Can't compare: emissions trading and reforms from the past

It's now an accepted part of political folklore:  the era of reform is over.  Our boldness has gone.  No longer are we able to push through major economic changes.  We have no appetite for challenge.

Australian politicians are hesitant to take risks, intimidated by polls, and the Government is cripplingly scared of focus groups and opposition.

That's the broad outline.  Fill in the details yourself.

This story has a lot of truth in it.  In his recent Quarterly Essay, George Megalogenis carefully and convincingly documents the way federal Labor reacted to falling opinion polls in ways which only made those opinion polls drop further.

But the end-of-reform tale pivots on one critical comparison which doesn't hold up -- that between the liberalisation of the Australian economy in the 1980s and early 1990s, and the failure to (so far at least) introduce an emissions trading scheme.

The parallels are admittedly seductive.  The decade-long program of financial deregulation, reduction in tariffs and industry protection, privatisation and corporatisation of state enterprises, and labour market reform required unheard-of boldness.  It caused pain.  Industries which had relied on protection were no longer viable, workers were exposed to the stresses of competition and new private operators took knives to the bloated payrolls of formerly public sector businesses.

The emissions trading scheme will bring hurt too:  making some forms of energy production unprofitable (with the attendant risk to jobs) and add substantially to everybody's power bills.  The government that introduces it will be a bold government.

But that's where the similarities end.

The reform of the 1980s had one clear and unambiguous goal:  to clear up a century of accumulated, unnecessary or entirely counterproductive regulatory burdens.  These burdens were holding back Australia's economic growth, limiting personal income, and entrenching private interests at the public expense.

The goal of an emissions trading scheme is very different:  to impose burdens on the Australian economy.

Not a bug, a feature.  Placing new costs on the cheapest energy will inspire people to reduce their energy use.  It will also make technologies which were uncompetitive in a world of cheap coal suddenly competitive.

That's the plan, anyhow.

In practice, the emissions trading scheme was rife with exemptions, subsidies, wealth transfers and policy distortions which favoured some industries above others.  Emissions-intensive, trade-exposed industries were eligible for assistance, so the definition of what constituted ''emissions-intensive'' and ''trade-exposed'' was pretty important.

The lucky winners, according to a paper released by the Department of Climate Change in October:  Alumina refining (of which there are four companies operating in Australia), aluminium smelting (also four companies), carbon black production, (one company), carbon steel from cold ferrous feed (one company), clinker, copper, ethylene, flat glass, fused alumina, and glass container production, among others, are now considered ''highly emissions intensive'' and ''trade exposed''.

Other businesses, like tissue paper and white titanium dioxide pigment production, are considered to be trade exposed but only moderately emissions intensive.  They get a different rate of assistance.

Then there were the free and subsidised emissions permits.  And the household assistance payments to compensate poorer Australians for higher energy costs.

The end result of all this regulatory complexity, new subsidies, and tax-welfare churn shouldn't remind us of the great reform movement of the 1980s.  It should remind us of what that reform movement tried to clear away.

Treasury suggests emissions reduction will cost Australia's economy 2 to 3 per cent of GDP over the next 50 years.

That too compares poorly with the great reforms of the 1980s, which were designed to boost, not restrain, economic growth.

The pain of deregulation was limited to companies which had profited at the expense of the rest of everybody else.  Like the tariffs which kept inefficient clothing companies in business and inflated clothing prices.  The pain of emissions reduction will be borne by all Australians who use energy.

In a speech last week, the Chairman of the Productivity Commission, Gary Banks, tackled just this question:  what constitutes ''reform''?

At the very least, reform has to be productivity-enhancing.  Reform has to achieve its goal -- if carbon pricing is to be considered a success, it has to go some way to mitigating global emissions and then climate change.  And reform has to be long term -- not so precariously controversial it will be eliminated at the next change of government, like, for instance, WorkChoices.

Banks also cited the Baby Bonus, light globe bans, FuelWatch, Grocery Choice, and Cash for Clunkers as ''reforms'' which failed to meet these modest but important criteria.

Emissions trading would fail too.  No emissions trading proposal before Parliament could achieve its ambitious goal.  And no proposal before Parliament would be ''sustainable'';  that is, would be able to survive into the long term without major revision.

Banks does not go so far as condemning emissions trading.  But his argument for action on climate is half-hearted:  ''perhaps the strongest economic argument for carbon pricing is that it would displace more costly alternative measures targeted at particular products or technologies.''

In other words, it would be marginally better than the even-worse things we're doing now.  That's hardly an inspirational argument for bold new reform.

How desirable you think carbon pricing is will depend on your view of the science of climate change and the likelihood of significant global action.

But to compare it to the great reforms of the 1980s and 1990s is a mistake.  It does a disservice to the legacies of Bob Hawke and Paul Keating.  And it gives emissions trading a sense of historical inevitably which this compromised, undercooked, and ineffective policy has not earned.

Good intentions don't mean good policy

Banking is risky business.  Banking policy is even more risky.  Good intentions often lead to increased moral hazard and expensive policy failure.  Over the past three years we've all seen what happens to those economies with fragile banking systems.

The Rudd-Gillard government, with its poor track record of policy implementation, risks undermining our robust financial system.  At his press conference, Wayne Swan made the claim that he has worked methodically and consulted widely on his Competitive and Sustainable Banking System proposals.

After Fuelwatch, Grocerywatch, the green loans scheme, the home insulation scheme and other policy failures, this is very small comfort.

Proposals to second-guess private sector pricing decisions should always be carefully considered and evaluated.

The first point to acknowledge in any banking reform debate is that Australia is well-served by its banking system.  The industry is diverse, profitable and, most importantly, stable.

Swan's proposals emphasise competition and sustainability, but not stability.

When evaluating the government's reform package, the first question to ask is whether any of these proposals will benefit consumers.  It is just not clear that any of these proposals will lead to a lower mortgage rate for home buyers.

To be sure, in principle having a greater choice of provider is likely to lead to lower prices;  yet consumers already have substantial choice.  There is no clear evidence that banning exit fees will lead to overall lower prices for customers.

The second question to ask is whether the proposed reforms will actually work to deliver ''reasonably priced credit'', whatever that means.  Artificially low interest rates could lead to malinvestment (sometimes called bubbles), while making bad loans was the immediate cause of the subprime crisis.  That, with some US government bungling, metastasised into the global financial crisis.

The third question is whether the proposed reforms are consistent and coherent.  What economic benefit will Australia gain from the reforms?  Our banking system is already strong.  People who can afford home loans can get finance.  True, small business loans are currently very expensive, but that is largely a function of prudential requirements and risk aversion.

Bad ideas lead to bad policy.  On the issue of banking there is no shortage of bad ideas.  Promoting competition at the expense of other objectives is problematic.  It is widely recognised that excessive competition can lead to excessively risky banking practices and subsequently to macro-economic instability.

Swan's proposals do avoid some of the worst ideas currently on offer.  There is no mention of ''utility banking'', the idea that banks should be dull and boring institutions that simply borrow and lend in small niche markets with limited growth opportunities.  This idea doesn't work.  Recall the 1980s savings and loans crisis and the failure of state banks here in Australia.

Another bad idea, taking root in Liberal Party circles, is the notion that any illiquid bank is also insolvent.  The nature of the business means that viable and profitable banks can become temporarily illiquid.  This problem has a long history and a well-known solution in the Bagehot rule -- lend at high rates to good collateral.  While lender of last resort facilities are often used to bail out insolvent banks, it is not clear that taxpayers are underwriting all banking risks.

The Coalition has already proposed legislation to prevent ''price signalling''.

Yet there is no evidence to support the notion that this is a problem in Australia.  The government's proposal is bad too.  The ACCC harassed the fuel industry for years on this very issue.  The government now proposes to remove any need for signalling cases -- read any evidence of wrong doing allowing the authorities to accuse and convict at will.

There is merit is examining the potential for a ''fifth pillar''.  It seems that credit unions and building societies (really banks without shareholders) are at a regulatory disadvantage to banks.  But the government doesn't propose deregulation;  rather it imagines special privilege.

There is no need for that.  A clear-headed analysis into the role mutuals can play in the broader banking system should be undertaken.  Unnecessary regulations and impediments to their growth should be eliminated.

The idea of promoting a corporate bond market and issuing covered bonds should be well-received.  The devil will be in the detail.  But even this overlooks an existing source of finance that would especially benefit the mutual sector.

Credit unions and building societies are sitting on a massive stock of unused, and unusable, franking credits they pay corporate tax but cannot pay dividends.  They want to distribute these credits to their depositors.

A far more sensible idea would be to recognise that unused franking credits represent a loan to the commonwealth.  If the commonwealth would pay interest on unused franking credits, the non-profit banking sector would effectively have a permanent stock of AAA-rated bonds on their balance sheets.  Subsequently allowing them to package and on-sell unusable franking credits would allow them to benefit from an asset they already own.

That is just one idea.  There are a lot of ideas that need to be fully investigated and considered before we can know which ideas are any good, and of those which ideas could lead to good policy.

Right now we have the government promising to fast-track legislation, the opposition with its own legislation, and the Senate holding an inquiry into banking competition.  It is an ugly sight.

Rather than have several inquiries and proposed legislation all running at cross-purposes, it is probably wise that a single son-of-Wallis-type inquiry take place.

A cool, calm, non-populist approach to banking policy will do more for the national interest than the bank bashing and posturing that is being passed off as banking reform.

