Steve Keen’s DebtWatch No 20 March 2008: Double or Nothing?

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The revelation in the minutes of the RBA’s February meeting that debate focused, not on whether there should be a rise, but on whether it should be 0.25 or 0.5 per cent, shows that the RBA wagers that the threats to the Australian economy are upside ones–tighter labor markets and higher inflation–rather than downside ones–a global slowdown as asset markets collapse during a credit crunch. The February minutes implied that the RBA might really throw its cards on the table at the March meeting, with a 0.5% rise being a distinct possibility.

This is in stark contrast to the biggest gambler in the regulatory stakes, the US Federal Reserve. Not only did it drop US rates down by 1.25% last month, it is now signalling another 0.5% fall during March.

So which regulatory gambler is right–or, against the odds, are they both right? The answer depends on just how big a threat the current financial market turmoil poses to the global economy, and how well Australia is prepared to weather any storm this might cause.

A key issue for the former point is the size of the current financial bubbles, in both America and Australia. They are obviously bursting now, and the amount of pain that a bust can inflict clearly depends on how big the bubble itself was.

On that point, the answer is simple for the USA: the USA’s recent bubble was the biggest in world financial history.

Robert Shiller, the man who coined the phrase “irrational exuberance”, makes that clear in the 2005 update to his book, where he compares American house prices and stock market indices to the CPI.

Houses are normally purchased on credit, and while an individual can pay back his or her mortgage debt by selling the house to someone else, society as a whole can’t do that. Ultimately therefore, an economy’s mortgage servicing has to be financed from its income, which is derived from selling goods and services. The ratio of asset prices to consumer prices gives the best measure of how hard or how easy that is to achieve. While there is no obvious “magic number” for the ratio (and the servicing cost of debt will rise and fall with changes in interest rates), its level tells us how sustainable house prices are at any point in time. A low ratio implies very affordable housing; a high one implies very expensive housing–and one that towers over the long term average implies a bubble.

A similar observation applies to the Stock Market. Though the Price to Earnings (PE) ratio is a commoner measure of the veracity of the Stock Market’s valuation, earnings can be inflated by tricks ranging from outright fraud, to fancy “financial engineering”, to debatable revaluations of assets–something that is becoming painfully obvious as the dominoes fall in the current Australian and US stock market slumps.

No such problems apply with the CPI, and since earnings have to come from sales of goods and services, the comparison of the asset index to the CPI gives a better idea of how sustainable the share market’s prices are.

These calculations gives the lie to Greenspan’s assertion that a bubble can only be identified after it has burst.

The US House Price Bubble

The bubble in US housing prices is obvious: between 1892 and 1995, the average for this index was 103, while its prevous peak value–set over a century ago in 1894–was 133.6.

This long run maximum was breached in 1989, two years after Greenspan took over as Federal Reserve chairman, after he “rescued” Wall Street after the 1987 Stock Market Crash–a rescue which simply transferred the Wall Street bubble into a Main Street one, in commercial and residential property. The property market crash in 1989 ushered in the 1990s recession that helped Clinton come to power. House prices still hadn’t returned to the historic norm before the next boom began–fuelled by and feeding into the euphoria over the Internet. The housing bubble continued even after the Stock Market bubble temporarily burst, until it peaked in 2004 at 228, over twice the historic norm, and 70% above the highest level the index had reached over a century earlier. If the index reverts to anything like its historic norm, then US house prices have much further to fall. Even now, after a ten percent fall from its peak, the index is still almost twice the pre-1995 long term average.

Commentators who are predicting a further 25% fall in US house prices may turn out to be optimists.

Chart One: USA Real House Prices
 Chart One: America's CPI Deflated House Price Index

The US Stock Market Bubble

One intriguing fact that the deflated Dow Jones index reveals is that the previous biggest Stock Marketbubble wasn’t in 1929, but in 1966.

n 1929, the index reached an inflation-adjusted value of 407 (before collapsing to as low as 60 in 1932–an 85% fall). In 1966, theinflation-adjusted value of the Dow peaked at 567–after which it plunged for 16 years, to a low of 152 in mid-1982. This was a 73% fall in real terms.

Since then–with the dramatic exception of Black Monday in October 1987–it was all up until 2000. The Stock Market had already exceeded its Roaring Twenties peak by the time Greenspan took office in August 1987. Just two months later, it plunged back into near long-term territory with October 19th’s 23% crash. Rather than the reversion to the mean continuing, the Greenspan Put emboldened the market, which sailed through the 1929 record in 1992, and kept right on going into an unprecedented level of overvaluation.

