting to over-stimulate the booming property markets. Another way to put it – the RBA is stuck between wanting to reign in the property market but not wanting to add burden to already-debt-laden-and-static-income households. That is why they are opting for a low cash rate and the measures listed above.

But it’s okay because the cash rate is not the only tool at the RBA’s disposal. The above-listed actions are what is referred to as ‘macro-prudential regulation and oversight’ – a powerful tool of the RBA (and ASIC and APRA) in addition to its control over interest rates. This is what the US was lacking during the lead-up to the GFC – macroprudential regulation and oversight, not an effective cash rate policy (which is designed to tackle real inflation not necessarily financial/ property market inflation). And this is why these Australian bodies are stepping in with this tool to reign in property markets directly instead of using the RBA's cash rate. This is because increasing the cash rate for the purposes of cooling the property market will hinder the already-struggling real economy and not necessarily even effectively reign in the property market.

Also keep in mind that we don’t want to reign in house prices too much – if house prices actually fall, this will have flow-on impacts on household wealth and the broader economy. With investor loans accounting for over half of property lending and interest-only loans at 40%, falling house prices may trigger investors into selling, sparking a property crash. It’s a delicate balance to maintain – don’t let the market continue on its current path, otherwise it may crash, but don’t slow it too much, otherwise it might crash.

But it does reinforce the need for macro-prudential measures, which target specific trouble areas of the housing market, rather than the cash rate which affects the broader economy, potentially doing undesired damage. Furthermore, disruption can be minimised if banks have sufficient time to meet these new requirements, which APRA has assured they will.

So to suggest that the RBA should have raised its cash rate sooner, or not lowered it to this level in the first place, is ill-advised.



MORE AVENUES TO SUCCESS

Furthermore, while a contributing factor, interest rates aren’t the only (or even the most significant) cause of the property market bubble. As Philip Lowe, Governor of the RBA, says:

“The availability of credit is undoubtedly a factor that can amplify demand, but it is not the root cause”.

To suggest solely (or even primarily) interest rates are to blame overlooks the fact that in Perth and Darwin, house values fell 4.7% last year, and Adelaide and Brisbane grew only modestly at 3.5%. All these cities are subject to the same low interest rates, and yet they’re having a vastly different impact on house prices depending on the city. This implies something much more significant is driving property prices to different extents in different cities.

And that is … supply.



Long term success requires the supply of housing in these pressure areas to increase. Macro-prudential regulation and oversight can lessen financial risks and the housing market’s impact on the broader economy, but it is merely a temporary solution – even the RBA admits that it won’t address this underlying supply-demand mismatch. This is something over which the RBA and APRA have little control – or even responsibility. But not the government.

One avenue therefore, is government planning to open up new areas for residential development, as well as investment in public transport infrastructure. As inner urban areas fill up, public transport links to outer areas quite literally create new well-located land for housing.

“Nothing increases the supply of well-located land like good transport links”, Philip Lowe.

This planning and investment has not kept up with the strong population growth since the turn of the century (around 190,000 new permanent migrants each year), consequently driving this property price growth. Creating this additional supply will go a long way to addressing house prices (and consequent household debt) currently out-pacing wages and incomes.



Fiscal stimulus is another avenue. Accelerating household wage and income growth will better allow households to pay down their debt levels. Currently, property prices and debt levels are growing faster than wages and income – last year, household debt increased 6.5%, while wage growth is the lowest in some decades (household incomes grew just 3%). Household debt is now at around 125% of GDP and 189% of disposable income (the latter from around 160% for much of the 2000s, and just 60% 25 years ago). This makes Australian households the fourth most indebted in the OECD behind Denmark, The Netherlands and Norway.

A solution here is government fiscal policy – investments in infrastructure (including public transport above) to drive real economic activity and wages and incomes, allowing households to pay down debt faster, so the RBA can lift its cash rate faster, further easing any pressures on property markets.

The government still has a great capacity to borrow – our AAA credit rating and strong economic record means that demand for government bonds continues to be greater than the supply from Treasury – so Treasury could easily issue more if they wanted to spend more money. And even though interest rates are rising globally, the cost of financing government debt continues to fall as the debt is rolled over (from 5.2% to 3.5% over the last five years), i.e. higher interest rates on government debt will continue for some time to still be lower than the rates at which that debt was initially borrowed, with new borrowings such as an $800 million 10-year bond issued recently, paying just 2.75%. Furthermore, a larger share of our government’s debt is being sourced domestically, reducing our exposure to rising international interest rates.

And remember, in Australia gross government debt as a percentage of GDP is only 41% (net debt is only 20%) – low by international standards and much lower than household debt. If the government budget is like a household budget (it’s not, but for argument’s sake, let’s use the common political talking point), surely the government should be willing to incur a little more debt to help bring actual household budgets back into the black – or at least in line with their own debt levels.

