Note to Subscribers: I have been on study leave in Europe for the last month, and get back to Sydney late on Monday February 4th. I will be available for comment from the morning of Tuesday February 5th.
Chart of the Month: Who’s having a housing bubble then?
A SMH article claimed that 17 out of 19 economists surveyed expected the RBA to increase rates in response to the January CPI figure:
In that case, count me as number 18 of 20. But unlike the other 17, I believe that a rate rise now would be a mistake. The real danger to the Australian economy is not a mild resurgence in inflation, but financial fragility, caused by excessive debt–the phenomenon that is leading the US’s Federal Reserve to move rates aggressively in precisely the opposite direction.In fact, the disconnect between Australian and American interest rate policies is once again so extreme, that it seems the two Central Banks reside on different planets. Australia’s “Rambo” RBA is still waging the war against inflation, while the “Sensitive New Age” Federal Reserve is clearly trying to soothe the troubled financial markets. In mid-2006, Reserve rates had converged to differ by a mere 0.5%; now, they are 3.75% apart after the Fed’s dramatic January pre-meeting rate cut of 0.75%, and subsequent meeting cut of another 0.5%. Australia’s reserve rates are now 2.25 times those of the USA’s.
In 2002-06, when there was last such a policy disconnect, the difference was justified by clearly divergent economic conditions. The USA was severely affected by the bursting of the Internet Bubble, while Australia had escaped relatively unscathed. Then, the USA’s rate of growth fell to a barely positive 0.2%, while Australia’s real rate of economic growth slowed, but remained above 1.5% p.a. This time, a similar gap has opened up after the bursting of yet another bubble–the so-called Subprime Lending Crisis. To date, our RBA seems to have taken a punt that history will repeat itself, and the negative effects of this bubble’s collapse will also be confined to the USA.
But what if the wrong history repeats: what if, rather than replicating the 2000 experience, we replicate the 1990s?
Then, both countries experienced a stock market bubble and crash, followed in short order by a commercial property market bubble and crash.The Australian government increased interest rates far more aggressively that the US government, in an attempt to rein in both inflation and the rampant property market.It was excessively successful: not only was inflation driven out of the system, but growth collapsed as well. Australia’s rate of economic growth tumbled from more than 2 percent above the USA to over 3 percent below it. The 1990s recession in Australia lasted longer than in the USA, and drove unemployment higher. The Australian government was forced to rapidly change tack on interest rates, dropping them from 18 percent to under 5 percent over the next 3 years.
Which way should rates go?
Today, the US Fed clearly believes that rates have to fall substantially to avert a serious financial crisis and a possible recession, whereas the RBA believes rates have to rise to control inflation. Both Central Banks can’t be right, unless the fundamentals in the two economies are fundamentally different. So just how different are they?
The difference in rates of economic growth are exaggerated by the US practice of multiplying the current quarter’s rate of growth by four to estimate the annual rate of growth; Australia, on the other hand, uses the rolling sum of the last 4 quarters to estimate the annual rate of growth. When the less volatile Australian standard is applied to both economies, Australia’s economy still appears to be growing more rapidly than the USA, but the current gap was just one percent–prior to the release of the anaemic growth result for the December quarter.
The rates of inflation are almost identical today, and well below the mean for the last two decades, when generally Australian inflation was two percent higher than the USA’s. Today, as measured by the CPI, our inflation rate is the same as America’s.
So rates of economic growth are similar, and rates of inflation are almost identical. How different then are asset markets?
