RBA Annual Conference – 1991 What the Campbell Committee Expected Tom Valentine^[1]

1. Introduction

The purpose of this paper is to re-examine the deliberations of the Campbell Committee (the Australian Financial System Inquiry) which took place over the years 1979 to 1981 and the forecasts which the Committee made about the likely outcome of its recommendations. This re-evaluation will benefit from the hindsight provided by almost a decade of deregulation. As always, hindsight is a powerful tool of analysis, but it has some limitations which must be recognised. First, it is particularly vulnerable to the “grass is greener” syndrome. That is, we observe some unpleasant aspects of the outcome of deregulation and assume without adequate analysis that an alternative approach would have given superior results. Secondly, the ultimate outcome of deregulation has not yet emerged and it is quite likely that later evaluations will be based on different data. Also, deregulation was frequently “oversold” in the period following the release of the Committee's Final Report (AFSI (1981)) by its supporters. The discussion in this paper will be restricted to the more sober arguments entertained by the Committee in the course of its deliberations.

The aims of the paper are to:

• consider the criteria used by the Campbell Committee to arrive at its recommendations. This includes a discussion of the arguments rejected by the Committee;
• outline the reasons why the blueprint created by the Committee was so quickly and comprehensively accepted. This section will also examine the question – was deregulation inevitable?;
• examine the questions which may have been neglected by the Campbell Committee and the implications of this neglect.

In the latter case, some of the arguments supposedly ignored by the Committee will be considered in the next section.

Since the objective of this paper is to learn from hindsight, its nature is essentially negative. It is probably useful, therefore, to make it clear that the points raised in the paper do not detract from the magnificent achievement of the Committee. It produced a clear, integrated and well-argued blueprint for deregulation. At the time the Committee was criticised for its political naivety, but in the end its refusal to “compromise the document” (in Sir Keith Campbell's words) by recommending “politically acceptable” reforms carried the day. In the context of the present discussion, it is important to remember how many implications of deregulation the Committee did consider before we become too absorbed in the few that it missed.

2. The Basis of the Committee's Recommendations

The Campbell Committee based its recommendations on the general principle that the best results for the community will be achieved if the financial sector is subject to as little government interference as possible. This view arose out of a general predilection for free market outcomes, but it was supported by a great deal of economic analysis.

In general, the Committee did not attempt to forecast the outcomes which would arise from the free market it regarded as desirable. One of the advantages claimed for a free market is that it allows the system to develop in ways which are in line with the desires of users (including business borrowers) and most of these developments are basically unpredictable. That is, the Committee created a blueprint for the deregulation which was to create a competitive financial system, not a detailed plan for the future development of the financial system.

Nevertheless, the Committee did make some general forecasts of the impact of deregulation. These predictions were qualitative and they did not have a time dimension. In particular, the Committee argued that deregulation would increase the efficiency of the financial system in a number of areas (see Valentine (1982) for an outline). Efficiency was divided into three categories. The first was allocative efficiency. The Committee believed that deregulation would remove barriers to the flow of savings into the highest yielding investments and thereby increase the productiveness of the economy.

The second was operational efficiency. The Committee expected that in a deregulated environment financial intermediaries would become efficient in the sense that they would use up the minimum amount of resources in providing their intermediation services. The most important area in which this view was relevant was the very wide interest rate margins maintained by the Australian banks (see Revell (1980)) ^[2] which arose from:

• the ceilings on interest rates which prevented interest rate competition by the banks;
• the replacement of such price competition by non-price competition through the expansion of branch networks and the subsidisation of transactions on bank accounts (somewhat misleadingly described as the payment of “implicit interest”) producing high costs which had to be covered by wider interest rate margins; and
• a prohibition on the creation of new banking organisations which made it impossible for competition to control the level of bank profitability.

The Committee did not undertake a detailed analysis of the determinants of bank margins and how they were likely to evolve over time, largely because the required data were not available at the time.

The third form of efficiency which the Committee saw as being improved by deregulation was dynamic efficiency which is the capacity of the system to generate financial innovations to meet the needs of consumers of financial services. This is obviously an area in which attempting to forecast the outcome of deregulation would be very difficult.

A form of efficiency which received relatively little attention from the Committee was informational efficiency (i.e. the extent to which current market prices reflect available information; see Strong and Walker (1987)). Some implications of this form of efficiency will be considered in the following section.

In spite of its belief in the general desirability of a financial system largely free from government intervention, the Committee was well aware that there were cases in which this argument could fall down. Its Final Report considers some of these cases, but they played an even greater role in the Committee's deliberations. It wanted to ensure that all possible alternative arguments were adequately canvassed; the Secretary of the Inquiry – F. Argy – was particularly thorough in this area.

One proposition which attracted continuing attention was that the financial sector could be used to achieve various desirable social goals. For example, low interest rate finance could be provided to homebuyers, farmers and small business. The Committee did not comment on the merits of these goals, but restricted itself to an examination of the most efficient way to achieve them. Considerable discussion led the Committee to the conclusion that directing support through the financial system was not an efficient way to deliver it and that instead it should be transferred via a direct budget allocation. This approach would ensure that the support was received only by the target group and maintain the transparency of the process.