And any consequent government debt incurred can be paid down with the economic proceeds (and consequent tax revenue) of these investments themselves – but this will require convincing the government to spend more money, which is not easy right now (before the GFC, I never thought it would be hard to convince a government to spend more money).



Furthermore, the government can do more to address income inequality. One possible reason that a booming property market in Sydney and Melbourne is not translating into stronger general economic performance elsewhere is that income inequality has resulted in only a small section of the economy having the means to invest in and profit from asset markets. Lower socio-economic individuals tend not to have significant stock portfolios or (even indirect) property investments. Consequently, they can’t benefit from a booming eastern states property market. But if, through its infrastructure investments and redistribution efforts, the government were to better support the lower end of the socio-economic spectrum, giving them more capacity to invest in asset markets on the other side of the country, this would better share the eastern states boom across the economy, and the two-speed economy would start returning to a one-speed economy. Consequently, interest rates could recover faster before the property markets ever get out of control.

WA in particular needs a boost. The end of the mining and resources boom has brought high unemployment and underemployment, and flat wages and house price growth, with almost 3% of mortgage-holders over 30 days in arrears – the highest in the country, 60% higher than last year, and growing. Geraldton, Port Hedland and Karratha specifically have over 6.5% of mortgages delinquent – more than double the previous year. And while nationally this rate of mortgage-holders over 30 days in arrears has increased, it is still just 1.5% (up from 1.2% last year) – so while mortgage stress is appearing across the country, even in the stronger states of NSW and Victoria, the argument for fiscal support is especially strong in the west.



Fourthly – and more widely published – the government could adjust negative gearing and capital gains tax discounts on residential investment, and limit (or ban) the ability of superannuation funds to borrow. Such regulations (or lack thereof) have over-stimulated investor activity (by, for example, making housing tax-deductible – 50% deductible in the case of capital gains – for investors but not owner-occupiers), driving property prices up and rents down, as well as encouraging owner-occupiers to take on interest-only mortgages due to financial constraints. It’s as though politicians have actively sought to make property a more attractive investment. Unfortunately, the Australian government doesn’t seem eager to deal with these issues, preferring to leave it to the regulators.



RESULTS SO FAR AND CONCLUDING REMARKS

For the RBA to use its cash rate to reign in property markets, they are essentially admitting they have no confidence in the government to do its job, i.e. to invest in infrastructure, improve supply, utilise fiscal policy, reduce inequality, reform the tax system. And the fact is, the RBA actually wants to lower the cash rate further to stimulate the real economy, but are holding back over fear of reigniting property markets. So they’re effectively already partially admitting this failure of government. And they are clearly more worried at the moment about the risks of a lower cash rate to the overheated property market than the benefits to the real economy. They’re not stupid[2] – they know the likely risks of keeping the cash rate too low for too long, but they have to weigh that against the almost definite risks to the real economy of lifting the rate too soon.

But they’re not willing to concede the government’s total failure yet. The RBA is not willing to almost definitely hurt the real economy in exchange for possibly cooling the property markets.

And macro-prudential measures already seem to be working at least a little. Lenders have already started increasing their interest rates independently of the RBA, especially rates paid by investors (less so for owner-occupiers). Since December 2014, when APRA first raised concerns about the housing market, the RBA has dropped the cash rate by a further 1%, and banks followed by dropping owner-occupier rates by 0.63% – but rates on interest-only loans have risen by 0.1% (and by an estimated 0.25-0.35% if the above 30% risk-weighting floor is imposed, while leaving owner-occupiers steady), showing the ability of macro-prudential measures to target specific areas of the economy. Many may view these actions by the banks – raising interest rates independently of the RBA – with suspicion. But remember, this is precisely what we want them to do – help slow down the risky sections of the market, rather than the market as a whole. New apartment sales in Melbourne have also slowed in response to these measures. And time will tell how compliant the financial sector is regarding the 10% cap on investor lending, the 30% cap on new interest-only lending, loan-to-valuation ratios and credit checks.

If enough progress is not made, then the RBA may re-consider increasing their cash rate – but only as a second-best alternative in the face of a failure of government policy, regulation and oversight, and financial sector recalcitrance, not a failure of the RBA's cash rate policy.

I have confidence in the RBA’s ability to resolve this situation – even if our perfect 20-20 hindsight suggests they should have acted sooner and more strongly. But they are using the right tools for the situation.

I’m willing to accept that these regulatory bodies have dropped the ball regarding reigning in these property markets. I’m even willing to concede that a long period of a low cash rate has contributed to this boom. But I take issue with the commonly-spouted idea that the RBA should never have left the cash rate so low for so long – that these property markets could have been reigned in if only the RBA raised the cash rate sooner.

Remember – the cash rate for the real economy; regulation, oversight and supply for property markets.

