Debtwatch No. 25: How much worse can “It” get?

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Last month closed with some far from comforting news about the state of the US housing market (sales and prices still falling), US financial institutions (Fannie Mae and Freddie Mac in need of rescue), Australian banks (NAB’s 90% write-down of its US CDO portfolio). Then ABS figures showed that retail sales had fallen “unexpectedly” by one percent in June. The recent rally in stock markets came to a sudden end, and after a brief period of renewed confidence, the question “how much worse can “It” get?” is once again doing the rounds.

My answer is: a lot worse. The empirical grounds for this assessment are:

  • The ratio of asset prices to consumer prices–or the inflation-adjusted asset price index;
  • The ratio of private debt to GDP; and
  • Japan

In short, global asset markets have a lot further to fall, and a serious recession–the worst we have experienced since the Great Depression–is inevitable. Let’s first look at what the recent drop in retail sales implies for the economy.

An “unexpected” fall in retail sales

Retail sales fell sharply in June, taking most economic commentators by surprise. Even perennial optimists, such as Shane Oliver, were forced to consider that the odds of a recession were “at least 40 percent”.

In reality, the fall in retail sales was inevitable. Spending in Australia has been driven by the biggest debt bubble in our history, and when that bubble peaked, spending had to fall. Since households had taken on a far larger share of debt than business during this bubble, the impact was bound to be seen first in retail sales, rather than investment spending, as I pointed out in November 2006:

“If households reduce their debt levels smoothly, they will have less disposable income to spend and retail sales will slump. If bankruptcies become widespread, the sales downturn will be overlaid with a financial crisis.” (Debtwatch, November 2006, p. 18;


The suddenness of the turnaround is also no surprise, when you look at the data from a financial point of view. Just as your personal spending each year is the sum of your net income plus the change in your debt, aggregate spending for the economy is the sum of GDP plus the change in debt. As debt rises, the contribution made to spending by any change in debt also rises. Private debt–and household debt in particular–has risen so much in Australia that, at its peak, the change in debt was responsible for almost 20 percent of aggregate demand.


As is obvious in Figure 1, debt’s contribution peaked at the end of 2007, and it has been falling ever since. The monthly figures make this even more obvious (Figure 1 records change in debt over a whole year). The monthly increase in total private debt peaked at $30 billion in mid-2007, and trended up to $27 billion by the end of 2007. It has since fallen to a mere $5 billion in the month of June (see Table 1 and Figure 2).

Table 1

Figure 2

At some point, it will turn negative, and change in debt will therefore substract from aggregate demand rather than adding to it. Given that at its peak, debt financed almost 20 percent of demand, even stabilising debt at its current level–$1.85 trillion, compared to a GDP of $1.1 trillion–would result in a 20 percent fall in aggregate demand.

This hit will be felt by both asset and commodity markets: asset prices will fall, as will output and employment. The government’s attempts to counter this–by running a deficit rather than a surplus–will initially be swamped by the sheer scale of the turnaround in debt-financed spending. Even if the government runs a deficit of A$20 billion–the same scale as this year’s intended surplus–it will make up for less than a tenth of the fall in debt-financed spending.

The current “credit crunch” is, therefore, only the first act in a long-drawn out process of reducing debt levels. The second act will be “the recession we can’t avoid”. That recession–which will affect most of the OECD, since all major OECD nations bar France have suffered a similar blowout in private debt levels–will only add to the current decline in asset prices.

The USA: Double Bubble

While the Dow has fallen substantially in the last year, its inflation-adjusted value is still three times its long-term average, and more than 4 times its average prior to the start of this bubble.  Even if the index falls merely to its long term average, it still has another 62% to go (in real terms)  from its current level. If it reverts to its pre-bubble average, it has another 73% to go.

Figure 3

If those figures seem ludicrously pessimistic and unrealistic to you, take a look below at the CPI-adjusted Nikkei–which fell 82% from its peak at the end of 1989 to its low in 2003. At the time, most commentators blamed Japan’s Bubble Economy and subsequent financial crisis on the opaque and anti-competitive nature of its financial system. We were assured that nothing so ridiculous could happen in the transparent, competitive and well-regulated US financial system.

Yeah, right.

Figure 4

The story for the US housing market is little better. The index has already fallen 23% from its peak in 2006. A reversion to the long term mean implies a further 38% fall in the average house price in America; while reversion to the pre-Bubble mean implies a further 41% fall.

Writedowns by US financial institutions certainly haven’t yet factored in that degree of possible fall in housing values, and as Wilson Sy pointed out recently in two brilliant research papers (1 2), the banks’ “stress test” modelling greatly underemphasises the impact of such asset price falls on their financial viability. House price falls in the USA are far from over, and likewise “unexpected” writedowns by US financial institutions.

