Saul Eslake Chief Economist ANZ Group Melbourne, Australia September 23, 2007

Saul Eslake has been the Chief Economist of the Australia and New Zealand Banking Group (ANZ) since August 1995. In that capacity he is also a member of ANZ's Group Asset and Liability Committee, which oversees the management of ANZ' s balance sheet; and of the Corporate and Institutional Bank' s Sustainability Steering Committee, which is responsible for ANZ' s approach to environmental and social issues. Saul is someone who has worked in the private sector as well as the public sector in Australia and has a way of explaining key concepts and issues that is uniquely detailed. Team Latte' s Rahul Bhattacharya recently managed to talk to Saul about federal reserves' s recent rate cuts, supply side management of the US economy, oil and gold prices and a few other things in between. Here' s an excerpt of that discussion.

Team Latte :
Recently the US Federal Reserve Bank lowered the short term benchmark rate by 50 basis points. This was portrayed as an aggressive move and an acknowledgement by the Fed that all is not well with the US economy. The Fed, it seems, is afraid that the sub-prime credit crisis is going to affect other parts of the economy and there would be a slowdown.

Is this a correct world view?

Saul Eslake:
The Fed cut the funds rate more than the markets had been anticipating, and it would appear from developments over the remainder of last week that this move has had contributed to a partial unwinding of the extreme risk aversion which had developed in financial markets around the world since early August. Risk spreads which 'blew out' over the following seven weeks have begun to contract somewhat, not only in the US but also in other markets where central banks have not cut their policy interest rates.

The Fed provided an entirely plausible rationale for its actions in the FOMC statement accompanying the announcement of last week's rate cut, in which it noted that 'the tightening of credit conditions has the potential to intensify the housing correction and to restrain economic growth more generally' and that 'readings on core inflation have improved modestly'.

There's no doubting that 'economic growth more generally' in the US has slowed, from an average of 3.5% pa over the three years to the second quarter of 2006 to just under 2% over the year to the second quarter of 2007; while the Fed's preferred measure of 'core' inflation has slowed from a peak of 2.5% over the twelve months ended August 2006 to an annualized 1.9% rate so far this year. The Fed certainly wouldn' t have tightened monetary policy in these circumstances - yet the increase in risk aversion since early August amounted to a de facto tightening of monetary conditions, which the Fed' s actions have effectively offset.

Since the downturn in the US housing market has yet to reach bottom - not least because of the known profile of 'resets' on sub-prime mortgages over the next 18 months, which is likely to result in an on-going rise in defaults and delinquencies, in turn putting further downward pressure on house prices - it could well be that the Fed will cut rates again. Indeed, the only constraint on further rate cuts, should the economy weaken further, is the possibility that on-going weakness in the US dollar, and rising inflation elsewhere in the world, could put an end to the gradual downward trend in US inflation which has been evident so far this year.

Team Latte:
We have seen that both Gold and Oil prices have hit historic highs very recently. They have been on the rise for quite some time and now we see them headed for even higher levels. To an untrained eye like ours, it seems that the markets - the commodity markets, at least - are worried about inflation and that is why these key commodity prices have gone up, as a hedge against falling value of "money". If you look at it, in 1981 Gold prices hit $850 an ounce and the whole world panicked. We are not far from that price level today, and yet no one seems to even talk about inflation.

Also, Fed' s action signify that the US Central Bank is concerned about a deflation (perhaps, even a recession) rather than inflation in the economy. Is there are dichotomy in both these views? Or have we not understood something?

Saul Eslake :
To my mind the rise in oil prices largely reflects the interaction of supply and demand. Demand for oil has been rising, even in the face of rising prices, driven largely by the rapid growth and industrialization of developing countries such as China and India, as well as by the seemingly unquenchable enthusiasm of American motorists for gas-guzzling vehicles; while OPEC (perhaps in conjunction with Russia) has regained some of its former leverage over oil supplies given declining production elsewhere in the world and the dearth of significant discoveries of new sources of commercially recoverable crude. Given that oil-exporting nations nowadays source a much smaller proportion of their imports from the US than at the time of the first two oil shocks, the weakness in the US dollar against other major currencies may be encouraging them to hold oil prices in dollars higher than otherwise.