By 1996, it had left 1966 behind, and at the height of the Internet frenzy, it hit 1252–almost five times the average that had prevailed up until 1995. Then in 2000, just as Greenspan was reiterating his belief that a bubble can only be identified in its aftermath, the one he was riding burst.

Chart Two: USA Real Stock Prices 

Chart Two: America's CPI Deflated Dow Jones Index

Quick rescue work by the Fed–both injections of liquidity, and dropping the reserve rate to 1%–and massive government deficits to finance the war in Iraq, turned the market’s reversion to the mean around by mid 2003. By late 2007, it revisited its 2000 peak.

Then its recent plunge began.

A more current value of this index must await the US CPI figures for January and February, but it must be of the order 1050 now. Even so, this puts it at more than four times the pre-1996 average.

Where could the index head to, if the market finally heads back to its historic norm? As the USA basked in the collective delusion of the Internet Bubble, some authors put out books with the titles Dow 30,000, Dow 36,000, and even Dow 100,000 (Zuccaro; Glassman, Hassett & Hassett; and Kadlec; look for them in the remainder bins of your local bookshop). On this data, Dow 3,000 looks more the go.

Of course, it is also possible that the bubble could re-form–but that would require a renewal of the trend for an ever-increasing debt to GDP ratio, since leverage is what has driven house and share prices to their current levels.

This is possible, but unlikely, for the same reason that a similar “solution” is unlikely here: America’s debt to GDP ratio is already at record levels. Even if the Fed drops official rates to zero (as Japan’s Central Bank did during the ’90s), and average commercial interest rates drop to three per cent, the debt servicing burden on the economy will still be immense. And a cut in official rates won’t rescue home buyers who have signed up for fixed interest loans, which are the norm in the US market.
Chart Three: USA vs Australian Private Debt Ratios
Chart Three: Private Debt to GDP Ratios in the USA and Australia

How Big Are Our Bubbles?

How do the Australian house and stock market bubbles compare to America’s? The bad news is that Australia’s housing price bubble is at least 50% larger than America’s. I currently lack really long term data for Australia, but Nigel Stapledon at the University of New South Wales provided the following perspective in his PhD thesis: (the following chart, which compares Stapledon’s index for Australia to Shiller’s for the USA,is taken from:

Clearly, the Australian house price bubble dwarfs America’s.

Some may wish to explain the divergence on the basis of real factors such as Australia’s higher rate of population growth, etc. While these factors undoubtedly play some role, I very much doubt that they can explain the volatility shown in Stapledon’s data. The two country’s house price indices were virtually identical in the mid-1980s, for example, and then within a couple of years, Australia’s was almost twice America’s. We didn’t take in that many more migrants then–nor could their influx explain a bubble focused on the middle to upper-range suburbs.
Chart Four: USA vs Australian Long Term Real House Prices
Chart Four: USA vs Australian Long Term Real House Prices

It’s also apparent that Australian house prices have increased more than the USA’s since 1987, and remain in a bubble today, while the USA’s index has clearly turned.

Chart Five: USA vs Australian Recent Real House Prices
Chart Five: USA vs Australian Recent Real House Prices
Given that our household debt to GDP level was half that of America’s in 1990, but is identical now, I expect that the true explanation of Australia’s greater housing bubble is financial, not “real”. If so, we face just as serious a potential downside to house prices as does America, if not more so. The differences in outcomes to date may result from the China Boom, combined with the very different mortgage default laws in the two countries.

Chart Six: USA vs Australian Household Debt Ratios

Chart Six: USA vs Australian Household Debt Ratios
So much for the bad news. The good news is that Australia’s stock market hasn’t been nearly as bubble-based as the USA’s since 1987. In 1984 (when the ASX data begins), the CPI-deflated value of the Dow Jones was 2.3 times that of the ASX; by 2000, when the DJIA first hit its historic peak, the US index was 5.2 times the Australian one.
Chart Seven: USA vs Australian Real Stock Market Indices
Chart Seven: USA vs Australian Real Stock Market Indices
On the other hand, it’s also apparent that its performance in the last four years has been more speculation-driven than the USA’s. By time time both indices had peaked, the divergence between the USA and Australia had fallen to 3.2 to 1. It is likely that the recent obsession with margin lending as a “wealth enhancement strategy” has played a role here.

