Debtwatch April 2007: Who’s having a housing crisis then?

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Who’s having a housing crisis then?

Glob­al eco­nom­ic atten­tion has been focused on the sub-prime lend­ing cri­sis in the Unit­ed States recent­ly, and many local ana­lysts have made sooth­ing nois­es to reas­sure Aus­tralians that “it could­n’t hap­pen here”.

The USA’s sub-prime mar­ket is indeed a pecu­liar­ly Amer­i­can phe­nom­e­non; but the lev­el of Aus­tralian house­hold debt (the sum of mort­gage debt and per­son­al debt) is every bit as extreme as the USA’s. And con­trary to pop­u­lar opin­ion, our debt binge dwarfs Amer­i­ca’s. As the chart below shows, Aus­trali­a’s house­hold debt to GDP ratio has been grow­ing more than three times as rapid­ly as the USA’s since 1990. The ratio has grown at an aver­age of just over 2% per annum in the USA; it has grown at over 6.8% per annum here.

As a result, while Aus­tralian house­holds car­ried less than half the debt that Amer­i­cans did in 1990 (21% ver­sus 48% of GDP), now they are bur­dened by even more debt: 96% of GDP in ear­ly 2007, ver­sus 94% in mid-2006 (the Amer­i­can data report­ing cycle lags ours). Since Aus­tralian inter­est rates are high­er than Amer­i­ca’s, the debt bur­den on house­holds is actu­al­ly high­er here. Amer­i­ca has expe­ri­enced a lend­ing cri­sis because the qual­i­ty of bor­row­ers at the tail of the US cred­it sys­tem is low­er than at the tail of ours. But the aggre­gate fig­ures give absolute­ly no rea­son for Antipodean com­pla­cen­cy.

We are also with­in reach of an Aus­tralian his­tor­i­cal water­shed: the increase in debt since 1990 has been so great that inter­est repay­ment now takes up more of GDP than at any time since mid-1990.

A one per cent rise in rates, or an 18 per cent rise in the debt to GDP ratio, would put us at the same repay­ment bur­den lev­el that ush­ered in “the reces­sion we had to have”.

Those two hypo­thet­i­cals might both seem unlike­ly. But a half a per cent rise in rates is pos­si­ble if the RBA per­sists in try­ing to “fight infla­tion” by rais­ing inter­est rates; and on the most recent trend, the debt to GDP ratio will be ten per cent high­er than today by the begin­ning of 2008. That com­bi­na­tion would also take us to the same pain lev­el as in 1990.

Should the RBA increase rates?

Espe­cial­ly after Dr Edey recent speech, there has been strong spec­u­la­tion that the RBA would increase rates soon, with the objec­tive of “fine-tun­ing” the rate of infla­tion.

In these cir­cum­stances, rais­ing inter­est rates to con­trol infla­tion would sim­ply accel­er­ate an ail­ready unsus­tain­able trend of debt accumulation–since one impact of a 1/4% rise in rates is to increase the rate of growth of debt.

The RBA’s eco­nom­ic mod­els do not take the debt to GDP ratio into account (see RBA Research Dis­cus­sion Papers 2005-11 and 2007-01). The lev­el of pri­vate debt was also about the only eco­nom­ic sta­tis­tic not men­tioned by Dr Edey in his How­ev­er, it is obvi­ous that the impact of a rate rise is pro­por­tion­al to the lev­el of debt–after all, this is why the RBA moves rates in 1/4% incre­ments now, com­pared to the 1% steps it took in the 1980s–when the pri­vate debt ratio was less than a third of what it is now.

Giv­en that debt ampli­fies the impact of a rate change, and that debt ser­vice ratios are already with­in reach of lev­els that have induced reces­sions in the past, the impact of the rate rise on the econ­o­my may be far more defla­tion­ary than the RBA’s mod­el­ling antic­i­pates.