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The weight of the word

Are Julian Assange and WikiLeaks really doing anything that unusual?  After all, leaks are one of the foundations of contemporary journalism.  Leaks are one of the best techniques we have to peek behind the curtain of government.  So the aggressive political reaction to WikiLeaks is very disturbing.

Governments, whether democratic or totalitarian, do not deserve a presumption of secrecy.  Few people objected on a philosophical level to the leaks out of Labor's cabinet during the federal election.  Few people have principled objections when the press releases documents they've received from whatever legal or illegal source.

There's no question Assange is a media publisher.  He describes himself as a journalist, albeit of an unconventional type.  So the only material difference between what WikiLeaks is doing and ''normal'' leaking is scale.  The diplomatic cables have dominated global politics for two weeks, but we've only seen the contents of just over 1000 of them.  There are 249,000 to go.

The slow (and for US diplomats, excruciating) drip-feed is far from the ''data dump'' critics have accused Assange of doing.

Few of the cables have been released without first having been given exclusively to the mainstream press.  The Sunday Age has some today.  These papers have been vetting the documents for sensitive or risky information.

WikiLeaks only publishes the edited cables.  WikiLeaks even asked the US State Department for help editing unnecessarily risky documents, a practice common when the press deals with classified material.  The State Department refused.  The Pentagon has had to admit there is no evidence anybody has ever been harmed due to a WikiLeaks release.  Yet the WikiLeaks cables depict more than just ''gossip''.  They reveal things we didn't know and shed substantial light on things we thought we did.

For instance, it's one thing to hear commentators and self-aggrandising leaders in the Labor Right say Kevin Rudd was a control freak.  But it's quite another to read it in a private internal memo of our closest ally.  We now know that Rudd's freakishness was affecting our relationship with the world.

Since the cables have been released, we've learnt that:  Silvio Berlusconi and Vladimir Putin have a relationship bordering on corruption, US diplomats have been asked to spy on UN leaders, the same US diplomats believe a disturbing number of foreign leaders have mental health issues, and the US pressured Spain to shelve human rights cases against American officials.  There will definitely be more.

To oppose WikiLeaks is to oppose freedom of the press and, more critically, free speech.  Strip away Assange's revolutionary libertarian rhetoric and inflated sense of self, and what we have is a media outlet that's innovative but is not really doing much different from what the press has been doing for centuries.  Which makes the events of the past week particularly significant.

Corporate support for WikiLeaks is being stripped away.  Amazon.com, which was hosting WikiLeaks for a short time, dropped its account.  The company had received calls from staff of the chairman of the Senate Committee on Homeland Security:  asking ''Are there plans to take the site down?''

Another company, Tableau, which was providing software for WikiLeaks to visualise the data, was also contacted by congressional staff.  They severed their relationship with the site too.

Visa and MasterCard followed suit, banning donations to WikiLeaks.  So too did the Swiss PostFinance, which held a WikiLeaks bank account.  PayPal suspended payments to the site because it felt threatened by a letter implying WikiLeaks had broken an unspecified law.

There are too many volunteers and donors and copies of the site around the world to fully shut it down.  But these political attempts to choke WikiLeaks' funding and foundations are a clear breach of freedom of the press.  They illustrate the use of political pressure to silence a media outlet that has done no more wrong than cause embarrassment to the United States government.

Sure, PayPal and Amazon.com could have refused to co-operate.  It is not at all clear that WikiLeaks has broken any US laws.  But put yourself in their shoes:  would you defy Congress, the 535 members of which could destroy your business model with the stroke of a legislative pen?

After all, if we give governments power to make or break businesses through tax and regulation, we also give those governments power to threaten and cajole those businesses into co-operating with their political aims.  This is a far more disturbing turn of events than highly publicised rantings of bloggers calling for Assange's assassination.

Assange may be reckless.  From the US government's point of view, he is virtually stateless.

And the retaliatory attacks by the independent internet hacking group Anonymous on those corporations gives WikiLeaks an unjustified veneer of illegality.

Yet it is not the job of journalism to make the diplomacy easier, or to grease the wheels of communication between foreign leaders.  Nor is it to protect diplomatic privacy.

The US government was unable to secure its internal communications.  Whatever the long-term repercussions of the diplomatic leak -- and they may be substantial -- that colossal failure is to blame;  not a journalist who, having received newsworthy information, publishes it.

The last thing we want is our media to be deferential or subservient to the interests of the state.

Of course, the battle between governments and the press is an old one.  In a moment of well-timed irony, this week the US Department of State announced it would be hosting World Press Freedom Day in 2011.

No matter how new the medium, or how irresponsible its publisher, it is an absolute and fundamental infringement of free speech when a government tries to gag a media outlet it doesn't like.

Pursuit of climate change treaty is a waste of energy

Climate change negotiations should be put on ice.  This morning Australian time, the sun will set on the UN climate change negotiations in Cancun, Mexico, with very few expected deliverables.

But any outcome will be hailed as a success after governments across the world deliberately downplayed expectations.

Lead US negotiator Todd Stern said this week negotiators shouldn't ''get hung up'' about having an agreement to take to the Durban, South Africa, talks this time next year.  Governments cannot even agree about what they are seeking to agree about.

On a macro level, developed countries want a new non-binding emissions reduction agreement without treaty status that includes most countries.  And they want it at the expense of the second emissions reduction period under the Kyoto Protocol that's set to expire at the end of 2012.  It's a position principally advocated by Australia, Canada, Russia and the protocol's sponsor, Japan.

Broadly, developing countries want the reverse:  a continued Kyoto that doesn't bind them.

And then there are China and the US which, pardon the Cancun pun, have been caught in a Mexican stand-off since the 1997 Bali conference over whether China should accept obligations.

At one point this week there were reports China would, but they were quickly corrected.  Indian Environment Minister Jairam Ramesh experienced a similar lapse after saying to a climate change activist-filled room that all countries, including India, should ''take on binding commitments under appropriate legal forms''.  But he's since backed away.

On a micro level the problems get worse.  Accepting a universal standard of measuring, reporting and verification so a tonne of reduced carbon is the same in Washington, New Delhi and Beijing also remains contentious.

India won't agree to it until penalties exist for breaching commitments.  But penalties will require an adjudicator with punitive teeth.  Only one equivalent body now operates through the World Trade Organisation's dispute settlement regime.  Governments won't agree to another one.

And the $US30 billion ($30.5bn) climate change adaptation fund financed from rich countries for poor ones is on shaky ground.  Governments are now badging already committed foreign aid as ''climate aid'', and the US is including export credits as part of its offering.  The real test will come when rich countries are asked to commit 1.5 per cent of their gross domestic product into a similarly designed $US100bn-a-year fund to operate from 2020.

The stagnation of negotiations concludes a horror year for securing an international agreement.

Former executive secretary of the UN's climate change body Yvo de Boer resigned from his post after he realised Copenhagen's collapse would ensure having his name inked on a new treaty was beyond his tenure.

And public confidence in aspects of the science took a dent after the leaking of the climategate emails and the expose that the Intergovernmental Panel on Climate Change on occasion has relied on green activist claims in its scientific reports.

On the back of these problems governments couldn't even agree there was a broad scientific view on temperature increases in a pre-Cancun negotiating text.

But a big bombshell has been the movement of a climate change known back into the unknown column.  Four years ago the IPCC concluded deforestation was responsible for one-fifth of global emissions, primarily sourced from developing countries.

But reported research by an environmental consultancy to the World Bank has found the figure is probably 8 per cent and possibly as low as 5 per cent.  And it excludes offsets from stored carbon resulting from regrowth.

If the research is correct, sustainably managed deforestation could become a lead contributor to emissions cuts and will lead developing countries to reject many deforestation obligations.

Ironically, text to stop deforestation has been one of the few areas of progress in Cancun.

Faced with so many uncertainties, it's time governments reassessed seeking a new agreement.

It's universally accepted that individual countries should find their own ways to cut emissions.

Focusing on that principle, there is far more goodwill between countries on how to help each other reach their nationally set objectives than turning them into codified, binding commitments.

Until governments are prepared to admit these realities, flying negotiators, the media and activists across the world to negotiations for the un-negotiable is a waste of time, energy and carbon emissions.

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Overreaction to terrorism the big threat

Governments take terrorist threats very seriously.  But the seriousness of terrorism has to be balanced against how very ineffective -- even incompetent -- most terrorists actually are.

When printer cartridge bombs were found on a flight about to depart from East Midlands Airport in England to the US on October 29, the regulatory and security response was immediate and uncompromising.

The packages originated from Yemen, so all cargo from Yemen was banned.  And Somalia, too.  The German government even stopped all passenger flights from Yemen.  Toner and ink cartridges above 450 grams were completely banned from passenger flights travelling to the US, not just coming from Yemen, but coming from anywhere at all.  The pat-down security procedures on all passengers travelling anywhere within or into the US were boosted.

A substantial reaction, but not an unusual one.  Security agencies always hastily crack down on all sorts of activity when terrorist plots are discovered.

Yet just a few weeks later, it is hard to be scared by the printer cartridge bombs at all.

The plot failed on multiple counts.  The bombs were found, they were disarmed, and they posed a minimal threat to human life and property.  Neither does it represent innovation in terrorism -- mail bombs have been around for centuries.