Since the Subprime Crisis broke, the Federal Reserve has clearly been concerned that the collapse in US house prices will drive its economy into recession–and the precipitous fall in the US stock market since the beginning of 2008 has only added to the worries that a serious “credit crunch” is taking place. It is ignoring signs of a resurgence in inflation–driven by rising global energy prices–and driving interest rates down aggressively.The Australian RBA, on the other hand, has been outwardly confident that there is no local parallel to the Subprime Crisis, and more worried that a fast growing economy is inducing rising inflation. They seem to believe that Australian asset markets–both stocks and housing–are not as fragile as their US counterparts. They therefore regard the pain that higher interest rates might damage growth and asset markets are as worth the gain of lower inflation.I think the RBA’s judgment here is flawed. On the data, the Australian stock market has outdone the US market on irrational exuberance since mid-2004, while the Australian housing market makes the US look subdued by comparison. The historic parallels are not with 2000, but with 1987/89.On the stockmarket front, while our market has been growing more slowly and sanely than the US since 1984–and it clearly didn’t join the US in its orgy of speculation over the Internet–since mid-2004 the ASX has clearly been in a bubble. The annual growth rate doubled from the 1984–2004 average of just under 9% to almost 20%. On the other hand, the US market’s growth rate in the last three years has been 13%, only slightly above its trend rate of growth since 1984, of about 11%.
On the other hand, the long run rate of growth of the DJIA (since 1914) is only 6%, and the long run result for the ASX (since 1984) is 9%… So whatever way you cut it, both Australia and the USA have been Bubble Economies for the past two decades–and the stock bubble is clearly bursting in both economies. The real “gimme” though is in housing, where our bubble makes the USA’s look positively anaemic. Ours began earlier, climbed higher, grew faster, and is still growing–whereas the US’s market is clearly in free-fall.
The US price index is now falling at a rate that exceeds one percent per month–an unprecedented rate of decline.
Both asset bubbles in both countries were driven by the Ponzi-Scheme belief that house prices could forever rise faster than consumer prices, so that leveraged speculation on housing was a sure “road to riches”. But while Ponzi Schemes work for those who get in and out early, those who hang around too long find out the hard way that it’s the sure road to bankruptcy instead. Once a Ponzi Scheme ends, all that’s left at the national level are
- overvalued assets
- much higher debt, and
- a compromised financial sector.
These are the consequences that the USA is now grappling with–and while I think the Federal Reserve is right to worry about the state of the USA’s economy, it is also undoubtedly complicit in allowing these bubbles to develop in the first place.
As is obvious from the above graphs, Australia’s asset prices are just as overvalued–and just as shaky–as those that are currently tumbling in the USA. What we gain by way of a comparatively responsible stock market since 1987 (recent bubble behaviour excepted), we lose in terms of an even more overvalued housing market.
We can tick the first box on the Ponzi scheme checklist.
The second is even more easily ticked. Though the Subprime Crisis has distinctive features that are not replicated here–such as the widespread use of “Adjustable Rate Mortgages”–lending to households for real estate speculation has been even more rampant in Australia than in America. In 1985, Australia’s household debt to GDP ratio was half that of America’s; today, it is the same.
What about the third box–the state of the financial sector? Here, though there have been obvious casualties–RAMs, Centro and now Tricom in particular–the widespread banking trauma that has afflicted Wall Street has been notably absent here, and the levels of personal bankruptcies and mortgage foreclosures are much lower.One important reason as to why may simply be the nature of the housing market. In many American states, a borrower who can’t meet mortgage commitments has the option of a “key drop”, as an almost cavalier means to hand ownership of a house back to the lender. Mortgage originators are then obliged to sell as soon as possible–hence the precipitous decline in US house prices.Given that so many of these loans were syndicated into bonds, the collapse in house prices has in turn undermined the bond market, and in particular the “repo” business (when companies extend short-term loans to each other by selling a bond and an agreement to buy it back a short time afterwards at a higher price). The collapse in house prices can force these bonds to be “marked to market”, eliminating their notional values–and making holding them even for the short term of a repo agreement too risky for financiers to contemplate.In Australia, even though repossessions and bankruptcies are occurring at a heightened pace, the process of liquidating a repossessed house is much more cumbersome, and lenders prefer to pressure a mortgagor into a forced sale to avoid the 15–20% hit on prices that a mortgagee sale causes. So house prices hold up, bonds don’t need to be marked to market, and the financial system continues to function, albeit at a reduced pace.The role of the China boom also can’t be overlooked: just as China has boomed selling consumer goods to the USA, we have boomed selling the raw materials to China. As long as China continues to boom, we are to some extent quarantined from the US’s problems.