article published in Quadrant Magazine December 2009
The Limits to State Regulation
It is now more than thirteen years since I established the Institute for Private Enterprise, which (rather strangely) seems to be the only think-tank in the world with the specific objective of promoting private enterprise as government policy. Stranger still, perhaps, is that I established it because the previous institute for which I was working after I resigned from the Treasury, and which also supported free enterprise in principle, thought I should be less “fundamentalist” in publicly promoting its virtues. That reinforced my view that it is not only the believers in socialism and big government that have to be combated. The recent experience of the Liberal Party seems relevant.
But the image of fundamentalism painted by outright opponents and even sympathisers is a problem: a not unusual reaction to smaller-government proposals is—“well, yes, but I wouldn’t go as far as that”. I want to suggest some points the Coalition might use in support of the undoubted virtues of private enterprise and the dangers of big government, but avoiding the fundamentalist label. I am assuming, of course, that the Coalition believes in a low-taxing, minimal role for government and a society in which most individuals have and accept responsibility for their own welfare, but within an efficient legal and policing system.
Let me start with the obvious comment that the extensive worldwide intervention by governments in response to the global financial crisis (GFC) poses a major challenge. Those interventions have not only been widely portrayed as necessary to restore economic growth but also to correct the supposed failure of deregulatory changes in recent years or, as our Kevin has put it, the failure of neo-liberalism. We have seen an outburst of Keynesianism which purports not only to solve the financial crisis but to calibrate the response as if government has the capacity to steer a clear course for the way ahead.
I do not want to spend time on that absurd “failed neo-liberalism” thesis except to point out that believers in the free market system accept the need for a degree of regulation of economic activity. Even Adam Smith did not argue that markets should be self-regulating: in The Wealth of Nations, published in 1776 just after a banking crisis in Scotland, he advocated regulation of banking. But he also recognised the dangers of over-regulation through what he called “The Man of Zeal” who “is apt to be very wise in his own conceit; and is often so enamoured with the supposed beauty of his own ideal plan of government that he cannot suffer the smallest deviation from any part of it”. That brings to mind at least one prominent present-day politician!
In the Centre for Independent Studies’ Policy of Spring 2009 there is an interview with P.J. O’Rourke, who has written a book in appreciation of Smith. O’Rourke explains Smith’s “invisible hand” very nicely when he points out:
What he was trying to say was if you leave people alone, if you let them pursue their own presumably informed self-interest, and you provide them only with a structure of law and property rights, and sort of get out of their way, you will be amazed at the things they can do for themselves.
Historical analysis published by the OECD shows that, since 1820, real growth per head has been fastest in the countries which have been most inclined to adopt free market policies, the top four being the USA, Canada, Australia and New Zealand.
Although it is difficult to be conclusive about the underlying causes of the GFC, the failure of government regulatory arrangements and policies was undoubtedly a major contributor, particularly (but not only) in the USA, in encouraging or allowing risky lending by financial institutions. On top of obvious specific regulatory failures, such as the inbuilt moral hazard situation arising from institutions such as Fannie Mae and Freddie Mac, there was also a failure to understand the limits to regulatory arrangements in general. The mere existence of such arrangements has the potential to cause problems in the financial sector because, once operators are surrounded by a regulatory fence, some are challenged to get under the fence and take risks that would otherwise be unacceptable.
My view is that, contrary to post-GFC assessments at meetings of the G20, and to the view taken by the Prime Minister, the case has not been made for a major increase in regulation. Two important questions need to be considered first. One is why the agencies of government failed to apply existing regulations and whether anyone seriously believes that new controls on, say, executive salaries would help prevent another financial crisis.
The other important question that seems to have been dodged in G20 and Australian assessments is why there was a failure of the fiscal and monetary policies for which governments are responsible. Why didn’t those government policies prevent the private sector having a crisis?
I suppose it is unrealistic to have expected answers to emerge from meetings of those who implemented the policies, such as G20 ministers advised by treasury and central bank officials. Even so, it is surprising that in assessing a financial crisis little attention appears to have been given to why monetary policies in particular appear to have operated dysfunctionally. The existing US Treasury Secretary, Timothy Geithner, who was head of the Federal Reserve Bank of New York when the crisis emerged, did acknowledge early this year that “monetary policy around the world was too loose, too long”. But he did so in the heat of the moment in a radio interview and there has been little public analysis of the basis on which monetary policies have operated, or should have operated, over the last five years or so. It is pertinent to recall that free marketeer Milton Friedman did not trust central banks to determine monetary growth, but nor did he want to leave it to the market. Instead he attempted, unfortunately not successfully, to develop automatic rules for limiting monetary growth.
