Reserve judgement: RBA review needs to be more the a health check

Meanwhile, our banking system and tax concessions encourage investment in the wrong places. The lion's share of new lending has been spent on existing residential property rather than on projects that enhance productivity. So the release of the details of the review of the Reserve Bank - the first independent review of the bank and monetary policy since 1981 - is a cause for hope that things might change.

The panel comprises Carolyn Wilkins, a former senior deputy governor to the Bank of Canada, macroeconomist Renée Fry McKibbin, and Gordon de Brouwer, a Commonwealth departmental secretary for public sector reform. They have been asked to report "with a set of clear recommendations to government" by March 2023.

A quick scan of the review's terms of reference, released by Treasurer Jim Chalmers, shows they are broad enough to leave scope for interpretation.

Overreliance on boosting home lending and construction every time the economy needed stimulus, and in between those times generating a debt- fuelled housing boom.

This approach to central banking is anathema to historical theory and practice. It actually makes you wonder if current central bank executives have any conception of previous policy missteps prior to the mid-1980s - our reading is that history is replete with similar episodes.

The boom they have created contains the conditions for a bust at the end of decade of low rates.

We are going to need a frank discussion about the generous risk-weighting the Prudential Regulation Authority applies to housing in the calculation of lenders' "capital adequacy ratios", which rewards them for directing lending to housing.

Housing prices are pro-cyclical, meaning they move in line with the rest of the economy. Funnelling lending into housing therefore magnifies booms and busts.

There have also been policy backflips and missteps, among them joining other central banks in quantitative easing by buying billions of government bonds to support a COVID-ravaged economy in September 2020 after earlier indicating it would not.

The government debt associated with the bond-buying program is likely to leave future governments with less ability to spend big the next time fiscal stimulus is needed. It was run up without buying permanent structural reform or lasting infrastructure. We ask why not let the market fund the debt?

The bank's actions have been asymmetric - it has bought bonds to expand the money supply, but not sold bonds to contract it again.

Our feeling is that it would have been better to avoid that sharp bulge in money supply.

The bank has also been blind to the consequences of its actions for financial sector concentration, rising inequality and lack of housing affordability. It has tolerated former bank officials moving into management and board roles in the financial sector they used to regulate.

A key issue identified in the review terms of reference is how to operate monetary (interest rate) policy, fiscal (spending and taxing) policy, and prudential (lending standards) policies in tandem, especially in a zero-interest environment. They worked together when COVID hit, acting as one to stimulate the economy.

But from the perspective of individuals, investors and corporations, each needs to make sense in its own terms to allow them to borrow and invest with confidence. Robust central bank anchors, such as simple rules for the quantity and quality of credit, give investors and savers certainty.

Yet central banks are continually adopting new roles, such as targeting asset prices and funding deficits. They can have the unintended consequences of distorting prices and calculations of risk, directing resources to lower-valued activities.

The review panel will need to come to a view as to the common sense or otherwise of big expansions in central bank balance sheets. Was this necessary, even supportable? Who gave central bankers new roles re: backstopping asset prices and moving overnight from market game keeper to poacher? How sure are they that we are wrong and they are not inadvertently guiding resources to lower valued activities, thereby distorting prices and risk?

Indeed policies like QE and may even be irreversible. Time will tell. Earlier generations of central bankers were far more modest about their limitations.

They would not have allowed monetary policy to become a crutch or substitute for structural reform levers - effectively abetting weak governments at both the federal and state level to kick the policy can down the road.

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None of the panel are monetary experts of the stature of some of those who have led such inquiries overseas. But the review will become what the panel makes of it, and it can seek advice from whoever it chooses.

We suggest that they consult with those economic experts that take an old school monetary view. That includes, Carolyn Sissoko from USC and Perry Mehrling from Bernard College. Reserve Bank Governor Philip Lowe described the review as a "health check". It should be more than that.

At the very least we ask that the RBA not be handed a get-out-of-jail-free card. It should make a full accounting of current policies that may impinge on our future macroeconomic stability, equality and trend productivity growth. The last time it got close to doing this was prior to 1983.

The RBA could assist structural reform efforts by not letting the banks get away with placing most of their lending chips on housing, by occasionally lending to lend to small- and medium-sized businesses as was the original rationale for financial deregulation.

It must again help to diversify the Australian economy by intermediating credit across a diverse set of industry/sectoral risk classes. Let's be honest.