I'm not aware that many investors regard oil as a hedge against inflation. And although some investors regard gold as a hedge against inflation, it certainly didn't serve that function very effectively during the 1980s, for example. To my mind, gold is more accurately seen as a hedge against currency depreciation, especially if you live in a country where the range of other investment opportunities is restricted by government policy or where there is some risk of arbitrary confiscation of wealth by governments. The rise in the gold price over the last five years, and its movement over US$700 per oz in the past few weeks, may well reflect hedging against expectations of a weaker US dollar. But the longer-term trend also reflects more fundamental supply influences, including the self-imposed limits on gold sales by central banks, and declining mine production especially out of South Africa.

It is quite possible that we have seen the bottom of the great global disinflationary cycle which began in the early 1980s. China, which has been a major source of global disinflationary pressure over the last decade, is now experiencing rising inflation; and while much of that appears to be largely the result of higher food prices, it is also notable that prices of Chinese goods landed in the US and other Western markets are now rising. The backlash against allegedly tainted Chinese food and toy exports will probably also lead to higher prices.

More generally, food prices appear to be moving higher, not merely because of adverse weather conditions in some major supplying countries (including Australia) but also because of changing consumption patterns and rising demand in developing countries.

I don't see this as presaging a major uptrend in inflation similar to that which began in the early 1970s, but it may mean that central banks have to 'work harder' to keep inflation under control? over the next five or ten years than they have needed to do over the past decade. And in that context it is perhaps significant that central banks in developed countries other than the US have responded to the increase in risk aversion by putting on hold previously planned rate increases, rather than cutting rates; while central banks in many developing countries have continued to raise rates in recent weeks.

Team Latte:
There has been some demand management in the last decade almost everywhere in the developed world. However, very little is seen in terms of supply side management. Is this a fair statement to make?

Further, we know that Milton Friedman is dead. Is the quantity theory of money dead too? Are we all finally Keynesians now?

Saul Eslake:
Actually central banks and governments in developed countries have tended to eschew 'demand management' , in the traditional Keynesian sense, at least since the mid-90s.

The Bush Administration has cited the 2001 recession as an ex post justification for its tax cuts (including in responding to criticism of them in Alan Greenspan's book); but the truth is that the Administration was always going to push through those tax cuts, for ideological reasons, no matter what the state of the US economy at the time. Elsewhere in the developed world governments have opted for 'medium term fiscal strategies' focused on objectives such as debt repayment, rather than seeking to ameliorate fluctuations in the business cycle.

'Monetary targeting' as most famously advocated by Friedman died in most countries in the 1980s, as a result of the instability in the relationship between monetary aggregates (however measured) and economic activity occasioned by financial deregulation and innovation. It lingered on in the European Central Bank until the retirement of Otmar Issing deprived it of its last remaining committed advocate.

Central banks in particular are neither monetarists nor Keynesians;? rather, particularly in the industrialized world, they have become 'inflation targeters', eschewing the notion that they can or should 'fine tune' the business cycle. For some years now there has been a vigorous debate within central banking and academic circles as to whether 'inflation targeting' is a sufficient lodestar for central banks.

Some, notably the Bank for International Settlements, have been making the case that central banks need to have regard to movements in asset prices as well as to goods and services prices, and to be willing to 'lean against' major upswings in asset prices (that is, tighten monetary conditions if they believe a 'bubble' is forming) even if inflation of goods and services prices remains within acceptable limits. That position has probably gained ground in the light of recent developments in financial markets.

But although I personally have a fair bit of sympathy with this view, it does run into the problem that elected governments (who are not, in general, particularly keen to see interest rates rise under any circumstances) would not take to kindly to central banks raising interest rates in circumstances where CPI inflation is within the targets they have laid down, simply because those central banks thought that investors had become 'irrationally exuberant'. And there is also the question, as Alan Greenspan so memorably put it, as to how a central bank is to know that investors have become 'irrationally exuberant', rather than rationally pricing significant new economic, technological or political developments.

Team Latte:
Milton Friedman talked about (human) expectations in creating inflationary bubbles. Isn't the US Federal Reserve creating expectations by cutting interest rates, somehow giving the impression that they are always there to pump in more money whenever it is needed; isn't the US Federal Reserve sending out a signal (as they have done during the Greenspan era as well) that no matter what at the end of the day it is the financial markets that matter the most and protecting asset prices is their only sacred goal?

Saul Eslake:
There is obviously some risk that, in once again cutting rates in response to a financial crisis, the Fed could be accused of 'bailing out' imprudent investors, and of exacerabating 'moral hazard' by underwriting excessive risk-taking.

