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

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.
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  • foun­da­tion

    This would, the­o­ret­i­cally, pro­vide a dis­in­cen­tive to prop­erty spec­u­la­tion,”

    How exactly? Cur­rently the cost to investors is com­prised mainly of:

    inter­est pay­ments on land
    inter­est pay­ments on house
    prop­erty man­age­ment, rates & insur­ance

    rental income

    tax deduc­tions against reg­u­lar income

    The LVT pro­posal would sim­ply replace the “interest pay­ments on land” com­po­nent with LVT. The only dif­fer­ence I can see is that the investor cur­rently faces fairly fixed inter­est pay­ments that are effec­tively reduced by infla­tion, whereas the LVT would rise in line with infla­tion.

    In fact, such a scheme might pro­vide a greater chasm between own­er­ship and spec­u­la­tion, given investors would have rent to cover much of the LVT, and off­set any other short­fall against income, whereas own­ers would bear the full cost of this ‘land rent’ which would undoubt­edly be much higher than cur­rent munic­i­pal rates and would rise over time.

    - Could we trust the gov­ern­ment to off­set this new LVT with a com­men­su­rate reduc­tion in exist­ing taxes? Nope.
    — Could we trust the gov­ern­ment not to use the added rev­enue to spend them­selves into a hole from which they decide to extri­cate them­selves by increas­ing LVT? Nope.

    As a home­owner, the first thing I’d do under such a sys­tem is sell my house. The sec­ond would be to emi­grate to a coun­try that recog­nised the impor­tance of full prop­erty rights (includ­ing land) and their rela­tion­ship to national pros­per­ity.

    My main goal in home own­er­ship is to have a place that is mine, and only mine. Where should I lose my job, I can rest assured I’ll not lose the roof over my head. If I had to pay ‘land rent’ levied against half the value of the prop­erty (or more, depend­ing on land value), I would lose this secu­rity.

    The cur­rent sys­tem works fine, except that it doesn’t pre­vent spec­u­la­tion from push­ing prices up into bub­bles. One very sim­ple way to dis­cour­age spec­u­la­tive bub­bles (more effec­tively than LVT I’d war­rant) is to end or heav­ily restrict ‘equity bor­row­ing’ or remort­gag­ing at into larger loans. If houses could only be bought with a sig­nif­i­cant deposit – say 15% to 20% actual SAVINGS (not ‘equity’), the cur­rent irra­tional feed­back loop would be bro­ken.

    I say irra­tional because as things stand, when a small pro­por­tion of the hous­ing stock (nor­mally ~5% per year) is sold at inflated prices, these inflated prices set the com­pa­ra­bles by which all other houses can be remort­gaged. A small amount of extra debt secured against a few over­priced houses becomes 20 times more avail­able ‘equity’. If some of this is bor­rowed against and rein­vested in hous­ing, this puts fur­ther pres­sure on prices and quickly becomes an irra­tional feed­back loop, then a bub­ble…

  • bear-foot econ­o­mist

    In response to the issues raised by Foun­da­tion:

    Firstly it is more accu­rate to say that we have had a boom in land prices rather than house prices…

    QUOTE (foun­da­tion): How exactly?

    The dis­in­cen­tive for land spec­u­la­tion of LTV arises from the premise that “land value is the dis­counted present value of expected future after-tax rents“…so by reduc­ing the expected future rents from the land, the exchange price will be reduced to a neg­li­gi­ble amount (other than enough to pro­vide a bench­mark of rel­a­tive land value (“site value”) and an incentive/compensation to move off the land in favour to allow more pro­duc­tive use). The price of the land could not increase because that would raise the rental and hence erode any per­ceived spec­u­la­tive gains. 

    Before you say that is an “expro­pri­a­tion” of pri­vate prop­erty you need to ask your­self whether the orig­i­nal “appro­pri­a­tion” of land value is just, leav­ing aside (if that’s pos­si­ble) the emo­tional asso­ci­a­tion of “a man’s house is his cas­tle”. The right to exclu­sive access and use would remain….but as far as rights to land value….what has the landowner done to add value to the land ? (granted there may be some effect of beau­ti­fi­ca­tion of dwellings etc on the streetscape, which may effect land val­ues within the area, but even that is a col­lec­tive endeav­our) … the major­ity of land value arises from loca­tional char­ac­ter­is­tics, access to ser­vices and facil­i­ties, absence of bad smells and noises etc, and gen­eral increases in income — for which the land­holder can claim no credit…the impact of these or a change in these cur­rently results in an “unearned wind­fall gain” to the land­holder.

    Also remem­ber rights and prof­its from the value of the “improve­ments” (build­ings etc) would remain, so there would still be incen­tives to prop­erty invest­ment (for rental pur­poses), it is just that the land com­po­nent (the site value) would be taken out of the equa­tion (in decid­ing whether to invest).

    QUOTE (foun­da­tion): “My main goal in home own­er­ship is to have a place that is mine, and only mine. Where should I lose my job, I can rest assured I’ll not lose the roof over my head. If I had to pay ‘land rent’ levied against half the value of the prop­erty (or more, depend­ing on land value), I would lose this secu­rity.”

