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.

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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.