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[1] Unemployment has trended upwards in the last few months. Cyclone Debbie will also complicate matters, hitting coal exports in the March quarter, along with the fall in commodity export values in January and February. These, as well as threats of a Donald Trump trade war, will subtract from economic growth, furthering the RBA’s incentive to keep the cash rate low. But over the medium term, global recovery and higher commodity prices are expected to drive Australia’s economy.

[2] Although you may think they’re just corrupt – a conclusion I prefer not to jump to just yet.

Corporate Taxes contd.

The world waits for no one.

It seems real-time events were too fast for me. For the last few weeks, I was researching and writing a blog on the global trend (specifically, the US, the UK and Australia) of decreasing company tax rates (and my corresponding recommendations), which I managed to upload today. Two days earlier though, the Australian government had already managed to pass their intended tax cuts. I need to be faster with my blogging!

On the plus side though, Australia’s decision is somewhat consistent with my recommendations.

Company tax cuts could represent effective fiscal stimulus to currently sub-trend investment rates across the advanced world (especially in light of recent global protectionist rhetoric). And while I was concerned that such a trend could degenerate into a mutually-destructive international price war, and I did have a preference for governments around the world to make the first move in terms of their own public infrastructure investment, rather than immediately outsourcing to the private sector via company tax rate cuts, Australia’s decision does focus its tax cuts on smaller businesses. Specifically, businesses with a turnover under $10 million will receive an immediate 2.5% cut (from 30% to 27.5%), extending to businesses up to $25 million by July 1, and businesses under $50 million in financial year 2018/19, before dropping the rate to 25% for all businesses under $50 million over the next 10 years.

This should address some of my concerns that corporate tax cuts would worsen income inequality by favouring large companies.

But there is still a desire in the government to expand these tax cuts to all companies which Australia, while risking a worsening of income inequality, may be forced to do if other countries are doing the same thing, forcing Australia to follow suit just to maintain its share of global investment, even if not stimulating it per se.

Time will tell – I’ll just have to keep up to speed.

Penalty Rates vs. the Univeral Basic Income

Australia’s Fair Work Commission recently decided to scrap/ reduce penalty rates on Sunday for certain industries, and it got me thinking. I have written previously on the notion of a universal basic income (UBI), and several countries already trialling such programs. I think the idea of penalty rates is quite relevant to this discussion.

What if Australia were to scrap all penalty rates, minimum wages, etc. and replace them with something arguably much simpler – a UBI?

There is evidence that some small businesses simply can’t afford to open on Sundays (or if they can, only for limited hours) because of the cost of hiring workers at these penalty rates. At the same time, many workers depend on them to make ends meet, such as students who have no other option but to work weekends. So I wouldn’t suggest taking away workers’ penalty rates without replacing it with something equivalent – or better.

And that’s what I think a UBI (or just free government services) is. Without necessarily requiring any additional taxes to be collected from the economy, government should be responsible for making sure everyone has the means and the resources to survive – food, water, shelter, clothing, basic health care and education – via a tax system that redistributes from top to bottom, rather than outsourcing it to the private sector in the form of penalty rates.

Is this not the point of government? To step in where the private sector fails (refuses) to do something important? The government should not be required to meet private sector financial objectives. So why is the private sector being forced to meet the government’s social objectives? The private sector exists to make money and indirectly serve society, while the government exists to step in when these two goals don’t coincide, not force the private sector to achieve their social objectives via unprofitable means.

I don’t believe a UBI will destroy people’s incentives to work. I’m not talking about giving everyone a free no-questions-asked life of luxury here. I’m talking about keeping people alive and healthy, no questions asked. There are so many wonderful things in this world that cost money – 70-inch TVs, the latest iPhone 50 (or whatever number they’re up to now), overseas holidays, restaurant meals, expensive cars, beach-front holiday homes. These alone will continue to provide people with an incentive to work and earn, so that they can afford more than just the basics. We don’t need to add the threat of hunger and homelessness to create this incentive. So giving people the basics of life for free (which Australia virtually already does, just a little inefficiently) won’t destroy incentives. And even if there are a few individuals with no ambition or desire to better themselves, and are just happy to survive on this welfare and nothing more, so what? A few people gaming the system should not be enough to completely re-write the system itself and ruin it for the rest of us. And I wouldn’t be surprised if the savings in administration and interrogation of welfare recipients to determine what they ‘deserve’ would more than offset the cost of the occasional ‘bludger’.

So again, this is not about taking away from workers. And it is not about taxing society more than it already is. It’s not about how much tax we pay as a society, it’s about who pays it.

At the moment, business and industry is forced to pay this tax in the form of penalty rates, thereby distorting their usual economic decision-making. But if penalty rates and minimum wages were removed, business and industry could pay their workers only for the value of their labour, not the cost of their lives. More businesses would be able to open/ expand, the economy would grow, and naturally, government would enjoy more tax revenue. The example I gave in my earlier blog was of McDonalds – without the minimum wage, McDonalds may be able to hire more burger-flippers during busy times, and maybe even open up entirely new branches in currently-low demand areas.

