Transcript of Question & Answer Session National Wealth, Land Values and Monetary Policy

I’m a professional engineer and I’ve been involved in entrepreneurial development and major projects for some time. The major part of my superannuation investment: I took on board small and mid-cap stocks because of the potential in them. The investigations I put into selecting those stocks were very clear, they were not speculative. And yet, what I found is that when we get into that realm, those stocks are the subject of attack from hedge funds and margin lenders, to the point of any incentive for the wealth in those stocks is taken away. Have the RBA or others looked at the possibility of seeing how something can be introduced or whether I’m on the right track in my assessment, which has probably gone on for more than 10 or 15 years now, whether I’m right in the fact. These small companies, if they succeed, are the key to wealth. They become big companies like Wesfarmers and the big BHPs and so forth. So it’s quite essential that the incentives be maintained to invest in those companies. Thank you.

Well, I’m not in a position to address your specific question. I think if there are things that are going on there that concern you, they should be raised with ASIC. It’s not the area of the Reserve Bank’s responsibility. But I think you did touch on a, kind of, an important point. And that is that the role that small and medium size businesses play in the economy. They are typically the part of the economy where the innovation occurs, the driver of new ideas. They’re the businesses that come in, and compete with the existing, well established businesses, with new ideas and new ways of doing things. So making sure that that sector of the economy is very healthy is important and this culture of innovation, how do we build the culture of innovation? I think it does partly start with small or medium size businesses, but the specific issue raised about trading in those stocks, I’m not in a position to answer that.

I just wanted to ask about China’s devaluation of its currency in the past two days, which has seen the Yuan fall by the most since 1994. It sparked a significant amount of turmoil in markets and speculation that China might have taken this action in response to an increasingly faltering economy. What are the implications of a weaker yuan for Australia and how concerned are you about the trajectory of China’s economy?

Thank you. I think there are multiple interpretations about what’s going on here at the moment. One is that the Chinese currency, having moved up against the US dollar over, moved in parallel with the US Dollar, over the past year or so, has moved up quite a lot against other currencies. And so, on an effective basis it has had a substantial appreciation, and what we’re really seeing is some unwinding of that. So that’s one interpretation. Another is that the growth momentum in China is a bit weaker than the authorities had expected. And the exchange rate adjustment is part of the correction for that, as has been the lowering of interest rates and increased spending on infrastructure. And the third possible interpretation is that they’re actually taking steps to move to a more market-based exchange rate. They’ve been saying for years that that was their intention. Many international observers have been encouraging them in that direction and I think it’s quite probable that this is actually a step to a more flexible Chinese currency. All three interpretations probably have some element of truth to them, but this is a very recent development so I think it’s too early to tell which of those … well, perhaps they’re all correct.

The implications for us, and again it’s very early, so I think it’s hard to tell. It partly depends upon what’s driving this change. If it supports growth in our largest trading partner, it’s probably good. More fundamentally, if it reflects a commitment by the Chinese authorities to move to a more market-based system, a more market-based exchange rate system, then I think that’s good for China over the medium term. So if it’s a positive sign about structural reform, a stronger commitment to markets, then that’s ultimately good for China and, if it’s good for China, then it’s probably good for us. So while it’s led to some movements in currencies and stock markets and interest rate markets around the world, it’s possible that it’s actually, in the longer term, exactly what’s needed. But,, it’s too early to tell.

We know that movements in exchange rates often set off a chain reaction of events which can be difficult to predict. So I think we’ve all got to watch what’s going on very carefully, particularly in Asia because many currencies have adjusted in the last couple of days. So we’re watching that carefully, but as I said, if it does reflect a genuine commitment to reform then I think ultimately this is good news.

I’d like to draw a link between the last question and your talk and perhaps start by making a brief comment on the last question, which is, that the underlying real exchange rate, if you do it on producer prices for China, in the last four years or so has been declining fairly continuously. So they’ve had deflation on producer prices which suggests that their monetary policy, maintaining a fixed exchange rate against the US, a pseudo fixed exchange rate against the US, has been too tight and that this is merely a possibly positive as you suggest monetary expansion. Now, to try to link the two stories, the critical thing that emerges from your talk to me is this rise, which in your graphs is a very sudden rise, over a period of three or four years or so in Australian land prices. And that rise tends to coincide very closely with the most rapid surge in Chinese growth, which makes me think that there is a broader story than just the Australian market to tell here. That is, that Australia is small, we’re in a corner of the world which has expanded extremely rapidly since about 2002, and that has meant all land in safe and well supported cities in our region has become more valuable simply because Asian demand for that land has risen.