The Committee was also aware of the second-best argument which suggested that establishing competitive conditions in one sector of an economy subject to many other deviations from full optimality in its other sectors would not necessarily lead to an improvement. This argument actually counteracted some of the intellectual underpinnings of the Committee's general position in that it raised doubts about whether the move to a free market in one sector of the economy was clearly beneficial. In addition the Committee could not find strong evidence that large efficiency gains would be made. The only attempt to quantify these benefits occurred in a debate between Withers (1982) and Swan and Harper (1982). The correct estimates appear to be those made by Swan and Harper, who put the benefits at about $145 million per year. Both Withers and Swan and Harper emphasise that there are benefits from deregulation not captured in their calculations, but the Committee was certainly unwilling to have its case rest on such a comparatively small figure.

The Committee's response was to subject each piece of regulation to a separate cost/benefit analysis and to recommend its removal only if costs exceeded benefits. For reasons touched on in the following section, the Committee concluded that in most cases the costs outweighed the benefits and recommended that the regulation in question be removed.

The Committee believed that the authorities had a responsibility to maintain the stability and integrity of the financial system which involved maintaining confidence in the banking industry and, especially, the payments mechanism. The Committee also recognised that the Government was concerned to protect the funds of small savers. It maintained, however, that there was good reason to retain a risk/return spectrum so that investors had the possibility of investing in a riskier asset paying a higher return. The Committee believed that if the authorities attempted to restrict the range of risk/return combinations available to investors by prudential regulation, there would be a growth of institutions outside the regulatory network to meet this need. Recent events suggest that the Committee may have overestimated investors' demand for riskier and higher yielding assets or, alternatively, that it overestimated investors' ability to understand the risk/return pay-off.^[3]

The Committee did outline a system of prudential control aimed at maintaining stability. This system had the following characteristics:

• competitive neutrality, which means that similar types of financial transactions were to be treated equally so that financial institutions with the same mix of business are subject to the same regulatory burdens;
• the prudential controls recommended by the Committee relied heavily on a variable capital ratio the size of which was to be dependent on the risk involved in their assets and liabilities; and
• the Committee also recommended the retention of required liquidity ratios.

This framework was criticised in detail in Hogan (1982). It is yet to be seen whether the Committee's framework dealt adequately with the impact of the volatility of interest rates and exchange rates on the stability of the financial system. Certainly, the Committee underestimated the extent to which this volatility would increase over the 1980s, a point discussed below. In addition, the Committee did not consider the “unintended consequences” of the capital adequacy requirement it recommended. Some of these unintended consequences have surfaced in response to the introduction of the BIS Capital Adequacy Requirements (Valentine (1989)).

It is also clear that the Committee failed to come to terms with some of the problems which arise in attempting to achieve competitive neutrality. First, the fact that many financial institutions are under State control makes it unlikely that they will be subject to the same controls as those under the supervision of the Reserve Bank. Secondly, the Committee could produce no solution to the departure from competitive neutrality created by the advantages possessed by banks – an implicit government guarantee and control of the payments system.

3. The Reasons for Deregulation

The purpose of this section is to consider two questions. First, why did the deregulation of the Australian financial system occur so quickly and with so little opposition? Secondly, was deregulation inevitable or were there better responses to the problems identified by the Campbell Committee? These two questions are inter-related and it is necessary to discuss them in tandem.

It is clear that there were alternative proposals to the one adopted by the Committee. As Pauly (1987) discusses in some detail, the banks took some time to settle amongst themselves whether they should argue for deregulation or for the extension of regulations to non-bank financial institutions (NBFIs). The latter view was also supported on the grounds that it would strengthen the effect of monetary policy if the authorities could control the lending of NBFIs and prevent the transfer of business to them when bank lending was being restricted. Not surprisingly, the banks were particularly anxious about the possibility of the entry of foreign banks to the Australian banking industry.

In the end, the banks presented a united front in favour of deregulation to the Committee. This left very little support for the approach of extending regulation in the evidence presented to it – obviously NBFIs tended to oppose such a view.

A view which received greater attention in the Committee's deliberations than in its Report was that deregulation should occur in stages in order to ease the adjustment which it would necessitate. This type of gradual deregulation had obvious political attractions, but there were a number of reasons for rejecting it. First, a staged deregulation might actually add to the costs of adjustment. After each stage, the system would adjust to the new configuration of controls, but most of this adjustment would need to be undone when the next stage was reached. As the paper by Grenville in this volume shows, deregulation did not in fact come all at once. The distortions which this staged deregulation caused are touched on below.

Secondly, the partial deregulation which would occur at each stage would create additional distortions and stresses in the system. For example, if ceilings on bank interest rates were removed but the restriction on the entry to banking retained, bank profits could easily become excessive. An example of the dangers of partial deregulation is provided by the retention of the controlled mortgage rate for existing loans which contributed to an increase in bank interest rate margins. A more striking example is provided by the case of the US Savings and Loans. A major source of their problems was the deregulation of their deposit rates while retaining the control on their lending rates.