And any gap that was remaining between a workers’ (potentially lower) wage and their reasonable cost of living would be covered by government support. And some industries may choose to continue to pay workers at these penalty rates anyway, if that is the only way to get them to work on weekends – which is fine. If businesses can’t afford to pay workers at the rate required to attract and retain them, perhaps they shouldn’t be in business – this is demand and supply at work. The difference is, if businesses chose to continue to pay these rates, it should be because their private incentives demand it, not because it was forced upon them legislatively at a rate that the government probably isn’t best positioned to estimate.

It may seem that this simply constitutes swapping one wage (penalty rates) for another (government support), but there is logic to it. Instead of business and industry being forced to pay the entire penalty rate, it is spread more thinly across all members of society (businesses, customers, households, etc.). Is this not fairer and more efficient – everyone contributing a little rather than a few contributing a lot? Furthermore, it will allow business and industry to more closely focus on what they are supposed to – their profitability – thereby reducing distortions on, and allowing for efficiency gains in, the private sector.

Again, the removal of penalty rates, minimum wages, etc. is only acceptable if something replaces it to allow everyone a basic standard of living – surely that should be a basic key performance indicator for any society. Is that not the whole point of society? To act as a collective, as well as individuals? If we only wanted to act as individuals, surely we should just go back to the cave.

And while the benefits may not be monumental – swapping penalty rates for a UBI is after all more of a transfer of responsibilities rather than a fresh injection – there would still be very real and worthwhile efficiency gains if it focuses our attention towards what we want to achieve, and who is best positioned to achieve it. The private sector would focus more closely on its financial objectives and the government would have a simpler and smaller number of tools with which to more directly achieve its social objectives.

Corporate Taxes

The new price war.

This current trend of countries lowering their corporate tax rates (Trump is proposing reducing US rates from 35% to 15%, the UK from 20% to 17%, Australia from 30% to 25% - maybe lower) is like a price war. And during normal times (I will discuss abnormal times too), this strategy is not wise.

Consider a price war between Coke and Pepsi – both know that they can’t win market share based on price. If one of them lowers the price of a bottle in an attempt to gain market share and profit, the other will just follow suit. Consequently, both will end up with the same market share, but less profit, resulting in both Coke and Pepsi being worse off. So both Coke and Pepsi have an invisible ‘gentlemen’s agreement’ to not engage in a price war because both would end up worse off. To gain market share, they need to win based on non-price competition, specifically advertising/ marketing.

This is similar to attempting to gain international investment by lowering national corporate tax rates – each country would try to gain/ maintain advantage by cheating/ breaking the rules of the ‘game’ (the gentlemen’s agreement), and stealing investment share off others. Philip Lowe, the Governor of the Reserve Bank of Australia, recently made a similar point to the House of Representatives Economics Committee:

“…from a global perspective … lowering of the corporate tax rate from one country to another just changes the location of investment and does not increase aggregate [global] investment.”

But ‘winning’ depends on others not following suit. If all others ‘cheat’ too, everyone ends up with the same shares of global investment but with a lower level of tax revenue, so everyone is actually WORSE off. Income inequality will probably also get worse as governments have less money to support the disadvantaged through redistribution.

Furthermore, corporate tax rates are just one consideration international investors take in their decision making (others include legal, political and broader economic considerations). So even if other countries don’t follow suit, it is possible that only a small amount of additional international investment would actually be enticed by lower corporate tax rates, while lost tax revenue will be more significant.

During normal times, Australia shouldn’t try to win market share by doing something everyone can do – lowering tax rates. They should do it by marketing Australia as the economically and politically most stable and profitable place to do business – something which shouldn’t be hard to do, given our competition is the politically and economically tumultuous Europe and the US.

“… in a perfect world we would have a common global corporate tax rate, so business could decide where to locate based on the strategic and comparative advantages and not on corporate tax. But that is not the world we live in.” (Philip Lowe).

So now for abnormal times…

The only way lowering global corporate tax rates can win is in abnormal times when the global investment pool is smaller than usual (such as following a major global economic crisis when business and industry is undertaking fewer investments out of fear, uncertainty and/ or tight budgets), so lowering global tax rates arguably will cause more TOTAL investment in the world, beyond what monetary policy can do alone, rather than just splitting the global investment pie into different shares. This is basically the fiscal policy stimulus I’ve been supporting. Once monetary policy reaches its limits and the economy is still depressed, fiscal policy becomes an increasingly powerful means of properly bringing the economy back to trend.

But it should only be temporary, otherwise, once the total investment pool returns to normal, countries will be missing out on tax revenue, and inequality will get worse because low tax rates will go back to only being able to steal from your neighbour (not even that if your neighbour follows suit), not being able to expand the total pie.