The bombs travelled on passenger jets, certainly, but only by accident.  As they were cargo, the bombs were carried on passenger aircraft early on the journey from Yemen through the Middle East.  The plan was to explode the bombs in US airspace, but investigators suggest it could have exploded over Canada.

Had the bombs exploded, they would have destroyed a cargo jet and its tiny crew, not the synagogues to which they were addressed.

The bomb maker to whom this has been attributed -- Ibrahim Hassan al-Asiri, al-Qaeda's chief engineer in the Arabian Peninsula -- is responsible for the failed Christmas Day 2009 bomber, and a failed assassination attempt on a Saudi intelligence chief.  The only fatality of that latter incident was al-Asiri's brother, who had hidden the explosives in his rectum.

The printer cartridge bomb plot was detected by traditional counterterrorism intelligence.  Some reports suggest information about the plan came from undercover Saudi agents within al-Qaeda's Yemen operation -- the terrorist network is, apparently, a lot easier to infiltrate as it tries to stave off long-term decline by expanding its franchises into Yemen and the Maghreb.

So, like many other terrorist scares, in retrospect, there is a lot less to the printer cartridge bombs than first seemed.  There seems little reason to be worried.

But nothing quite demonstrates the strangely pathetic nature of the terrorism threat more clearly than al-Qaeda's new English language magazine.

The October issue of Inspire contains some bizarre suggestions for jihadists plotting in the West.  For instance:  one article recommends terrorists weld steel blades onto the hubs of a four-wheel-drive and drive up onto a crowded footpath.  Doing so, we read, will ''achieve maximum carnage''.  But that seems more like a terrorist plot hatched by Mad magazine than professional, trained Islamic revolutionaries.

When they're not utterly stupid, they are oddly banal.  Another Inspire recommendation is to shoot up lunch spots that are popular with government workers.  So in a decade, al-Qaeda has gone from targeting the World Trade Centre and the Pentagon -- the two symbolic organs of American power -- to threatening Starbucks outlets one at a time.

Then there is ''Make a bomb in the kitchen of your mom'', which suggests repurposing a home pressure cooker to become an explosive device.  Such a device is weak, apparently, so the magazine recommends it is placed ''close to the intended targets''.

It is surprisingly hard to detonate explosives successfully.  Despite the large number of detailed guides to bomb-making littering the internet -- whether written for anarchists or jihadists or self-destructive teenagers -- the history of terrorism suggests budding bomb-makers are undertrained and underprepared.

The shoe-bomber, Richard Reid, who tried to blow up a flight from Paris to Miami in late 2001, failed because his explosives were damp.  The Christmas Day bomber, Umar Farouk Abdulmutallab, burnt his trousers off trying to ignite explosives in his underpants.

The May 2010 Times Square bomber, Faisal Shahzad, could not get his car bomb to detonate.  He just set the car on fire.  Shahzad was apprehended, in part, because he left his house keys in the ignition.

In late November, the ''Portland car bomb plot'', in which a 19-year-old Somali-American tried to blow up a Christmas event, was foiled because his car bomb was a fake.  The explosives had been provided by undercover FBI agents who -- it appears -- had goaded him into becoming an operational terrorist in the first place.

If so, it would not be the first time:  a 2007 plot to attack a US army base in New Jersey was almost certainly a case of FBI entrapment.  And it will no doubt occur again.  There was a bizarre case reported in The Washington Post this week of a mosque in Los Angeles taking out a restraining order on a man spouting pro-terrorism views, and reporting him to the FBI.  The man turned out to be an FBI informant trying to infiltrate the jihad.

Despite all this clownishness, the overreaction to every failed terrorist attack has serious consequences.  Terrorism succeeds not because of what it does to its target, but what its target does to itself in response.

Measured in money, the cost of terrorism is dwarfed by the cost of the reaction to terrorism.  Security responses threaten civil liberties and the rule of law.  Nobody needs to be reminded how, since the September 11, 2001, attacks the legal, political and administrative security apparatus has been unalterably changed in the US, Australia and throughout the Western world.  The economic cost of this alone is staggering.  There are now 1271 separate American government bureaucracies dedicated to security.

Millions of Americans have security clearance and access to this sprawling bureaucracy -- apparently allowing a disaffected, low-ranking soldier to gather a huge number of military and diplomatic records and send it to WikiLeaks.

Our government has embarked on its own national security empire-building.  The size of the Australian Security Intelligence Organisation has tripled in the past decade.

Then there are the inconveniences caused by knee-jerk reactions to failed terrorism plots.  The discovery of the printer cartridge bombs may mean in-flight wireless internet is scrapped, in case the internet is used to detonate explosives.  After all, if it is possible to imagine, it is necessary to ban.

There's also political pressure in Britain to install high-tech screening devices to scan every piece of cargo travelling on aircraft, with the cost borne by freight companies.

After November's car bomb attempt, Portland is now beefing up security and getting rid of parking at public events.

And after the Christmas bomber, the US government dramatically increased the number of body scanners and intrusive pat-downs.  The outcry over the privacy and health consequences of these extraordinarily invasive measures has been deafening.  The phrase ''security theatre'' has become widely used, even among commentators predisposed to being tough on terrorism.

Two things to note:  the invasive body scanners have been installed in response to a failed terrorism attempt, not a successful one.  And independent security experts have discovered that the scanners are unable to detect the sort of explosives the Christmas Day bomber tried to use.

So, naturally, the Australian government plans to spend $200 million introducing body scanners here within the next few months.

And measured in lives, the reaction to terrorism is often far worse than the potential damage caused by terrorists.

Admittedly, this point does not apply if you believe drone strikes and other military actions kill terrorists exclusively.  There are indications the US will respond to the printer cartridge bombs by escalating its covert war in Yemen to include drone attacks.

Next year will be the 10th anniversary of September 11.  The devastation of those attacks now looks like a rare fluke.  It is one which is unlikely to be repeated.  If nothing else, aircraft passengers will no longer passively allow anyone to forcibly take over a plane.  Passenger awareness is probably the most powerful airline security ''innovation'' in the past decade.

And it is becoming increasingly clear there are no great terrorist ''masterminds''.  The war on terror has no great Bond villain.  There is no Einstein of al-Qaeda.

Incompetent terrorists are still dangerous;  they can still kill.

But after the initial panic, the vast majority of terrorist incidents are less threatening than they first seem.

The director of the US National Counterterrorism Centre said last week ''we help define the success of an attack by our reaction to that attack''.  Let's try not to make our reaction to terrorism worse than the threat of terrorism.

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Libs make policy sense

The front page of The Australian Financial Review last Friday provided some hope that government and opposition might yet provide some good policy.  First there was federal shadow treasurer Joe Hockey talking about aligning the company tax rate with the top personal income tax rate.  Then just a few columns away new Victorian Premier Ted Baillieu was discussing the virtues of ''competitive federalism'' and how his state could maximise its competitive advantage.

Both are potentially significant developments.  It's welcome that Hockey has taken a break from bank-bashing.  At last he's doing what a Coalition shadow treasurer should be doing, which is pushing a smaller-government, lower-tax agenda.  Instead up until now he has been spending his time trying to outflank the Labor Party from the left.

It's pleasing that Hockey hasn't swallowed the line that the only thing that counts when it comes to Australia's attractiveness as an investment location is the company tax rate.  Certainly tax matters, but a stable political and policy regime counts as well.  It's ironic that at the same time as the Henry tax review was urging a reduction in the corporate tax rate to ensure Australia's competitiveness, it was advocating the resources super profits tax.  The damage done to the country's reputation as a result of the mining tax has more than compensated for any potential benefit that could have been gained by reducing the company tax rate.

The Henry review never seriously considered the relative merits of cutting personal income tax rates compared with the corporate rate.  It should have, and part of the reason it didn't is politics.  When the top personal income tax rate (including the Medicare levy) is 46.5 per cent and the company tax rate is 30 per cent, the potential for arbitrage and tax minimisation is enormous.  Any reduction in the top rate of personal income tax is inevitably portrayed as an unfair benefit to the rich and a threat to the concept of a progressive personal income tax system.

And that's true.  Cutting the top rate would provide in nominal terms greater benefits for the wealthy, and make the tax system less progressive.  But the reason the wealthier get the biggest tax cuts is because they pay more tax -- a fairly obvious point that few politicians (at least in Australia) have ever been brave enough to make.  Karl Marx was a fan of progressive taxation.

As Treasurer Wayne Swan was quick to point out, lowering and flattening personal income tax is expensive, especially if you're not going to increase company tax.  But this is not a reason not to have it as an aspirational goal.  And it's a welcome alternative to the prevailing wisdom of the Henry review, which is that the only tax the government should ever consider cutting is that imposed on companies.

Another welcome alternative to prevailing wisdom is Baillieu bucking the trend of national centralisation, harmonisation and uniformity.  As businesses have rushed to embrace a ''seamless'' national economy, they've forgotten there's no point having uniform regulation across the states if that regulation is bad regulation.

This is not an argument about the merits or otherwise of states' rights, it's simply a matter of commonsense.  Uniformity should not come at the expense of quality.

One of the reasons Baillieu won is because he promised to make the trains run on time -- literally.  Better service delivery was the core of his election commitment.  But simply doing the same things better than Labor isn't going to revitalise the Victorian economy.  Victoria has looked good compared with NSW, but on a per capita basis during the last few years Victoria's economy has been shrinking.

If, for example, the Gillard government were to impose a national occupational health and safety standard that had the worst features of the NSW system, Baillieu would be absolutely right to reject it and go it alone.