    If you loose your job now and can’t cover the mort­gage, you’re going to loose your house anyway…with LTV once you have paid the mort­gage on the house you would just have the LTV to pay….and once the spec­u­la­tive ele­ment (and “sav­ings” incen­tive in land) is removed the total out­lays (even with the mort­gage on the house) would be less than what is being paid now. With­out the spec­u­la­tive ele­ment of land invest­ment peo­ple are unlikely to pay more than that the site is worth (the “site value”). The premise of “site value” is that the value of any par­tic­u­lar site is pred­i­cated on the income stream pos­si­ble from that site (or what people’s incomes can sup­port in the case of res­i­den­tial sites)….so sites near rail sta­tions (for exam­ple) have high vol­umes of foot traf­fic, so the shops on that site can sell more, so busi­ness incomes are greater, thus higher rents can be paid (above the com­po­nent of the shop structure/building)…just as is the case now….only the site (value) rental cur­rently goes to the land­hold­er… who ben­e­fits from the pub­lic deci­sion to ferry peo­ple past the site.

    Any such a scheme would need to be intro­duced over a decade or more, and so it would need bipar­ti­san sup­port, so it is obvi­ously not going to be intro­duced any time soon….but that is not my point. If the only objec­tion to any propo­si­tion is “oh well…you will never con­vince peo­ple of that”, it is IMHO a weak objec­tion. Also it is my view that such a mea­sure would need to be com­bined with other poli­cies (unfor­tu­nately no less rad­i­cal than this one), but that is for another post (and pos­si­bly not here).

    Clearly there are other issues here, and get­ting credit under con­trol is prob­a­bly more impor­tant, but I think our society’s atti­tude to the “right” of pri­vate cap­ture of land value is at the heart of our unhealthy obses­sion with prop­erty.

  • foun­da­tion

    If you loose your job now and can’t cover the mort­gage, you’re going to loose your house any­way…”

    What mort­gage? 🙂

    I under­stand and am sym­pa­thetic to the phi­los­o­phy behind LVT. I just wouldn’t be pre­pared to live with it. I also under­stand and and am sym­pa­thetic to some much broader social­ist phi­los­o­phy. I just wouldn’t be pre­pared to live with it!

    Clearly there are other issues here, and get­ting credit under con­trol is prob­a­bly more impor­tant, but I think our society’s atti­tude to the “right” of pri­vate cap­ture of land value is at the heart of our unhealthy obses­sion with prop­erty.”

    I think “society’s atti­tude” will change dra­mat­i­cally over the next few years, if the mar­ket is left to do it’s thing.

  • bear-foot econ­o­mist

    QUOTE (Foun­da­tion): “I just wouldn’t be pre­pared to live with it!”

    Another good rea­son to intro­duce such a thing grad­u­ally (like over an adult lifetime)…to allow expec­ta­tions and invest­ment deci­sions to adjust.…but I am interested…is that because you feel you would per­son­ally be worse off under such an arrange­ment or because you fig­ure the prac­tice is unlikely to be as good as the the­ory — like some other sign­f­i­cant left-ist (and lets face it right-ist) exper­i­ments of the past ?

    QUOTE (Foun­da­tion): “What mort­gage?”

    Good for you.…I sup­pose I have the ben­e­fit :/ of not hav­ing a mort­gage either…but that is because I didn’t “get in” before the boom and am not fool­ish enough to try it on now.…so that no doubt colours my view. But most peo­ple are only mort­gage free (if they ever get free at all) for a short period before they die or move on to greyer pastures…but for sure the biggest bar­rier to intro­duc­ing such a mea­sure is intrenched interests…and of course our inter­ests colour our per­cep­tions (mine included), for exam­ple under cur­rent arrange­ments being a mortage-free owner-occu­pant and thus liv­ing “rent free” can be seen either as an enti­tle­ment or a pub­lic sub­sidy…

    QUOTE (Foundation):“I think “society’s atti­tude” will change dra­mat­i­cally over the next few years, if the mar­ket is left to do it’s thing.”

    Agreed.…I think of a cou­ple of other major chal­lenges fac­ing our soci­ety (cli­mate change, peak oil, pop­u­la­tion aging…) that will require some sig­nif­i­cant atti­tu­di­nal changes as well !!

  • Lord Kelvin

    Hi Steve,

    Thanks for putting your thoughts on the web. It’s very inter­est­ing to an eco­nomic layper­son. The math­e­mat­ics of money seems to cause a lot of con­fu­sion. Cer­tainly seems dif­fer­ent from account­ing for tan­gi­ble things.

    One conun­drum I would be keen to hear your opin­ion on: Does hav­ing a trade deficit push up hous­ing prices? At first blush you’d say “No! Peo­ple are poorer, as the whole coun­try is poorer, so they can’t afford as much.” But this is not what we are see­ing at all, is it? We have a huge trade deficit and a hous­ing bub­ble together.