And it seems that the ‘abnormal’ times of the GFC are not entirely over – at least from an investment perspective. The below graphs illustrate that while World investment rates have returned to their pre-GFC peak, this was driven by investment in Emerging market and developing economies. Advanced economies are still below their pre-GFC peak (or in Australia’s case, its mining and resources boom peak), but these were arguably unsustainable booms. Furthermore, maybe the developed nature of our economies simply doesn’t justify those levels any more anyway (it wouldn’t be surprising if Advanced economies had naturally declining investment rates over time – as occurred in the below graphs even before the GFC struck – as the simplest investment opportunities are exploited[1]). But even if we assume that we don’t want to return to these investment peaks, investment levels in Advanced economies, including the US, the UK, the EU and Australia, are still arguably below long term trend.

It is also true that the protectionist inclinations of countries recently (Brexit, EU nationalists, Trump, Australian minority parties) have the potential to not just disrupt trade flows, but also investment flows, so one may be able to justify lower corporate tax rates in order to compensate for the negative investment-effects of this growing protectionism (but there is an even better alternative for countries – don’t go down the protectionist road in the first place!). Consequently, a boost in investment could still potentially be justified to bring levels back to long term trend and end the legacy of the GFC once and for all.

Consequently, lowering corporate tax rates to spur investment could work – even if such fiscal stimulus should have happened seven or eight years ago. But, on average across the advanced world, it isn’t just private investment that is lacking – public investment is lower than trend also. So governments arguably need to boost investment in public infrastructure, not just outsource such stimulus to the private sector via corporate tax cuts – especially given the potential of the latter to worsen income inequality.

But if everyone is lowering tax rates – even if the advanced world investment pool weren’t unusually low – Australia possibly should still follow suit – not because it will stimulate investment per se, but because it may just stop Australia losing share.

Unfortunately, once one player ‘cheats’, it’s often rational for the other players to cheat too. This is a concept known in Economics – among others – as the prisoner’s dilemma:

Prisoner A Rat Don’t Rat Prisoner B Rat -5,-5 1,-10 Don’t Rat -10,1 0,0 Essentially, here is the scenario: two criminals are arrested and held in two separate interrogation rooms. The police don’t have enough evidence to prosecute yet, and are relying on at least one of the criminals ‘ratting out’ the other. Here are the possible outcomes: ·         If neither criminal ‘rats’, they are both allowed to go free (both get a ‘payoff’ of 0) ·         If both criminals ‘rat’, they both go to jail for 5 years (a payoff of -5 each) ·         But if only one criminal ‘rats’, he/ she is given a reward (a payoff of 1) and the other who stayed silent but was ‘ratted out’ goes to prison for 10 years! Given that the criminals can’t force each other to cooperate (stay silent) because they are in separate interrogation rooms, it can be seen that, no matter what Prisoner A does, Prisoner B always has an incentive to ‘rat’. Similarly, no matter what Prisoner B does, Prisoner A’s payoff is always larger if he/ she ‘rats’. Ideally, both criminals would remain silent and go free. Consequently, this was a frustrating notion in Economics because it implied that individuals behaving perfectly rationally would actually generate a sub-optimal outcome – something economic theory (but not common sense) had long believed to be impossible.

Nobel Prize-winner John Nash observed a similar phenomenon (according to the movie, ‘A Beautiful Mind’, portrayed by Russell Crowe in his Oscar-winning role) in a bar. He and three of his male friends observed five women walk into the bar – a beautiful blonde and four comparably less appealing brunettes. All the men wanted the blonde, and were tempted to act as ‘every man for himself’. But John made an observation that would end up winning him a Nobel Prize: “If we all go for the blonde, we block each other. Not a single one of us is gonna get her. So then we go for her friends. But they will all give us the cold shoulder because nobody likes to be second choice. But what if no one goes for the blonde? We don’t get in each other’s way and we don’t insult the other girls. It’s the only way we win. That's the only way we all get laid.” This revolutionary idea reinforces the notion that sometimes, cooperation – and not pure self-interest – actually leads to the optimal outcome in the end. Obvious, right?

In conclusion, I suppose I do support lowering corporate tax rates if the rest of the world is doing so. In current circumstances, it does have the potential to drive global investment and economic activity in Advanced economies back to trend levels, and keep Australia from losing share. However, it also has the potential to worsen income inequality, especially if such a policy is pursued for too long. Consequently, I would prefer to see governments of Advanced economies cooperate by making the first move in terms of their own public investment. There are certainly investment opportunities available for a willing government, at least in the US with its ageing infrastructure needing replacement, and Australia with its vast land resources that could support expanded public transport networks, broadband, and water and power infrastructure. Global interest rates are also still historically low for any credit-worthy advanced economy.

