Costello has nothing to brag about

Former Treasurer Peter Costello has been on Lateline and Insiders recently bragging about how his legacy of zero government debt leaves Australia “well placed” to deal with the banking crisis.

It is true that the lack of government debt that Costello’s term as Treasurer produced will be helpful in this crisis as it will give the Federal Government flexibility to create economic stimulus through increased spending. However, the benefits of low government debt are likely to be outweighed by the damage to the economy created by the record private debt levels created under Costello’s Treasury. Australia now has more private debt than at any other time in its history with about half of that debt (that being the dangerous half) accrued during the Costello years. With its accompanying housing bubble, it now forms the Achilles’ heel of the Australian economy.

I have previously made the argument for the need for revisions to monetary policy to target debt fueled asset price bubbles and for an explicit rejection of the Greenspan doctrine. Encouragingly since then, RBA Governor Glenn Stevens has indicated that the Reserve Bank is again interested in revising its approach to asset price bubbles with an implied opinion that a post-fact Greenspan like approach is no longer tenable.

We can only hope that Wayne Swan takes up Glenn Stevens on his suggestion. The RBA investigated the option of dumping the Greenspan approach under Ian Macfarlane in 2003 after the tech-wreck but Costello never took it anywhere. No doubt this was because proceeding with the RBA’s proposal would have pushed up interest rates more quickly to avoid the excessive private debt Australia was accruing. That would have been good for the country but not good for the government.

At the time there seemed no urgency as the Howard government was quietly enjoying the bring-forward of activity and wealth effect that the growth in credit was creating in the economy.

Monetary policy changes, however, are only ever going to be part of the answer. Fiscal policy and the broader regulatory framework must do their share of the heavy lifting to avoid creating an economic vulnerability. And this is beyond just getting the budget surplus-deficit cycle in sync with the needs of the economy. It must create an environment that discourages speculative bubbles particularly in housing but also in the share market by directly targeting volatility.

Volatility is the standard deviation of the rate of return of an asset or asset class. To fight volatility is to fight for steady economic progress and against the booms and busts that naturally tend develop in the business cycle. Avoid all the booms that you can, and you might just avoid the worst of the busts.

When the rate of return in an asset class inexplicably exceeds its historic levels and valuation metrics, alarm bells should ring in the Treasury of any responsible government.

The main valuation metric for housing would be its rental yield, supplemented with some form of median household income to house price ratio. When housing prices (and debt) started soaring in 2000 for no reason except that money was cheap, Treasury should have immediately started fearing a future slump and doing everything possible to keep prices in-line with long term valuation metrics and trends.

But the Howard-Costello government did not even turn up to the fight with volatility, and certainly not in the housing sector. The Federal Government did nothing as house prices spiraled out of control powered by a debt binge that will haunt us for many years to come.

Then, Prime Minister Howard often responded with one of his most ill considered pat phrases when asked about house prices; “I don’t hear many people complaining about their house price going up” he would say. House prices going up not only locked a generation out of owning their own home but has now overcommitted many to debt levels they will not be able to service during a downturn.

Economically this is bad news and not just for those overcommitted and risking negative equity. Falls in house prices are bad news for the economy, putting a dampener on activity and spending, punishing developers and putting real pressure on the banking system.