Chart Eight: USA vs Australian Stock Market Indices Trends

Chart Eight: USA vs Australian Stock Market Indices Trends
Chart Nine: USA vs Australian Stock Market Indices Trends

Chart Nine: USA vs Australian Stock Market Indices Trends
So which Regulator is “on the money”?

Neither the Federal Reserve nor the RBA deserves accolades for its management of the financial system. While they are diverging now over the threat posed by inflation, versus that emanating from systemic fragility, both have shared an obsession with keeping commodity price inflation under control, while asset prices and debt have spiralled out of control.

That said, the Federal Reserve clearly appears more realistic about the major threat facing the economy at the moment–even if that threat was fuelled by its own complacency during the greatest financial bubble of all time. Now is not the time to be fighting commodity price inflation, while ignoring both debt and asset price inflation.

An aside: “Low” Business Leverage?

I’ve seen a number of media reports claiming that the current string of business defaults is unexpected, since business leverage is quite low these days.

That may well be true when debt to equity is the measure of leverage, but as I remark above, both asset prices (which determine the equity denominator in debt to equity calculations) and indeed earnings are rather rubbery figures.

A far better guide is to compare business debt levels to Gross Operating Surplus–the business component of national income. On that basis, the level of business gearing today substantially exceeds the previous peak set in 1990.

Chart Ten: Business Leverage

Chart Ten: Business Gearing

Of course, the debt servicing burden on business is much lower than in 1990, when the rate of interest was twice what it is now. But when a cash crisis hits, the rate of interest is irrelevant: what matters is the cash flow you have on hand to service debts as and when they become due. The current turmoil in our most heavily geared companies emphasises that point.

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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14 Responses to Steve Keen’s DebtWatch No 20 March 2008: Double or Nothing?

  1. Pingback: Bad Debt » Blog Archive » Steve Keen’s DebtWatch No 20 March 2008: Double or Nothing?

  2. Ken says:

    A reasonable explanation is that the Federal reserve isn’t being honest about their reasons. Rather than trying to prevent a recession, they are trying to avoid the collapse of their financial system. By lowering wholesale interest rates, they allow for increased margin without an increase in retail interest rates, so lenders can offset their defaults. For the moment it seems better than watching the banks go bust, and having to clean up the mess. Not to mention the mortgage insurers.

    We haven’t got there yet. It might be interesting to consider how secure the money lent by super funds for mortgages is, as I suspect mortgage insurance isn’t going to be worth a lot if the insurer goes broke. One of the more stupid things to happen has been not to require at least 20% deposit. In the UK the required deposit is increasing rapidly, which is one reason for falling house prices as first time buyers leave the market. One more example of positive feedback in economics.

    A question: Does the RBA have any choice in how it manages the economy, as it is restricted to certain interventions and for certain reasons? I know they have done evaluations but they seem restricted to questions about whether our financial institutions will survive a recession than will it be pleasant for the population.

  3. david says:

    So good to see our M3 only growing at around 22%. For a while I thought we might have had an inflation problem here too. Fortunately our board of the reserve bank has a got a good handle on the cause of inflation, it’s a couple of percent on the lending rate that will make a difference! Meanwhile our M3 growth is competing with Zimbabwe..

  4. historyman says:

    Professor/Doctor/Guru Steve Keen, from the ABC 1 May 2006. Do you have any clue??

    “A leading economist says even though inflation is at the upper end of the target range, the Reserve Bank should not raise interest rates.

    There has been speculation that the bank will raise interest rates at its next meeting tomorrow.

    Associate Professor Steve Keen, from the University of Western Sydney, says household debt levels are too high to withstand a rise of even 0.25 per cent.

    He says putting up interest rates now could be disastrous.

    “The thing which is at the upper end of the target rate is the level of debt,” he said.

    “Inflation might be touching 3 per cent which is not exactly scary, but the level of debt is to me quite scary.

    “Anything which could accelerate that or make the burden that it is putting on people at the moment would be, as I said, playing with fire.”

  5. john h says:

    This is all very interesting and could ‘scare the pants off’ but what would help me (and everyone else who’s every thought of jumping out the window after reading these) would be an acknowledgement of the data source.

    Not that I’m an unbeliever but go to: to understand just how we can be influenced, especially by people who know more than us.