Yet is it really sensible to expect the Fed to stand idly by as the risk of a recession mounts, simply in order to avoid that charge? For the Fed to have effectively endorsed a tightening of monetary conditions in circumstances where, in its own words, 'the tightening of credit conditions has the potential to intensify the housing correction and to restrain economic growth more generally' and when 'readings on core inflation have improved modestly' - as a decision not to cut rates last week would have implied - out of a fear of adding to 'moral hazard' would have been the monetary policy equivalent of 'destroying villages in order to save them', as the US military did in Vietnam.

At the end of the day, those who have lost money through what hindsight now reveals to have been unwise or imprudent investments in CDOs or other exotic debt instruments are not going to have their losses made good by a central bank or a government, any more than investors who lost their money as a result of the 'tech wreck' were compensated by central banks or governments. If they have a good legal claim for redress because they were misled or deceived into making unwise investments, then that will be sorted out by the legal system, not by economic policy-making agencies.

As I have noted in response to the previous question, there is an active debate as to the extent to which central banks should have regard to movements in asset prices on the upside as well as the downside, a view with which I have a lot of sympathy, but it does run into some real political problems as well.

Team Latte:
In the late 1970s Paul Volcker, the then Chairman of Federal Reserve Bank in the U.S., took quantity theory of money to his heart and quashed inflation once and for all by raising interest rates and controlling the supply of money in the US economy. Inflation in the U.S. has been in check ever since and the economy has been experiencing inflation free growth for two decades.

Are we actually reaping the benefits of Volcker's strategy today?

Saul Eslake:
Paul Volcker 'broke the back' of the 1970s inflation in the United States, and his actions were mirrored by his counterparts in other countries over the ensuing decade (for example, Australia didn't have its 'Volcker moment' until ten years later). In some respects history has failed to give Volcker his due.

But the fact that inflation has remained low and stable since the early 1980s in the US (and in Japan and Germany), and in most other advanced economies since the early 1990s, is not solely the result of Volcker' s achievement.

It also reflects the greater credibility which central banks have attained as a result of gaining independence from political interference in the setting of interest rates; from their demonstrated willingness to use that independence to tighten monetary policy when required to keep inflationary pressures at bay; and from the emergence of other forms of competitive disciplines on the setting of prices and wages, including trade liberalization, technological change, and the rapid expansion of 'supply' from developing countries capable of producing a growing range of goods and services at lower prices than industrialized countries.

Team Latte:
Two recent developments in the past decade and a half have been the innovations in the credit derivatives markets and the use of structured finance vehicles by financial institutions to finance leveraged deals and transactions. Until the sub-prime crisis broke out in June-July of this year, everyone thought that these were great developments that had truly revolutionized the finance and banking landscape. Now everyone thinks that they are toxic waste that needs to weeded out of our banking and financial systems.

Where do we actually stand with respect to these two markets (i.e. credit derivatives and structured finance)?

Saul Eslake:
Innovations in the credit derivatives market, the 'originate-to-distribute' approach to banking, the use of off-balance sheet vehicles, and the development of structured investment products are, for the most part, developments to be welcomed. Among other things they have facilitated a more efficient use of capital, and allowed borrowers who have hitherto to been precluded from accessing the capital markets to do so.

This is even true of the now much-maligned sub-prime mortgage market. Even if, by the end of next year, 25% of those mortgages are in default, that still means that the remaining 75% have helped into home ownership people who might otherwise never have attained that status and its attendant advantages.

Clearly, there was a significant element of fraud and deception, on the part of both lenders and borrowers, in that market, as there was in the lead-up to the savings and loans debacle of the late 1980s, and during the 'dot com' bubble of the 1990s. That such behaviour can occur tells us something about human frailties (about which little can be done) as well as about the existence of gaps in systems of regulation (about which something can and inevitably will be done).

Right now, there is a 'witch hunt' on; and as happened in mediaeval witch hunts, a lot of people who are not witches may end up being burnt at the stake or drowned in ducking-boxes. The credit markets are behaving the same way: in the absence of a generalized and complete disclosure as to who has lost what, all market participants are presumed to have lost something. An analogy which I have seen used in the past week (but the source of which I can't remember) is that it' s like being told that someone has put anti-freeze in bottles of claret, but since no-one knows which bottles it has been put in, no-one will drink claret at all.

The latest crisis does point to a need for better regulation of some parts of the credit market in many nations. But it would be a great pity if a generation of babies were thrown out with the bathwater. The last thing we need is a Sarbanes-Oxley for mortgages, or for other credit instruments.

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