Transcript of Question & Answer Session Why Financial Stability Matters, and What We Can Do About It

I'm George Shearer, a state public servant. You talk about stability, now are you talking about a long-term or short-term stability and the United States seems to have been pursuing stability with quantitative easing. It might have achieved stability but some writers argue that it is only to counteract deflation and that it might be postponing some sort of crunch that will come in the long term. So is quantitative easing working and is it in the service of stability and is it deferring a crisis or is it a useful thing in its own right?

Thanks it's a very interesting question and I think it gets to the heart of the nexus between monetary policy and financial stability policy and why those functions need to work together, including across agencies. Quantitative easing is what you have left once you hit the zero lower bound on interest rates in some modern monetary policy. It's a harder thing to manage, it's less well understood because it hasn't been tried as often, but deflation in a world where there is debt, is surely a much worse outcome than macroeconomic stimulation on the other side, so there is an asymmetry to the policy mistakes you can make. So without wanting to comment in too much detail on other countries' monetary policy I think this is a policy that seems to work at some level, and I think certainly financial stability policy is something where you've got to think about all of the phases, all of the time horizons both shorter term and longer term and that's absolutely one of the things that we think about. I think there has been a little bit of an assumption that you will get yours in the end. There's always this idea that you know, how dare you sail through the crisis. Well, we didn't sail through the crisis, but how dare you not have the crisis, surely you will get your comeuppance. And there's an assumption that there are comeuppances lying in wait for people, and I don't think we should assume that. But certainly thinking about the long-term as well as the short-term is absolutely part of what we do in financial stability circles.

Hi Dr Ellis, can I just follow on with a supplementary to that question.

Sure.

Now that quantitative easing has taken place, which has doubled or trebled the world money supply in much of the developed world in the last few years, on a pretty much stagnant real asset base, would we not think that that would contribute to financial instability if that real asset base starts growing again around the world that the classic case of driving down the value of money on a growing real asset base, we're unleashing an inflation monster. If we can just get some commentary on that please.

Well I think there has been actually some very useful research about monetary policy on the zero lower bound, and we haven't seen that in Japan. Japan has actually been trying this for 20 years and we haven't yet seen the inflation monster, I think there is actually some very useful academic research that models that and it doesn't find that the inflation monster, and guess what, if we suddenly find you have inflation and the real economy is growing, well we know what to do.

Greg O'Connell, I'm an engineer, I'm not an economist, I'm a private investor.

Good for you.

Thank you.

Not everyone should be an economist, we'd all be very boring.

I'd like to pursue the quantitative easing question a little bit further. You talked about risks and policy and pressing and mitigating risks. Would you be prepared to speculate on what risks you see with the Australian economy when quantitative easing does start to wind up and come to an end and what that might mean for those us in Australia?

You've asked a very interesting and very big question, and I will do my best to answer it. Essentially what you're saying is what happens when the US economy starts looking better. That's probably not a bad thing.

There's an assumption that it gets better, but yes when it gets …

But I mean, that's the thing you've got to say under what circumstances would the US start, I mean they've already started tapering their asset purchases. I think the more important question is what happens when interest rates rise? This is something that has been imagined, this is something where people have thought through some of the implications. There's a lot of work being done in international thinking about what is the interest rate risk in the banking system. I talked in the speech about the sort of broader run of crises, particularly in emerging markets where people have foreign currency borrowing and then suddenly exchange rates move and they weren't prepared for it. I think Australia is in a very useful position in that most of the time the exchange rate is a shock absorber rather than a shock creator. So I think another way to frame your question is what happens when the US economy has recovered enough that the Fed starts raising interest rates. Well, some people probably will get caught out by the infinite global financial markets, but I can't help seeing that as good news.

Jeff Harcourt, I used to be here.

Professor Harcourt.