I there­fore can­not con­cur with the RBA’s over­all assess­ment that “in aggre­gate, the house­hold sec­tor is cop­ing well with the high­er lev­els of debt and inter­est ser­vic­ing” and “Over­all, the house­hold sec­tor remains in good finan­cial shape” (RBA FInan­cial Sta­bil­i­ty Review 0307, pp. 16, 17). Giv­en that debt ser­vic­ing lev­els are approach­ing record lev­els, putting up rates now in order to con­trol infla­tion could amount to “hit­ting the brakes wear­ing lead shoes”.

This is clear­ly what hap­pened in 1990, when a very sim­i­lar debt bur­den brought the econ­o­my quick­ly to its knees. Infla­tion dropped pre­cip­i­tous­ly (along with every­thing else), from 8 per cent to vir­tu­al­ly zero, and the RBA was forced to drop rates even more.

I have heard some mar­ket econ­o­mists say­ing that an addi­tion­al rea­son to put rates up now is that it might help dis­cour­age bor­row­ing. This hope ignores the time lags that abound in our mon­e­tary economy–and a quick look at his­to­ry would make that obvi­ous. Rates peaked at 19.95% in 1990, and the econ­o­my rapid­ly fell into a recession–but the debt to GDP ratio con­tin­ued to climb for anoth­er year.

The rea­son is sim­ple: when you can’t afford to ser­vice your debts, they rise more rapid­ly because the missed pay­ments are added to the debt. Putting rates up now would sim­ply make that prob­lem worse.

Sustaining the unsustainable

The debt to GDP ratio con­tin­ues its seem­ing­ly inex­orable rise, and is now at 152 per cent of GDP. The rate of growth is above the long term trend. If it con­tin­ues, the ratio will reach 160 per cent of GDP by the begin­ning of 2008 (this is the lev­el that applies in the USA now).

All pri­vate debt ratios rose last month. All except the busi­ness ratio are at his­toric highs, and with the busi­ness ratio now at 56.36%, won’t be long before it cracks the 1989 record of 56.39% of GDP.

America: Home of the Brave, Land of the Leveraged

The one way in which the USA is dif­fer­ent from Aus­tralia is that every com­po­nent of Amer­i­can soci­ety is in debt: not just house­holds and busi­ness­es, but gov­ern­ment as well. This may become an impor­tant dis­tinc­tion if a debt-defla­tion occurs: the USA will begin the process with sub­stan­tial gov­ern­ment debt, where­as the Aus­tralian gov­ern­ment will start from a fis­cal­ly neu­tral posi­tion.

The aggre­gate lev­el of debt in the USA, at over 320% of GDP, is staggering–especially since this does not fac­tor in the “off-bal­ance sheet” activ­i­ties of the deriv­a­tives mar­ket.

I can’t do bet­ter as a com­men­tary on this sit­u­a­tion than to quote a recent edi­to­r­i­al from the New York Times:

Investors who fail to take a hard look at the vul­ner­a­bil­i­ty of the Amer­i­can econ­o­my are court­ing tremen­dous risk. The fact that after years of profli­ga­cy the fed­er­al gov­ern­ment is fis­cal­ly ill pre­pared to respond to a desta­bi­liz­ing down­turn only increas­es those risks. New York Times “Unwary Investors” (March 24 2007).

In con­trast, one pos­i­tive side effect of the Aus­tralian obses­sion with elim­i­nat­ing the gov­ern­ment debt is that our gov­ern­ment is fis­cal­ly well pre­pared to respond to a pri­vate debt cri­sis, should one ulti­mate­ly occur. Whether it is intel­lec­tu­al­ly pre­pared is anoth­er mat­ter alto­geth­er.

Steve Keen

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About Steve Keen

I am Professor of Economics and Head of Economics, History and Politics at Kingston University London, and a long time critic of conventional economic thought. As well as attacking mainstream thought in Debunking Economics, I am also developing an alternative dynamic approach to economic modelling. The key issue I am tackling here is the prospect for a debt-deflation on the back of the enormous private debts accumulated globally, and our very low rate of inflation.