As Pauly (1987) and Harper (1986) document, there was little effective opposition to an almost complete adoption of the Campbell blueprint once it had been endorsed by the Martin review (Review Group (1983)) and adopted by the Hawke-Keating Government. This made financial deregulation a bi-partisan policy (the Campbell Inquiry having been set up by the Fraser Government, which also took some tentative steps in the direction of deregulation). It may have become more attractive to the Labor side of politics after the mergers of the Australian banks in 1981. Competition, especially the entry of new banks, was seen as necessary to control their profit levels. The banks themselves were prepared to see the entry of foreign banks in order to obtain reciprocal privileges in other countries.

It is probably true, as Harper (1986) says, that the opposition of bank unions to deregulation was lukewarm because they expected that their members would benefit in a deregulated environment. If this was the case, however, they made a bad judgment. As argued below, bank employees probably earned rents in the regulated environment and these were likely to be removed by deregulation. The employees likely to benefit from deregulation were those with a high degree of sophistication and these people represented a small proportion of bank employees.

It is also possible that there was a widespread recognition that deregulation was inevitable. If this view is accepted, it would suggest that the Committee's role in the process may have been overestimated. It certainly provided a consistent blueprint for deregulation and speeded the process up, but it probably would have occurred even without the Committee's input.

There are two groups of arguments which support the view that deregulation was inevitable. These are:

• the existing system of regulation was breaking down and creating increasingly larger distortions; and
• further development of the Australian financial system could only occur in the context of a deregulated market.

(a) The Breakdown of Regulation

The system of regulation was breaking down because it created pressures within itself and because it was subject to a number of external stresses. The internal pressures arose because regulations created perverse outcomes and because attempts at avoidance led to increasing problems. Avoidance took a number of forms. For example, banks avoided controls on their lending by moving some of their business off-balance sheet (for example, by using bill endorsements) or by directing customers to their non-bank subsidiaries. The growth of such subsidiaries created prudential problems. In spite of these adjustments, the banks lost ground to NBFIs. This development created many problems:

• the fragmentation of financial intermediation probably increased its cost (particularly if there are economies of scale or scope in the provision of financial services);
• it also led to prudential problems, with an increasing proportion of financial transactions moving outside the direct control of the Reserve Bank; and
• it possibly reduced the Reserve Bank's control of monetary growth.

Some other important problems with the system of regulation were:

• the wide interest rate margins and high level of profitability in banking (mentioned above);
• the perverse outcomes of some controls. For example, interest rate ceilings favoured borrowers at the expense of savers and the first group were not necessarily less well off than the second. More importantly, many lower income earners were “rationed out” and received no benefit from concessional borrowing rates;
• lenders had become credit rationers and very conservative lenders, relying on security rather than cash flow in evaluating applicants.

The regulatory system also came under pressure from outside sources in the 1970s. Harper (1986) discusses these pressures. Two of the most important were:

• the high and variable rate of inflation; and
• the increasing integration of the Australian and global financial and economic systems.

The second development created a dependence of Australian interest rates on overseas interest rates which can be illustrated with the “uncovered interest rate parity” equation

where RA is the Australian interest rate, RO is the overseas interest rate and DE is the anticipated depreciation of the Australian dollar. If effective exchange controls are in place, this equation may not be established. The increasing integration of the Australian financial sector with overseas markets meant that it tended to be satisfied more and more closely.

When the authorities are fixing the exchange rate, equation (1) determines domestic interest rates. In the 1970s they were subject to upward pressure because of two related factors. First, the authorities tended to over-value the Australian dollar so that the term DE was positive. Secondly, the high rate of inflation in Australia relative to that of our major trading partners tended to increase DE.

The interest rate parity relationship in turn put pressure on interest rate ceilings. For example, if the process described in the previous paragraph pushed market interest rates up and the authorities attempted to maintain the ceilings on bank interest rates, the shift to non-bank financial institutions would be accelerated. To the extent that the controls were successful in keeping interest rates down, there would be greater pressure on the fixed exchange rate.

The growth in international financial markets is illustrated by the growth of the Eurocurrency market. Using figures given by Morgan Guaranty (Dennis (1984), p. 79), total liabilities in the Eurocurrency market were US$15 billion in 1971 but had grown to US$1,800 billion by 1981. In addition, considerable deregulation had occurred in overseas markets and as Perkins (1989) points out, this represented an incentive for Australians to move financial transactions offshore which created pressure for deregulation within Australia.

There had been some deregulation in Australia before the setting up of the Campbell Committee and this created pressure for further deregulation. One area in which this occurred was the partial deregulation of interest rates (for example, on government securities, consumer loans and on bank interest rates via the introduction of negotiable certificates of deposit) which made the areas in which rates were still controlled relatively less attractive. The removal of some exchange controls (combined with the probable decline in the effectiveness of the system as a whole) increased the integration of the Australian financial system with global financial markets with the effects just discussed (see Grenville's paper in this volume).

