Do We Really Want To Be A Financial Services Hub?


The mining giants have been hogging the current affairs spotlight recently but as Evan Jones argues in today, financial services have staked out a position of growing significance in the Australian economy.

This is what Gerard Epstein was referring to when he coined the term financialisation: "the increasing importance of financial markets, financial motives and financial actors in the operations of the economy".

In a 2007 working paper (pdf) for the Levy Institute, US economist Thomas Palley examined financialisation and its impacts on the US economy. According to Palley, there are three discernible elements to the principal impacts of financialisation. Firstly, financialisation "elevates the significance of the financial sector relative to the real sector". Secondly, it acts to "transfer income from the real sector to the financial sector". Thirdly, it increases income inequality "and contributes to wage stagnation".

In a chillingly prescient observation, Palley added — in 2007, remember — that "there are reasons to believe that financialisation may put the economy at risk of debt deflation and prolonged recession."

Sounds like financialisation is a bad thing, right?

Not according to the Rudd Government. According to Chris Bowen, the Minister for Financial Services and Superannuation, the Rudd Government wants Australia to become a "financial services hub". Bowen was speaking at a media conference in January, on the release of the Johnson Report, yet another of the Rudd Government’s grand inquiries, this time titled "Australia As A Financial Centre — Building On Our Strengths".

"The Rudd Government has already taken a range of actions in line with its policy of promoting Australia as a financial services centre," Bowen said at the time. He announced that from 1 July, "the withholding tax rate on certain distributions of income to non-residents by Australian managed funds will be cut … to 7.5 per cent — one of the lowest rates in the world".

For anyone familiar with the proliferation of opaque financial innovations that eventually proved so damaging to the US economy, there’s an element of déjà vu reading the Johnson Report . Australia has a strong and stable system for financial regulations, it says. But if we want Sydney — and it is Sydney we are talking about, not Melbourne and certainly not Perth, Brisbane or Adelaide — to grow into a global financial centre, then we will need to roll back our financial regulations, welcome more footloose investor capital across Australian trading desks, and encourage Australian banks and financial institutions to go on expansion binges overseas.

Indeed, reading the Johnson Report is an exercise in alternative realities that left this correspondent amazed. It’s as though the Global Financial Crisis never happened. The recommendations are a laundry list of the worst policies adopted by US regulators in the 1990s and 2000s. My favourite occurs on page 42, in which the report argues that Australia needs more residential mortgage backed securities — yes, that’s right, more sub-prime mortgages — and that the industry’s "self-regulation proposals" should be welcomed. It’s as if you watched your neighbour’s house burn down, and decided the lesson you would take from it would be to sell your fire extinguishers and stop paying for insurance.

It would all be a little hard to believe — unless you work in the finance industry, which is exactly where Mark Johnson, a former deputy chairman of the Macquarie Group, and his panel of experts hail from. The entire report is a hard sell for the benefits of a bigger financial sector.

The Johnson Report knows where it stands on this score: "economic research demonstrates a well-established causal link from financial sector development to economic growth", as it states in its executive summary. This statement is not only highly partial, it is arguably untrue — as a glance at the shattered economies of the countries with the most highly developed financial sectors, the US and the UK, immediately shows.

The Johnson Report’s contention that there is a causal link between finance sector development and economic growth is based on the work of economist Ross Levine. Levine’s work on the links between financial innovation and economic growth is theoretically sophisticated and highly respected within the profession — although he does also have his scholarly critics. And there is no doubt that economic growth requires some level of well-functioning financial services — as any small businessperson struggling to get a loan to expand her enterprise could tell you.

But the growth of the finance, insurance and real estate industries in the United States occurred so rapidly after 1973 that they soon threatened to overwhelm the rest of the economy. As Simon Johnson observed in his trenchant 2009 article on the US roots of the global financial crisis:

"From 1973 to 1985, the financial sector never earned more than 16 per cent of domestic corporate profits. In 1986, that figure reached 19 per cent. In the 1990s, it oscillated between 21 per cent and 30 per cent, higher than it had ever been in the postwar period. This decade, it reached 41 per cent. Pay rose just as dramatically. From 1948 to 1982, average compensation in the financial sector ranged between 99 per cent and 108 per cent of the average for all domestic private industries. From 1983, it shot upward, reaching 181 per cent in 2007."

