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.

The fight against volatility should have begun early to mid 2000 when housing speculation really took off. There was much that could and should have been done. The capital gains tax could have moved to parity; the First Home Owners grant could have been cut; negative gearing for investment properties could have been removed for existing property purchases (and expanded for economically-useful new properties); and the immigration intake could have been cut and refocused on the most at need industries.

A co-ordinated land release program could have begun with the states; aggressive rezoning to higher density could have been forced on the states. A vendor tax could have been introduced to discourage speculation; money from the bursting Federal budget could have gone to the states on a per new house basis to remove charges and levies that have ballooned to well over $100,000 in some cases.

Instead, a report was belatedly commissioned from the Productivity Commission in 2003 which duly found an urgent need for more reports to be commissioned.

The options now are a lot tougher. The Rudd Government appears to be trying to prop up the market with a new record immigration intake, even in the face of its own projections for rising unemployment, and with its $4 billion foray into the mortgage backed securities market. This may not be the best approach. The key to getting out of this mess is to create a building boom in one to two years time to offset the sudden drop in mining investment and the real economy fall-out from the credit crisis.

We have the pent up demand for such a boom, but until affordability improves - that is, prices come down - it is likely to be stalled. Therefore what is needed is a controlled deflation of the bubble and a return to more typical historic multiples of income and rental yields. Brace the banks, take the hit on the chin, by doing what should have been done five years ago and get the nation building. One gets the feeling that such a gutsy approach is not the Rudd Government’s preferred style, but delaying a recovery by delaying the pain will definitely make things worse.

In judging the Howard years, history is likely to forget about Tampa, the GST, the “say sorry” saga, PTE Kovco, Australia’s token involvement in Iraq and perhaps even the East Timor intervention. It may well be remembered as a time of a mismanaged resources boom, ballooning debt, and fiscal and monetary policy errors. Hardly the stuff to be bragging about, particularly while it is unwinding.

Could somebody please keep Mr Costello off the tele?