(b) The Maturing of Financial Markets

The second argument which suggests that deregulation was inevitable is that it was necessary to allow further development of Australian financial markets. In order to discuss this argument, we must consider the factors which contribute to the maturity of financial markets (see Wilson (1966), Chapter 9).

The characteristics which define maturity are as follows:

1. Liquid financial markets in which buyers and sellers can carry out their desired transactions without disruptive and large changes in price and at a low cost. The latter requires a narrow margin between buy/sell quotes in the market.
2. A range of financial instruments which gives market participants an opportunity to find configurations of assets and liabilities which suit their needs (including their attitude to risk). This includes a range of hedging instruments which allows users to reduce the risks they run.
3. Informationally efficient markets in which prices reflect all the available information. In this case prices will properly reflect underlying values, i.e. they will give market participants the correct signals.
4. A low volatility of financial variables such as interest rates and exchange rates. Low volatility gives market participants greater certainty about the rates at which future transactions will be carried out.
5. A high degree of integration of financial markets (defined in terms of the absence of arbitrage opportunities) which ensures that savings are allocated to the most productive investment opportunities.

When these conditions are satisfied, financial markets will be better able to carry out their functions. Allocative efficiency will be achieved because markets provide savers and borrowers with the correct signals. Borrowers will be able to issue securities into the appropriate market and investors can purchase them with the assurance that they can be resold when necessary. The availability of a wide range of financial instruments (including a full coverage of the maturity spectrum) would allow investors to reduce risk by diversification or by matching maturities. Risk can also be reduced through the use of instruments designed for this purpose. Monetary policy is likely to be more effective in mature markets because monetary impulses are more evenly spread over the economy and create less disruption.

Mature markets do not appear overnight. They develop over decades and in many cases Governments take action to encourage this process. An illustration is the short-term money market. The development of a short-term money market is a crucial element in the maturing of financial markets. It provides liquidity and enables investors to obtain reasonable interest returns on cash holdings. It is also necessary for the development of a forward foreign exchange market because dealers in such a market can only cover their exposures effectively when such a market exists.

In the Australian case, the authorities encouraged the growth of the short-term money market by setting up authorised dealers who enjoyed a privileged relationship with the Reserve Bank in return for holding Government securities. However, this process followed the development of an unofficial short-term money market. The authorised dealers undoubtedly contributed to the further growth of the short-term money market, but over time it became evident that they were doing little for the liquidity of the market for Government securities. The authorised dealers held securities but were not true market-makers (i.e. dealers who quote a buy/sell price for the asset in question). In the case of the forward market, Government action once again followed the actions of the private sector in setting up a hedge market.

The growth of the bill market also contributed to the development of the money market. This growth is traced by Peters (1987). He attributes it to an increasing demand for funding produced by economic growth, restrictions on the extent to which banks could meet this demand because of regulation and the growth of merchant banks anxious to find ways of accommodating their customers. Merchant banks frequently had overseas parents and this meant that a large part of capital inflow was channelled into the bill market. Peters (1987) also argues that the growth of the market received a boost in 1973/74 when the Reserve Bank used purchases of bills to add to the liquidity of the financial system. As already noted, the growth of the bill market derived from regulation to a large extent and to this extent it was probably excessive.

The examples illustrate two points. First, the private sector will generate changes which tend to increase the maturity of financial markets. Secondly, although governments can encourage these developments, their controls can also restrict growth or direct it into channels which differ from those which would be used if development had followed its natural path.

This suggests that the full maturing of the financial system required the removal of regulations. This applied particularly to controls which restricted the trading of securities and reduced the influence of market forces on interest rates. Failure to deregulate would have resulted in greater pressures and distortions and the continuing emergence of “black” or “grey” markets where they were needed to complete the maturing of financial markets.

The implementation of the Campbell program does appear to have allowed the further maturing of Australian financial markets. A number of signs of this development can be mentioned here:

• bank interest rates and returns on government securities have become more sensitive to market forces;
• financial markets are highly integrated and, as a result, the shape of the yield curve is more dependent on interest rate expectations;
• conditions in the cash and money markets have been stabilised, particularly by the floating of the Australian dollar and the measures which dissolved the seasonal fluctuation in liquidity (which was the dominant feature of the Australian money market in the 1970s and early 1980s); and
• an increase in the availability of financial instruments, particularly hedging instruments, which allow greater diversification and which have increased the liquidity of financial markets.

4. Questions and Arguments Ignored by the Committee

It is often suggested that the Campbell Committee ignored a number of important factors in formulating its recommendations and it is the objective of this section to consider some of these suggestions. They fall into two major categories:

• questions on which the Committee should have made recommendations but did not; and
• problems with its recommendations to which the Committee gave insufficient weight.

The discussion will proceed in this order.

One problem frequently noted with the Committee's interpretation of its Terms of Reference is that it did not consider the very significant interaction of the taxation code and the financial system. While the Committee was sitting, the Treasury argued strongly that its Terms of Reference did not cover the question of taxation at all. The Committee rejected this view to the extent that it undertook a detailed study of the corporate taxation system. The major objective of this analysis was to throw light on the impact of corporate taxation on the supply of equity and the importance attached to this question reflected in part Sir Keith Campbell's deep and continuing interest in the topic.

