Thursday, August 11, 2016

Defenders of banks are the ones who don't get capitalism

Why on earth am I attacking the banks? "They make profits, that's the way the capitalist system works," or so I have been told repeatedly since I questioned their decision to hang on to a good chunk of last week's official Reserve Bank cut in interest rates instead of handing it to their customers.

"It's not the job of government to dictate the margins of business," one of their shareholders told me. "Profits are the basis of free-market capitalism," another wrote.

That second claim is only partly right. And yes, sometimes it is the job of governments to restrain profits.

The founder of modern economics Adam Smith was the first to mount a case for the pursuit of profit.

"It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner," he wrote more than two centuries ago. "But from their regard to their own self-interest. We address ourselves not to their humanity but to their self-love."

The search for profits - the search for that extra money that exceeds the cost of production - is what motivates the brewer, the baker and the banker. Without it they wouldn't bother. Yet miraculously, in pursuing profits each of them (Smith believed they were each men) ends up providing almost exactly what we need.

"He intends only his own gain," the author of The Wealth of Nations went on, in the sentence that came to define him. "He is in this, as in many other cases, led by an invisible hand to promote an end which was not part of his intention."

I'm with Smith, completely (as you would expect from an economics editor). But reread him and you'll see that he isn't actually defending high profits, or even profits at all...

He is defending the pursuit of profits. As the American satirist PJ O'Rourke notes in his excellent book about The Wealth of Nations, Smith thought attempts at super profits would be competed away. That was how the pursuit of profit benefited customers. Unrestrained profits were "always highest in the countries which are going fastest to ruin".

On Wednesday the Commonwealth Bank announced an unrestrained record profit of $9.45 billion. Its return on equity was well above 15 per cent at 16.5 per cent, way in excess of the 11 or 12 per cent typical of companies listed on the stock exchange, and far above the typical return for unlisted companies which is closer to zero.

The figures show the Commonwealth went out ahead of the other Big Four banks in announcing it wouldn't pass on the full cut because its net interest margin (the difference between what it pays for money and what it charges) had slipped from 2.09 to 2.07 per cent. It wanted to build the margin back up.

There was nothing to stop it.

In the United Kingdom a week later, greater competition and a sense of decency obliged all of the big banks to fully pass on the Bank of England's cut. The banks over there get by with returns on equity of less than 10 per cent.

There's something wrong with a culture in which investors expect such obscenely large returns in order to invest. Australian Competition and Consumer Commission chief Rod Sims sees it repeatedly when airports, ports and the like are privatised.

In order to get its sale of the Port of Melbourne over the line, the Victorian government at first offered to lift the rents charged by the port 750 per cent. The federal government got a magnificent price for the Sydney Airport by doubling landing charges, removing the regulation of landing charges and offering the new owner right of first refusal over any second airport. The new owners probably run the facilities better, but from the point of view of their customers, there's scarcely any point.

"I've always felt that commercial enterprises are better off in the private sector," Sims tells me. "But the only way the community benefits from that better operation is if either they are being sold into a competitive market, or if it's not competitive [as with electricity distributors], there's appropriate regulation in place.

Within months of taking over, the new operator of the port of Newcastle raised its fees 50 to 60 per cent. It then revalued the port it had bought for $1.75 billion to $2.4 billion. It did exceptionally well at our expense, but the government that sold the port did not.

Last year University of Queensland economist Paul Frijters and University of NSW economist Gigi Foster examined the make-up of the BRW 200 Rich List. More than half had made their money from property (where rezoning helps), from mining (where leases are granted) or from investments. They concluded most of Australia's richest got there in industries subject to political favours, hardly any by inventing something new.

It's a mentality that's holding Australia back while enriching those lucky enough to be in those industries. It's why shareholders get upset when I talk about our banks. It's why we need real competition, or regulation. To make them work for us.

In The Age and Sydney Morning Herald