And if governments made the first move on investment, this could drive economic growth and private sector confidence (and eventually, investment) without the need for corporate tax cuts.

Either way, Australia doesn’t need to go as hard as some other countries though, because we’re arguably already in a better place – economically and politically – than much of the advanced world, so we’re already more attractive to foreign and domestic investors and consequently are in less need of stimulus (though still, some more would be good, especially in WA).

But if we do go down the path of corporate tax cuts, we need to understand that this must not be an attempt to steal share from our neighbours, but rather to collectively increase the size of the pie so everyone is better off. And hopefully, once the investment pool in Advanced economies has returned to normal, international cooperation can result in countries bringing their corporate tax rates back up to normal, otherwise inequality will rise as governments will miss out on tax revenue and won’t be able to finance income redistribution efforts.

And we mustn't be afraid to let this result in more debt – that can be dealt with over the longer term via the returns from the investments themselves. We certainly must not cut benefits to the lower end of the socio-economic spectrum (cuts that will hinder economic growth and worsen inequality more than benefits to the top end would stimulate economic growth and reduce inequality) to try to pay for these tax cuts – that would be (more than) self-defeating. Similarly, tax cuts for small and medium businesses may be more stimulatory than cuts to large companies, given the tendency of the latter to just absorb any new windfall and consolidate their existing positions, rather than actually invest further. But again, it will depend on what the rest of the world is doing and what types of investment risk being lost if Australia does not follow suit.

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[1] Interestingly, Australia actually doesn’t exhibit a downward trend, and has a higher-than-average investment rate versus Advanced economies as a whole. This could be because Australia, while being a high-income country, is still relatively young. Not undeveloped – just in possession of more investment opportunities that older economies like the US and the EU have already exploited – namely, vast land resources.

Universal basic income

Simple but not easy

It looks like I may have been on to something with one of my recent blog entries (I know, I couldn’t believe it either).

I hypothesised that while historical job losses as a result of technological progress and automation have consistently been more than offset by job gains in other/ the same sectors, in the future these job gains may not be sufficient to offset continued job losses, especially if machines become sophisticated enough to replace not just administrative and routine manual labour tasks but also tasks involving creative thinking. Consequently, a larger and larger social safety net will be required to support these structurally unemployed individuals – maybe permanently.

But this need not be unsustainable, as long as a sufficient share of the benefits from automation are taken by the government in the form of taxation and redistributed to the newly redundant ex-workers, rather than just absorbed by the owners of this automation in the form of profits. As I mentioned in my previous blog entry:

“The point of technology and automation was never to replace humans and leave those humans with nothing – it was to find a way to complete the task without the need for humans. But the humans that were replaced by technology should still be supported by the wealth generated by those machines, unless and until they can reasonably find alternative work”

However, sufficient profits would still need to be allowed to provide business and industry with incentives to invest in such efficiency-improving technology and automation in the first place. Alternatively, if business and industry aren't allowed to sufficiently profit directly by replacing labour with technology, then this technology must at least provide the capacity for additional profits via expansion of operations.

And now it seems Finland, in response to such forces, is trialling a universal basic income (UBI), whereby 2,000 of its unemployed/ already-welfare-supported citizens are guaranteed a minimum income. Furthermore, individuals won’t lose this social safety net the moment they re-enter employment – this will maintain the incentive to work (or study, start a business, volunteer, care for others, etc.) without creating the fear and desperation associated with potential hunger and homelessness that can just result in desperate people accepting whatever low paying and insecure jobs they can find, not necessarily the most satisfying or productive job. Consequently, a UBI could be beneficial not just to the individual, but also the community and broader economy. It wouldn’t just be ‘money for nothing’.

There is also the benefit that a UBI is potentially much easier and cheaper to administer than the endless rules, regulations and bureaucracies associated with many current social welfare programs, without necessarily requiring any additional cost to the taxpayer. This is important to note – a UBI need not increase the size of the welfare state by itself in order to enjoy these efficiency gains from a simpler system. But for countries with relatively small social safety nets and high inequality, a UBI in addition to a generally larger welfare state is indeed likely to not only improve social outcomes, but also economic ones by helping the lower end of the socio-economic spectrum become productive members of society, not get locked in an endless cycle of disadvantage and dependency. The IMF itself highlights this positive link between income equality and economic growth.

With a UBI, we may also be able to do away entirely with the idea of a minimum wage – how stoked would business and industry be about that. Of course, for the government to cover the difference (to compensate the workers being paid below minimum wage), additional taxes would have to be collected from business and industry, at least partially offsetting some of these benefits. But by allowing the free market to entirely determine the level of wages, rather than forcing a minimum wage upon it, additional efficiency gains would be generated that may offset these additional taxes. For example, if McDonalds were able to pay its burger-flippers less than minimum wage, they may be inclined to hire more burger-flippers during busy times/ in busier branches – maybe even open entirely new branches. And the workers would be no worse off because the difference would be covered by the government.