The taxation system has a number of other impacts on the financial system. As Sieper (1983) pointed out, the Committee's treatment of the interaction between inflation, the taxation system and financial variables was inadequate. In particular, the Committee made no recommendations aimed at correcting the distortions created by the different taxation treatment of interest receipts and payments and capital gains and losses. Nominal interest receipts are taxed in full and nominal interest payments are fully deductible, while at the time the Committee was sitting capital gains were free from tax. This distortion has continued to the present time because the capital gains tax is indexed while no allowance for inflation is made in the case of interest payments. This distortion provides an incentive for speculation in assets and certainly contributed to the speculative bubble in asset prices in the 1980s and the associated expansion of credit.

There are three important implications of this distortion. First, it encourages speculative booms of this type. Secondly, it distorts the pattern of investment, encouraging funds to go into areas which generate capital gains rather than the ones which produce the highest returns (i.e. are the most productive). There are other distortions in the taxation system which lead to distortions of funds flows (see Freebairn (1990)). For example, the favouring of owner-occupied housing has probably encouraged over-investment in this type of asset. It would have been within the Committee's brief to examine this question although it is obviously one which has a large political component.

The third result of the distortion created by the way in which interest income is treated in the tax code is that the incentive for saving is reduced – through much of the 1980s savers faced negative after-tax real interest rates. Once again, discussion of this problem was certainly within the Committee's brief. It is fair to say, however, that the importance of influences on the saving ratio was not obvious in 1980. It was only in the 1980s that the emergence of a high current account deficit and an accumulating external debt focussed attention on the importance of saving. On the other hand, the removal of exchange controls made it easier for the shortfall between domestic saving and the domestic demand for funds to be covered by overseas borrowing. The failure to consider this possibility was a major omission from the Committee's analysis of the implications of its recommendation to remove these controls although the point was not made by commentators at the time.

The favouring of superannuation in the taxation system also has distortionary effects on the patterns of saving and investment. It encourages savers to invest their funds in a particular type of financial institution which represented a deviation from the competitive neutrality which the Committee was anxious to achieve. Secondly, it leads to a distortion of funds flows into investment because superannuation funds do not lend to small and medium-sized businesses.

(a) Expansion of Lending in the 1980s

At this point it might be worthwhile outlining the causes of the rapid growth of lending and the related increase in asset prices which occurred in the second half of the 1980s (see also Macfarlane (1989) and (1990)). These developments are frequently attributed to deregulation and, if this view is accepted, it can be argued that the Campbell Committee should have predicted them and taken them into account as an argument against deregulation.

In the case of the growth in credit, it is clear that it was made possible by an increased willingness of banks to lend which arose in turn from the competitiveness engendered by deregulation, but it was also encouraged by an expansion of the money base by the Reserve Bank (as an offset to the restrictiveness of deregulation, as discussed below) and by an easing of reserve requirements on banks.

These supply side influences cannot, however, be the whole story. Bankers could not compel customers to take funds and there must have been forces on the demand side creating a desire to borrow. The major influence on this side was the asset price inflation which occurred in the second half of the 1980s. Given the distortions in the taxation system described earlier, even a moderate rate of asset price inflation will make borrowing to invest in assets a highly profitable activity.

(b) Asset Price Inflation

It remains to explain the asset price inflation. A number of factors contributed to this development. First, it was to some extent a classic speculative bubble of the type which arises from time to time in asset markets. Once asset prices start increasing, this process is underwritten by the expansion of credit which in turn leads to higher asset prices. The origins of this process, however, lies in the psychology of markets. It is a process which is repeated at least once a generation.

Secondly, the asset price inflation was encouraged by overseas interest in Australian assets. This interest was necessary in order to fund the high current account deficit (external borrowing) and so long as it persists, it will be a force putting upward pressure on Australian asset prices. In the 1980s, this interest was probably encouraged by the sharp depreciation of the Australian dollar over 1985 and 1986 (see below).

Thirdly, the deregulation increased the integration of Australian financial markets with global markets and established parity relationships between local and overseas asset prices (fixed interest securities, shares and possibly even property). Australian asset prices, particularly those of shares, are now very dependent on overseas prices. The implications of this increased integration is best illustrated by considering the case of shares.

In an integrated global market for shares, arbitrage would establish the following parity relationship (Gordon (1985)):

In this case, US shares are taken as representative of the shares of any country which is open to international capital flows. The expected return on shares includes two elements – the anticipated capital gain and the expected dividend yield.

In order to illustrate the arbitrage process, assume that the expected return on Australian shares is greater than the expected return on US shares plus the expected exchange gain. Funds will flow into the Australian stock market from overseas and this flow will establish the parity relationship. The mechanism which produces this result includes the following components:

• the flow of funds into the share market will push Australian share prices up which will dampen expectations of capital gains and reduce the expected dividend yield;
• the inflow of capital will cause an appreciation of the Australian dollar which will produce an increase in the anticipated depreciation of the currency; and
• the outflow of funds from the US share market will cause a fall in US share prices and an increase in the expected return on US shares.

