Monday, 15 July 2019

THE FIRST LINE OF DEFENCEAustralian Conference of Economists, Conference Dinner, MelbourneKaren Chester, Deputy Chair, ASIC

Good evening. I would like to begin by acknowledging the Traditional Custodians of the land on which we meet today, and pay my respects to their Elders past, present and emerging. I extend that respect to Aboriginal and Torres Strait Islander peoples here tonight.

And my thanks to the Economics Society for asking me to speak tonight. Allowing me to reflect and ruminate on public policy after five wonderful years at the Productivity Commission. And five years that balanced the spirit level between my time in the private and public sectors over the past three decades.

For the political and policy fray of the last 30 years frame the tapestry of public policy. Policy that sought to deliver economic growth alongside fair outcomes. And it also framed my unexpected career as an economist. And one having traversed ten distinct jobs across five industry sectors.

But I now learn today (from a Royal Commission no less) a career that ultimately traversed the four lines of defence for competitive and fair markets. The first line of defence being public policy. The second line, the consumer themselves. The third line, the conduct of firms. And the fourth and final line of defence, the regulator. And I’ll come back to these all important four lines of defence.

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So to the end of day one of the Australian Conference of Economists 2019 – Economics for Better Policy. And what a program of speakers. Today you’ve had the opportunity to hear, debate and learn from 67 economists. Sharing analysis, evidence and insights. Challenging themselves and each of you in how to think about no less than 16 distinct streams of policy relevant economic endeavour.

And now to dinner and economist 68. Tonight I’d like to share some thoughts on why a few critical markets today seem to be falling short in delivering competitive and fair outcomes to Australian consumers. And to do this I’ll reflect (and perhaps indulgently so) on one or two vintage stories. And then more importantly on a few contemporary ones.

And no surprise public policy, competitive markets and not so competitive markets will figure prominently in the storytelling. And why? Because competitive and efficient markets when nurtured through good public policy deliver growth alongside fairness. But absent the right policy settings, they can readily become a growth detractor and fairness the collateral damage. Especially as it relates to our financial and superannuation systems. Systems that today represent $7.6 trillion in assets. That account for over 9 per cent of our economy. And their services and products impact the wellbeing of all Australians.

And systems more recently subject to the antiseptic of sunlight – in the form of a Financial Services Royal Commission. And also the sunlight of a not so Royal Commission, the Productivity Commission. With the Commission’s ‘book end’ reports last year on the competiveness of the financial and superannuation systems.

So let’s first rewind the clock to 1988. For me, one of the early wonder years of public policy. Where economics had become the go to toolkit of the policy carpenter. Where a Government was daring greatly.

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Forging and soldering good public policy. Where markets and fair outcomes were seen as partner, not polar. Where a microeconomic reform agenda was taking its first steps – soon to be up and cantering. And timely, coming off the back of floating the dollar and Australia hitting its personal worst on the OECD leader board.

It wasn’t a time of easy policy wins. Much political capital was both curated and spent. But it was a time of confident policy narrative. A time of real policy inroads.

It was also a time of inflection across so many frontiers. And not just public policy. Technology, trade, communications. The precipice of the internet. Where numbers that mattered to inform good public policy and the accompanying public debate would be modelled on a desk top. No longer needing a concrete and steel reinforced basement full of computer monsters whirring and calibrating over days. All of these frontiers would play out powerfully in the public policy story that was about to unfold.

The Government, led and inspired so well by the formidable double act of Prime Minister Hawke and Treasurer Keating. Where political leaders convinced a Cabinet, and then the ACTU, that tariffs are a pernicious regressive tax. The estimated economic growth dividend of tariff cuts was big. Politicians also liked big numbers back then. But it was the distributional effects of across the board tariff cuts – the fairness factor – that ultimately forged the decision to dare greatly.

Now this reflection is shared not out of some romantic lament for the past. There was nothing romantic about modelling in Lotus 1-2-3. Nor with hard copy ABS data and no internet. But more to grapple with how we’ve ended up where we are today. Where the fairness factor seems to be missing in many of our markets.

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But the political leaders did not have a monopoly on daring greatly. Officials did too. And to quote Geoff Carmody, it was also a time where “Good policy springs from evidence based policy not policy based evidence.”

Where the ‘three E’s’ of good public policy – evidence, evaluation and experimentation – were being steadfastly applied. And soldered together in the pursuit of competitive and efficient markets. In doing so, delivering growth alongside fairness.