So this represents an alternative story to the one that says we’ve borrowed too much and we’ve competed with one another to have larger houses. Moreover, relating to the last question, there are signs of slowing and weakening of the Chinese economy. At the same time China’s outward capital controls have been weakened in recent years and that means very wealthy people are able to move their money out more easily and this I suspect may be accelerating this demand for Australian housing.

Thank you, I’m going to disagree with you on one thing and then strongly support you on another. The rise in housing, the really big rise in housing prices in Australia relative to our incomes, took place between 1996 and 2003. That was before the resources boom. Through much of that period Australia was an old fashioned economy, people were saying ‘oh you need to produce computer chips’. We were doomed. The terms of trade were in decline, so the predominant reason for this rise in housing prices, I don’t think can be the growth of China, because a large part of the story predates that. But I do want to agree with you on the second part of your observation. As really the potential for capital outflows out of China to have profound effect on asset markets everywhere, because over recent years the central bank has accumulated a very large stock of foreign currency reserves. It was up to around $4 trillion US dollars, so effectively it has taken Chinese savings and invested them in the rest of the world. As the Chinese capital account liberalises, the central bank is no longer going to be doing that. The private Chinese citizens and entities within China, other than the central bank, are going to be taking Chinese savings and investing them around the world. And Chinese citizens are going to want to hold internationally diversified portfolios, just like everyone in this room effectively does through their superannuation funds. So there’s going to be quite a large change in the type of assets that Chinese entities want to hold, relative to what the central bank held. The volatility of those flows is going to be different and it’s one of these, I think, really big issues that we don’t fully understand and it may well turn out to be one of the biggest issues in global finance in the next decade, the liberalisation of the Chinese capital account and the ramifications that come with that.

In the 1980s rising land and rising housing prices made many, but not all, Japanese people better off and changed the distribution of wealth in Japan and changed the intergenerational distribution. And that’s been followed by two decades of stagnation. What are the grounds you believe in Australia won’t follow a similar pattern?

I think that the major one, and this is a huge difference, is population. The Japanese population is already in decline and from my recollection the official projection is in the next 25 years the Japanese population will fall between 15 and 20 per cent. It’s staggering. In Australia, population has been growing, well, last year at one and a half, and over the last decade close to an average of two. It’s a very, very different dynamic and when the population is rising strongly it’s hard to see how land prices actually come down relative to incomes because the demand for well located land is increasing every day. The supply of that land is not increasing every day. So, then contrast that with Japan, there are fewer and fewer people living on the land every year. I think that’s the main, I mean you could point to things about the underlying dynamism of the economy, but the population or demographics are something we don’t really talk about very much, it’s profound in this area.

I’m just a simple lawyer and company director, not an economist, and I was very interested in your comments in land values, the way they have increased. And I’m also reminded, David Airey who is the President of the Real Estate Institute, he’s constantly said in recent times that the average value of an American home is about a quarter of a million dollars, whereas the average value of an Australian home is half a million dollars. To my non-economic mind it’s hard to grasp the fact that an economy like America which is so very much more diverse and stronger than Australia has housing average of a quarter of million dollars, so I would be very interested in your comments on that.

That’s a very interesting observation. Of course America, at least the United States on average, has one of the lowest housing prices relative to incomes ratios in the world. Ours is in the range, it’s in the ‘high-ish’ range, but in a range that a number of other countries are in. I think the fundamental reason is that we as a society have chosen to live on blocks of land, detached housing in large cities on the coast. And you look around the world, where do you find the highest house prices? They’re in kind of large coastal cities with a lot of amenity, so that’s where we’ve chosen to live. And we also want to consume a lot of land, each house in Australia has a lot of land and they’re located in these cities. And we’ve chosen simultaneously not to invest, that much at least in many states, in infrastructure. So the ability to move around our cities is compromised by under investment in infrastructure. Yet we’ve chosen to live in these cities on large tracks of land and that’s why we have high land prices.

In the United States, while the population’s much bigger, it’s much more dispersed. There are many more medium sized cities, typically the zoning restrictions aren’t as strong and there’s better, at least there’s better road transportation, I think that’s at the heart of it. It’s where we chose to live as a society and the under investment in transport.

I wanted to ask: you showed that IP makes up a smaller percentage of asset wealth and numerous other categories, how do we compare to other developed nations in this regard? Why do we get this specific outcome and is it a concern? Do we simply not have the capability of commercialising knowledge we create to the same extent as competitor nations or are we not creating knowledge? Is it simply our knowledge is in small-to-medium businesses and is being bought up and taken overseas or being exploited without being built upon and what should do about this, if anything, as we are often told we need to be knowledge economy?