The parity relationship will not be satisfied exactly because of two factors causing deviations from it. First, there will be transactions costs which make it unprofitable to respond to small differences in the anticipated returns. As Kupiec (1991) argues, deregulation and improvements in communications have probably reduced these costs. Secondly, the actual relationship will involve a risk premium because the predicted returns and the anticipated depreciation of the Australian dollar involve uncertainty.

It is difficult to test this relationship because none of the terms entering into it are directly observable. They will be affected by many factors. For example, expectations about the return on Australian shares will be influenced by such domestic forces as changes (or anticipated changes) in interest rates and levels of profitability. In order to test the parity relationship, it would be necessary to model the process generating the expectations involved in it. In this case, any statistical test is a test of the joint hypothesis that the parity relationship holds and that the expectations generating mechanisms adopted are the correct ones.

The theory does, however, indicate some empirical relationships which are likely to arise, namely:

• a positive correlation between Australian and overseas share prices; and
• an inverse relationship between Australian share prices and the exchange rate.

Figure 1 shows the US Dow Jones share price index and the Australian All Ordinaries index since deregulation. It suggests that there has been a strong positive correlation over the period. Table 1 gives the simple correlation coefficient, based on monthly data, for each year of this period.

Table 1 Correlations Between the All Ordinaries and Dow Jones Indices 1984–1990

Year	Correlation
1984	0.78
1985	0.72
1986	0.68
1987	0.96
1988	0.53
1989	0.88
1990	0.45

It is clear that there is a significant positive correlation, but that it varies from year to year. This variation is to be expected because the parity relationship discussed above involves much more than a simple relationship between share prices. The highest correlation occurs in 1987, largely because of the coincidence of the sharp downturns in both markets in that year. This result is in line with the conclusions of earlier studies which found that the correlation of international share returns tended to increase in periods of high volatility (see Kupiec (1991)).

It is interesting to note that Australian share prices rose more sharply than US share prices in 1986. One possible explanation for this rise is the significant depreciation of the Australian dollar which occurred over 1985 and 1986. This depreciation created an anticipated appreciation of the Australian dollar which made Australian shares attractive to overseas buyers. If this view is correct, it suggests that the depreciation of the Australian dollar, beginning in 1985, played an important role in igniting the asset price inflation of the second half of the 1980s.

(c) Volatility and the Costs of Adjustment

In terms of consequences not adequately discussed by the Committee, the related questions of volatility and the costs of adjustment to deregulation are most frequently mentioned. The Committee recognised that deregulation was likely to make financial variables more volatile, but it did not predict the extent to which volatility would increase in the 1980s. For example, in discussing the volatility likely to arise from the floating of the dollar:

“On the whole, the statistical evidence on exchange rate stability is difficult to interpret confidently, but it is not clear that variability is necessarily greater under the more flexible exchange rate regime.” (AFSI (1981, p. 123))
“Another reason why uncertainty may not increase is that market-determined exchange rate movements are not necessarily less predictable than those emanating from the application of discretionary bureaucratic judgments. For this reason, the present administered exchange rate system may generate, on balance, greater uncertainty than would be the case in the exchange rate environment favoured by the Committee.” (AFSI (1981, p. 126))

In the interest rate area, the Committee expected the floating of the dollar and other reforms it recommended to stabilise short-term interest rates and this turned out to be the case. The floating of the dollar also gave the authorities control of domestic monetary conditions and made monetary policy more effective. Recent events have indicated just how effective it has become. Arguments that Australia should go back to a fixed exchange rate regime fail to come to terms with the loss of these benefits which it would involve. The Committee did expect that freeing-up bank interest rates and allowing the return on government securities to be market determined would make longer-term interest rates more volatile, but it did not predict the extent of this increase in volatility. Nor did it predict the high average level of interest rates which would result from reliance on them to achieve monetary policy objectives.

It would be incorrect, however, to assume that the Committee was mistaken in its forecast of the impact of deregulation on financial volatility. Much of the volatility of the 1980s had sources other than financial deregulation. These other causes of volatility included a high and variable rate of inflation, high levels of government borrowing and frequent shocks arising overseas. These factors put pressure on the exchange rate and forced the Reserve Bank to maintain a tight monetary policy for most of the post-deregulation period. Deregulation cannot be blamed for the emergence of economic problems elsewhere in the economy. Indeed, the increased volatility is a sign that the increased flexibility of financial variables is making it easier for the economic system to absorb these pressures.

One area in which the Committee itself was responsible for “overselling” deregulation was that of housing finance. It argued that implementation of its recommendations would not necessarily increase mortgage rates; and increase the stability of the flow of funds into housing lending.

Yates (1987) surveys the evidence on these questions. The arguments in favour of the view that deregulation would not increase mortgage rates are:

• deregulation will attract funds into the major housing lenders (for example, the banks) who can borrow and therefore lend at a lower interest rate because there is a lower risk premium involved (e.g. because of an implicit government guarantee); and
• borrowers will be able to shift out of expensive forms of secondary finance (e.g. second mortgages from finance companies).

