DebtWatch No 11 September 2007: Why didn’t they see it coming?

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I expect–and hope–that the tenor of dis­cus­sion at this mon­th’s RBA Board meet­ing will be very dif­fer­ent to last mon­th’s. In August, I imag­ine, the com­mu­ni­ty mem­bers of the Board lis­tened sage­ly as the RBA’s econ­o­mists explained why the risk of future infla­tion had risen, why this jus­ti­fied a “pre-emp­tive strike” of rais­ing inter­est rates, and then reluc­tant­ly agreed to the rise.

I hope that this mon­th’s dis­cus­sion is more along the lines of “if you guys are the mon­ey experts, how come you did­n’t see it coming?”–it, of course, being the unfold­ing col­lapse of the US hous­ing mar­ket, and the result­ing extreme tur­moil on finan­cial mar­kets.

That tur­moil had begun before last mon­th’s meet­ing. No doubt, Board fears about its poten­tial impact on Aus­tralia were assuaged:

  • by ref­er­ence to FRB Chair­man Bernanke’s assur­ances that loss­es in the US sub­prime mort­gage mar­ket would be in the rel­a­tive­ly triv­ial range of “in the order of between $50 bil­lion and $100 bil­lion” (Reuters);
  • by the assur­ance that the expo­sure of Aus­trali­a’s finan­cial insti­tu­tions to US sub­prime loans was lim­it­ed; and
  • by the obser­va­tion that lend­ing prac­tices in Aus­tralia were far supe­ri­or to those in the USA–with sub­prime lend­ing account­ing for 13 per­cent of US loans ver­sus 1 per­cent for the equiv­a­lent Aus­tralian clas­si­fi­ca­tion of non-con­form­ing loans.
    That is all so last month now.
  • Bernanke observed last week that “glob­al finan­cial loss­es have far exceed­ed even the most pes­simistic pro­jec­tions of cred­it loss­es on those loans”.
  • Sev­er­al Aus­tralian finan­cial insti­tu­tions and funds have fold­ed, and quite a few more are fac­ing the need to increase their rates above the 0.25% increase man­dat­ed by the rise in the cash rate; and
  • If Aus­tralian lend­ing prac­tices are so much more pru­dent than those in the USA, how come house­hold debt has risen more than three times faster in Aus­tralia than in the USA? (see Chart 1) And why can Aus­tralian house­holds cope with an aggre­gate lev­el of debt ser­vice that, clear­ly, Amer­i­can house­holds can’t han­dle? (see Chart 2; but also see my clos­ing note below)

Note: I’m hav­ing trou­ble upload­ing charts, but they are avail­able in the PDF doc­u­ment that is acces­si­ble from the Debt­watch Reports page.

Chart 1: House­hold Debt vs GDP, USA and Aus­tralia

Chart 2: Inter­est Pay­ments vs House­hold Income, USA and Aus­tralia

One expla­na­tion that I don’t expect the RBA’s econ­o­mists will give the Board is pos­si­bly the most impor­tant: its eco­nom­ic mod­els con­sid­er nei­ther cred­it con­di­tions, nor debt, nor even mon­ey itself. As a result, its tech­ni­cal advi­sors don’t even pay atten­tion to the key vari­ables that brought us the sub­prime cri­sis in the first place.

In this, they are no dif­fer­ent to the vast major­i­ty of econ­o­mists, who share, as Fed­er­al Reserve Gov­er­nor Bernanke and Board mem­ber Mishkin once put it:

the wide­spread accep­tance of the view that there is no long-run trade­off between out­put (or unem­ploy­ment) and infla­tion, so that mon­e­tary pol­i­cy affects only prices in the long run” (Bernanke and Mishkin, 1997, “Infla­tion Tar­get­ing: A New Frame­work for Mon­e­tary Pol­i­cy?”, Jour­nal of Eco­nom­ic Per­spec­tives 11, pp. 97–116)

As a con­se­quence, most econ­o­mists omit mon­ey, cred­it, debt and the like from their eco­nom­ic models–because they don’t believe that they have any impact on the econ­o­my (apart from caus­ing infla­tion).

As the sub­prime finan­cial cri­sis spreads, I expect that Bernanke and Mishkin will look back on this state­ment as so much naive wish­ful think­ing. Hope­ful­ly, the RBA’s econ­o­mists will do like­wise. In the mean­time, they–and the RBA Board, hav­ing agreed to a rate rise at the last meeting–must now be won­der­ing how long it will be before this “unan­tic­i­pat­ed mon­e­tary shock” forces them to con­sid­er low­er­ing rates to avoid an even more seri­ous eco­nom­ic down­turn.

… And Deeper in Debt: Australia’s obsession with borrowed money

The Cen­tre for Pol­i­cy Devel­op­ment ( will be launch­ing mini-book by me with the above title on Sep­tem­ber 18, at the Syd­ney Mechan­ics School of Arts (280 Pitt Street) at 12pm. Please email the Cen­tre ( if you would like to attend, and/or reserve a copy of the report. Go to…and-deeper-debt for more details.

Abbreviated Report

This is an abbre­vi­at­ed Debt­watch, since I’m putting most of my ener­gy into … And Deep­er in Debt. My stan­dard charts are append­ed below, but the major­i­ty of my analy­sis for this month will be reserved for that book.

Closing Note

While I play down the dif­fer­ences between Aus­tralia and the USA above, there are some aspects of the US mar­ket that do make it sub­stan­tial­ly worse than here–notably the prac­tice of extend­ing “teas­er” loans to bor­row­ers with ini­tial­ly low inter­est rates, where the gap between the ini­tial and stan­dard inter­est pay­ments is added on to the prin­ci­pal. The “hon­ey­moon” peri­od on many of those loans expire in the next few months, and house­holds who took them out will face the dou­ble wham­my of increased debt and high­er repayments.But Aus­tralian house­holds are still under sub­stan­tial debt-stress, and the recent blowout in per­son­al debt may indi­cate that it is real­ly start­ing to bite hard. Last mon­th’s growth rate in per­son­al debt was astro­nom­i­cal (see Chart 3), and it may be a sign that house­holds are resort­ing to eas­i­ly avail­able cred­it-card debt to meet liv­ing expens­es and still be able to pay the mort­gage.
Chart 3: Month­ly growth rates in types of debt

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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.