Are Australian banks and supermarkets killing the goose that laid the golden egg?

The phrase Killing The Goose That Laid the Golden Egg comes from Aesop's. Interestingly, and this bears upon the discussion on the nature of civilisation, there is debate as to whether Aesop drew from India or India from Aesop.  However, that's a discussion for another day.

The point of the story and saying is that greed can lead to its own destruction. Two stories in the Sydney Morning Herald bear directly on this question.

Ian Verrender's Banks playing risky game with rates looks at the approach adopted by Australia's big banks to the setting of interest rates.

For the benefit of readers who don't know the Australian scene, four big banks dominate. There are smaller local banks and other financial institutions, but they play a subsidiary role. Overseas banks are present, but their role is even more limited and has become more so since the global financial crisis. This is a matter of economics, not legislation. Even in the days of the internet, It is very difficult to access the domestic savings base without an extensive network of branches, ATMs (Automatic Teller Machines) and EFTPOS facilities,

The smaller local banks, the regionals, and other institutions do provide a measure of competition at the margin.

Over the last thirty years, there has been a pattern in which the big banks effectively vacate certain niches because they can't make enough money out of them. Sometimes those decisions make sense, at other times not. The closure of bank branches in the name of efficiency is an example of the second. In recent years, all the majors have had to spend quite heavily rebuilding branch networks in order to maintain access to their customer base.

The niches neglected by the big banks create opportunities for other players. They move in and grow. That's competition. Government policy prevents the big banks buying each other, That's competition policy. Instead, the big banks buy the more successfully minnows, thus regaining the markets they abandoned, Again, that's competition.

In market terms, the Australian banking scene is best described as an oligopoly, a market in which a small number of players have the ability to be price setters rather than price takers. They watch each other and respond to each other, but try to do so in ways that will not damage their profits.

This is where Ian Verrender's article comes in. He argues that the approach adopted by the big banks to the setting of interest rates actually threatens the Australian economy. Instead of trying to sell money, that's what banks normally do, they are focused instead on increasing the margin between their costs of borrowing and the return obtained on loans. Watching each other carefully as they do, they wait for one bank to move and then the others follow. It's a ratchet effect.

To Mr Verrender's mind, this approach has two adverse results. It limits the availability of credit to new borrowers, while increasing costs for new borrowers. Profits rise as margins rise, However, if all the banks follow this approach, total lending will be adversely affected. Economic activity will decline, and so will bank profits. The goose will have been killed.

If the Australian banking sector displays oligopalistic tendencies, the Australian retail sector is a very clear oligopoly with two huge chains dominating most market sectors. To their many competing suppliers, those chains are an effective oligopsony, a few buyers and many sellers. The buyers control the market.

In competition terms, oligopoly is inherently unstable. Profit maximisation effectively depends on firms not competing on price, for if one firm shifts on price, the others must follow. Subject to price elasticities, the extent to which lower prices increase demand, profits fall for all.

The equation changes if the oligopolists are also oligopsonists. Their market power allows them to pass the costs of price competition on by squeezing their suppliers. Now the costs of competition are carried in whole or part by the supply chain.

This is just what is happening in Australia at the moment.

The two retail giants are in a price war centered on essential groceries. From an overall consumer perspective, the immediate gains are not as clear cut as might appear, for the chains have been increasing prices on other items. Still, products like bread and milk are at prices not seen for decades. This affects the consumer price index, for we actually have deflation in some areas. In turn, this makes it easier for the Reserve Bank to lower interest rates.      

So far so good. The problem lies in the squeeze placed on suppliers. This is explored in another Sydney Morning Herald article, Suppliers count the cost as Woolies and Coles shoot it out over prices.

As a consumer, I have noticed the progressive withdrawal of products I like from supermarket shelves. I do buy store brands, often I have no choice, but I don't have to like it. Beyond my personal response, the supermarkets are now effectively forcing industry restructuring in those sectors most dependent upon them as they seek to cut costs and build their own brands. They are holding their profits despite the competition, but the costs of that competition are being forced on suppliers.

In the longer term, that's not sustainable. Again, it seems another case of the golden egg.