The workers compensation scheme established by Jeff Kennett and left basically unchanged by the Bracks and Brumby governments provided businesses in Victoria with an important commercial advantage.

A report prepared for state governments a few years ago identified that countries with strong federal structures have more efficient governments and higher rates of economic growth than countries with centralised administrations.

This is something for Liberal premiers Colin Barnett, Ted Baillieu, and (after March next year) Barry O'Farrell to ponder.

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Bank on basin's resilience

John Quiggin argues that taxpayers should buy 34 per cent of the water now used by Murray-Darling basin irrigators and add this to the 50 per cent of water that now flows for environmental purposes (''Billions down the drain'', December 9).

However, the present wet spell has demonstrated the resilience of the river system, which is now in the process of a full recovery from the prolonged drought.

The Murray-Darling's natural state is one of alternating floods and trickles and the river often ran totally dry before it became managed to allow modern agriculture.

The plants and animals associated with it have genetically engineered themselves to cope with vast changes in water availability, though nobody thinks we should return the river to this natural state.

Quiggin is correct in arguing it is cheaper to buy water than to undertake engineering measures to increase its flow to the sea.

But the Murray-Darling is a working river, and its basin supplies 40 per cent of the nation's agricultural output.  Reducing the quantity of irrigation water must adversely affect the area's agricultural output.

We need to ask why should we unnecessarily marginalise rural communities by diminishing their agricultural income and replacing it with government handouts.

Murray-Darling irrigation and agricultural production are critical

Under Labor, Victorian water policy had an urban-orientation.  Its focus was on reducing city usage and providing more water to Melbourne without building new dams.

That is set to change with new Liberal Premier Ted Baillieu having appointed National MP Peter Walsh the minister in charge of water and agriculture.

Agriculture is where the key issues lie.  Despite all the political attention that brought wasteful spending on the Wonthaggi desalination plant and the Sugarloaf pipeline, irrigation accounts for 85 per cent of water use.

And irrigation issues are vital to the half of Victoria that is located in the Murray-Darling Basin, where almost 40 per cent of Australia's agricultural output is produced.

The recent drought brought calls to ''save the Murray'' from irrigation, which was said to be causing widespread ''stress'' on the Basin's natural ecology.

Irrigators take around half of the Basin's water.

Delivering this has entailed controlling the river system that previously alternated between floods and trickles.

Dams, levies and channel deepening now mean a continuous, relatively even flow to the benefit of farmers, recreational users and local communities.

Environmental activists, many of whom fundamentally oppose using modern agriculture, are calling for a 37 per cent reduction in irrigators' allowable water use.

The Federal Government has legislation which appears to support this.

The controversy of this is clear from angry meetings of communities in the Basin when its implications were first aired, and this week's resignation of Mike Taylor, the chairman of the Murray-Darling Basin Authority.

Nobody has specified the costs and benefits of reducing irrigation use.

A report by the Committee for the Economic Development of Australia argued we would gain from reducing the Murray-Darling's water for irrigation if we prioritised the water for growing fruits and nuts.

This misunderstands the unevenness of Australia's rainfall, which brings a massive variability of the river's flows, severely limiting its capacity to underpin the very high security water needed for such crops.

Former Australian of the Year Tim Flannery also has called for greater environmental flows.

He said this was affordable, pointing out that the Basin's agricultural earnings last year were higher in spite of drought-constrained water availability.

But the higher earnings were because of higher world food prices, and price falls invariably follow good prices.

The World Wildlife Fund argues that the region might benefit if, in return for water licences, it got a $9 billion taxpayer handout.

But somebody must pay for taxpayer handouts, which are poor substitutes for productive activities like growing food.

Moreover, even the WWF has recognised the river's resilience in quickly recovering from drought following the recent rains.

Australia's climatic extremes mean the natural condition of the Murray-Darling is to be ''stressed'', even if half its water was not used for irrigation.

Like the Nile and the Mississippi, it is a working river critical to the nation's agricultural output.

Taking water from farmers would reduce agricultural production, harming many regional centres that depend on it.

And few would see advantages in returning the river system to its natural highly variable flow rate.

Breaches will breed secrecy

Why such a panic about WikiLeaks?

Didn't we already know that Silvio Berlusconi has an eye for pretty ladies?

Or that Kevin Rudd is a control freak with an inflated opinion of himself?

Or that the Americans have a low view of Afghanistan President Hamid Karzai and his corrupt family?

Besides, wouldn't the world be a better place if we knew absolutely everything about absolutely everyone?  Shouldn't information be free?  What about the public's right to know?

As these charges indicate, one of the most frequent arguments made in defence of WikiLeaks and Julian Assange is that the release of 250,000 US diplomatic cables represents a triumph of democracy.

In fact, there is compelling evidence information released in the document dumps can cause real harm to not only security but the principle of transparency itself.

Start with security concerns.

Assange's supporters insist his efforts have not done serious damage to Western interests.

Yet the WikiLeaks arguably put US soldiers and their allies at risk.

For example, dozens of Afghan civilians are named in the documents as US military informants.  Aren't their lives, as well as those of their families, now at risk of reprisal?

Protests that no one has ever been hurt as a result of Assange's activities have recently come unstuck at the hand of the man himself.

Bragging to Britain's The Guardian, Assange claimed that documents he released ''flipped the election'' in Kenya while causing serious civil unrest.

''Thirteen hundred people were eventually killed, and 350,000 were displaced,'' Assange admitted, adding ''on the other hand, the Kenyan people had a right to that information''.

He can't have it both ways.

Either the documents represent harmless, albeit embarrassing, gossip, or they have real security consequences.

Assange's supporters say his actions represent a triumph of democracy.

In July, the WikiLeaks founder said:  ''We are transparency activists who understand that transparent government tends to produce just government.  And that is the modus operandi behind our whole organisation.''

Paradoxically, though, the lesson of the WikiLeaks' controversy is that authorities will have to work harder to keep secrets in the internet era.

Far from leading to more transparency, governments will tighten cyber security, keep fewer secrets and restrict access to fewer people.

In some respects, this is understandable.  In the corridors of power in Washington and around the world, leading figures need to be able to exchange ideas, put forward different proposals and ponder and reject various schools of thought before making decisions.

Effective policy often requires secrecy about detail.

Why would public servants write sensitive memos if they think their words will make headlines around the world?

Why would foreign officials speak candidly if they think their conversations will form the stuff of tomorrow's front pages?

Just as some measure of privacy is imperative in our private lives, so is a degree of confidentiality an essential tool of government.

Imagine if the correspondence between then US president John F. Kennedy and his senior advisers had been revealed during the Cuban missile crisis of 1962.  They would have been derided as warmongers and mad men.

Thankfully, we can judge the Kennedy White House's record by what the president did -- avoid a nuclear war with the Soviets -- and not by what he and his advisers sometimes thought or considered before making their final decision.

Already in Australia, canny bureaucrats know to be careful what they put in an email lest an embarrassing statement be caught up in a Freedom of Information Act request or a parliamentary call for papers.

In the wake of WikiLeaks, expect government officials to clamp down on the dissemination of information.  Failing that, they'll be more likely to opt for telephones over emails.

Submission to the Senate inquiry into Competition within the Australian Banking Sector

INTRODUCTION

Banking regulation can have one of three objectives;

• Consumer protection -- this ensures that firms (including banks) do not take advantage of their customers.
• Investor protection -- this ensures that firms do not take advantage of the providers of finance.
• Prudential regulation -- this ensures that financial institutions are financially sound.  This type of regulation is the most common regulation that policy makers consider when discussing bank regulation.

This list, of course, is not mutually exclusive.  Regulators may wish to achieve all three goals.  Yet it must also be recognised that some trade-offs may exist between different regulatory objectives.  For example, it might be the case that some regulations that promote greater consumer protection might undermine prudential regulations.  The difficulty that regulators face when dealing with banks (and deposit taking institutions generally) is that consumers of bank services are simultaneously investors and prudential regulation is really just a form of consumer and investor protection.

Traditional regulation theory suggests that regulation is justified by some or other market failure.  Economists recognise three broad sources of market failure.

• Monopoly power -- It is not clear that banks in Australia exercise monopoly power.  (See Box One).  It is true that barriers to entry and exit exist in the banking sector, but it is not clear that these barriers ought to be relaxed.  The argument that banks have monopoly power as evidenced by their profitability is to misunderstand the role of profits in a modern economy.
• Externality or spillover -- The notion of systemic risk is an externality argument.  This is the idea that financial distress at one financial institution can cascade to other institutions causing a system wide collapse even among otherwise healthy institutions.  This idea is very common and is a popular justification for banking regulation, yet the evidence of systemic failure is in fact quite rare.
• Information asymmetry -- This is the recognition that different parties to any transaction have different information sets and different ability to access additional information.  Information asymmetry is very common in economics and thought to be high in financial markets.  This is both a negative and positive feature of banking.  As a negative asymmetric information gives rise to moral hazard and adverse selection, while as a positive the management of asymmetric information (and the resulting different opportunity sets) makes banking viable as an industry and accounts for the profitability of banking.

Regulation may impact upon the structure of the industry.  Here the regulator may create either barriers to entry or exit, or indeed as in the case of banking both barriers to entry and exit.

Regulation may impact upon the conduct of firms within an industry or across industries.  Here the regulator may insist of pricing conventions for example (the quoted price must include all prices and taxes passed on to the consumer) or truth in advertising.