    Is it that the export debt must appear some­where, and it appears in hous­ing? So in order for trade deficits to con­tinue, hous­ing debt must keep increas­ing? As a corol­lary, does it mean that house prices must rise in order for it to be nec­es­sary to bor­row more money to buy them? To make this higher bor­row­ing pos­si­ble, inter­est rates must fall. If this were the case, would revers­ing the bal­ance of pay­ments prob­lem result in mod­er­at­ing house prices and increas­ing inter­est rates?

    Sup­pos­ing for the moment that my spec­u­la­tions above are cor­rect, it would seem an unsta­ble sys­tem is cre­ated, because a higher debt load leads to lower inter­est rates. For sta­bil­ity, you’d want higher debt to lead to increased inter­est rates in order to dis­cour­age fur­ther bor­row­ing, thereby sta­bil­is­ing the sys­tem through lim­it­ing the debt car­ried.

    Any cor­rec­tions to my mus­ings would be wel­comed.

    Best regards,

  • Dear Lord Kelvin (I think I’ll call you Kev, if that’s OK!),

    There is a link there, but not quite the one you sur­mise. I must credit aone time fel­low stu­dent and now semi-col­league of mine, Peter Switzer, for first sug­gest­ing this to me.

    Con­ven­tional eco­nom­ics argues that the cur­rent account dri­ves the cap­i­tal account: that a deficit on the for­mer (trade and income flows) causes a sur­plus on the other (with nec­es­sary adjust­ments in the country’s exchange rate).

    The uncon­ven­tional one, which I first heard Peter put in a dis­cus­sion we were hav­ing dur­ing the “Banana Repub­lic” days, was that bor­row­ing pro­vided the finance that enabled more imports to be pur­chased than exports; as long as the debt (or port­fo­lio or actual invest­ment) was forth­com­ing, the cur­rent account could be in the red.

    This I think is the mech­a­nism we’re suf­fer­ing under (obvi­ously Japan did not–it is pos­si­ble for a truly pro­duc­tive coun­try to have its real activ­i­ties dom­i­nate its finan­cial; unfor­tu­nately, we’re not that coun­try).

    So the causal mech­a­nism is closer to the reverse of what you pro­pose: ris­ing hous­ing prices dri­ven by a spec­u­la­tive bub­ble encour­age fur­ther bor­row­ing, which finances both the house pur­chase and the buy­ing of com­modi­ties to stuff into it. Given that we don’t pro­duce those com­modi­ties ourselves–plasma TVs, com­put­ers, … –we buy them from over­seas… and up goes the trade deficit.

    Japan doesn’t have the “given that we don’t pro­duce those” dilemma–hence its out­come is dif­fer­ent.

    I also believe that the rever­sal will take a dif­fer­ent tack–with again finance in the dri­ving seat. Once the lend­ing spig­got gets turned off, there will be a pos­i­tive feed­back loop between reduced spend­ing, eco­nomic out­put and, for a while, debt too–we’ll see that con­tinue to rise rel­a­tive to GDP. But that’s too com­plex an argu­ment to go into at this time of the morn­ing!

    On that note, I’m speak­ing today at an event organ­ised by the New Matilda pol­icy off­shoot the Cen­tre for Pol­icy Devel­op­ment. It’s part of the ALP Fringe Con­fer­ence; I’ll put up a proper blog entry about it now.

  • Lord Kelvin

    Hmmm. Thanks Steve. Your line of rea­son­ing makes sense. I was push­ing on the string, as it were. Depends whether the dri­ving force is our desire to con­sume, (and there­fore bor­row), or financiers’ des­per­a­tion to get that bulging cap­i­tal account out into the hands of bor­row­ers and earn­ing a return. The lat­ter urge would tend to reduce inter­est rates.

    Speak­ing of which, recently I seem to be get­ting an increas­ing num­ber of offers of credit from finan­cial insti­tu­tions with which I do no busi­ness. They seem to know I exist, despite me never hav­ing dealt with them!

    Your point about us not man­u­fac­tur­ing very much is well made. That has upset me for many years. [It makes it hard for me to find work.] This is not some­thing which seems to con­cern Australia’s gov­ern­ments of either stripe. Gov­ern­ment and eco­nomic com­men­ta­tors seem quite chuffed with how things are going, trade and cur­rent account deficits no longer being of any con­cern. “Mir­a­cle econ­omy” they say. Mir­a­cle we can get away with it.

    Best regards,

  • Fred­Bloggs

    In reply to Steve Keen, April 9th, 2007 at 8:13 am:

    The Lorentz­ian curve is a lit­tle bet­ter fit than the Hub­bert curve to many mar­kets where price has been dri­ven by debt.

    Aus­tralian house­hold debt to dis­pos­able income is a good exam­ple:

    Another clear exam­ple is the Shang­hai stock exchange:

    Case-Schiller USA house prices, an exam­ple of over­lap­ping lorentz­ian curves:

    Perth Aus house price index is another:

    The R^2, the coef­fi­cient of deter­mi­na­tion, is high, (>0.99 in many cases).