I always thought that quantitative easing was aiming at the wrong assets or the wrong nature of spending. I would have thought it would have been much better when repercussions on the real economy occurred, if central banks had allowed governments to write cheques on them to finance green-friendly infrastructure to help the construction industry to tackle global warming and to reduce the high levels of unemployment that resulted from the crisis. Whereas they've concentrated on buying financial assets in the hope that people would build up liquidity someone would want to borrow, but as we know if expectations and animal spirits dim, no one wants to borrow. So it seems to me you built in huge amounts of holdings of financial assets, whereas you could have done real and useful things as you stress, that the integration of finance in the real economy is what our objective ought to be.

Professor Harcourt you've asked a very pertinent question. If it were possible for governments to purchase goods and services instead of assets, for the public sector broadly to purchase goods or services instead of assets, wouldn't that be more direct? I think it probably would have been, but I think one of the things we have seen over the last few years is concern about the appropriateness of fiscal positions, rightly or wrongly. And of course in Europe at least there is actually a treaty that says the ECB can't do that, so that's not about the ECB allowing something or not allowing something, or indeed you know, Reserve Banks around the world allowing or not allowing something. If the legislation says they can't, it's up to the political you know infrastructure to actually say well let's do it that way. And it's not clear to me that that would have been politically possible in some countries and that's probably about as far as I want to go on that.

Thank you my name is Jim Orcan, I'm a business man and I'm just wondering whether long periods of stability, which is what you are aiming for,eventually lead to overconfidence which leads to crisis.

It is actually – that is a really pertinent question.

So by promoting the stability you're going to promote the profits.

And I think it is, will in fact just before this event – just before this event I gave a talk to some students here at University of Adelaide and I pointed out to them that when I started my working life I graduated into the 1991 recession, in Melbourne. Which as an Adelaide businessman you would know how bad that was also in Adelaide. And of course a lot of the people who are graduating now weren't born during that. And so, I mean there is a real direct question about can you end up with a situation of complacency and can you end up with people becoming complacent about risk, pricing risk too low. I think that does describe what was going on in ‘05 and ‘06, the price of risk in global financial markets had gotten very low. And I think the main bulwark against that is people like me who are paid to worry and will do reflexively anyway. And so I think having the right mandate is really important there, but I agree, can people be lulled into a sense of complacency by things being good all the time? And you know something could go wrong at some point but as I mentioned earlier with another question, we also shouldn't assume that means that there is some kind of moral comeuppance lurking lying in wait for us. I think it is a matter of – of remaining alert but not alarmed.

Dr Ellis, my name is Mark Connell, and I'm chartered accountant so I'd like thank you for your presentation and I'd like to thank as an economics alumnus I'd like to thank Professor Harcourt for teaching me economics. But my question in my work I see a lot of dislocation in China. I see a lot of dislocation because of shadow banking and you haven't mentioned it really a less regulated field.

Well I didn't mention it directly in this talk, there are, in the G20 Reform agenda post crisis, there have been four legs. One was making banking safer, that's primarily the Basel III package, not only that. There's making derivatives markets safer, that would be a whole lecture in itself. There are resolutions and dealing with banks that are failing and other institutions that are failing so that when they do fail, they don't fail so ugly, the way London did. But shadow banking is the form of – well I mean – you know we actual list in a different order, but shadow banking is one of those four. And we're very aware globally that if you tighten regulation on one sector of the financial system activity will move into the less regulated areas and that's an important issue. The Chinese authorities are very aware of this, it is very hard in an economy that is so big and so complex and has so many pieces, and there's still, I mean it's evolving quickly in the financial system so it's hard to get a handle on. I think in Australia we're quite lucky in some ways you know most of our financial sector is prudentially regulated in some way, it's a very bank-oriented system so there just aren't these sort of other kind of entities or if they are it turns out they're part of a banking group they actually get supervised as a group. And quite a lot of the so-called shadow banks in China also are parts of banking groups and so it's within the remit of the agencies there, to actually do something about that, and there have been a number of policy responses to deal with that and in particular to bring some of that within the supervisory umbrella. But it is definitely a challenge for a lot of countries where you have this sort of big, not prudentially regulated sector, I absolutely agree that that's important.