  6. john h says:

    All this is very interesting but it would be helpful to me at least, if the data source was achknowledged.

    Not that I don’t believe but go to for an idea how we are influenced by those who have more knowledge.

  7. Steve Keen says:

    Re Historyman,

    I presume the “do you have any clue?” is a query about whether I was wrong in 2006 to say that the RBA shouldn’t increase rates?

    No, rates were too high then given the debt burden on households and businesses, and they are higher still now.

    Interest rate changes operate with a lag. They are also amplified by debt levels, which are not taken into account by standard economic models.

    The momentum behind an asset price bubble can also mean that rate rises are ineffective at stopping it until they reach ridiculous levels–or have far greater impact than expected by those who ignore debt levels. Both applied during the 1989-91 period; both apply now, even with much lower rates than then.

  8. Steve Keen says:

    Dear John H,

    I wish I could say that I was making all this up, but unfortunately my data sources are the RBA, US Federal Reserve, and Standard & Poors, and Robert Shiller’s well researched data:,0,0,0,0,0,0,0,0,1,1,0,0,0,0,0.html

    I simply analyse this publicly available information from a perspective that takes debt seriously.

    My worry about the attribution theory you refer to is that we have for too long believed neoclassical economists who have a flawed understanding of the economy. One effect of this is that they have ignored debt, and now we’re seeing the consequences of that “omitted variable bias” in their models.

  9. Punchy says:

    Interesting Charts Mr Keen.
    Seems we have one less problem or catalyst for a crash. We dont have the same overbuilt housing market like the US. Will this make any difference in Australia? Or is the credit crash so big it wont matter?
    I also think we have a problem with China exporting inflation to the world. The effects of Chinese inflation on Australia has been masked by our rising dollar. If the AUD falls this inflation will be unmasked and inflation will shoot up. As inflation shoots up the RBA will put up interest rates. Negative feedback loops seem to be compounding every week and will eventually overcome all possitive news.
    The media are providing the public with mixed signals every day now. The Brisbane Sunday paper reported a massive increase in home repos and on the next page ran a story on home prices increasing 5% this year. This is confusing the public (and me).

  10. david says:

    China exporting inflation? Sorry, you haven’t followed the problem back to it’s source: The U.S. is creating the inflation with M3 growth around 16%. We are too – but worse: M3 Growth around 22%. Either interest rates keep going up here, or the dollar declines. The end result is the same; we will see much higher prices for anything imported – particularly energy.

    The trade deficit is approaching 7% here. We will not be able to sustain that if there is a global downturn.

    It’s quite obvious that we are facing a global de-leveraging, all asset prices will fall if central banks can’t get liquidity into the system – Or more specifically, to prop up leveraged asset prices. The liquidity that they are providing is going into hard assets. i.e. commodities.

    Anyone who is leveraged to the hilt to buy a house is doomed. Shortage of supply means nothing if people cannot get credit. This is what is happening now. Watch houses prices tank as loans tank.

  11. david says:

    Do you really understand what causes inflation? Loose monetary policies by both our reserve bank and that of the Federal Reserve have contributed to a rise in money and even more significantly, credit.

    The answer is not to allow this to continue, but rather to eliminate the devaluing of our currency.

    Just look at the A$ in terms of gold. It has lost approx 40% in purchasing power in 5 years!

    The debasement of our dollar is scandalous. Anyone who thinks our reserve bank have been good stewards of the A$ are being deceived.

  12. Steve Keen says:

    Dear Punchy,

    The fact that Australia has a housing shortage–a side effect of a truly insane housing system–will attenuate how far and how fast our house prices fall compared to the USA, where absolutely nothing is slowing the decline. But we’re still going to have to return to a rough historic balance between house and consumer prices at some point, and that implies house prices falling–or rising more slowly than consumer prices–for a very long time.

    As for China, it’s been exporting DEflation for a long time–its cost levels were so much below those of the West that as it took over manufacturing, Western prices had to fall. But it now appears to be reaching its limits in that regard, so at some stage there could be inflation exported from China.

    Which brings me to Dave’s posts. More anon.

  13. Steve Keen says:

    Dear David,

    While I agree with a lot of your comments–deleveraging has to occur, unsustainable deficit,e tc.–I don’t agree with your analysis of what causes inflation.

    You ask whether I really understand what causes it. Firstly, I don’t think anybody truly “really” does: we have models of its causation, and there has been substantial championing of rival models, and precious little comparison of them unfortunately, within economics.