Little has been said about the fact that, while from 2003 to 2008 inflation rates increased in almost all OECD countries by only a percentage point or so, there was a major increase in the rate of growth in credit extended to private sectors during or before that period. Money chasing goods is a recipe for problems and those problems emerged not in high inflation but in much higher debt in the private sector. Some blame the GFC on the large build-up of holdings of US dollars by China and Japan—reflecting the so-called global imbalance problem. But that does not explain why the US central bank allowed those funds to be used to finance an excessive addition to the supply of credit to domestic borrowers instead of taking offsetting action domestically. Nor does it explain Geithner’s “too loose” operation of monetary policies in other countries.
Even in Australia, where policy is usually judged to have been implemented “responsibly”, the rate of growth in net lending by financial institutions during the five years to September 2008 jumped sharply to about 14 per cent per annum, or about double the rate of growth in (nominal) GDP, and household debt jumped commensurately with the proportion of household income paid in interest increasing from 9 to 15 per cent. This is not to suggest that our targeting of inflation was wrong, but it is to suggest that monetary policy should have taken more account of the rapid increase in private debt, the unwinding of which is now constraining economic growth in Australia.
The fact that we have an “independent” central bank does not mean—and should not mean—that it is exempt from criticism. Yet for some reason a view seems to have developed that critical comments on monetary policy by opposition parties are “political”. That should not be the case, and nor should it stop oppositions from questioning the basis on which monetary policy is operated. Given the excessive growth in credit prior to the GFC, and the major continuing policy issues such as the unwinding of the expansion in debt, the apparent existence of “banks too big to fail” and the accompanying moral hazard problems, and the guarantees of deposits of financial institutions, there is a case for an independent public review of monetary policy. That need is, of course, even greater in overseas countries.
It is important that Australia has a monetary policy that minimises the risk of financial crises and, as the economy recovers, that will become of increasing importance. But despite its predilection for reviews, the government has given no indication of instituting or asking for a review. One strange suggestion is that this reflects a reluctance by Australia to avoid creating the impression that it thinks “a wholesale re-regulation of its financial system is needed”. Why would we do that when our regulatory arrangements have been praised? More likely is that there is a reluctance to review the broader matter of how monetary policy should be operated.
I notice also that in his new book Ross Garnaut is reported as being critical of Reserve Bank and Treasury “complacency” about the current account deficit and its reflection in “excessive private debt”. He appears to be repeating a similar critical public analysis I made about monetary management after I resigned from Treasury in the late 1980s before Australia ended up with the (supposed) “recession we had to have”. But it is not the fact of a current account deficit that we should be concerned about: it is any accompanying excessive increase in private debt allowed by monetary policy.
Let me turn now to fiscal policy and government spending. Much attention has been given to whether the so-called fiscal stimulus has helped in limiting the reduction in economic activity. This is difficult to assess because nobody knows what the level of economic activity would have been if there had been no discretionary addition to spending. What we do know, however, is that the Prime Minister is quite wrong is suggesting that the reduction in government spending in the 1930s recession caused lower economic activity and higher unemployment. Following the spending reductions agreed at the 1931 Premiers’ Conference, Australia experienced a strong recovery in both activity and employment during the rest of the 1930s.
We also know that, because of different assessments of the likely reactions of households and businesses to spending increases, modern modelling by academic economists produces widely different outcomes over a four-to-five-year period, with some showing negative effects in later years. One recent authoritative US assessment concludes that the modelling by the Chair of the President’s Council of Economic Advisers and the Chief Economist of the Office of the Vice-President produced favourable effects that are six times greater than the small effects estimated by academics. In addition, we know that modelling of spending increases by overseas governments has not so far produced anywhere near the predicted favourable effects on activity and employment. Indeed, there is already talk of additional “stimulatory” action in the USA.
