Mutually Assured Independence
By Mike SeccombeApril 23, 2012
There’s high interest in lower rates for Australian loans, and public pressure is on the Reserve Bank. Just don’t call it political pressure; the bank operates independently … doesn’t it?
In December 1974 the Governor of the Reserve Bank of Australia, Sir John Phillips, wrote an exceptionally strong letter to the new Labor Treasurer, Jim Cairns, warning of impending economic disaster.
The bank, he said, was "concerned and apprehensive" about the economic situation. Rapid inflation and high unemployment posed "grave threats", not just to the economy, but to the society.
"Achieving and maintaining full employment will be impossible if inflation is not reduced," the letter said.
And to achieve that, the government simply had to rein in its free-spending ways.
The warning had no impact. Phillips wrote again in December, even more strongly, but to no greater effect.
On July 10, 1975, just after Cairns was replaced as Treasurer by Bill Hayden, Phillips wrote yet again, warning that entrenched inflation threatened to "destroy" Labor's wages policy and undermine capital markets, with "disastrous" effect.
Hayden finally got the message, too late. Labor was replaced by the Fraser Government, which came in promising to "fight inflation first".
Alas, it proved in the end to be no better. It too eventually put short-term politics ahead of the advice coming from the central bank, and fell from power, having made a comprehensive mess of the economy.
Indeed, says Selwyn Cornish, economist, official historian of the Reserve Bank and adjunct associate professor at the Australian National University, the Fraser Government was "one of the worst when it came to telling the Reserve Bank to get lost".
The reason for all this ancient history is not to re-litigate the economic records of the Gough Whitlam/Jim Cairns period or the Malcolm Fraser/John Howard period. It is to make one simple point.
"Basically in the 70s and 80s all the bank could do was write some severe letters to the Treasurer or the Prime Minister, saying, 'If you continue down the track you're on, you're facing disaster,'" says Cornish.
"And the politicians didn't take that very seriously."
Some Treasurers did — Cornish nominates Hayden and later Paul Keating — but most were "absolutely hopeless".
At the heart of the problem was that the Reserve Bank of Australia, which was separated from the Commonwealth Bank in 1959 specifically to carry out central banking functions (while the Commonwealth continued to fulfill its commercial and savings bank functions), lacked independence. The legislation which established the RBA, says Cornish, said the bank "would recommend changes to interest rates, but those changes would have to be approved by the Treasurer of the day."
And that is still the case.
It may surprise those who have become used to hearing, over the past couple of decades, about Australia's "independent" reserve bank that its independence is really little more than a matter of convention and political expediency.
A cynic might observe that politicians, after the disasters of the 70s and 80s, came to realize it was best not to be at the scene when hard and often unpopular decisions had to be taken, like rises in interest rates. Better to be able to point to the econocrats and say "It was them wot done it. Independently."
We'll get back to the evolution of the RBA's independence shortly, but first, we need to explore the reasons why that independence has lately become a matter of some quite heated debate. This will involve a few numbers, but bear with us.
Like just about everything in economics in Australia over recent years, the contentious issues relate essentially to two things: the parlous international economy and the mining boom.
Phase one of that boom, in the early part of the 2000s, saw the economy going so strongly that the RBA felt the need to slow it by raising rates. As is the bank's preference, it moved gradually and deliberately, one quarter per cent at a time. Between mid 2002 and early 2008, there were 12 such successive rises.
Then came the global financial crisis, and the bank reversed its policy dramatically. It lopped three whole per cent off rates in the last four months of 2008 and another 1.25 in early 09. That's huge.
At the same time, on Treasury advice, the government pumped money into the economy, to try to avoid falling into recession, like almost everyone else.
This combined action worked a charm. Australia's response to the Global Financial Crisis was arguably the most successful undertaken by any developed country.
But it also left the government with a big budget deficit. Now, for reasons we have explored before, the government is determined to get the Budget back into surplus this year.
The other thing which helped save Australia, of course, was the fact that our major trading partners in Asia also came through the GFC in good shape; so we continued to export vast quantities of resources to them. The concerns about potential inflation returned. And so, once the immediate crisis was past, the Reserve started moving rates up again — 1.75 per cent between October 2009 and November 2010.
With official interest rates in much of the world around zero, this made Australia very attractive for money. Combined with the boom, our dollar zoomed in value.
Net effect: an economy in which some sectors are doing very well, such as mining and finance, and other sectors that are not doing well at all, including manufacturing and tourism and retail.
This presents a dilemma, and has led to a lot of people second-guessing both the government's determination to slash spending and bring in a surplus budget, and the RBA's interest rate setting.
The bank has most recently trimmed rates again — just a little (0.5 per cent). But some people, mostly those in the slow lane of the economy, would like to see more. In March, for example, retail mogul and former Reserve Bank board member, Solomon Lew, declared the bank should immediately (i.e., at its April meeting) cut them another half to three-quarters of one per cent.
"I'd be calling on the Reserve Bank to cut interest rates by 50 to 75 basis points at the next meeting. I think the Australian economy's in trouble," he said.