These predictions have to some extent been borne out, but the major influence on interest rates since deregulation has been monetary policy which has continued to involve high average interest rates. It also appears that deregulation has to some extent stabilised funds flows from housing lenders.

Deregulation has also produced another outcome expected by the Campbell Committee – innovations in housing finance (such as low-start loans) which have made it easier for borrowers to afford mortgages.

It has also been suggested that the Committee ignored the costs of adjustment involved in deregulation. This is probably a general problem with those advising on economic reform – they tend to compare comparative static equilibria, on the basis of their efficiency or their contributions to social justice, and to ignore the costs involved in moving from one to the other.

In fact, the Committee did give some attention to the costs involved in the process of adjustment and made a judgment that they would be offset by the benefits produced by a free financial market. It did, however, under-estimate adjustment costs in certain respects. First, the slow speed of adjustment has been a surprise to most observers. For example, it is only recently that banks have moved to “unbundle” their charges, i.e. have adopted a “user pays” approach to charging for the services provided through their accounts. One reason for this is the strong media pressure which is exerted against any move towards rational pricing.

It is probably also explained by the failure of the banks to rapidly develop an understanding of their cost structure. Indeed, the Committee probably over-estimated the capacity of private financial organisations to deal with a deregulated financial environment. Another example of this is the strategies adopted by many banks. Many of them pursued the objective of increasing their market share, whereas it would have been more appropriate for them to attempt to develop profitable business even if this meant losing market share.

It has been suggested that the large bad debts which were revealed in 1990/91 also resulted from this lack of knowledge and there must be some truth in this assertion. It appears that the credit evaluation techniques used in the 1980s were quite rudimentary. They did not, for example, take account of interest rate and foreign exchange exposures at a time when these variables had become more volatile. This omission is perhaps more understandable when it is remembered that other observers also failed to see the implications of increased volatility. Many other people, including brokers and the financial media, praised the “entrepreneurs” who created a large proportion of the banks' bad debts at the time when the loans were being made. Also, the replacement of credit rationing with rationing by interest rates meant that access to finance was given to many borrowers subject to greater risk than those who qualified for a bank loan in the earlier environment. The cost of the access was always likely to be an increase in the percentage of bad debts. It is likely, however, that the interest rates charged did not adequately reflect the risk involved in many of the loans.

Nor were bankers the only market participants disadvantaged by a lack of knowledge. Many businesses failed to take advantage of hedging instruments to manage their foreign exchange and interest rate exposures and therefore experienced windfall capital gains and losses. The availability of hedging vehicles was not expanded as rapidly as the Campbell Committee might have supposed, partly because banks (and the Reserve Bank) were concerned about the prudential implications of positions in such instruments as swaps and options. Nevertheless, many instruments (including forward foreign exchange contracts and futures) have been available for some time and they have not been utilised by many businesses.

Hindsight suggests that the Committee should have paid more attention to the problems which would be created by the shortage of trained and experienced personnel in the financial sector. The adjustment to the deregulated environment would have been eased if an extensive educational program had been embarked upon at the time the reforms were initiated.

Another adjustment problem not predicted by the Committee was the confusion which was created in the implementation of monetary policy by deregulation. The changes in structure produced by deregulation made growth rates of monetary aggregates meaningless. The Reserve Bank has been forced to rely on interest rates as its major indicator and instrument of monetary policy, an approach which was considered by the Committee without much enthusiasm. (AFSI (1981, paragraph 3.14))

A further problem not considered by the Committee was that deregulation is in fact a restrictive policy. Deregulation leads to a contraction of direct financing and non-bank financial intermediaries. The extinction of some financing done in this way (which can be regarded as the removal of some near-money) would normally lead to a slowdown in economic activity because banks cannot expand their balance sheets unless additional money base is made available. The Reserve Bank was forced to allow banks to grow more rapidly in order to prevent a contraction, both by allowing money base to grow more rapidly and by easing reserve requirements on the banks. In the period following the abandonment of monetary targetting, M3 grew at rates well in excess of those used in the targets. This did not represent an expansionary policy, as was indicated by the high interest rates which prevailed at the time, but rather an attempt to avoid a contractionary outcome. This reaction, however, contributed to the expansion of credit discussed above.

The Committee was probably mistaken in assuming that the entry of foreign banks would add to the competitiveness of the financial system. As Hogan (1990) documents, the foreign banks have had little impact on the banking sector although this is a conclusion which may be falsified by developments in the 1990s. Also, it is possible that foreign banks may have speeded up the introduction of financial innovations. It does, however, raise the question of the costs which may be generated if a number of these institutions are forced to exit the system.

Competitiveness has in fact increased although largely because of increased competition amongst Australian-owned banks. One illustration of this competitiveness is the extent to which banks are now paying market-related interest rates on their deposits. The proportion of non-interest bearing deposits in total bank liabilities is falling rapidly and, as Battellino and McMillan (1989) note, there is a high correlation between the rates paid on bank term deposits and money market interest rates.