Now fast forward the clock to today. After 28 years of uninterrupted economic growth. And as the Productivity Commission’s self initiated analysis last year revealed (in its report, Rising inequality?), economic growth pretty much delivered alongside equity (when measured by equivalised income and consumption). But yet we find ourselves in a world where so much has changed. Where fair outcomes are today not being delivered by some of our key markets. Nor by some of the firms in those markets.

For a firm that simply does the right thing was then – and even more so today – of much corporate value. For today we find ourselves in a world where doing the right thing no longer seems the default business model for many. Where a Royal Commission revealed conduct beyond unbecoming. Where good people seem to confuse firm loyalty with doing the right thing. For it is only when the firm’s leaders do the right thing should such loyalty be owed. A little understood but fundamental distinction. But one thoughtfully studied and well espoused by the Princeton ethicist Professor David Miller.

The Final Report of the Financial Services Royal Commission is a sobering read. But it ultimately proved a solid and safe landing for

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policy, markets, regulators and ultimately consumers. And a solid landing in perhaps four ways.

First, there are no grey swan recommendations. But importantly a sober recognition that disclosure in and of itself does not deliver fair outcomes for consumers. And to quote:

This idea of ‘disclosure’ underpins the now teetering edifice of product disclosure statements and Financial Services Guides.

Second, there is no regulatory overreach. Akin to the Productivity Commission findings, the vertically integrated business model remains structurally intact. But importantly better disciplined by legislative belts and braces.

Third, legislative reform to remove the damaging swiss cheese world of exceptions in the legislative norms of conduct for the financial system.

And fourth, the twin peaks regulatory architecture is retained – but strengthened and modernised to lift performance and rebalance across the regulators. And in a way that plays to their respective regulatory DNA and comparative advantage.

Now the 76 recommendations of the Final Services Royal Commission can arguably be grouped into three buckets. First, 23 recommendations directed at the public policy settings – albeit much of the focus here to remove exceptionalism from legislation. Second, 33 recommendations directed at lifting obligations on the corporate and trustee world. And third, 20 recommendations directed at the regulators – lifting the bar on expectations of regulators, expanding their remit and powers and strengthening the twin peaks model.

But much of the Financial Services Royal Commission’s sobering evidence can also be explained by recent public policy being more incremental. And not reshaping policy architecture such that it no

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longer serves us. For in the absence of effective competition, fostered and nurtured by good public policy, firms not doing the right thing can go unchecked. Think the banks. Think superannuation. With consumers ultimately paying the price, and often regressively so. And a trust lost by business the inevitable collateral. And now in a post Royal Commission world, the mismanagement of non-financial risk crystallising as a realised financial risk with remediation bills and provisioning reported as now totalling some $9 billion.

And this misconduct bill, provoked a sense of déjà vu. Recalling the Bank of England Governor (Mark Carney’s) estimate in 2017 that the total post GFC cost of misconduct for the banks globally was US$320 billion. So our interim tally of $9 billion perhaps not out of step when adjusted for the size of our economy. Only out of step in terms of timing and more a mismanagement of non-financial risks.

Where the (John Laker led) APRA Prudential Review of the CBA last year concluded that the CBA’s continued financial success had “dulled the senses of the institution”. What we economists call economic rents. The consistently high returns of Australia’s largest financial institutions are over and above those of many other sectors in the economy. And for the banks, not replicated in any other comparable banking market globally since the GFC. And with those senses dulled, the poor management of non-financial risks. And most demonstrably in the form of the consumer voice being lost.

And where economic rents are described by some today as toxic revenues. That go beyond products or services with persistently higher prices (and returns) attached to sticky customers. Where revenues from products and services also cause significant consumer harm and erode market integrity. Think case studies of the Royal Commission.

The Productivity Commission in assessing the competitiveness of the

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financial system found (and I quote) that ‘while the Australian economy has generally benefited from having a financial system that is strong, innovative and profitable; the larger financial institutions are able to exercise market power over their competitors and consumers’. That Australia’s banking sector is an established oligopoly with a long tail of smaller providers. Where pricing power (the reliable Lerner index) for the major banks exceeds the global average, including for high income countries. And materially and persistently so (remaining above 40% since the GFC).

And where many of the highly profitable financial institutions have achieved that state with way too sticky customers. Findings that demonstrably point to an absence of effective competition.

And in the final report the Productivity Commission made 34 recommendations to Government in July last year.

The Productivity Commission’s parallel Superannuation Inquiry, delivering a final report six months later also revealed a system of twin failures. Persistent underperformance and unintended multiple accounts. And the costs revealed to be highly regressive in their impact – harming the young and lower income workers the most. And why? The policy architecture had not kept up with what was needed to deliver competitive, fair outcomes.

