Building a New Age of Certainty

The Hon Joe Hockey is the Member for North Sydney and shadow treasurer. He was first elected to the federal parliament in 1996 and held a number of ministerial portfolios in the Howard Governments, including that of Small Business and Tourism, Financial Services, Regulation, Human Services and Employment, and Workplace Relations. On Thursday 30 August, Joe Hockey addressed The Sydney Institute to discuss how government can promote renewed entrepreneurial spirit for business. As Hockey put it: “The ‘uncertain knowledge’ that Keynes spoke of will always be present – but the government should not add to these risks. The least the government can offer our innovators and economic drivers is stability and consistency of policy.”

 BUILDING A NEW AGE OF CERTAINTY

JOE HOCKEY

Eighteen years ago, on a typical hot November day at Stanwell Park just south of Sydney, local engineer, explorer and, according to all reports, cantankerous inventor Lawrence Hargrave strapped himself to four box kites and bravely lifted himself off the sand dune 16 feet or 4.87m towards the blue sky.

A few years later, equally gifted risk-taking aviation pioneers, Orville and Wilbur Wright, credited Hargrave for his seminal work in identifying that a curved surface can lift weight and that there is “no limit to the weight that may be buoyed up in a breeze”.  Their “heavier than air” craft lifted off the ground at Kitty Hawk in North Carolina USA just eight days before Christmas in 1903. It took only 75 years for mankind to rise from 16 feet into the air to a single foot on the surface of the moon.

There was no certainty that each journey would succeed. Indeed, there would not be an aviation pioneer that would not be aware of the risks of failure. The combination of scientific and mathematical knowledge combined to reduce the risk of failure to a mere percentage figure. This gives innovators confidence. They have measured the risk. Measuring and containing risk gives people the confidence to try and make bold ambitions a reality. As Neil Armstrong later said:

The important achievement of Apollo was demonstrating that humanity is not forever chained to this planet and our visions go rather further than that and our opportunities are unlimited.

On every life journey, a risk is taken. From borrowing money to renovating a home to flying to the moon, we seek to work out the benefit of taking a risk before we take our first step. Some risks are quantifiable, others aren’t, but the principal is the same – risk is present in everything we do.

John Maynard Keynes, not a usual source for me, described two types of risks – those that are quantifiable and can be calculated, and those that are unquantifiable, such as the possibility of a world war a hundred years from now. He referred to these unquantifiable risks as “uncertain knowledge”. Keynes observed back in 1937:

 By “uncertain” knowledge, let me explain, I do not mean merely to distinguish what is known for certain from what is only probable. The game of roulette is not subject, in this sense, to uncertainty; nor is the prospect of a Victory bond being drawn…The sense in which I am using the term is that in which the prospect of a European war is uncertain, or the price of copper and the rate of interest twenty years hence, or the obsolescence of a new invention, or the position of private wealth owners in the social system in 1970. About these matters there is no scientific basis on which to form any calculable probability whatever. We simply do not know.

Risk assessment is therefore about quantifying the “certain” risks, and hedging against the risks that are unknown (and unknowable).Both forms of risk are simply just a bet on the future. Of course we cannot eradicate risk from our lives…we can only manage risk and calculate its impact. As Peter Bernstein noted in his significant work, Against The Gods: The Remarkable Story of Risk:

The revolutionary idea that defines the boundary between modern times and the past is the mastery of risk; the notion that the future is more than a whim of the gods and that men and women are not passive before nature.

 Men and women have never been passive before nature. However, we can and do take different roles as creators, assessors, regulators or avoiders of risk. Taking risk and reaping the associated rewards lies at the heart of our modern society. It also drives our modern global economy.

Without the willingness to take risk there would be no investment in business or infrastructure. Without the willingness to take risk there would be no borrowing and lending.  Without a willingness to take risk there would be no production to meet anticipated future demand for goods and services.  In short, without taking risks there would be no innovation, and no progress. Risk is two sided. It carries with it the chance of reward but also the chance of failure. And the key to successful risk management is that the chance of reward or failure must be properly assessed and appropriately priced.

Opportunity cost of not taking risk

Risk is not just about doing something. We all know that the opportunity cost of doing nothing can be considerable – so by doing nothing households and businesses are still taking a considerable risk. A family that decides not to take the plunge to buy their first home can be caught out in a rising property market when prices increase to levels beyond their reach. And an investor who puts their money under the bed will forgo the returns which might have been made on prudent financial investments.