The costs of adjustment involved in deregulation can be appreciated better when we understand the way in which an economy adjusts to a system of regulation. In general, the present value of the benefits and costs produced by regulation will be incorporated into asset prices so that new purchasers derive no advantage or disadvantage from acquiring the asset.

It is true that in some cases regulation may lead to “rents” being earned by participants in the financial sector. These are payments in excess of those necessary to keep the individual in question in his present activity. It has been argued, for example, that banks received rents arising from a combination of:

• a monopoly of the domestic and international payments system;
• the implicit government guarantee; and
• the prohibition on the entry of new banks into the industry.

On the other hand, we would have expected rents to have been dissipated in a number of ways. First, bank share prices should have been bid up so that the expected return to any new investor was driven to a normal level (including any necessary correction for risk). Secondly, in many areas the banks were faced with increasing competition from NBFIs.

At the time, it was believed that these pressures would not be strong enough to remove the rents earned by banks. For example, it was argued that it was necessary to tax banks by requiring them to hold deposits with the Reserve Bank at low interest rates (the Statutory Reserve Deposit Requirement) to offset their advantages. Also, Reserve Bank (1991) shows that the return on equity was higher in the pre-deregulation years than in the years which followed deregulation. This suggests that higher than normal returns were being earned in the regulated environment. An alternative view, for which there is some evidence, is that banks are currently making less than normal profits. It is also possible that some of the rents earned by banks were appropriated by management and staff in the form of higher salaries and better working conditions than were necessary to retain their services.

Deregulation required the economy to re-adjust to the new set of rules and it is this which in part explains the costs generated by deregulation. Deregulation would have generated windfall gains and losses for participants in the financial sector and re-adjustment requires them to move into new jobs or new activities. As noted above, this is one reason why a deregulation by stages would not have been appropriate – it would have produced continuing disruption as the economy adjusted to successive changes in regulations.

In evaluating whether deregulation is advantageous, we should calculate the present value of the net benefits produced by deregulation. In this calculation, the costs of adjustment are deducted from the benefits produced by deregulation. This raises the possibility that although a system of regulation might not have been introduced if this analysis had been done initially, the calculation shows that it is not cost-effective to remove it. Of course, it also suggests that even if it was a mistake to embark on deregulation, now that it has been done, it would be a mistake to go backwards.

In effect, the Committee made a judgment that the benefits of deregulation offset the costs. This judgment was largely non-quantitative and any attempt to quantify the costs and benefits would be essentially arbitrary. One reason for this is the point made above – the Committee supported deregulation because it would create conditions which produce desirable outcomes, but the details of these outcomes depended on the basically unpredictable responses of market participants. Any attempt to quantify the costs and benefits would require us to consider how the costs created by regulation would have changed over the 1980s.

In this context, it is important to recognise that deregulation was bound to create losers as well as gainers and the Committee was well aware of this fact. Losers include: holders of bank accounts with low balances and high activity; non-bank financial institutions and participants in direct financing; the authorised dealers in the short-term money market; and some bank staff.

Unfortunately, deregulation was sold by politicians and the media as delivering direct benefits to all Australians. The Committee never claimed that this would be the case. Its position was that most of us would receive an indirect benefit from increased competitiveness and productiveness, but that some of us would lose in a direct sense.

5. Conclusion

This survey has shown that, in many respects, the Campbell Committee's expectations about the likely outcome of its recommendations were borne out by the events of the 1980s. This included its views that monetary policy would become more effective, that short-term interest rates would be stabilised, that the competitiveness of banking would be increased and that credit rationing would disappear.

There were some areas, however, in which the Committee failed to predict the events of the 1980s. These areas included:

• the slow rate of adjustment to deregulation;
• the extent to which a saving deficiency, caused in part by the interaction of inflation and the taxation system, would lead to an increase in offshore borrowing (the current account deficit);
• the rapid expansion of credit and asset prices in the second half of the 1980s; and
• the high level of losses from bad debts suffered by banks at the end of the 1980s.

In evaluating the Committee's performance in this respect, a number of points must be made. First, many of these outcomes arose from developments which could not be predicted at the beginning of the 1980s. For example, it had no way of forecasting the speculative boom of the late 1980s or the appearance of the “entrepreneur”. Secondly, it is important to repeat the point made at the end of the previous section. The Committee sought to develop a program which would create the pre-conditions for the favourable development of the financial system. Its solution was to create a free market situation and, by its very nature, the outcome of such a market is essentially unpredictable. It should, however, reflect the desires of consumers and maintain the productiveness of the economy.

Footnotes

Professor of Finance and Director, Centre for Applied Finance, University of Technology, Sydney. [1]

See also the article by Phelps in this volume. [2]

Attitudes to the recent failures of various financial institutions and investment trusts and the reactions to losses on foreign currency loans suggest that while users of the financial system are anxious for high returns, they do not wish to bear risks. Such an attitude can arise only from a misunderstanding of the risk/return trade-off. [3]

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