    You appear to subscribe to the Austrian theory: “money growth IS inflation”–if I’ve remembered a statement by Contrarian earlier. While money growth is a factor, to me, this Austrian perspective is rather like a quote that I’m currently using in an academic paper:

    “If you call a tail a leg, how many legs has a dog? Five? No, calling a tail a leg don’t make it a leg.” (Abraham Lincoln)

    Technically, inflation is measured growth in commodity prices–and that generates all sorts of index number problems which Austrians rightly point out, but nonetheless, that’s its technical definition. To say that “money growth IS inflation” is to conflate a theory with the data.

    The dilemmas for the “money growth is the only cause of inflation” perspective–which this effectively is, and therefore puts it in the same camp as Neoclassical theory–are:

    (a) that the stats frequently show substantial short term (ie, a decade or two) divergences between money growth and measured inflation. That’s happening right now–as it normally does during asset price bubbles. Of course, you can always find another commodity to rebase your price system–such as measuring inflation in gold terms, as you imply–but money is used to buy commodities in our credit system, not gold (though I realise there are nuances there that I won’t go into now); and

    (b) more interesting timing data shows the relations between (A) money growth, (B) wages and (C) prices is often the reverse of this theory. Rather than being A–>C–>B, it tends to be B–>C–>A. In other words, changes in cost structures in the economy force, somehow, a change in money.

    For those empirical reasons, I am more persuaded by the Post Keynesian theory of inflation–which is that it is driven by struggles over the distribution of income, and cost pressures from commodities that cannot be reproduced (minerals) or finely controlled (agricultural goods).

    The money supply is then “accommodating”–it expands to suit these pressures, rather than causing them via “too much money” in the first place.

    Of course, you can get situations like Zimbabwe where “the government printing too much money” is clearly the culprit–but those are hyperinflations, not the garden variety inflation we get typically in the West.

    So no David, I don’t “really understand”, but I am aware of a range of empirically-oriented debates that advocates of one position or another (Austrian or neoclassical predominantly) don’t appreciate.

    Two key aspects of this argument are:

    the nature of price-setting in an advanced economy (see Alan Blinder’s “Asking About Prices” for the best coverage of that–or read my review of it on for a precis); and

    How the money supply can be accommodative to those cost pressures. Here the data is also AGAINST the standard Austrian perspective: if the Austrian case was correct, the accommodation would occur because the RBA and its corresponding institutions willingly “printed (fiat) money” rather than confronting these cost pressures head on, and the “money multiplier” then generated the additional (credit) money.

    In fact, the empirical evidence is the other way around: credit money moves first, and then subsequently government money follows. The monetary authorities therefore AREN’T in control of the money supply–in effect, the money supply is in control of them.

    The best evidence of this actually comes from the staunchly neoclassical authors Kydland and Prescott in “Real Facts and a Monetary Myth”, (which you can locate on the web for free). To cite their conclusions on that front:

    “There is no evidence that either the monetary base or M1 leads the cycle, although some economists still believe this monetary myth. Both the monetary base and M1 series are generally procyclical and, if anything, the monetary base lags the cycle slightly…

    “The difference of M2-M1 leads the cycle by even more than M1, with the lead being about three quarters. The fact that the transaction component of real cash balances (M1) moves contemporaneously with the cycle while the much larger nontransaction component (M2) leads the cycle suggests that credit arrangements could play a significant role in future business cycle theory…

    “Introducing money and credit into growth theory in a way that accounts for the cyclical behavior of monetary as well as real aggregates is an important open problem in economics.”

    So the empirical data “lets the authorities off the hook” vis-a-vis the Austrian critique of monetary policy and theory of inflation. However they are on another hook, from my point of view, with their attitude to asset price inflation.

    There’s a lot more I could say, but this is already almost blog-length, so I’ll stop here. I will at some point explain my model of money creation in a pure credit model, but I’m too busy doing that for an academic paper right now to write up another version here; maybe after I get back from the speaking tour I’m doing this week and next.

  14. Nuffield says:

    Get your cash behind agricultural based assets such as land. That’s why this farmer is with Rabobank. Purely agricultural lending book and least exposed of major banks to current housing/commercial property deflation.

    Invest in organic infrastructure – the stuff that builds itself. Trees that produce staple food commodities and preferably oil. Once established low production costs and dependency on imported resources for productivity gains.

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