Regulation may impact upon the performance of firms within an industry.  Here the regulator may restrict how much profit a firm may earn.  In the banking industry these types of regulation are likely to lead to capital rationing and reduce the freedom that consumers have in choosing a financial institution as a business partner.

Box One:  Are Banks Monopolies? Economists usually define monopoly as being a single seller of a commodity or service.  Of course, this criteria is seldom, if ever, realised.  Arthur Seldon argues in his Everyman's Dictionary of Economics that in practice a monopoly is taken to be a seller of a product or commodity with no near substitutes.  The banking industry does not meet this requirement. Furthermore monopolies are often said to earn profits by restricting supply of their commodity or service.  A major criticism of the banking industry, however, is of ''predatory lending'' which would suggest that the industry is not restricting supply. An additional indicator of monopoly is persistent supernormal profit -- I discuss the profitability of Australian banks in the paper below.

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THE BUSINESS OF BANKING

While banks perform a multitude of functions on behalf of their clients, the core business of banking consists of borrowing money in order to lend it.  Banks earn their profit by managing the mismatch of risks arising from the different preferences of borrowers and lenders.  While this activity might be considered risky, the basic business model is similar to that of any market intermediary.

The major argument that banks are somehow different from other types of firm is based on the notion that banks are subject to high levels of systemic risk.  This is due to fractional reserve banking, high levels of leverage, and strong interrelationships between banks as they lend and borrow from each other.  This leads to the view that a bank run could easily and quickly lead to a loss of confidence in the entire banking system.  (See Box Two).  This, in turn, imposes very high costs on competitors, suppliers, consumers, and the economy as a whole.  Benson (2000), however, suggests that these arguments are oversold.  He divides those individuals and firms affected by a bank failure into two groups.  First, those with a contractual relationship with the failed bank;  Benson (2000, p. 190) makes the argument that these individuals should be well-placed to understand the risks of their relationship and should not get any greater protection than any other contractual relationship.  Then there are those who may suffer an externality due to bank failure.  Here Benson (2000, p. 191) argues that attempts to prevent this sort of externality has had the perverse effect of increasing the risk of failure.

Box Two:  Do Sound Banks Fail? The standard theoretical economic model describing bank runs by Douglas Diamond and Philip Dybvig suggests that anything that causes depositors to anticipate a run will cause a run to actually occur.  That suggests that contagion should be a common cause of bank failure, i.e. that healthy banks will fail during a banking crisis along with unhealthy banks.  This model also suggests that bank failures and banking panics will occur (somewhat) at random. The empirical evidence, however, does not support this theoretical view.  Gary Gorton (1988) tests the view that bank failures occur at random by investigating bank panics and failures during the US National Banking Era (1863-1914).  He tests two hypotheses.  The first hypothesis is that bank failure and bank panics are unrelated to economic events (this can be described as a ''pure panic hypothesis'') and second hypothesis is that bank failure and bank panics are related to economic events (the recession hypothesis or an information-based run).  His evidence is consistent with the view that bank panics occur when consumers perceive a recession being imminent -- they then withdraw money from the banking system in anticipation of bank failures.  Banking crisis are not random events, but rather are a rational response to expected future loss. Similarly Charles Calomiris and Joseph Mason (1997) find that runs on Chicago banks in the early 1930s were information based -- those banks that experienced runs were already insolvent.  It seems that depositors were able to differentiate between those institutions that were insolvent and those that were not.

There are, of course, the macroeconomic effects of a systemic crisis in banking.  The macroeconomic issue at hand is due to the interaction between the banking system and the money supply.  A run on the banking system can cause the money supply to contract quite sharply imposing huge costs on the real economy.  The problem here is in differentiating between solvent and insolvent banks.  There is a large theoretical literature dealing with this problem -- yet the empirical evidence suggests less of a problem.  Kaufman (1994) undertook a review of theory and evidence and reports that banks are only slightly different from non-bank firms with respect to failure.  Kaufman (1994) does provide some argument that is worth quoting in full.

However, there is no evidence to support the widely held belief that, even in the absence of deposit insurance, bank contagion is a holocaust that can bring down solvent banks, the financial system, and even the entire macroeconomy in domino fashion.  Indeed, losses to depositor creditors at failed banks, one of the major fears and causes of runs, are smaller on average than in nonbank industries.  Even at its worst, as in the 1980s with deposit insurance, resolution of bank insolvencies appears far more efficient than resolution of nonbank firms through the bankruptcy process.

Benson (2000) concurs with Kaufman (1994) and suggests that even if banking crises could impact upon the macroeconomy, then the monetary authorities could quickly and easily intervene.  He concludes (1994, p. 192) that protecting the macroeconomy is not a valid basis for regulating banks.

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THE ROLE OF REGULATION ⁽¹⁾

The economics of regulation can be broken up into three strands.  The first strand, generally associated with Arthur Cecil Pigou, is the ''public interest'' theory and suggests that governments intervene in order to correct for externalities and other market failures.  The second strand, associated with George Stigler (1972), suggests that industry seeks out regulation in order to create barriers to entry for new rivals and to maintain profitability.  This strand of literature is known as the ''special interest'' or ''capture theory'' theory of regulation.  The third strand, associated with Andrei Shleifer, sets out an institutional analysis of regulation that draws upon both the public interest and capture theories of regulation.

Shleifer (2005) describes four broad general mechanisms to exert social control over organisations;  ''market discipline, private litigation, public enforcement through regulation, and state ownership''.  The trade-off in distinguishing between these mechanisms is between disorder and dictatorship.  These notions are described by Djankov, Glaeser, La Porta, Lopez-de-Silanes, and Shleifer (2003).

• 'Disorder refers to the risk to individuals and their property of private expropriation in such forms as banditry, murder, theft, violation of agreements, torts, or monopoly pricing.  Disorder is also reflected in the private subversion of public institutions, such as courts, through bribes and threats, which allows private violators to escape penalties.'
• 'Dictatorship refers to the risk to individuals and their property of expropriation by the state and its agents in such forms as murder, taxation, or violation of property.  Dictatorship is also reflected in expropriation through, rather than just by, the state, such as occurs when state regulators help firms to restrict competitive entry.'

Market discipline is a very powerful force, and should be considered as a regulatory default.  Shleifer (2005) argues that the ''case for public intervention relies crucially on the presumptive failure of market discipline to control disorder''.  At this point the control strategy becomes private litigation.  Courts, however, cannot always resolve disputes cheaply, predictably and impartially.  When this occurs the scope for regulation opens up.  Regulation occurs when the state not only provides a dispute resolution mechanism but also writes the rules that govern economic behaviour and transactions.  There is substantial variation in how government can enforce its regulations.  It can, for example, allow bureaucrats to engage in a regime of inspection and verification with fines being issued for non-compliance.  Alternatively, the state can provide a set of rules that are privately litigated, or publicly litigated.  Public litigation can consist of either civil or criminal charges.  Similarly the regulatory agency can initiate litigation itself for breeches of the regulations, or act once a complaint has been received.

State ownership appears to be an efficient response to those situations where the disorder costs are likely to be very high.  Shleifer (2005) gives the examples of prisons, police force, and military where this is likely to be the case.  The costs of disorder resulting from private ownership here are potentially so large that government needs to maintain control over these institutions.  This, however, is not the case with financial institutions -- governments should not own banks.  Andrei Shleifer and Robert Vishny (1994) have argued that political interference in firm operations is likely to result in inefficiencies, misallocation of resources, and corruption.  Government ownership of banks, however, is common.

Rafael La Porta, Florencio Lopez-de-Silanes, and Andrei Shleifer (2002) investigate government ownership of banks across 92 economies (including Australia).  They consider two hypotheses that could explain why government ownership of banks is pervasive across economies.  A ''development hypothesis'' is associated with the great Harvard economist Alexander Gerschenkron, who argued that banks were an important mechanism for allocating finance to industry in economies with underdeveloped financial systems.  Under a ''political hypothesis'', government takes control of banks in order to capture benefits of ownership and to direct those benefits to friends and supporters in the form of subsidies and employment opportunities.  After careful analysis, they report that the evidence supports the political hypothesis more than the development hypothesis:  Government ownership of banks is higher in economies with ''underdeveloped financial systems, interventionist and inefficient governments, and poor protection of property rights.''

It is one thing to have a generalised argument for regulation as an effective control mechanism, it is quite another to advocate regulation for a specific industry.  The argument for regulating financial markets appears to be strong.  As indicated, financial markets face what economists call an ''asymmetric information'' problem.  Of course security markets are hardly unique in this respect.  Friedrich von Hayek (1945) has written that asymmetric information is the economic problem to be resolved.  This represents a classic case of ''market failure'' and gives rise to the need for regulation under public interest regulation theory.

It is important to recognise that an argument for some regulation is not an argument for any regulation.

La Porta, Lopez-de-Silanes, and Shleifer (2006) investigate the impact of how security laws in financial markets across 49 economies to protect investors and whether regulators with public enforcement or rules with private enforcement lead to better outcomes.  After exhaustive empirical analysis, La Porta, Lopez-de-Silanes, and Shleifer (2006) report

our findings suggest that securities laws matter because they facilitate private contracting rather than provide for public regulatory enforcement.  Specifically, we find that several aspects of public enforcement, such as having an independent and/or focused regulator or criminal sanctions, do not matter, and others matter in only some regressions.