 The current fear of financial risk

Businesses and households are risk averse because we are still recovering from an excess of mispriced and misplaced risk-taking in recent years. In the financial markets, the current heightened level of risk aversion is being reflected in typical ways – volatile and poor equity market returns, wider credit spreads, significant central bank easing and low interest rates for the debt of so called “safe” sovereigns.

However, what is more interesting since the 2007 Financial Crisis is the length to which investors will go to avoid taking risks with their money. For example, the United States Federal Reserve’s target rate was reduced to between 0 per cent and 0.25 per cent in December 2008 and has been held there ever since. This means that banks lend money to each other overnight for almost zero return. This is one of the longest periods of such monetary easing since electronic records began in 1954.

The deposit facility rate of the European Central Bank has recently been reduced to zero. There are reports that consideration is being given to having a negative cash rate – to encourage banks to lend and take a risk rather than deposit cash with the ECB. This is uncharted territory.

I know you are asking yourself who would lend money to a developed economy central bank expecting zero or even negative return? I can’t remember a time when the numbers suggested it was a better investment to put your money in a safety deposit box than to deposit it with a modern western central bank.

Bond yields for six European economies have, very recently, been below zero. Germany just issued 2 year bonds with a yield of negative 0.06 per cent. That means investors are willing to lend to Germany for two years to receive less back…all they get is the assurance they will get most of the money back. Germany, Finland, Denmark, Switzerland, the Netherlands and Austria have all experienced some part of their yield curve trading with negative yields in 2012.

The situation in the United States is also historically significant. While recovering slightly in the first few months of this year, United States 10 year government bond yields are still trading well below two per cent. With all these low or negative yields there is no real expectation of inflation in the Western world for some time yet. As if lending to governments for zero or even negative return weren’t enough to confuse investors, the same central banks are so worried about their local economies that they are rolling out monetary stimulus as if there is no tomorrow.

The United States Federal Reserve is printing so much new money that its balance sheet is now four times the size of its pre Financial Crisis level at USD$3 trillion. The European Central Bank has had a similar experience with its zealous engagement with their printing presses since the Financial Crisis.

Whilst unprecedented times do require unprecedented actions the downside risks in the global economy just will not go away. No respected analyst or investor believes that the Eurozone has dealt properly with all of its systemic fiscal and financial services failings. On every measure Europe faces significant economic challenges. Just to add to the global risks the world is watching carefully the outcome of the United States elections in November.

President Barack Obama and his rival Mitt Romney have very different fiscal strategies. But unless consensus emerges in a bitterly divided political environment what is certain is that from the end of this year there will be an automatic tightening of fiscal policy through cuts to spending programs and increases in taxes.

The Congressional Budget Office estimates that this “fiscal cliff” may lead to recession, with real GDP declining by 0.5 per cent in 2013, and with unemployment almost a full percentage point higher at 9 per cent. On top of America’s near technical default on its debt last year, this fiscal cliff will add massive uncertainty to the global economy for many months to come. It is a hell of a way to run a country.

But, even in Australia, we are experiencing unique times. The Reserve Bank cash rate of 3.5 per cent is only 50 basis points off the lows seen in the Financial Crisis. And 3 per cent was the lowest since Reserve Bank electronic records began in the mid 1970s.  (Before Wayne Swan gets too excited I just want to point out that no one is actually paying 3.5 per cent on their mortgage!)

Ten year Australian government bonds have recently traded at historical lows of 2.89 per cent in recent times and are still trading at less than 3.5 per cent – still historically low levels. Compare this to pre-Financial Crisis levels of 6.6% in June 2008, and a far cry from the 7 per cent in 2000 and the 16.4 per cent in June 1982. In financial markets this is termed the “flight to quality”. Really this means that people do not have the confidence to put their money anywhere else.

From a household perspective, we have seen risk aversion reflected by the growth in bank deposits and the increase in household savings from around 4 per cent of disposable income pre Financial Crisis to around 10 per cent now. Consumer sentiment, as measured by Westpac and the Melbourne Institute, is down. Households have become more cautious as their confidence has fallen. They are spending less and they are saving more for the rainy day which they see as inevitable.

