Last week was bank profit bonanza season, during which very senior bankers took their moment in the sun to declare that Australia needed to press forward with a reform agenda aimed at boosting national productivity. Ian Narev of the Commonwealth Bank, Mike Smith of ANZ and Brian Hartzer of Westpac all, in their own way, declared that as a nation we should get out of the way of markets and let creative destruction shift capital to its most productive uses.
It is an admirable sentiment that makes perfect sense in theory. Productivity growth is the key to national prosperity, never more so than in Australia right now as we struggle with failing competitiveness after the mining boom.
But Australia’s senior bankers should perhaps pause for a moment to reflect upon how productivity works. Capital efficiency is a key input into the equation and has been dragging the chain far more than labour for the past decade. Some of that is the result of a capital-intensive mining boom, yet to see its big returns, but another unexamined factor is also strongly at work. The price of land is a key input cost for most businesses. So when costs are inflated, it reduces the competitiveness of industry, making it harder for Australia to compete abroad. The associated higher housing cost also places upward pressure on wages.
For decades, the resource allocation governed by the banks has been channeled away from the tradable sector and infrastructure investment towards the financial sector, as home buyers have taken on ever-bigger mortgages and chased house prices higher. It should be no surprise that the finance and insurance industries — which are dominated by mortgage lending — have grown at more than twice the pace of the rest of the economy since financial markets were deregulated in the mid-1980s, due in part to the housing quango operated by the various levels of government (see below charts) …
Australia’s housing obsession has also starved productive sectors of the economy of credit. In the early 1990s, Australia’s banks lent nearly two-thirds to businesses, with the balance split between housing and personal lending. However, after the mid-1990s explosion of housing values, these ratios have reversed, with housing lending dominating at the expense of businesses …
To add insult to injury, much of the boom in mortgage lending has been funded by heavy offshore borrowing by Australia’s banks, in turn driving up Australia’s net foreign debt.
At the heart of the problem are Australia’s unique mix of tax concessions, such as negative gearing, a constipated supply system, and major banks that use internal risk models that make mortgage lending their most profitable business. The end result is too much of the nation’s capital is tied-up in housing, which has choked-off productive areas of the economy.
“The ABS explains that they take the balance sheet value of land from the national accounts to include as the land component of capital stock. We can observe in the chart below the rise in the value of the land balance sheet value against the estimate of MFP, and indeed against an estimate of the land balance if land values simply tracked inflation. Quite clearly, from about 2002 onwards the abnormal increase in the value of land lead to a flattening and falling estimate of MFP. More telling is that fall in all land asset values in 2009 lead immediately to an increase in the MFP measure, only for the next wave of land price escalation, especially FHOB stimulated residential land, to cause a deterioration in MFP during 2011.
“We can dig a little deeper into the ‘land balance sheet’ in the system of national accounts and look closely at the type of increases in land value estimated. The chart below shows in blue the neutral holding gains — that is, the change in the value of land expected if prices tracked inflation.
“In red we see the real holding gains, which are market-based increases in land values. As the ABS notes: ‘Holding gains and losses accrue to the owners of assets and liabilities purely as a result of holding the assets or liabilities over time, without transforming them in any way.’ In economic terms, they are pure rents.
“When red is greater than blue, we find a significant downward bias in the MFP estimate. It is really that simple. And we are not alone in this. Spain’s land price boom resulted similar pattern of declining MFP during their land price boom in the early 2000s.”
One can only wonder how Australia would have looked if the billions of dollars of excess capital that had been poured into pre-existing housing had instead been funnelled into businesses and infrastructure, as occurs in places like Germany. Instead, Australia has been left with non-mining companies that are struggling to compete and an infrastructure deficit that former Treasury secretary Ken Henry last week claimed was hindering Australia’s ability to provide goods to Asia.
David Murray, head of the new Murray banking inquiry, added his voice last week to the banker’s lament, pledging to examine the “allocative efficiency” of the financial system’s funding of the various components of the economy:
“An issue will be whether there are distortions in the system that favours the funding of some users and/or providers of capital over others.”
Let’s hope Murray, a former high priest of the very system that misallocates Australian capital, has the courage to look deep into the roots of Australia’s failing competitiveness. To fix it will require changing the tax system so that it rewards productive investment, liberalises the myriad constraints on land supply and planning, as well as banking system reform that no longer favours blowing repeated land bubbles.
*Leith van Onselen is an economist who has previously worked at the Australian Treasury, Victorian Treasury and Goldman Sachs