And it’s not just Finland. Elsewhere in the world:

·         High costs of living and concerns about automation resulted in Switzerland having a referendum last year on a proposed UBI (though it was defeated, with only 23% supporting it)

·         The Dutch city of Utrecht is also developing a pilot project scheduled to begin in January 2017

·         California is trialling a $20 million UBI this year

·         Scotland in trialling a UBI this year in Fife and Glasgow in light of, among other things, increasing employment insecurity in the ‘gig economy’, as well as health inequality in Glasgow, and generally stagnant living standards

·         The Canadian province of Ontario is proposing its own $25m pilot project, scheduled to be formally launched early this year. This trial is in light of:

o   High child poverty rates across Canada

o   The success of a mid-1970s basic income policy for seniors in the province in reducing senior poverty from over 30% to 5%, improving food security, longevity and independence from the health care system, which was consequently spread to seniors countrywide

o   The success of a basic income experiment in Dauphin, Manitoba in the 1970s in reducing hospitalisations, accidents, injuries and mental health issues, with minimal reductions in work incentives (except some extended maternity leave uptake and high school retention rates) before the program was cut short due to budget tightening

·         The Indian government may be endorsing a UBI soon, with two pilot schemes already launched in Madhya Pradesh in 2010, and one other in West Delhi. As a result, “welfare improved dramatically in the villages, particularly in nutrition among the children, healthcare, sanitation, and school attendance and performance”, as well as improved emancipation of women, and individual debt reduction

·         Uganda and Kenya are also trialling their own programs

This possibly reflects an increasingly held belief that society as a whole has the capacity to support all its members – no questions asked – without destroying incentives to generate wealth. Perhaps society always had this capacity and we’re only just now coming around to the idea.

I hope the results of these trials are definitive – one way or the other. And if these programs prove to be a successful means of improving the government’s income redistribution role, the full benefits of globalisation can be enjoyed more fairly within nations – not just at the top end – without the need to succumb to the desires of rising right wing nationalists to retreat and isolate one’s self from the rest of the world.

The road to conflict is paved with financial crises

In a couple of recent posts (here and here), I discussed how the rising popularity of right wing nationalism in Europe, the US and Australia could be the final trigger to massive global conflict, much like the 1930s leading up to WWII.

But if worldwide conflict does truly erupt, it may not be between nations, or on traditional battlefields. It may be between civilians on our very streets. Societies in Europe, the US and Australia are becoming increasingly polarised, and these conflicts have already started spilling over into the street. Nationalistic groups across Europe are criticising the EU and demanding a halt to what they see as dangerous mass immigration. And social justice groups such as Occupy Wall Street and Black Lives Matter are opposing what they see as entrenched economic and societal discrimination.

Keep in mind that I am not making any value judgements on the merit any of these groups’ causes – I’m only saying that their grievances have spilled over into active protests, if not actual Parliamentary representation.

And these groups are not entirely separate. In fact, there have been occasions in Australia where so called ‘anti-racism’ groups have clashed with anti-Islam/ anti-immigration groups, one group often protesting in direct response to the other.

I am nervous that a single event, such as a terrorist attack in a Western country, could trigger a series of truly violent and destructive riots between anti-immigration and ‘anti-racism’ groups all over the Western world. And governments will be caught in the middle, unsure as to which side of their polarised society they should be submitting.

And as it turns out, it’s not a coincidence that these events so closely resemble the 1930s.

A recent study (summary and full paper) by Manuel Funke, Moritz Schularick and Christoph Trebesch, assessing 144 years of data in 20 rich countries over more than 800 general elections, more than 100 financial crises and historical data on street protests, discovered that there is a very strong link between financial crises and the subsequent growing popularity of right wing nationalist groups. Specifically, in the five years following a financial crisis, far-right votes grow by about one-third – this means actual Parliamentary representation.

This is unsurprising, as the study explains, given the fact that financial crises, unlike normal recessions or even severe non-financial macroeconomic shocks, negatively impact not just employment, but also asset values (property, stock markets). Consequently, the pain of financial crises tends to be greater, and the recovery weaker and more prolonged. Furthermore, financial crises are often viewed as the direct result of the failure of a specific group – governments, banks, etc., rather than external events such as oil price shocks, natural catastrophes or wars, for which it is harder to attribute blame to a specific group. Financial sector bailouts and disputes between creditors and debtors that are more inherent in financial crises are also likely to cause more widespread social dissatisfaction than non-financial shocks, as well as the potential for rising inequality following a financial crisis.

This causes the disenchanted and disaffected to seek out someone to blame, abandoning the major centre-left and centre-right political parties that they see as having failed them, and jumping on the bandwagon of the attractive easy solutions offered by radical right wing nationalist (and sometimes xenophobic) parties (radical left wing parties also grow in popularity, but to a lesser extent). And not just at the political level – street protests, including general strikes, violent riots and anti-government protests increase in number as well.