Households and businesses alike have been de-leveraging like no other time in our history. A McKinsey study of the 10 largest mature economies in the world recently noted that the process of de-leveraging started quite soon after the Financial Crisis. In fact, for three countries surveyed, the United States, South Korea and Australia, total debt ratios have fallen since 2008. Sadly for Australia, while the private sector was de-leveraging, the level of our government debt has continued to grow.

The after-shocks of the Financial Crisis and the loss of confidence across western economies shows no sign of abating. Investors are purchasing assets perceived to be risk free to shield against risks they just can’t manage and are unable to price. We are living in a dramatic age of uncertainty. And the movement of global money proves that beyond any doubt.

This new “age of uncertainty” affects every government, every economy, every business and every household. Attitudes will not change without concerted government action to deal with the reasons why!

Causes of risk paralysis – global

 Before the 2007 Financial Crisis, the world experienced free flowing credit, consistent equity market returns and a steady accumulation of household wealth based on positive superannuation fund returns and housing price increases. Our exporting businesses benefited from rising terms of trade and strong global growth, especially in China and other emerging markets. Our local businesses experienced high levels of consumer discretionary spending, often thanks to easy and affordable credit.

The economic backdrop to life just seemed more certain. It seemed to be a lot less complex than it is today. People and businesses took risks.

What went wrong is that we all got complacent and a culture of underpricing risk thrived in many parts of the global economy.  Ratings agencies dropped the ball, financial institutions traded products so complex that they didn’t understand where the liability ended, and leverage at multiples of equity become the norm. Then the party ended.

The bail out of failing financial institutions transferred an unprecedented level of debt and risk from the private to the public sector. As a result already debt-laden countries have become even more indebted to the point where markets are now questioning the capacity of governments to service and repay the debt.

Ratings agencies are far more cautious and regulators, fearing the wrath of public anguish, have taken extraordinary steps to re-regulate the financial system to the point where global standards are most heavily influenced by the worst performing jurisdictions.

It is time for all of us to refocus our financial systems and our economies back onto the tried and true commercial principles of risk and reward.  This will involve the acceptance that, occasionally, businesses will fail.

The challenge for policymakers is to protect the innocent customers, where appropriate, and to minimise the collateral damage whilst ensuring that shareholders, creditors and management bear the consequences. No one celebrated the demise of state banks in the 1990s or HIH in 2000. No one cheered when Ansett, Compass or Bond Corporation fell over.

But it happened because the business models failed. Taking risk can’t be done in hindsight.  All we can do in hindsight is to clean up the mess from poor risk decisions. We collectively pay a heavy price but we also learn from these past mistakes. The clear message from the financial crisis is that the damage from the private sector mispricing of risk was made worse by the actions of governments.

The role of government in increasing risk

At the heart of risk is the notion of personal accountability. The taker of risk will reap the rewards of successful innovation and entrepreneurship but must also bear the costs of failure. That notion of personal accountability has been blunted by the intervention of governments. More regulation, more red tape and slower approval processes are all designed to take the risk out of business.

I often wonder how many government permits Lawrence Hargrave would have to get, and how much insurance he would have to pay, to be lifted 16 feet off the ground at Stanwell Park in 2012. I often wonder how many entrepreneurs and innovators have just given up. The financial reward for risk taking has diminished with higher taxes on profit and income which penalises success. After all, our government has declared war on individuals because they are billionaires, and miners because they are profitable.

The global bail out by governments of financial institutions, and some corporates which were deemed too big or too important to fail, has effectively removed one of the disciplines of the system of risk taking.  It has undermined the risk calculus. I well understand the political pressures to bailout a General Motors. But how some banks could survive while others like Lehman Brothers are allowed to fail leaves people confused about how the market economy will work.

Citizens across the globe saw the biggest institutions and the most highly paid individuals reaping enormous rewards in the good times but they have not paid the price when the risks they took went bad. And worse, the burden of these failures was borne by the taxpayers, who did not take the risks in the first place and who often did not reap the rewards when times were good.

I have no doubt that high unemployment, business uncertainty and greater constraints on the availability of credit will put new pressure on political leaders for reactive and prescriptive corporate regulation. The march of reactionary policy making has not finished and it is arguable that it has only just started.