Thank you it’s a very good question. Unfortunately the comparable data across countries here is quite limited. From having looked at the material that’s available my conclusion is we’re not that much different to most other developed economies in terms of the value of our stock of intellectual capital relative to our incomes. The question is how do we really create the environment where there’s greater investment in intellectual capital, intellectual ideas and business processes and research and development and that’s a kind of great question. I’m not going to give you a great answer though. The things that I’ve read where Australia stands out on the negative side are really, and this is maybe something I shouldn’t be saying this in this building, but the relationship between business and universities. That somehow in Australia we haven’t managed to create that dynamic environment and positive feedback between business and university. We’re quite good at doing, kind of, base research but we’re not as good at commercialising that and the fact that we’re not as good as commercialising it feeds back into the incentives to do it in the first place. So I’m way beyond my area of expertise here, but this is, kind of, just reflecting on the international stage. The kind of other related issue, the one I touched on before, is really kind of the culture of innovation. How as a society do we increase the incentives or our capability to innovate and to come up with new ideas, because in a speech that I gave last year I reflected on the increase in risk aversion in our society. That in many respects, we’ve become more risk adverse as a nation, which in a sense ironic because we’re really a nation of migrants. 40 per cent of, I think, of Australians either were born overseas or have a parent who was born overseas. So these are people who’ve come to Australia, kind of, prepared to take a risk of appearance. So we should be a nation of great entrepreneurs and yet our culture is becoming more risk adverse. So how do we as a society, government, business, universities, become less risk adverse and be prepared to invest in risky ideas that can often pay off. So I know that’s a very specific answer to your question but I think you’re pointing at a really important thing and others in the room are probably better placed to answer it than I am.

We’re getting near the end, so one, two, three, need more time.

You’ve talked a lot about investment in infrastructure. In recent years we’ve seen a lot of the investment in the resources sector, infrastructure come from the private sector. So, for example ports and rail and even roads. Going forward, what proportion of that investment do you think needs to come from the public sector and what should fall back on the private sector?

I think it’s hard to divide it between the public and private sector because the private sector can do toll roads, they can build railways. So I don’t really see it as a public/private split in terms of kind of the financing of it. The issue is, I think, the main issue is really which projects do you do. There are plenty of projects that could be done around the country and it’s really the governance of selecting the projects. How do we get that right? Because there’s plenty of money to finance infrastructure, in my job I speak to a lot of investors and a lot of them, particularly international ones, say they want infrastructure assets, they want Australian infrastructure assets. But there’s just not the generation of these assets coming through for them to purchase. So what is it that, and this really a rhetorical question, what is it that can be done to kind of bring that pipeline of infrastructure projects, which there is clearly financing for, and clearly make our, in many cases, make our society better off, how do we organise ourselves to actually do that? And I think, in my own view, there’s a lot to be said for governance here because, in a broad sense, the public don’t trust the political class about which projects are selected. And so they don’t like spending public money and this is something that Shan talked a lot about, how do you bring that … How do you give the public confidence that if the public sector are going to do it they’re going to choose the right projects. So it’s not very specific to your question but I think it’s a really good issue.

I wanted to make two observations, the first one is you had a graph of the different categories of land and one thing that it showed is that it’s mainly been urban land values that have gone up and rural land values have not, which implies the ratio of urban land values to rural land values has gone up. And given you can convert land from rural use to urban use, that suggests that restrictions on that conversion capability are really important in driving the increase in urban land values. So we’ve had more restrictions on, zoning restrictions on that have stopped that. I want to relate that to the comments about the United States and very low house prices there. One thing you’ll notice, of course, if you look at some of the states where there have been lots more zoning restrictions, California, Oregon, Florida, the sum and so on, compare that with, let’s say Texas, where it’s very, very easy to convert land from agricultural use to urban use. You’ll find that the really low house prices in places like Houston and Dallas, I don’t know, maybe also Atlanta and some of these other cities where it’s also possible, whereas some of these cities where there are lots and lots of zoning restrictions it’s very hard to convert the land where you had the big house price, or land pricing as you say. So it seems to me a lot of this increase in the ratio of urban price to rural price is driven by policies restricting the growth of cities. That, of course, advantages like you said home owners but it disadvantages the young people who are wanting to get into the business. So these policies have significant affects, apart from sort of people who are opposed to urban sprawl and so on and want to stop the evolvement. Anyway, a couple of observations I wanted to make to get your comments on and it follows from some of the data you’ve got plus the observations about the United States.