The upshot of this analysis is that legal rules matter, but that regulators do not always matter.  So long as rules can be enforced in courts investors do not need to be protected by regulators.

Barth, Caprio and Levine (2004) find an analogous result in their investigation of bank regulation and supervision across 107 countries (including Australia).  They summarise their results as follows (Barth et al. 2004, p. 245-246).

In terms of broad implications, these findings raise a cautionary flag regarding reform strategies that place excessive reliance on countries adhering to an extensive checklist of regulations and supervisory practices that involve direct, government oversight of and restrictions on banks.  Instead, our findings are consistent with the view that regulations and supervisory practices that

1. force accurate information disclosure,
2. empower private-sector corporate control of banks, and
3. foster incentives for private agents to exert corporate control,

work best to promote bank development, performance and stability.

Regulations involving prescriptive behaviour and powerful regulators using public enforcement mechanisms are not the better techniques to employ for the purpose of social control.  These sorts of results raise the important question of why governments' pursue those types of regulation.  Not only do they appear to be nonoptimal from an economic perspective they must be non-optimal at a personal and political level.  After all, as the Wall Street Journal Europe (2009) points out, ''The bankruptcy of a systemically important bank is, necessarily, also a failure of the regulators who were overseeing it''.

An important component of any regulatory policy is competition policy.  This is an area fraught with difficulty at the best of times, let alone in financial services.  With the exception of the United States, the banking industry tends to be highly concentrated.  US policy has tended to promote a large number of smaller banks rather than allow for higher levels of concentration.  Generic arguments in favour of competition include costs being minimised and resources being efficiently allocated in the economy.  Competition ensures that the benefits of an efficient and effective banking sector are broadly spread across the economy.

An important issue to consider, however, is the potential trade-off between competition and financial stability.  (See Box Three).  Despite vigorously promoting competition in the banking sector, the US seems to be characterised by higher levels of financial instability.  This observation suggests two inter-related questions:  What is the optimal amount of competition in the banking sector?  and what are the tradeoffs between increased competition and increased concentration?

The academic literature has not provided a clear answer to the first question. ⁽²⁾  It is likely that the deadweight costs of bank failure are larger than the efficiency gains of additional competition.  In other words, increased competition may be less valuable, at the margin, in the banking sector than in other sectors of the economy, i.e. the benefits of competition, everything else being equal, are quickly exhausted.  Banks, which are highly leveraged, are also more likely to experience moral hazard problems.  In particular, banks face an ''asset substitution'' problem.  Policies that promote excessive competition are likely to provide incentives for banks to take on too much risk.

In answer to the second question, there is some empirical evidence that supports the notion that concentrated banking systems are more stable than fragmented systems.  In an analysis of sixty-nine economies over the period 1980-1997 (including Australia) Thorsten Beck, Asli Demirguc-Kunt and Ross Levine find that greater bank concentration is associated with a lower probability of a banking crisis.  In particular they find ''no support for the view that banking system concentration is a proxy for a less competitive banking environment''.

Box Three:  Glenn Stevens on the Competition-Stability Trade-off At his recent appearance before the House of Representatives Standing Committee on Economics the Reserve Bank of Australia Governor Glenn Stevens had this view of this very important question. *** Dr LEIGH—I will turn to banking.  Do you think there is a trade-off between competition in the banking sector and system stability? Mr Stevens—At one level there probably is, but I will articulate that a little more.  Like I was saying before, banking is not just any other business.  In many areas it is probably the case that more competition is always better for consumers, but in banking more competition is good to a point but beyond a point more competition is not good, because the bankers can be led to do things that ultimately cause a lot of subsequent damage.  I think we have to understand that.  That is not to say that the current amount of competition we see in any particular market is necessarily enough, but there is a point beyond which extreme competition in lending money leads to problems. That is actually the background to why, after the Great Depression, there was so much more regulation brought in.  A lot of that regulation was designed to prevent competition from going too far, frankly.  That is the way people thought then.  Of course, we probably overdid regulation historically and had to come back to letting there be some more competition.  I think to a point that was good.  But there is a kind of point somewhere beyond which the competition pushes down lending standards and ends up lending money to people who really should not get it.  That is not a good thing.

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PROFITABILITY AND COMPETITION

Australian banks appear to be highly profitable.  The general argument seems to be that banks somehow earn monopoly profits.  This perception is untrue, and if translated into policy action could seriously undermine the Australian banking industry.

Australian banks are often criticised for the profits that they earn.  Despite the positive role that profits play in the economy, the broader community are often ambivalent about profitability.  It is important to understand that profit is not a conspiracy against the public.  Consumers should not begrudge the profitability of firms but rather recognise it as a manifestation of the value of a transaction.

As Ludwig von Mises (1952) indicated,

There would not be any profits but for the eagerness of the public to acquire the merchandise offered for sale by the successful entrepreneur, but the same people who scramble for these articles vilify the businessman and call his profit ill-got.

But we should investigate this issue further before drawing any judgement.  After all von Mises (1949) also argues that entrepreneurs earn profit through serving consumers, while the monopolist ''reaps monopoly gains through impairing the satisfaction of consumers''.  It is not unreasonable for consumers to question whether or not Australian banks are truly entrepreneurial or if they exercise monopoly power.

One way of evaluating competition in an industry is to make use of the well-known Structure-Conduct-Performance (SCP) model. ⁽³⁾  This approach works on the principle that the structure of the industry (either concentrated or diffuse) leads to conduct (either monopolistic or competitive) which in turn leads to performance (monopoly profits or normal competitive returns).  The SCP approach has been criticised by economists such as Harold Demsetz, nonetheless the approach itself is widely used and appears to be intuitively attractive to non-economists.

Jacob Bikker and Jaap Bos (2008) have investigated the SCP approach in a massive analysis of 7,266 banks across 46 countries spanning 1996-2005.  Their Australian sample includes 36 financial institutions.  In their analysis they make use of the wellknown Herfindahl-Hirshman Index and various concentration ratios (in the empirical test of the SCP approach they employ a top-three bank concentration ratio).  They are able to find no statistically significant relationship between concentration and profitability for Australia (pg. 87) and no statistically significant relationship between the Herfindahl-Hirshman Index and profitability for Australia (pg. 88).  They interpret this result as follows, ''for most countries the impact of market structure on performance is limited''.

Of course, the argument at present is that the banking industry has become more concentrated and less competitive since the global financial crisis.  To be sure it does appear that the banking sector is more concentrated and some smaller financial institutions are struggling in the current environment.  It is instructive to examine what Australian regulators and public officials were saying about bank competition at the time the crisis first began and to compare that to what they say now.  In particular what was reported to the 2008 House of Representatives Standing Committee on Economics Inquiry into Competition in the Banking and Non-Banking Sectors.

At that time The Treasury argued (emphasis added)

Notwithstanding the prominence of the five major banks in the Australian banking sector, there is evidence that the sector is contestable.  Australian banking customers are served by a wide range of banking providers, including:  13 domestic banks;  12 building societies;  139 credit unions;  and a subset of Australia's 10 foreign bank subsidiaries, 31 foreign bank branches, and more than 100 non-ADI financial institutions.  According to financial services research firm CANNEX, there are currently around:  140 providers of over 2,400 mortgage products;  70 providers of over 300 different credit cards;  and 130 providers of over 2,400 different types of deposit accounts.

Similarly the RBA argued, ''By international standards, Australian borrowers are offered a wide range of mortgage products and are able to choose from a large number of different loan types, with many of these offering more flexibility than is available in other countries.''

The view of both the RBA and the Treasury seems to indicate that the structure and conduct components of the SCP model do not suggest monopolistic behaviour.

Similarly on profitability there was little evidence that the Australian banking industry earns monopoly profits.  The Treasury indicated that, ''The profitability of the major banks appears to be broadly consistent with other large Australian companies''.  Ric Battellino of the RBA reported a far more comprehensive analysis to the House of Representatives inquiry into competition in the Australian banking sector. ⁽⁴⁾

When we look at bank profitability, we find that Australian banks are around the top of the international range.  On the surface, this could indicate a lesser degree of competition than elsewhere.  But when we look a bit deeper it seems that an important reason for the high profitability of Australian banks is their unusually low bad debt experience.  Over the past decade or so, bad debts of Australian banks have been about half the long run average, and also around half the experience of overseas banks.  This has been the result of the very strong domestic economy.  It is also worth noting that other Australian industries have been very profitable over this period.

Ric Battellino made far more expansive comments at the hearing held in Sydney and these comments are reproduced from Hansard:  ⁽⁵⁾

Some commentators have recently been concerned that financial turmoil over the past year has lessened the degree of competition.  This is because the turmoil has made it harder for lenders who fund themselves in capital markets to compete. … While it is true that lenders relying on securitisation have lost market share in recent months, it has always been the case that some phases of the economic cycle favour some forms of financing more than others.

In other words we can expect to observe that competitors with different business models perform differently in different stages of the economic cycle.  Good policy provides a framework for economic behaviour it should not determine outcomes.  At present some business models are at a disadvantage but that is not sufficient grounds for government intervention.