The bank ignored him.
More recently, on April 11, Paul Howes, head of one of the large manufacturing unions, the Australian Workers' Union, and vice president of the ACTU, went further and questioned the RBA's entire modus operandi, saying the government should urgently review its charter.
Howes claimed the bank had "consistently got it wrong" on interest rates this year. He suggested that the bank was too focused on inflation and that was threatening the manufacturing sector, in particular risking the future of the Australian steel industry.
Six days later, Garry Weaven, a former senior ACTU official who now, as head of Industry Funds Management, oversees the retirement savings of some five million superannuation fund members, repeated the dose on ABC radio's AM program.
He said inflation was under control, so there was room to lower rates, which would boost employment and drive down the value of the dollar.
"…I know it's very hard to get the balance right, but I think consistently for many years now the Reserve has had far too much focus on inflation only and not enough on full employment and economic prosperity generally, which is their requirement under the act," he said.
Unlike Howes, who criticized the bank's rates decisions this year, Weaven suggested the bank had been getting it wrong for the better part of a decade.
"I think there were a whole series of rate rises before the GFC which were somewhat inappropriate and which set the whole framework then at a higher interest rate level than it ought to have been. You know, so I think that the whole interest rate environment in Australia has been too high for too long. And now it's dangerously high…"
Weaven talked carefully around the subject of Reserve Bank independence, suggesting "at the end of the day no-one is truly independent", and saying there should be greater "dialogue" between the government and the bank about policy setting.
The Treasurer was having none of that sort of talk. Asked about it the next day, Wayne Swan said the bank's charter was "more than adequate" as it was.
"I don't agree with Mr Weaven. What I do is I support the Reserve Bank implementing its current charter. It takes its decisions independently of the Government and that is as it should be."
Which brings us back to this mythic thing, independence. And to Selwyn Cornish.
Independence, in the sense of the RBA having discretion to set the cash rate without getting the approval of the Treasurer, only goes back as far as the latter part of the Keating period, he says.
"And more formally it is even more recent; it goes back to 1996 when Peter Costello became Treasurer and signed a joint letter with the governor-designate Ian Macfarlane … [which] gave the bank responsibility for setting the cash rate according to the agreed inflation target, which was 2 to 3 per cent over the medium term.
"That letter has been re-signed every time there is a new governor, or an existing governor has got a new term, that letter has been signed again. And when there has been a new Treasurer, the letter has been signed again."
But, says Cornish, "what we have is only a letter. It's not enshrined in legislation.
"It's possible that with a new Treasurer or Governor, the terms of that letter could change."
Why would anyone want a change, though, he asks, given the facts of history.
"In the 1970s and to a lesser extent in the 1980s, the Reserve Bank didn't have a great deal of power [and] we had one of the worst 20 years [periods] of our economic existence ever. In the period from the early 70s to the early 90s, we had five recessions. Five.
"Move to the next 20 years, and it's been one of the most remarkable periods in Australia's economic history — 20 years without a technical recession. That is unprecedented.
"In the last 10 years we've had full employment, roughly five per cent. We've had stable growth, consistent growth," he says.
That record is not due solely to the bank, of course, "but giving the bank a definite economic objective — namely to keep inflation down — and giving it independence to adjust its main instrument, which is the interest rate … has been critically important."
Cornish reflects the views of others in the central bank community, who were bemused by Weaven's entry into the debate.
"I couldn't believe it. He specifically mentioned Costello and Macfarlane and said they made a mistake and it should be revisited," he says.
"I had to laugh when he said full employment was in the charter of the bank," he says. "We've got full employment. What more does he want?"
As for the suggestion that there should be greater "dialogue" between the government and the bank, Cornish says there is already a great deal of it, formal and informal.
"After every board meeting the governor briefs the Treasurer on what happened and why a decision was made. The Reserve Bank Act says quite clearly that these communications must take place."
And he has no doubt there has been a lot more going on informally, given the current economic circumstances.
Cornish refuses to speculate what the outcome might be, in terms of budget or interest rate outcomes.
But another Reserve Bank insider offered this to The Global Mail:
"You get the dollar down by a tight-fiscal/loose-monetary policy package. That's exactly what we and Canberra are delivering," he said.
Translated, that would indicate the government and central bankers are coordinating things quite closely. We'll get a contractionary budget, offset by lower interest rates.
Indeed, Wayne Swan and Prime Minister Julia Gillard have been suggesting as much over recent days. Not that the government and the RBA have a deal, of course, for such a suggestion would undermine the independence myth.
The language is more circumspect than that. Thus, Swan, when asked about his plan for a budget surplus at a media doorstop in Washington on Friday (April 20), said the budget would give the bank "the opportunity to reduce interest rates should they decide to do so." (Our emphasis.)
It seems a pretty safe bet that they will decide to do exactly that.
And what does this say about independence?
It suggests the modern Reserve Bank is independent of government in the same way one member of a choir is independent of another. They have different parts, but they're working off the same songsheet.