Where the Commission found that inadequate competition, governance and regulation led to these outcomes. Where rivalry between funds in the default segment is superficial, and signs of unhealthy competition in the choice segment (think 40,000 options). Where many lack scale, with 93 APRA-regulated funds — half the total — with assets under $1 billion.

And while the default segment outperforms the system on average, the way members are allocated to default products has meant many (at

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least 1.6 million member accounts) have ended up in a persistently underperforming product, eroding nearly half their balance by retirement.

And notably the Commission found that policy initiatives had chipped away at some problems, but architectural change is overdue.

And super’s elevated role in intergenerational wealth escalates its policy imperative. For the super system’s performance will underscore much of our future fairness story when it comes to wealth equality.

But some have suggested the Super Inquiry also revealed institutional failures. Revealed in three ways across the Productivity Commission’s three years of super endeavour.

First, and after 26 years of compulsory super, it is telling in and of itself that this is the first time a Government has comprehensively asked the evaluation question. Is the now $2.7 trillion super system efficient and competitive, delivering good outcomes for its 14.8 million members?

Second, when the Commission embarked on its super trilogy in 2016, it quickly learned the ‘must have’ data was pretty much missing in action. Indeed it is near impossible for a mere mortal (let alone an actuary) to follow the money. And where data was collected, it was done poorly and from the perspective of the fund. Not the member.

When it ought to be the reverse constellation. For super is not a prudential world. For members (and future taxpayers) pretty much underwrite the investment risk. Nor is it a world of caveat emptor. It is a market distinguished by Government fiat and a trinity of C’s – compulsion, complexity and cognitive biases. And much of that complexity induced by ineffective competition.

Third, the Commission procured and presented much novel data and analysis. And novel globally. In doing so it revealed a government

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induced and supervised system that has become an unlucky lottery for many members. Where 1 in 3 member accounts are unintended multiples – costing members $2.6 billion each and every year.

And a system in which 1 in 2 funds, 1 in 3 default products and at least 1 in 3 choice products persistently underperformed. And seemingly unchecked over the past 12 years. And why only 12 years – the data doesn’t allow us to look back any further.

And unsurprisingly disparate views and interests have begun to play out on the Superannuation Guarantee rate. Some increasing it, some decreasing it and some ‘resting it in peace’. But this bypasses where we find ourselves today. For the SG rate simply deems what flows into the super system. Leaving the system’s performance untouched. And it’s here the immediate policy imperative lives and breathes. Architectural improvements to raise the odds for the super member beyond the PC [hashtag] ‘# unlucky lottery’. And in doing so lifting the retirement balance of today’s new job entrant by $400,000.

But setting aside the need to ensure the system delivers competitively, efficiently and ultimately fairly, we ought to ask ourselves the precursor public policy question. Is it also delivering a net increase in national savings. And in a way that is fair. The policy genesis of our super system. And questions not comprehensively asked and answered since the FitzGerald report on national savings.

Now the Financial Services Royal Commission in some ways proved the personification of some of the system wide shortcomings the Productivity Commission identified in last year’s ‘book end’ reports.

The Royal Commission not simply revealing contumelious behaviour of business. But failings of policy. For a collective read of the Royal Commission’s interim and final report rightly identified our four lines of

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defence to consumer harm in markets – public policy, the consumer, the corporate and the regulator. And all demonstrably breached in the Royal Commission’s thoughtfully curated case studies.

But what resonated most in the Royal Commission’s interim report and the one outlier recommendation in the final report (the daring greatly recommendation), is the importance of the first line of defence. For it is the policy architecture that needs to do the heavy lifting. Setting the incentives and thus bandwidth for behaviour – within which the consumer (or member) and the corporate (or trustee) coexist with aligned interests. And then monitored and enforced by confident (fairness champion) regulators – the fourth line of defence. Where I find myself today for job number ten.

And notably the Royal Commission’s 76 recommendations are nearly matched by the Productivity Commission’s 65 recommendations. Recommendations that ought be viewed collectively in thinking of our first line of defence.

Because the Productivity Commission’s book end reports form part of a rare constellation. A once in an economist’s lifetime alignment of polar stars – the Belt of Orion. Where the Commission’s twin inquiries on the financial and super systems come together with the Hayne Royal Commission. And a Government has all three to wrestle the twin behemoths of the financial and super systems into effective competition. Policy settings that will impact the fairness of markets and the wellbeing of all Australians.