These points were more or less reiterated by the RBA when officials appeared before the House of Representatives Standing Committee on Economics on November 26, 2010.  The cost of capital for Australian banks (and lenders in general) has risen over the past few years.  As Glenn Stevens explained ⁽⁶⁾

What we have seen in the past several years is that those wholesale funding sources, which for some years up to the middle of 2007 were very available, very inexpensive and, apparently, quite reliable and quite stable, changed dramatically after the problems began in 2007 and especially after the Lehman failure in September 2008.  I think every banker in the world and every supervisor concluded that it was a more unstable and risky source of funding than had previously been assumed and that banks, therefore, needed to change their funding mix more in the direction of things that could be expected to be stable.  Our banks have done that.  I cannot say that I regard that as something to regret.  I think it is probably prudent.  What that has meant is that there has been much more intense competition to raise funds by financial institutions in that space than there had been before.  You have seen that in the rises in their costs and the relatives of the cash rate.  The cost of several types of deposit funding has increased quite markedly over this period.

At present those financial institutions that are better able to access capital will have an advantage over those that cannot.  Furthermore, we can expect to see higher prices in the banking industry.  This is not due to monopoly power per se, but rather due to a reassessment of risk.

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SHOULD GOVERNMENT SET PRICES?

The primary function of government is to establish and maintain conditions for society to flourish.  The rule of law acts to restrict the extent and scope of government intervention in society.  The rule of law has economic consequences.  Government should only undertake those tasks which the market will not undertake, for example the provision of a reliable and stable monetary system.  Importantly any form of price control or government mandated price manipulation is inconsistent with the rule of law.  As Friedrich von Hayek (1960) has argued:

Appropriate prices depend on circumstance which are constantly changing and must be continuously adjusted to them.  On the other hand, prices which are not fixed outright but determined by some rule (such as that they must be in a certain relation to cost) will not be the same for all sellers and, for this reason, will prevent the market from functioning.  A still more important consideration is that, with prices different from those that would form on a free market, demand and supply will not be equal, and if the price control is to be effective some method must be found for deciding who is to be allowed to buy or sell.

Hayek does not argue against government regulation, but he does indicate that the price mechanism must be free to operate and determine prices.

It has often been argued that government can maintain and enhance public welfare by operating business firms.  The basis for this type of argument is that the profit motive is somehow inconsistent with public welfare.  This argument is wrong, of course.  Yet economic history is littered with examples of where governments have attempted to operate firms best suited for private operation.  Examples in recent Australian history include the State Bank of South Australia.  This State Owned Enterprise collapsed in 1992 following many years of poor financial management.

It is important to reflect on the one bank that is owned by government -- the Reserve Bank of Australia.  Historically the Commonwealth Bank operated both as a commercial bank and as a central bank.  The Reserve Bank of Australia was created in 1960 as a separate entity from the Commonwealth Bank.  It was broadly felt that a single entity should not operate as both a (profit-seeking) commercial bank and also as a (non-profit seeking) central bank. ⁽⁷⁾  Furthermore, the Reserve Bank operates at arms length from the government.

It seems somewhat incongruous that government should influence the pricing of banks when it does not do so for its own wholly owned instrumentality the Reserve Bank.  Similarly, the government owned the Commonwealth Bank, but chose to privatise it in the 1990s.  Again, it seems incongruous that the government should now attempt to control pricing arrangements of a private sector entity when it made little attempt to do so when it owned the bank.  Despite the rhetoric, government clearly needs to recognise the limits of its powers and influence.  This is especially so given the history of ownership of the Commonwealth Bank (and current ownership of the Reserve Bank) and the behaviour of government at the time of ownership.

The present concern about pricing revolves around the differences between changes in the RBA cash rate and the standard variable rates charged by banks.  Using data from the RBA I have plotted the differential between the two for the period January 1990 to October 2010 (the standard variable rate for November 2010 was not available at the time of writing).

Figure One:  Difference between the RBA cash rate and standard variable rates

Source:  RBA

While it is true that the differential has increased since January 2008, it is also the case that the cost of capital has increased since that time and it is now widely recognised that risks were under priced prior to the global financial crisis.

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RECOMMENDATIONS

• Australian banks do not have monopoly power and should not be treated as such.  Normal consumer protection legislation should apply to the banking sector.
• The business of banking is complex and risky.  Government officials, regulators and politicians should not consistently and persistently secondguess private decisions.
• Profitability in and of itself is not a measure of monopoly.  An unprofitable banking sector would have deleterious effects on the Australian economy.  Government should focus on establishing the conditions under which the private sector can seek out and earn profits though meeting the needs of the Australian community.
• Policy makers and regulators should adopt an evidence-based approach to regulation.  Pure panics seldom, if ever, cause banking crises.  Financial institutions should be allowed to fail if insolvent and be subject to the wellknown Bagehot Rule if illiquid.
• The Australian government should not seek to own a bank (either outright or through the Post Office), nor seek to set prices at any bank (including the Reserve Bank).

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REFERENCES

Allen, F. and D. Gale. 2001. Comparing Financial Systems, Cambridge, MIT Press.

Barth, J., Caprio, G. Jr., & Levine, R. (2001). Banking systems around the globe:  Do regulations and ownership affect performance and stability?  In Mishkin, F. (Ed.), Prudential supervision:  What works and what doesn't. Chicago, University of Chicago Press.

Barth, J., Caprio, G. Jr., & Levine, R. (2004). Bank regulation and supervision:  What works best?  Journal of Financial Intermediation, 13, 205-248.

Beck, T., A. Demirguc-Kunt and R. Levine. 2006. Bank Concentration and Fragility:  Impact and Mechanics, In Mark Carey and Rene Stulz (eds), The Risks of Financial Institutions, Chicago, The University of Chicago Press.

Benson, G. 2000. Is government regulation of banks necessary?  Journal of Financial Services Research, 18, 185-202.

Bikker, J. and J. Bos. 2008. Bank Performance:  A theoretical and empirical framework for the analysis of profitability, competition and efficiency, London:  Routledge.

Calomiris, C. and J. Mason. 1997. Contagion and bank failures during the great depression:  The June 1932 Chicago banking crisis. American Economic Review, 87(5), 863-883.

Davidson, S. (2010). Bankers and Scapegoats. International Finance Review, 11, 119-134.

Djankov, S., Glaeser, E., La Porta, R., Lopez-de-Silanes, F., & Shleifer, A. (2003). The new comparative economics. Journal of Comparative Economics, 31, 595-619.

Ferguson, P. and G. Ferguson. 1994. Industrial Economics:  Issues and Perspectives, Second Edition, New York University Press.

Gorton, G. (1988). Banking panics and business cycles. Oxford Economic Papers, 40, 751-781.

Hayek, F. 1945. The use of knowledge in society. American Economic Review, 35(4), 519-530.

Hayek, F. 1960. The Constitution of Liberty, Routledge.

Kaufman, G. (1994). Bank contagion:  A review of the theory and evidence. Journal of Financial Services Research, 8, 123-150.

La Porta, R., Lopez-de-Silanes, F., & Shleifer, A. 2002. Government ownership of banks. The Journal of Finance, 57(1), 265-301.

La Porta, R., Lopez-de-Silanes, F., & Shleifer, A. (2006). What works in security laws?  The Journal of Finance, 61(1), 1-32.

Mises, L, von. 1952. Planning for Freedom, Libertarian Press

Mises, L. von. 1980. The theory of money and credit. Indianapolis:  Liberty Fund.

Schedvin, C. 1992. In Reserve:  Central Banking in Australia 1945-75, Allen & Unwin.

Shleifer, A. (2005). Understanding regulation. European Financial Management, 11(4), 439-451.

Shleifer, A. (2010). Efficient Regulation. Unpublished Working Paper, Harvard University.

Shleifer, A. and R. Vishny. 1994. ''Politicians and firms'', Quarterly Journal of Economics 109, 995–1025.

Stigler, G. (1972). The theory of economic regulation. Bell Journal of Economics and Management Science, reproduced in Stigler, G. 1975. The citizen and the state:  Essays on regulation. Chicago:  The University of Chicago Press.

Wall Street Journal Europe. (2009). When regulators fail. Wall Street Journal Europe, November 3, 2009, available at http://online.wsj.com/article/SB10001424052748703740004574513413224061606.html

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BIBLIOGRAPHY

1.  This section relies on section three of my paper Bankers and Scapegoats.

2.  See Allen and Gale (2001, pg. 268).

3.  See Ferguson and Ferguson (1994).

4.  http://www.rba.gov.au/Speeches/2008/sp_dg_140808.html

5.  http://www.aph.gov.au/hansard/reps/commttee/R11143.pdf

6.  http://www.aph.gov.au/Hansard/reps/commttee/R13346.pdf

7.  See Schedvin (1992).

Retreat now, before the cost soars

Prime Minister Julia Gillard is strongly promoting a carbon tax to combat what she calls an ''externality warming the planet''.  The government's army of advisers promoting a carbon tax is also counselling the Multi-Party Climate Change Committee, which comprises non-Coalition parliamentary representatives.

The committee's briefings say that higher Australian electricity prices are an inevitable result of measures already enacted.  These include requiring new renewables to supply 20 per cent of electricity by 2020, substituting unreliable windmills for coal-powered electricity at threefold the cost.

In addition, a prospective carbon tax means a virtual prohibition on new coal-powered stations.  The financial risk is too great for any private firm to absorb.

As well as driving up electricity prices, this is now threatening to bring capacity shortages.  The Australian Energy Market Operator is foreshadowing a 7 per cent supply shortfall in Queensland by 2013-14 (726 megawatts) and a 249 MW deficit in Victoria by 2015-16.