This is why now, following the biggest financial crisis since the Great Depression, we see the rise of right wing nationalist parties in Europe blaming the EU for, among other things, perceived excessive immigration. Far right and far left populist parties have doubled their vote shares in Britain, France, Finland, Sweden, Portugal and Japan. On average, the far-right vote share approximately tripled between 2004 and 2014 across Europe (from 5% to 15%). Of particular note in European elections are:

·         Austria’s Freedom Party at 35.1% of the vote

·         The Swiss People’s Party at 29%
·         The UK Independence Party (UKIP) at 28%
·         The Danish People’s Party at 27%
·         Front National in France at 25%
·         Hungary’s Jobbik at 21%

And though several of these shares have declined since 2014, they are still much higher than their pre-crisis levels.

Brexit too was driven by dissatisfaction with the EU and perceived excessive immigration from Poland. In the US, Trump’s success was, at least partially, due to his capitalisation on/ fuelling of anger towards Mexico, China and the establishment’s trade policies. Even in Australia, where the GFC was largely avoided, their two major centre-right and centre-left parties have experienced shrinking majorities following the increasing popularity of Pauline Hanson’s nationalist One Nation party, Nick Xenophon’s populist party, and “more crossbench odds and sods” (The West Australian, Centrists up against history, 12 December 2016).

On average, street protests also more than double following a financial crisis, especially anti-government demonstrations (as opposed to violent riots or general strikes), and recently especially in Greece and Spain.

And this is a pattern consistent over history. The most obvious examples are during the interwar period in Germany and Italy, but also elsewhere around the world:
·         Following the post-WWI global recession and the Italian banking crises of the early 1920s, Mussolini gained 19.1% of the vote in 1921 and about 65% in 1925
·         Following the breakout of the Great Depression, the Nazis gained 18.3% of the vote in 1930 in Germany, over 30% in 1932 and over 40% in 1933
·         Far right parties gained in Belgium in the 1930s, e.g. the Rexists and the Flemish National Union
·         Denmark’s National Socialist Workers’ Party in the 1930s
·         Finland’s Patriotic People’s Movement
·         Spain’s Falange
·         Switzerland’s National Front
·         The UK’s Independent Labour Party and National Liberal Party which both broke away from the Labour and Liberal parties respectively before the 1931 election
·         Australia's New Guard, the Emergency Committee of South Australia in 1931 and other groups, and WA’s vote to secede from the rest of Australia (which obviously didn’t take)
·         Canada’s Reconstruction Party and the Social Credit Party, both in 1935
·         The US’s Wisconsin Progressive Party.

But there was also similar growth in nationalistic sentiments and government representation following the Scandinavian financial crises of the late 1980s/ early 1990s:
·         The right-wing populist Norwegian Progress Party increased their share of the vote from 3.7% in 1985 to 13% in 1989 – two years after the crisis broke out
·         The Danish Progress Party grew from 3.6% to 9% over the same period
·         Right wing parties in Sweden grew from less than a 1% share before their 1990 crisis to 6.8% in 1991, including the right wing populist party New Democracy
·         Italy’s North League won 55 seats in the first election after the outbreak of the 1990 crisis.

These trends tend to last for about a decade from the crisis, which means we may still have a couple of years of right-wing nationalism and street protests left. Furthermore, given this rise in the power and number of other (right wing) parties and decline in centre-left and centre-right parties, governing becomes much more difficult because no one party controls sufficient power to achieve their party’s goals. Consequently, the public becomes even more disenchanted with the establishment, sowing the seeds of potential disastrous international conflicts when governments and the public start looking for international scapegoats for their troubles. So ironically, this disenchantment with the establishment actually has the potential to create more problems than it solves, especially in a post-crisis environment when decisive government actions are required, slowing the recovery even further.

This really does highlight the importance of macroeconomic management, not just in maintaining and furthering economic well-being, but also in maintaining political stability. Delayed and (in the case of their austerity policies) counter-productive economic responses to the GFC and sovereign debt crisis in Europe caused deep economic contractions, price deflation and soaring unemployment, sowing the seeds of significant political tensions, with the rise of right-wing nationalist parties very much threatening to pull the EU apart. In the US however, despite being ground-zero for the GFC, their economy was largely kept afloat with swift and strong monetary responses. Australia too was largely sheltered from the GFC. But for both the US and Australia, inadequate fiscal stimulus has arguably led to a more prolonged and less complete recovery than ideal, as well as their own brands of inward-looking nationalism. And the additional pressure this fiscal impotence has put on monetary policy to keep the economy afloat – and arguably inadequate financial market reforms – could be causing greater problems down the line.

History really does like to repeat itself. Is it too late to nip this in the bud before everyone turns their back on the world?