All of this would have been fine if the Wall Street merchant bankers had been selling widgets. But they weren’t: they were racking up trillions of dollars of debt in complex financial instruments they didn’t fully understand. And if confidence in those instruments evaporated, the entire global financial system would be placed in jeopardy — which is exactly what occurred in September 2008.

In any case, even before the GFC, the growing financialisation of the US economy since the late 1970s does not appear to have been accompanied by increased growth. Quite the contrary: US GDP grew more slowly in the 1990s and 2000s than it did in the 1950s and 1960s. US average wages did not grow at all in real terms in the 2000s, while poverty grew and inequality soared.

Perhaps the most important diagnosis and critique of the US financial meltdown is by one of its most celebrated figures: former Federal Reserve Chairman, Alan Greenspan. In gripping testimony to US Congress in 2008, Greenspan blamed the disaster that befell global markets after the collapse of Lehman Brothers on, among other things … financialisation.

Greenspan didn’t use that term in his remarks to Congress. What he did say was that markets had catastrophically underpriced risk, particularly in assets backed by subprime mortgages. Greenspan blamed the disaster on faulty risk-management models. But those models would never have existed if sub-prime mortgages had not been "securitised" — in other words, packaged up as collateral and onsold as corporate bonds.

Securitisation was in fact a financial innovation of the kind that Ross Levine thinks is good for the economy. But when those complex financial innovations proved too opaque for ratings agencies or investors to adequately understand, trillions of dollars of mortgage-backed securities and collateralised debt obligations suddenly became worthless. In Greenspan’s memorable words, "the whole intellectual edifice" came tumbling down.

But you don’t hear much about the potential risks or downsides of financial innovation in the Johnson Report. It’s all upside. The word "risk" is almost always followed by the word "management", and the word "inequality" doesn’t appear at all. That’s right — the Johnson Report doesn’t even consider income inequality, widely regarded as one of the main consequences of increasing financialisation in a rich economy.

Another part of the Johnson Report deals with what it sees as one of Australia’s greatest assets as a financial centre: our high standards of education mean "Australia’s skilled workforce is one of its greatest strengths". This section also shows just how blinkered its perspective is.

Australian universities produce some very talented graduates in fields such as accounting, finance and law. And it’s not hard to see why ambitious young people gravitate to the highly paid graduate positions at merchant banks, management consultancies and big accounting firms. But few have stopped to ask whether making finance the ultimate destination for the greater part of our nation’s most talented young people is the best thing for Australia. Like much of the Johnson Report’s recommendations, this idea rests explicitly on the assumption that what is good for the finance sector will be good for the rest of the country.

But Australia faces many serious challenges, all of which require access to our gifted and talented people. Sure, the efficient provision of capital is one important challenge. But where does it rank compared to the problems of climate change and renewable energy? Or alleviating poverty and disadvantage in Indigenous communities? Or growing enough food for a hungry planet? Highly talented young people are constantly being lured away from a future discovering ground-breaking science or fighting poverty and injustice by the big dollars available in the finance sector.

And who can blame them? Australian of the Year Patrick McGorry certainly earns a good wage as a psychiatrist and Professor of Youth Mental Health at the University of Melbourne. A professor in an Australian university makes about $140,000 a year. But compare that to the salary package of Macquarie CEO Nicholas Moore, who took home $5.2 million in cold hard cash this year, plus another $4.6 million in share options, for a total package of $9.5 million.

Moore or McGorry — who do you think has made the greater contribution to Australian society? The answer is self-evident.

As for the Johnson Report, we now know what the Rudd Government thinks: just yesterday, Chris Bowen was at ING, spruiking his response to the Johnson Report’s recommendations. As Bowen told the assembled funds managers, "Our response provides in-principle or direct support for nearly all of the 19 recommendations in the report."

Ben Eltham

Ben Eltham is New Matilda's National Affairs Correspondent.