Thanks importantly to the policies of the Howard government, Australia entered the GFC in better economic shape than most overseas countries and, particularly given the maintenance of strong Chinese demand, a smaller adverse effect on activity is not surprising. Also, Treasury’s substantial errors in forecasting both the economy and the budget estimates of revenue suggest that its estimates of the spending effects also have a wide margin of error, particularly as state governments are very likely to have reduced spending in areas where the Commonwealth has intruded. Indeed, reports of latest Treasury forecasts indicate that in the absence of stimuli the reduction in GDP would have been only 1.3 per cent whereas the original estimated reduction was 3.2 per cent.
Account must also be taken of the likely stimulatory effects from the reductions in interest rates and other monetary loosening, such as bank guarantees. Given the increase in private sector debt before the GFC, this “emergency” loosening of monetary policy—some of which would have occurred “naturally” in any economic slow-down even without a central bank—may have contributed most if not all of any favourable effects on activity.
For all these reasons there is a strong case for concluding that the fiscal stimulus policy has had little positive effect. As is happening overseas, the government’s insistence on the importance of that policy should be seen principally as an exercise designed to portray the importance of government in the economy—and, of course, the importance of both this particular government and of the need for the Commonwealth to play the leading role. We are increasingly being told of the need for “national leadership”, not of course because of those who are leading the government but because of the alleged enormous challenges of the future. It seems difficult to justify as part of a stimulatory policy the seemingly large and ever-increasing number of areas requiring government involvement, including health, education, national infrastructure, water projects, cars, renewable energy and use of fossil fuels, employer– employee relations, human rights and so on.
One is left wondering what is left for the private sector to do. Actually, apart from the funding for schools about to close, my favourite government leadership program is Kim Carr’s $190 million “Commercialisation Australia” program. From this Kim will provide up to $2 million per private enterprise in 2010 to help the commercial development of “good ideas”. I have one good idea for Kim in that year but I suspect it would not be acceptable!
Thanks importantly to the media passing on the government’s spin, the fiscal stimulus policy in general seems to have popular support, even though it is difficult to believe that a worse job could have been done in implementing the largest chosen project. That involved, of course, spending on school buildings, including for schools about to close. The outcome of that Commonwealth initiative certainly provides no justification for running education and health services from Canberra. But it does provide a basis for questioning the level and future of Commonwealth spending.
On October 9, I attended the Menzies Lecture, during which Malcolm Turnbull promulgated a policy of “returning government’s share of the economy to the level achieved by the previous Coalition” and establishing the equivalent of the US Congressional Budget Office. The previous day the Conservative Party conference in the UK had heard David Cameron tell them that if elected he would cut back on “big government”, which he described as having “got us into this mess … [ they] did too much and undermined responsibility”. Cameron offered no target on government spending and, as the OECD estimate of 48 per cent of GDP in 2008 (compared with Australia’s 34 per cent) was seven percentage points higher than when Labour was first elected in 1997, and as Gordon Brown added another six percentage points of so-called stimulus, Cameron faces a big task even to get back to what John Major left.
Turnbull’s proposal is somewhat more modest, as he would need to cut only about four percentage points, or around $50 billion, off the May 2009 budget estimates for total spending (including stimuli) in 2010–11. If the reports of an early improvement in the economy turn out to be correct, the amount required to reach 24 per cent in 2010–11 would be less, but there may then be a need to go much further to make room for an expansion in the private sector. Whatever, bear in mind two points about Turnbull’s “target” of 24 per cent of GDP. First, it would be only slightly lower than at the end of the Whitlam era in 1976–77 (24.6 per cent). Second, it would be against the background of the failure of the Howard government to make any substantive progress towards the Liberal Party objective of small government. Comparing 1995–96 and 2007–08, the reduction in total spending of about two percentage points of GDP mostly reflected lower interest payments rather than reductions in discretionary spending and, despite announcements of tax “cuts”, the burden of taxation increased by over two percentage points of GDP.
In May 2005 I authored a paper commissioned and published by the Australian Chamber of Commerce and Industry proposing that Commonwealth spending in 2005–06 be reduced by 2 per cent of GDP, then about $16 billion. Implementation of my proposals, which were outlined in some detail, would have taken spending down to about 23 per cent of GDP. That would have been close to what the Howard government had done in one of its initial years in office. Relevant is the survey in the Spring edition of Policy on “What Do Economic Liberals Believe?” This suggests that a large majority of economic liberals support a smaller government and, although a large majority of social democrats do not, it is encouraging that about half do not want to increase the existing size.