Australia's impositions on coal for domestic use are accompanied by encouraging its rapid export expansion.  Such a reversal of the notion of trade protectionism is economic suicide.  Nor can it have any effect without an international consensus to reduce emissions.

The prospects of this are receding.  The US has abandoned cap-and-trade and Japan will not renew its Kyoto treaty pledges after 2012.  Cancun will continue the retreat from global action that was recognised at Copenhagen by everyone except agitators for emission-reduction measures.

These developments mean we should rethink our carbon emissions policy after May next year once the Productivity Commission provides us with an accurate fix on Australia's carbon emission penalties relative to those in other countries.

In the interim, we need to avoid unnecessary waste and risk to the reliability of the electricity system.  As a first step Australia should declare a moratorium on costly existing emission-reduction measures.  This should include inviting bids for the required new power station capacity in Queensland and Victoria with the winning bids, subject to assurances that they are '''state of the art'', being granted immunity from any future carbon tax.

In addition, the 20 per cent renewable program should be suspended alongside any subsidies for new wind facilities not yet financially committed.

Such an approach would leave us ready to re-embark upon emission reductions or dismantle existing measures depending on international developments.

Sequel to Copenhagen Resembles the Remake of a Bad Movie

One year after the Copenhagen climate change circus, the Gillard government is being dragged by the Greens towards policies that are out of step with the international community.

On Monday in Cancun the next major round of climate change talks started to mop up Copenhagen's mess.  Substantive negotiations broke down last December after the negotiating text for a successor agreement to the Kyoto Protocol swelled with contradictory proposals that made a conclusion impossible.  At the time then prime minister Kevin Rudd described it as a ''catastrophic collapse''.

In the end the text had to be junked and world leaders cobbled together the face-saving Copenhagen Accord, including vague commitments for countries to cut emissions.  But the accord failed to pass on the conference floor.

One year on, the Cancun conference is set to repeat history.

In the lead-up to Cancun the secretariat of the UN climate change body released a negotiating text including proposals from different countries, but again its size has grown with mutually exclusive proposals designed to protect the political and economic interests of its sponsors.

The only difference this time is world leaders are staying away from the impending fiasco.  Instead of planes full of presidents and prime ministers, only environment and climate change ministers are expected to attend, to sign the conference's concluding negotiating statement of good will.

The consequence of Cancun's collapse doesn't appear to have got through to the government.  In a speech yesterday to a Crawford School Forum, Climate Change Minister Greg Combet said:  ''we all know a carbon price signal is coming to the Australian economy''.

If it is, it is out of step with current international negotiations.  In the lead-up to Cancun the chairwoman charged with overseeing negotiations of a possible agreement, Margaret Mukahanana-Sangarwe, said a stumbling block was that ''parties have also divergent views on the role of market-based mechanisms''.

Even before the US mid-term elections.  America's Democrat-controlled Congress wouldn't pass the equivalent of our emissions trading scheme.  Now that the Republicans control the House of Representatives the proposal is dead.  And even emissions reduction remains a red-hot issue in international talks.

According to Mukahanana-Sangarwe, emissions reduction remains a central challenge because of the divergence in expectations of developed and developing country reductions, and whether these should be achieved under the Kyoto Protocol or a new agreement.  One proposal requires developed countries to cut emissions at home, undermining the Kyoto Protocol's flexibility for countries to sponsor cheaper reductions in developing countries.

Such a proposal is in conflict with Australia's previously modelled emissions trading scheme.

And the spirit of co-operative action is also disappearing from meetings.  In October's preparatory talks, chief Chinese climate change negotiator Su Wei said:  ''after five years of negotiation we have seen slow or no progress [because] developed countries are trying every means possible to avoid discussion of the essential issue, that is, emissions reduction.''

The divide between key countries has even got personal.

Su has started referring to the US publicly as ''a developed country [he] won't name'' before bucketing their involvement and negotiating position.

Considering the normal pleasantries of diplomatic exchanges, Su's comments demonstrate how little good will is left.

Another challenge is that in recognition of mitigation efforts, developing countries want an annual $100 billion international climate change fund established and financed by developed world taxpayers ''as part of the repayment of their climate debt''.

In response to the proposal, chief US climate negotiator Jonathan Pershing has described the financial demands on the US from some countries as being ''staggering sums out of line with reality''.

But there's been no discussion in Australia about how our contribution will be financed, including whether previous proposals for new taxes on internationally traded goods will be imposed that will disproportionately harm geographically isolated economies dependent on trade.

These realities bode poorly for Australia as the Gillard government continues to be pulled by the collar by the Greens to take on expensive mitigation commitments out of step with the international community.

For Australia's sake let's hope Combet gets a wake-up call when he arrives in Cancun next week.

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WikiLeaks and the virtue of transparency

WikiLeaks's release of American diplomatic cables ''may put lives at risk''.  The White House spokesman Robert Gibbs claims that the release may damage the ''cause of human rights''.  WikiLeaks's actions are ''reckless'' and ''dangerous''.

Sounds serious.  But we've heard these claims before.

When each of the Afghan and Iraqi war logs were released earlier this year, US officials lined up to condemn the whistleblowing site in the strongest possible language.  The Afghan documents, ''put the lives of Americans at risk'', according to the US national security advisor.  The Department of Defense said the Iraq files dump ''could make our troops even more vulnerable to attack in the future''.

On Sunday night a Republican Senator from South Carolina wildly argued on Fox News that ''The people at WikiLeaks could have blood on their hands.''

The operative word in that sentence is ''could''.

Having lived with WikiLeaks's release of the Iraq and Afghanistan war logs for months now, Pentagon officials concede there is no evidence that a single person has lost their life as a result.  Not one.

And when requested in the lead up to the latest release, the State Department refused to guide WikiLeaks as to which documents should be redacted to protect against ''significant risk of harm''.

Instead they insisted the site delete all the documents and forget it ever happened - something the messianic and volatile WikiLeaks head Julian Assange was quite unlikely to do.

Crazy-brave, with all those lives at stake.  But more likely just a bad bluff.  Major government departments aren't good at poker.

The passionate assertions that national security will be compromised, that lives will be lost, that the cause of human rights will be set back:  shameless, unadulterated hyperbole, by a government not even sure what's about to be released.  Transparent attempts to dissuade WikiLeaks from revealing uncomfortable material.

To take a random example out of the 243 documents released so far, it mustn't be nice to have it publicly known US diplomats think Bavarian premier Horst Seehofer is ''unpredictable'' and has only ''shallow foreign policy expertise''.

The full diplomatic archive of a quarter of a million documents will be released in dribs and drabs over the coming months.

Some of what we've seen is little more than banal gossip.  Nobody needed leaked diplomatic communication to realise, say, Dmitry Medvedev ''plays Robin to Putin's Batman'' as one cable put it, although it's great fun to see it in an official document.  Or that Kim Jong-Il is a ''flabby old man''.  That Silvio Berlusconi is ''vain'' with a ''penchant for partying hard''.  It will shock the international community to learn Hamid Karzai is ''extremely weak''.

One overwhelming impression from the cables which have been released:  professional diplomats are unimpressed by the politicians they're compelled to work with.  If only we could see their pens turned against their US political masters.

Other cables are more important, but still only embellish what we know already.

For instance:  the US government has been trying to convince other countries to resettle its Guantanamo Bay detainees for years.  But thanks to WikiLeaks we now know how desperate those US negotiators sound:  officials tried to convince Belgium accepting prisoners would be ''a low-cost way for Belgium to attain prominence in Europe''.

This is not materially new information.  But it is more revealing than the sterile reports we're familiar with.

After all, it is one thing to know the world's superpower is negotiating to resettle detainees.  It's quite another to learn that the superpower sounds like an anxious salesman as it tries to do so.  Or like a shonky political party treasurer selling tables to a fundraiser:  Slovenia was told resettling a detainee would earn Slovenian leaders an audience with Barack Obama.

These cables further underline how the original decision to set up Guantanamo Bay dropped the US into a complicated long-term legal bind from which it is still struggling to extricate itself.  It's not revelatory.  But the desperation is very, very revealing.

So too is the deep mistrust within the Middle East towards Iran.

Arab leaders in the region endlessly crow about Israel, but in private it is Iran they worry about.  The cables vividly show that the leadership of Qatar, Abu Dhabi, Oman and Bahrain are all deeply concerned about Iran's nuclear program.  Saudi Arabia has been urging a US attack on Iran.

Analysts have been saying this for years, of course.  But the unadorned cables make their points starkly and unambiguously.

Julian Assange is anti-war.  But when the world reads the Egyptian president telling the US ambassador to only enter dialogue with Iran ''so long as the [US] does not believe a word [the Iranians] say'', the case for dealing with Iran as soon as possible is strengthened, not weakened.

The documents are unlikely to damage America's global reputation.

While foreign governments will kick up a fuss about what they read, they know how diplomacy works.  They're worried they could be the victims of the next WikiLeaks release.

Neither are they likely to be of great interest to foreign intelligence services.  At a minimum, 3 million American soldiers and officials have access to the cables and the clearance to read them.  That's the security problem, not WikiLeaks.  Let's assume much of these cables have leaked before, just less publicly.

In the past, the US government itself made use of WikiLeaks to expose corruption and mismanagement in the United Nations.  One of George Bush's senior officials said in July, ''Transparency and accountability in government and international institutions is a best practice and of great importance and WikiLeaks previously has been a force for good in the area.''

It must be harder to see the virtue of transparency when you're the target.