Bankers should not be let off the leash

Saul Eslake’s proposition in the article “The low-interest road to ruin” is that low interest rates encouraged an asset bubble in housing. He indicates that Australia’s position of relative health was because of some interest rate hikes from May 2002. The consumers of credit are to blame.

This is nonsense, the bankers are to blame, and Mr Eslake wants to pass the buck for his profession.

The American and to a degree European financial markets created a system where the lender was no longer responsible for the risk associated with supply of credit.

The individual financial institution could trade hybrid securities two or three steps away from the actual loan. The risk associated with the debt was obfuscated to such an extent that the professional credit agencies were incapable of assessing the real risk of the individual loans that made up the hybrid security.

Bankers and financial institutions gorged themselves in lending practices that could not identify the risk. The financial sector had effectively created its own fiat monetary system. Essentially there was a “private” non-regulated monetary system created at the behest of the bankers and for the bankers.

The economic theory is that low interest rates should encourage long-term low-risk economic activity; and high interest rates drive economic activity to riskier ventures to ensure the activity can recoup the additional cost of money.

What happened instead was the financial sector became greedy: rather than investing in long-term productive investments it went on a flight of fancy with its new found money supply.

Eslake describes his brethrens greed as follows:

Second , the extended period of unusually low interest rates encouraged investors to take on more risk to obtain rates of return that could no longer be provided by relative low-risk investments. This prompted a response from the “supply side” of the financial services sector in the form of an ever-growing range of increasingly risky investment products to cater to the growing demand for them - products the risk characteristics of which neither their creators or regulators fully comprehended.

Taking the eco-jargon out, the punters got greedy and the finance industry sold their shareholders down the drain by gambling their future without sufficient regard to the prudential risk.

Eslake’s solution is because the finance industry cannot be trusted to act prudentially to stop asset bubbles we need to slug everyone for the inadequacies of the financial sector.

Why should the farmer have to pay higher interests to put food on yours and my table because the greed of the finance sector? Why should the owners of Australian manufacturing firms providing jobs for our citizens have to wear the burden of the greed of the finance sector?

There needs to be a fundamental rethink on the central premise that the price of a good is the best signal of risk.

The financial sector cries out for deregulation, let the market determine the outcome. That is until it is stuffed and ordinary citizens have to wear the burden of the bankers’ hubris.

Australia did not have a sub-prime crisis because there is no way the Australian Prudential Regulation Authority (APRA) would tolerate the same lending practices.

It could be argued that the interest rate rises of the Reserve Bank encouraged the carry trade which could have triggered asset bubbles within our economy.

The solution to guard against greed, excessive risk and lack of prudential behaviour is not increasing the price of money and slugging productive activities to curb speculative activity. It is to establish a regulatory framework that curbs the excesses of the speculators. It is to recognise the proper role of fiscal policies to damper asset bubbles and utilise quantitative monetary policy solutions rather than relying on the blunt tool of the price of money.

Eslake’s solution would have been for the Federal Reserve to raise interest rates virtually guaranteeing a world-wide recession.

The rises necessary to curb the speculators would choke the rest of the US economy and because of the imbalance in the world economy set a chain of events with dire consequences.

Unfortunately not only has the US become the international reserve currency it has also become the international reserve consumer.

When looking at the historic interest rate data the rates in 2003 were not fundamentally different to the rates in 1955. Did we see a financial crisis in 1955 because the financial sector threw prudential caution out the window? Did we see low interest rates in 1955 lead to consumers gorging themselves on easy credit?

No we did not, because the society at the time knew that bankers could not be left off the leash, there was a regulatory environment that provided the civil society of western democracies with suitable safeguards and controls.

Society had not been infected with the disease of the neoclassical economic religion. Maybe society remembered the excesses of the financial sector that led to the Great Depression and that appropriate regulation is essential.

Society must not abdicate control or responsibility to the ghost of the free market.