A debt fueled mess

It’s a bit of debt-fuelled mess in Australia at the moment, with consequences including a series of imploding companies, unaffordable housing, some families losing their homes and a very indebted, mortgage-stressed and vulnerable consumer. That makes it the right time for the Federal Government to look through the current mess, take a long term view, and see what it can do to limit or prevent the next debt binge and its inevitable hangover.

It was pretty obvious in Australia by 2002 that a debt party had not only kicked off but was already well out of hand. Particularly in the housing sector someone should have called the cops. Yet the RBA, following its charter to target only inflation, and with the full support of the then Treasurer Peter Costello did not respond adequately or even directly to the binge.

It was noted at the time that the RBA was concerned about the increasing indebtedness of the household sector and would be responding to the secondary effects of the debt binge as it pushed up prices throughout the economy. But this, as it turned out, was not an effective strategy delivering too little monetary tightening too late. Australia’s private debt continued to blow out.

Even at the time, to a lot of market observers, this looked frustratingly like willfully missing an opportunity to respond earlier rather than later to something that would come back to bite us. Looking back that is exactly what happened. The great Australian debt party continued unabated, fuelled by historically low interest rates, until it was too late and Australian private debt reached its current record level of about 165 per cent of GDP.

One political question that emerges is, what changes can be made to the monetary policy framework to avoid a repeat of this unfortunate turn of events five or ten years from now when private debt is (hopefully) again under control and threatening to break out?

This question is part of the broader question of “where to from here” for monetary policy and the future of inflation targeting. Given our recent experience it may be an easier part of the puzzle to answer. The solution may lie in altering the inflation targeting regime of the Reserve Bank to include a mandate to move against debt-fuelled asset price bubbles. Now is the time to make any such changes as they will not push up interest rates any time soon, and leaving the changes until they are needed will make them politically impossible.

Academic work has considered a number of alternative ways in which to include the consideration of debt fuelled asset bubbles in setting the policy bias. These include incorporating house prices in the CPI calculation and attempting to deflate already clearly identified bubbles. The most promising, though, is a conservative model that aims to reduce the extent of debt driven asset price bubbles through early and limited action. The aim is to be “leaning against the wind of an incipient bubble” by “adopt[ing] a tighter policy stance in the face of an inflating asset market” (PDF 1.61MB). This approach would be a significant but incremental change to the existing formal monetary policy framework. The work the RBA has already done in 2003 investigating this approach leans towards the practical feasibility of such a modification to monetary policy.

Internationally this may be the way things are heading as well. Some local investment banking commentators have, through their reading of the US Federal Reserve’s speeches, called the end of the Greenspan doctrine on asset price bubbles.

The Greenspan doctrine ran that:

1. asset price bubbles were too hard to identify to deal with;
2. in any case there is nothing the Fed can do to stop them if it were to find one; and
3. burst bubbles are no big deal anyway.

After sub-prime it has become apparent that rather than being no big deal the dangers of asset bubbles (in particular those fueled by excessive debt) actually include the collapse of the global financial system. In a sign of the changes in the Fed’s attitude FOMC Vice Chairman Donald Kohn in an April 17, 2008 speech stressed the need now to move to “a financial system with less leverage at its core” in order to “be a more stable and resilient system” and for banks to increase their capital base. Greenspan’s legend is looking more like Atlas crushed post sub-prime.

The debate on the arcane theory of monetary policy needs to move from banking conferences to the political mainstream before existing practices bring the economy undone again. The first step towards removing the simplistic straightjacket is to acknowledge the most glaring of the current monetary policy regime’s recent errors.

Of course this kind of progressive and fundamental change would most likely require a patient political champion and the kind of solid bipartisan support that enabled Keating as Treasurer to reform Australia’s financial system in the 80’s. In the difficult times ahead for the economy, though, an evolution of monetary policy and an acknowledgement that inflation targeting is not the end of the line may be essential to seeing us through.