My report for ACCI focused on reducing what is often loosely called middle-class welfare in the areas of social security, health and education. That may sound like a vote-losing exercise, but the other side of the coin was the scope to reduce taxation by a similar amount, and this could have at least partially offset the reductions in assistance to those in middle and upper income groups. It was proposed to achieve those reductions not by reducing benefit rates but by tightening the eligibility for obtaining them, which the Howard government subsequently did to a limited extent. My report argued that the approach suggested would have helped lift the low rate of personal saving and reduced welfare dependency. Those arguments remain valid today.
An important additional advantage of such an approach is that it would draw attention to the wasteful process under which a significant proportion of taxes paid by higher income groups is churned back to those who paid them. ABS data available at the time suggested that the benefits (social security and selected education and health benefits) paid to households with incomes in the top two quintiles were then equivalent to nearly half the taxes paid by them.
In the case of health and education, about $25 billion annually is currently paid in specific purpose payments to help the states run those services, in addition to the GST revenues of about $48 billion which are available for the same purpose. This is an area ripe for reform and for potential savings. But how would savings in government spending help overcome the widespread dissatisfaction with the standard of service provided by state government education and health? My answer is through additional spending by the Commonwealth on encouraging the less expensive (for governments) private counterparts. The use of private hospitals has increased from 32 per cent in 1997–98 to around 40 per cent today, and the proportion of students at non-government schools has increased commensurately to over one third.
These privately run institutions offer an important competitive challenge to their public counterparts and, while they do receive some government assistance, compared with “full” spending on government institutions this provides potential for a net saving to the taxpayer in return for a generally higher quality service. There is an opportunity for the Liberal Party to do more to promote the private sector’s role in these areas and, at the same time, offer a counter to the push by unions and others for a bigger government role.
My perception is that, although the Liberal Party is known to favour small government, the case for doing so publicly has not been pursued at the political level. Any major proposal for a reduction in the role of government requires the case to be put and debated publicly before specifics are adopted. The 1996 National Commission of Audit report, for example, required a much greater follow-up to persuade the community that governments should generally limit their assistance to individuals and families in lower-income groups. If Turnbull is serious about reducing government spending to about 24 per cent of GDP he should commission a report outlining how this might be achieved. He has already received but not released a report on taxation reform but both are needed, particularly given the potential for increases with our ageing population.
Turning to government expansion through regulation rather than spending, we are now starting to experience adverse reports from Labor’s increased regulation of employer–employee relations. This major step backwards has occurred despite the moves to a more flexible labour market under the Coalition that helped reduce unemployment from 8 per cent in 1996–97 to 4.5 per cent in November 2007, increase the participation rate over the same period from 63.6 per cent to around 65 per cent, and also allowed significant increases in real wages in circumstances where there was little change in the distribution of incomes. There was no substantive case for increased regulation and in my view the Coalition failed badly in not combating the lack-of-fairness argument advanced by Labor.
It is difficult to understand how Julia Gillard was allowed to sell the absurd line that the proposed legislation would increase productivity and stop employer “rip-offs”. Those supposed “rip-offs” did involve the payment to a relatively small number of employees of wages which were below rates determined under awards. But those awards were made by the quasi-judicial institution that has, since the election, again shown itself incapable of setting wages on an economic basis, let alone on a basis fair to the lower-skilled. The awards that provided the basis for the rip-off allegations before the election were wide open to questioning that never eventuated. Gillard has now established the right approach by rejecting some of the awards by the so-called independent umpire, whose head is attempting to avoid questioning by the Senate Estimates Committee. That umpire should not be immune from public criticism.
In fact, probably the worst aspects of Labor’s re-regulation are the provisions encouraging or allowing collective bargaining and the enhanced role returned to a quasi-judicial institution which under the pre-1996 arrangements consistently brought down decisions favouring unions and neglecting lower-skilled workers. Since the election the Coalition seems to have taken a defeatist view, promulgated by both Labor and (naturally) the biased media, that Labor won a mandate in the election to overthrow WorkChoices and to implement almost any addition to regulation in its place. Labor’s success in selling the mandate line has certainly been helped by its pre-election publication of details of what was being proposed, as well of course by its union cheer squad. But the Coalition failed to advance the available counter-arguments that could have been used to rebut Labor.