Well in preparation for this talk, one of my colleagues who was assisting me, I asked him whether he could find out, back when Shan was writing, what the value of the land value in Australia, how much of it was rural. And I can’t remember the name of the person who’d done the study, it’s footnoted in my remarks, but their estimate was, I think, in 1930, 30 per cent. Maybe a bit more than that of the value of the land in Australia was rural land. Today the figure is kind of in single digits, so it’s all in the cities. The observation of zoning is incredibly important, I think it’s hard to disagree, you can’t disagree with that. But, economics is about supply and demand. If you restrict the supply and the demand is going up, price goes up it’s not much more complicated than that. Of course if you just allow free zoning and you don’t put transportation in then still well kind of the land close to the city can go up in price, so I think it’s a combination of zoning and transport in the city, American cities that have quite low housing prices all right they don’t have very many zoning restrictions but and they’ve probably built freeways out there so people can live 35km from the centre of the city and still get around at least at some times of the day. So I think it’s this combination of zoning and transport investment.

We’ll go to the last two questions.

You talk about assets producing a return and you also mention Shan was looking at the returns of some of the public transport from years ago, rail transport.

Yeah.

I find it difficult to reconcile, sort of, expenditure on public transport, on one hand, where it’s supposed to make some economic return. On the balance sheet, of course, is the expenditure on the roads which I’m not sure how they actually work out the return on roads because, apart from private roads which might have a toll, the public road system is basically provided for free use. Are we getting the balance right in Australia in terms of those, because obviously there’s obviously implications, public transport avoids the cost of buying as many fully imported cars as we’re moving towards now and imported fuel and of course the cars are they have their own deficiencies in terms of time getting to the destination and things like that. So how do you reconcile those two expenditures, because I think at the moment the Federal Government is certainly biased towards funding in their sphere more to the road system?

Well public and private transport obviously have a kind of important role to play in increasing the supply of well located land. Whether we’re doing too much of one and not enough of the other I can’t really comment. I don’t want to comment, but there are, the quote that I recited in my talk about the return on railway investment in NSW and in Victoria. There are ways that you can capture, you know, in the 1920s the people were talking about the rate of return on so there are ways that you can capture both through the fares and something that we really haven’t talked very much in Australia about is kind of capturing by the state of the uplift in values. You’re seeking this is in Singapore and Hong Kong, they partly financed the investment in public infrastructure the government owning the land and put a subway system there, the land is all of a sudden more valuable when you sell it off. So the entity that’s financing the investment actually captures some of the capital gains and I was just reading in the paper yesterday in Sydney how land owners are getting together in large groups around the new railway stations and selling the property and capturing the value of the land privately. I’m not saying there’s anything particularly wrong with that, but there are ways that you can measure and in some cases capture the value of the benefits from these investments to help finance them. Whether we’re doing that optimally or not you can probably draw your own inclusion.

Yes brings us to the last question.

[inaudible]

Well I think my very narrow answer is the Reserve Bank has no role here at all in wages policy. We have the modest task of setting the overnight interest rates to banks and then to one another. I think if you look at the Australian labour market over the past decade I think it’s performed pretty well. I mean we had … I don’t need to say this in Perth we had the biggest terms of trade shock in 150 years, the biggest mining investment boom in at least 100 years, and we didn’t have a generalised outbreak of inflation across, we had certain pockets where there was very strong demand for labour and wages went up but across the economy that did not happen, and it happened very other time we’d had a mining boom and now as we’re coming on to the downside of the mining investment boom, wage growth has slowed a lot and it’s not very comfortable but it’s helping the adjustment and I think it’s one of the reasons why employment growth has been surprising strong in recent times that the slower wage growth has kept more people in jobs than would have been the case. So the labour market is turning out to be remarkably flexible, that’s not to say that there aren’t kind of things that we should be looking at all the time to make sure that it continues to service the needs of the economy but from where I sit as a macroeconomist, and I don’t have the same perspective as you but from a macroeconomist the labour market has performed remarkably well, and together with the exchange rate and interest rates the flexibility in those three key variables as it goes through at the type of external economic shock that in previous generations would have caused all sorts of economic dislocation and it hasn’t happened on this occasion. It’s not to say there aren’t things we should continue to look at though.

Well thank you very much Philip I think all of us are privileged here to hear your very wide ranging presentation on issues which are intergenerational equity, welfare and wealth in this broad way which perhaps not all of us would appreciate the future in central bank thinking. So that was really fascinating presentation. So on behalf of everyone in here and on behalf of the economic society as well as the business school thank you very much.

Thank you.