There are very few popular democratically elected governments in the Western world today. That is because some actions of government have made a bad situation worse. New taxes, new regulations and unpredictable decision making unsettles consumers and business alike.

In Australia, the uncertainty has been heightened by our government’s broken promises, backflips and capricious decisions. When peak business leaders such as Gerry Harvey and John Symond, Ivan Glasenberg, of Glencore, Mike Young from BC Iron, Jac Nasser of BHP and Jennifer Westacott from the Business Council are all complaining about the government and sovereign risk, then you know that we, as a nation, can do better.

What is undermining confidence is all Labor’s own work.  It is Labor’s policies, and Labor’s ad-hoc decision making, that is adversely impacting Australia’s sovereign risk profile. The only thing certain about this government is their inconsistency. Recently Rio Tinto’s Managing Director for Australia David Peever said:

There has been a deal of uncertainty created in the policy space which is making investment more difficult. We certainly need clarity and we need generally policies that meet all of the needs of the Australian community as well as allowing us to efficiently and quickly get on with the business.

 And he is not alone. David Knox, the Chief Executive of Santos, shares this concern when he says:

My clear message to the Australian government is: do not create uncertainty. Instead provide our investors with the confidence in Australia as a stable fiscal and regulatory region – allow us to stay competitive.

 In taxation policy alone this government changes the rules on the morning of game day.

Each change and each new tax is another disincentive for an entrepreneur, innovator or household to take a risk. If the rewards of risk are not reaped by the risk-taker, then the incentive to take a risk is diminished.

This is particularly the case for Australia’s 2.7 million small businesses. I could think of few bigger risks than taking out a mortgage against your home to fund your own small business. And I know how crushing it must be to have the potential rewards eroded by new or increased taxes. There have been 26 new or increased taxes since the 2007 election of the Labor government. What’s more there have been six versions of the carbon tax – the latest occurring as recently as 48 hours ago with the abandonment of the floor price and the linkage to the European Emissions Trading Scheme. This tax will erode the competitiveness of all Australian based businesses and will increase the price of everything. And it will not even reduce Australia’s locally produced emissions.

This tax is not just paid by the 300 largest polluters. It is clear that all businesses will bear higher costs due to the carbon tax on inputs such as electricity. Many will be unable to pass on the extra costs to customers. Schools and hospitals and charities and most NGOs will receive no compensation for their higher costs. And it is now questionable whether the compensation provided to many households will be sufficient.

The introduction of the mining tax is another case in point. The mining tax has also been through six iterations.  It is still not well understood by those companies who may have to pay it. Even one of the prime minister’s own special advisers, Dr Ken Henry, questions whether the mining tax was “worth bothering (with) at all”. He added that: “There’s no way the public can possibly understand what has actually been legislated….”

 The six versions of the mining tax have created enormous investor uncertainty – it has added significant sovereign risk for less than 1 per cent of federal government tax revenue.

It is also a compliance nightmare.

A recent survey of 200 tax managers from Australian mining companies by Thomson Reuters found that “almost all respondents singled out compliance costs as the biggest issue” of the mining tax. During a recent trip to Perth, I was confronted with a medium sized miner that is not liable to pay the mining tax, who had to spend $1.5 million per year on compliance, all for a tax they will most probably never have to even pay.

There have been promised cuts to company taxes which have then been cancelled. There have been promised benefits for personal income tax payers which have subsequently dropped off the agenda. And if they haven’t created enough uncertainty about the tax system going forward, then people should be aware that more than $5 billion of retrospective taxes have passed through parliament in the last three months.

This government is undermining certainty by changing tax laws for yesterday, today and tomorrow. And it is doing so because it needs the money. For example, Commonwealth government spending this year will be $364 billion, nearly $100 billion higher than in the last year of the Coalition government. The ratio of spending to GDP will be higher in every year of this government and over the forward estimates than in the last two years of the Coalition.

The government now has a $120 billion Budget black hole as a result of massive new unfunded spending announcements in disability services, education, border protection, dental services and aged care. This means higher taxes and greater uncertainty for consumers and investors. In addition, the constricting burden of government regulation has increased enormously under this government. This government has added 18,000 regulations to the books since 2008 – and has repealed only 86 regulations. That is 11 new regulations every day.

How can anyone be expected to be across all these new laws? Compliance is a nightmare.