What is to be done about this extension of government and unnecessary impingements on individual freedom?
As with the policy of reducing the size of government, and as Labor did with its workplace relations policy, it seems essential that the Coalition set out the arguments well in advance of the next election for the complete scrapping of the existing arrangements and their replacement with a policy supporting individual contracts. Such a document would include the promulgation of the view that, whatever the position in the distant past, the Australian labour market is nowadays not susceptible to exploitation in any meaningful way and that there is no imbalance of bargaining power. The fact that over 800,000 employers compete for labour prevents dictation of conditions by employers. Employees have alternative opportunities and in a normal year well over one million workers leave their jobs voluntarily.
The development over the last twenty-five years of a competitive market economy with a supportive social security system, and the massive decline in union members, supports the notion that workers in modern societies do not need special legal protection against employers. Employees are protected in ordinary courts under the common law and ordinary contract and criminal legislation and, like everybody else, employers are legally obliged to observe contracts including those containing agreed wages and conditions. The Coalition should be able to produce a document showing why Labor is pursuing an outdated policy that reflects its union ties and how that can be changed in the interests of the wider community.
I have left until last the most important threat from an expansion in the role of government. That is the proposal to regulate our use of fossil fuels, one of the most outrageous attempts ever put forward for government regulation of our lives without substantive evidence to support it. What threatens is not merely an expanded role for domestic government but, if a treaty is signed at Copenhagen or later, a major intrusion of government at the world level.
To resort again to Kevin language, “I make no apology” for describing this as outrageous even though there are claims of scientific consensus that the world faces enormous damage from rising temperatures unless governments start to effectively phase out the use of the earth’s enormous resources that provide the cheapest source of energy for humans. The reality is that there is no scientific consensus and there is no basis for taking even precautionary action on the basis of the views of a group of scientists that have not been tested in a public inquiry. Historically there are many examples of scientists, both groups and individuals, demanding government intervention on the basis of faulty analyses. In the case of “dangerous” global warming, its promoters have not only presented distorted or incorrect analyses knowing them to have a highly dubious basis but have also attempted to discredit opponents by ad hominem attacks not on scientific grounds but because (inter alia) they are allegedly funded by producers of fossil fuels.
While I recognise the political difficulty of opposing proposals to reduce emissions of carbon dioxide in circumstances where political parties around the world have succumbed to the scare, in my view it is totally irresponsible for an Opposition to accept the danger thesis. A policy based on adaptation by the private sector is the appropriate response to alarmist analyses proposing mitigatory action by governments. In addition, the fundamental faults in the science used to justify such action by governments should be exposed, not least the absence of any causal connection between movements in temperature and carbon dioxide concentrations; the absence of substantive evidence of threats from rising sea levels or meltings of sea ice in the Arctic or Antarctic; and the absence of substantive evidence that droughts occur when temperatures increase.
The Coalition should adopt the advice to Senator Fielding by four expert Australian scientists that an inquiry needs to be held into the science because “proper due diligence … can only be achieved where competent scientific witnesses are cross-examined under oath and under strict rules of evidence”. Would Rudd fight an election over a delay by a Senate seeking a proper inquiry into the “large uncertainties in the science” publicly acknowledged by Professor Garnaut and now much more widely acknowledged than when he wrote that?
Despite what I have said about the seriousness of the threat from an expansion of government, I want finally to suggest that the most serious challenge to our economic and political well-being comes from the external threats to our security that necessitate the use of government machinery and policy.
The most obvious and important threat is not saving the planet from global warming but from dealing with the increasing threat from terrorism, particularly from what former Prime Minister John Howard described at a recent Quadrant function as Islamic fascism. At present this threat to Australia does not emanate directly from an overseas country or even from a group within such a country. The main source comes from the many potential terrorists already in Australia and from an immigration policy that clearly is not geared to prevent more coming. There is also doubt as to whether Australian governments are sufficiently well equipped to forestall the plans of those already here and whether our legal framework allows maximum possible scope for detecting and dealing with potential acts in advance of intended action.
In conclusion, my message is that the Liberal Party needs to recognise the challenges to the role of the individual in society and indeed to the role of independent private enterprise. It needs to develop detailed policies designed to promote that role and, terrorism aside, to challenge the view that Labor is presenting of government as the driver of society and the solver of society’s problems.