Transcript of Question & Answer Session Ten Years of Research

Thank you very much, John. Now because this session is being recorded, I would ask you to use the microphone when you ask a question.

Hi John. Thanks very much for that very informative talk. If we have a look back at the GFC and particularly the prior speaker basically saying how the world handled that. I would suggest that that was a failure of central banking in that if central banking is responsible for financial stability, then if they had have been doing what they were doing, we should have never had a global financial crisis. You've also talked about the fact that we've learnt now in macroeconomics … Our understanding of macroeconomic theory has changed quite dramatically which would indicate to me that we didn't have a good understanding of how the economy worked before and I question whether we have a good understanding of how it works now. So the question I would ask now is, what do we not know about the next financial crisis? [Laughter]

I think it would be the height of hubris to say we understand everything about the world. I think we know more now than we did in the past and I think the process of crisis management, was better than in the past. Ben Bernanke had studied the Great Depression and the thing he learnt from that is what not to do. And as a consequence, I think the global economy did better. And also Keynes, he'd learned from the Great Depression as well, and we learnt from him. And the reaction to this crisis meant that we didn't have nearly the kind of results we had during the Great Depression because that was the prior crisis that was similar in scale to the GFC. So we have learnt something and indeed that was applied during the crisis. Whether things are perfect now, no, I wouldn't claim that things are perfect now, but we certainly know better.

And you'll see that institutions are being redesigned since the GFC. You'll see that through the Basel process. And looking across the world, we can see that some countries handled it better than others. Australia actually did remarkably well. And I think that is a reflection of the institutions we have here compared with the kind of institutions you have in other countries. With any luck, those institutions can change but that's actually a hard process. So what don't we know yet? If I knew that … but we can keep pushing on and keep trying to learn. A sign of learning is at least that we don't repeat the mistakes of the past. There are many more mistakes we can make in the future, I'm sure.

At the beginning of 2010, I started running a class in macroeconomics at the University of the Third Age in Brisbane because I thought that it would be very interesting to observe the follow-up from the GFC. And so I've been running that class now for nine years and therefore I've been studying macroeconomics for nine years. And the one thing that's really sort of leaped out at me in that time is that the biggest single driver of economic behaviour seems to be expectations. And Andrew referred to the psychological importance of whether we had a second recession or not. And I wondered whether it's commonly felt that expectations is as important as I think they are.

Certainly inflation expectations play a big role in the way we think about how monetary policy operates. The harder thing is thinking about whether you can change those expectations by words or you need to change them by actions. I think as I said, there's a lot more to be learnt about how expectations are formed. We know that rational expectations are not a perfect model of what's going on, but the alternatives unfortunately, are huge. You can come up with a huge number of ways of thinking about it and we need to go through all that.

This was essentially the work of Kahneman and Tversky, they were doing a bunch of individual experiments, just looking at, here's one way people behave at odds with perfect rational expectations. And here's another one and here's another one and here's another one. So expectations are certainly important, but what we don't yet know is really how they're formed. And then what do you do that affects them? Is it sufficient for the central bank to say: "We think inflation is going to be x, or does it require us to be moving interest rates around for that to happen?" There's more work to be done.

Did the focus on atomistic individuals with no market power become more or less important during the GFC and why?

Please repeat that.

Yes. Did the focus on atomistic individuals with no market power become more important or less important during the GFC and why?

Can you paraphrase the question?

The question is essentially, was this understanding of the way the markets work, which was this kind of efficient markets, if you will, version where you've got small individuals with no power, did it become more or less important? I think the events of the financial crisis made it irrelevant in the sense that people were dealing with very big players. They were dealing with very big markets and the fact that those markets weren't working. So, whether or not there were atomistic individuals, they weren't important. We we're understanding that we need to understand that these big players matter and that the markets were not efficient. So I'd say less important.

Other questions?

Hi. An earlier paper of yours was about generation rent and …. Remember that? So, will that phenomenon fit as, I don't know, one of your components to what's coming up? Relative change.

A summary of that work was essentially looking at what is it that is affecting first home buyer preferences. Why are there fewer first home buyers out there? What's going on? Now, one thing I learnt from that, actually was that you don't actually have to rely on hard and fast rules about who can have a loan and who can't have a loan. People are actually making choices for themselves. They may not be perfect, but the prospect of taking on a huge load of debt is a constraint in itself. And what you notice is that a lot of people don't borrow to the maximum. So recently we found that only 10% of people are borrowing up to the maximum that the bank would lend them.

And I think that is one of the things that we need to understand about human psychology is, you can understand that people will be self-limiting. Not everybody is going to go out and borrow irrationally and borrow the maximum they can because they are thinking ahead. And so in this Generation Rent paper, one thing we saw was that essentially there is this filtering device going on because in order to get a first home today, you need to save up quite a large deposit. The ability to save up that deposit is actually a very good filter in terms of demonstrating that you're an individual who can think about the future, who can put money away, who can budget. Rather than imagining that the only way we can prevent people from taking on unsustainable levels of debt is to put in rules that tightly prescribe what's going on.

You've got both going on and I think in terms of what are we thinking about for institutions for the future, you need to recognise that both of these forces are going on. You've got rules that are going to limit some excesses, because there are always going to be people who are going to try and borrow it to the limit. But you also need to recognise that the behaviour of people is going to take some of that into account. And if you can understand how they're going to behave, you'll be able to set rules much better, which means that people who actually can afford a loan and will be able to pay back it because they have the discipline to save up a deposit. They should be able to get a loan provided they've got that quality. And it's designing an institution in such a way that you can actually identify those people.

We have one more question.

Yes. While I'm no academic when it comes to economics, I understand the role of the RBA is monetary policy. And you mentioned levers that you have at your disposal. My understanding is that the only lever you have is interest rates. But I have heard on the radio a discussion along the lines of quantitative easing. Now are we there yet?

No, because we're at 1.5%. I think a few years ago we certainly explored the possibilities and as has been demonstrated in other economies, you have at least two options. But there are many. And I think the other thing that I want to emphasise, yes, quantitative easing is one of them. But monetary policy is one arm of government policy. Fiscal Policy is another one. And so the discussion of the financial crisis highlights that monetary policy is not the only game in town.

You actually have quite a few arms of policy. Actually, it's going to be a bit like Shiva, I think, because not only do you have fiscal and monetary policy, but you've got prudential policy. And a lot of the action since the financial crisis, there's been the monetary policy, but there's also been the prudential policy and thinking about how do we actually operate the financial stability framework. So, it's not a case of we need to do everything as the central bank. We've got more tools than we thought we did. But generally speaking, if all the arms of government are working together, you're going to get a much better outcome than if everybody's operating independently.

Quick question.

Yeah, just a quick one. I note of course that you have some competition, the Reserve Bank, with the big four banks seem to be setting their own monetary interest rate policy.

So they are setting interest rates responding to what's going on in the market. Despite what you may have heard, one of the big things going on in the market is what's the rate they can borrow overnight from us. While it may not be one for one as it was in the past, it's still a big influence on what's going on. At the end of the day, we can change interest rates in such a way that it has the effect we need on the economy. And indeed, that's one of the things about monetary policy is it's not a one shot deal. We don't get to make a decision and then we have to wait a few years and then we get to make another decision. The Board meets every month and they can keep looking at what's going on. And to the extent that the effect may not be exactly what you want, you can change and you can keep updating. So I don't think that's a significant concern.

We need to draw it to a close. Thank you so much, John, for that.