For any business this means they find it even harder to properly price risk. Sovereign risk in this global environment has intergenerational repercussions. Ever since 1788 when the first fleet arrived, Australia has relied heavily on foreign funding for investment in business, infrastructure and for the construction of housing.

And this reliance on foreign capital continues to this day. The banking system has foreign borrowings of $490 billion, around 18 per cent of their total liabilities. This proportion is well down on just a few years earlier, but is still a significant sum. And $200 billion – 85 per cent – of the federal government’s bond issues to fund its growing debt are now held by non residents. This is well up from around 60 per cent just four years ago.

Any disruption to foreign capital inflows will have severe impacts on Australia’s economic growth. Such a disruption could be the result of events offshore but it could also stem from a loss of investor confidence in the quality of government in Australia. Sovereign risk was never an issue before the election of Labor in 2007. Since then analysts and leading business people have added it into the Australia equation. This is a key vulnerability that must be addressed. And as a medium sized open economy we must do all we can to inoculate ourselves, as best we can, from international events.

The solution

 We are all hearing the commentary lamenting that Australians keep viewing the glass as being only half full. Imagine how easily we could fill that glass in the absence of additional uncertainty being created by the government.

The current federal government is fixated with its place in history. Everything it says and does needs to be a “big reform”. In tax, health care, education, the environment, disability services, financial services and the list goes on…the government is desperate to claim big landmark monument-like reforms. They are obsessing for the policy equivalent of Stalin’s seven sisters.

For everyday Australians, big reform means big change. It involves more dislocation and greater uncertainty. Australians, who are generally ambitious and innovative, are being forced to wrap up into a financial cocoon and avoid risk.

The “uncertain knowledge” that Keynes spoke of will always be present – but the government should not add to these risks. The least the government can offer our innovators and economic drivers is stability and consistency of policy.

That means no U-turns, no inconsistency and no lies. The solution to all this is not as complicated as one may think. Only within a strengthened framework of certainty will business and households have the confidence to again assess, price and take risk.

Part of the answer lies in smaller, less intrusive and more stable government. Smaller Government is helpful to business and households because it leaves more resources for the private sector to reap the rewards.

Critical to this is reduced spending. The Coalition will cut the waste and mismanagement. In the last election the Coalition announced $50 billion of savings and pledged to abolish a series of programs like the GP Super Clinics, computers in schools, and reducing funding to others such as the Green Car Fund. The government was so critical of our savings they copied over $12 billion of our announced cuts. We have done it before and we shall do it again.

For the next election, we shall announce a program of savings which will be sufficient to fund all our policy promises and leave some left over to improve the budget bottom line. In addition, through a Commission of Audit we will find ways to make further savings and to put in place more contemporary business practices such as “productivity cost down”, where appropriate, for government procurement.

A Coalition Government will run surpluses, we will repay the debt and we will live within our means. As I said in London in April, the age of entitlement is over. Households will gain confidence if they see a government that lives within its means. The result is no more surprise taxes like a flood levy, changes to superannuation or a carbon or mining tax.

We can only reduce the size of government by removing programs and regulations. The Coalition has committed to abolishing red tape and business compliance by $1 billion a year – and we have our Coalition Deregulation Taskforce dotting the “i”s and crossing the “t”s of their final report of how this will be done. For example, there is one area of regulation where reform is long overdue and that is in housing construction.

The objective should be to reduce the complexity of the regulations and the overlaps between different jurisdictions.  This can be delivered with a National Competition Policy styled process that includes incentive payments to the states as a means of distributing the economic and fiscal benefits of regulatory reform.

And keeping promises is critical. It gives us the predictability necessary for risk taking and investment. For example the Coalition will repeal the carbon tax and we will start the process on day one in office. This is only a fraction of the Coalition’s already announced plans. We have a consistent and predictable philosophy that is critical for the restoration of public trust and confidence.

Conclusion

We are not going to the next election with lavish, unfunded promises. We want to get out of your households and out of your businesses. We need to create an environment where people will again take the risk of heavier than air flight, of going to the moon, of starting new businesses and of dreaming mightier things.

We need to recreate a climate that welcomes and rewards the pioneer spirit. Stable and certain government does not constrain hope, limit reward or muzzle opportunity.

It is time for a new age of certainty in government. The rest is up to you.