For government policy ought to be the first line of defence here. Not the last nor late. And this for me is one of the enduring themes from Commissioner Hayne’s report. So allow me to share a snippet quote from the Royal Commission’s interim report (revealing the thoughts of perhaps an intuitive economist):

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‘Competition within the banking industry is weak ... Each of the four largest banks is a powerful player in the market. And there is a striking asymmetry of power and information between bank and customer that favours the bank. But there being little threat of failure of the enterprise, and there being little competitive pressure, pursuit of profit has trumped consideration of how the profit is made.’

So how to restore our first line of defence. What do we need to ensure our three E’s of public policy (evidence, evaluation and experimentation) form the bulwarks of our first line of defence?

For today we are in a world of fewer Better Angels. Where so much public policy has become intractable when it ought not be. Think tax reform. Think energy policy. Shifting the Dial, the Productivity Commission’s five year policy playlist to deliver economic growth, was crafted to provide a tractable playlist. The focus was on policy about people – affording a tangible and relatable narrative for governments. Both federal and state. And in doing so intuitively landed on economic participation. A quest to identify the policy failsafe to continue to deliver growth with fairness.

But in doing so it called out the one essential prerequisite. And it resides in Shifting the Dial’s poor cousin chapter. One that inevitably gleaned little attention – when perhaps it should have garnered more. It was rather boringly entitled More Effective Governments.

And this was an important stream of the Shifting the Dial endeavour. To avoid the risk of growing mistrust in public administration. Where hubris enchants the elite. A risk that contributed to the populist political tsunami that democratically installed a President who crowed after one primary victory: “I love the poorly educated.”

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And the evidence in Shifting the Dial suggests it is an outlier risk for us. One our policy archives reveal we have avoided in the not so distant past – when responsible government thumbed pernicious, populist policies. But a risk we ought not presume history affords our immunity.

Like the trade war between the US and China. And the on and off again threat of a trade war with Mexico. All at a real economic cost.

So to that same end Shifting the Dial identified more than a handful of much needed improvements in the quest for more effective governments. Putting the intergenerational and independence back into the Intergenerational Report. Defunding poor quality programs like we used to. And after some modicum of evaluation. The paucity of program evaluation being beyond perverse in today’s data and analytics driven world. Longer term fiscal projections for major programs alongside an expanded role for the Parliamentary Budget Office.

And in thinking of the scope of future Intergenerational Reports, a thoughtful consideration would identify looming intergenerational fiscal risks beyond ageing. Think obesity related chronic disease and mental health. For the Roman poet Virgil was on the money in his common sense view that the “greatest wealth is health”. Not to mention being obvious drivers of looming fiscal pressures.

For if we find ourselves in the absence of effective government, competitive markets delivering growth with fairness will become elusive. Our equality enhancing tax and transfer system will become unaffordable. And our vision of ‘handmade’ policies for the truly disadvantaged will be relegated to the Bardo world of policy intractables.

Perhaps the other most enduring change for effective government is restoring the policy capability of the Federation – working across levels

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of government. Captured in Treasurer Pallas’ revealing keynote speech to the McKell Institute in 2017.

So allow me to end on an optimistic (West Wing reminiscent) note. And it’s one of professional respect. Indeed admiration. To two institutions that matter much for our first line of defence. And it resonates with the aspiration for more effective government. The Productivity Commission and the Parliamentary Budget Office.

Where the PBO has established itself as a respected Caesar’s wife when it comes to fiscal transparency and budget sustainability. Under the inaugural leadership of Phil Bowen and now Jenny Wilkinson. Where independent and robust analysis of our fiscal position and looming pressures brings a sunlight all of its own.

And the Productivity Commission. A long-standing Caesar’s Wife when it comes to public policy. My 9th job. And, I’d like to think, it proved a terrific vintage for the Productivity Commission under Peter Harris’ leadership. A time of much policy relevance endeavour. Providing the public policy book ends to a Royal Commission. Securing the Treasurer’s blessing to curate Shifting the Dial. Taking an inquiry on Horizontal Fiscal Equalisation and procuring an evidence base to inform a politically fuelled debate. Self-initiating work in the all-important areas such as indigenous educational outcomes and gas markets. Taking on sacred cows like housing decisions of older Australians. Through to modelling the economic impact of a possible US led trade war when the President was only a President elect. Asking and answering the Rising inequality question last year. And securing what I’m sure will be a ground breaking Inquiry on mental health under Michael Brennan’s watch.

For independent institutions are uniquely placed, and we hope enduringly so. To objectively inform public policy and the corollary

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debate. With evidence, evaluation and at times experimentation. Much needed for our first line of defence. Good public policy. The one that matters most. For markets to deliver competitive and fair outcomes. Nothing more nothing less. Thank you.

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