Figure 5

Overall, if US markets fall back to their pre-Bubble levels, the stock market will plunge about 80% from its peak (much the same degree of fall as applied in Japan) and the housing market will fall 55% (rather more than happened in Japan, where average house prices fell 44%–but less than Tokyo, where they fell over 70%).

The unique feature of this US asset bubble is that it affects both stocks and houses. There have been three Stock Market Bubbles in the USA in the last century: the “usual suspects” of the 1920s and 1980’s, but also one that doesn’t normally rate a mention: a ’60s Bubble that peaked in 1966, and was followed by a slump that only ended in mid-1982 (see Figure 6).

As Figure 6 indicates, this dual bubble has no precedent. Not only is it a bubble in both asset markets, both bubbles dwarf anything previously experienced. Even the great Roaring Twenties stock market bubble barely pokes its head above the long term average, compared to the 2000s Stock Market bubble–and in the 1920s, as Figure 6 shows, the housing market was relatively undervalued. The overvaluation of today’s housing market far exceeds the now comparatively minor bubble when Keating (Charles, not Paul) was on the loose in the USA.

Figure 6

While the Australian Stock Market is not as severely overvalued as the American, it is still substantially over its long term trend. Even after the recent falls, the inflation-adjusted All Ordinaries Index exceeds its level before Black Tuesday in 1987. It has another 30% to go before it will have reverted to the mean of the last 25 years (see Figure 7).

Figure 7

The prognosis for the Australian housing market is substantially worse. Even on short term data–covering only the last 22 years–the market could fall 40% if it reverted to the mean, and 50% if it reverted to the pre-bubble mean. Nigel Stapledon’s research into long term house prices in Australia–which is not shown here–implies an even greater potential for a fall in house prices.

Figure 8

Of course, such talk can seem nonsensical and alarmist. Especially if you ignore what happened in Japan.

Japan: the world’s most recent debt-deflation

Japan clearly underwent a debt-deflation after its “Bubble Economy” spectacularly burst in 1990. In its aftermath, house prices across Japan fell on average by 42%, and by over 70% in Tokyo (though they have since recovered slightly).

Figure 9

Figure 10

What has happened there can happen in Australia, the USA, and the rest of the OECD–especially since our Bubbles, while smaller than the Tokyo bubble, are larger than that for Japan as a whole (see Figure 11).

Figure 11

The killer behind the Bubble: Debt

The level of overvaluation of asset markets reflects the unprecedented scale of private debt, both here and in America–since the vast bulk of that debt was undertaken to finance “Ponzi” speculation on shares and housing. This is the reason that this recession will be so severe–as will the asset market bust.

Every “recovery” from a debt-induced recession since 1970 has involved resumption in the tendency for debt to grow faster than GDP (see Figure 12, where the once seemingly major debt crisis of the late 80s is now just a pimple on the upward trend of the debt ratio to its current unprecedented level).

Yet today the debt to GDP ratio is more than twice that of the Great Depression. It is simply cannot go any higher. Who else, after all, can banks lend to, now that they have exhausted the “subprime” market?

The only way for the debt to GDP ratio now is down (unless we’re unlucky enough to experience deflation, in which case the ratio will rise further, as in the Great Depression), and as it heads down, so will output and employment. A serious recession is inevitable.

Welcome to “the recession we can’t avoid”.

Figure 12

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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72 Responses to Debtwatch No. 25: How much worse can “It” get?

  1. Lord Kelvin says:

    Dear Outback Oracle, I have a friend labouring in one of the big name legal firms in the Perth CBD. A couple of years ago he told me that his workload consisted predominently of doing the legal footwork required to transfer title of mineral / mining assets to Chinese ownership. There has apparently been a steady stream of Chinese acquisitions in WA as they seek to secure access to minerals. The buying only makes the papers when a big move is made, such as the 9% increasing to 11% blocking stake in Rio Tinto.

    The sale of assets has been one way we’ve balanced the books. It can’t be good for us – we’ll end up as tenants commercially and maybe residentially. The last two companies I’ve worked for have been purchased by overseas conglomerates. We really, REALLY need to develop the self control required to live within our means. This is the first step to being able to control our destiny. A debtor is in a weak position.

  2. Bullturnedbear says:

    The Japanese came to buy Australia in the late 80s and the cries were much louder than now. We now look back and see that they over paid for nearly everything they bought and left with their tails between their legs. A few years later the guys that sold, bought it all back sometimes for a fraction of the cost.

    It’s always safer and easier to buy on your own patch.

  3. Bullturnedbear says:

    I also meant to say. The best time to sell assets is during a boom and the best time to buy them back is when the bottom falls out. Don’t worry about foreigners buying our assets. It’s when they take it by force that we all need to stand and fight.

  4. The Outback Oracle says:

    Hello Bullturnedbear.
    I don’t want to stray too far from teh subject here as the “Debt Watch is the important topic which might provide us with actionable strategies.

    I know the Japanese got burned in Real Estate. They’ll get burned financing our CAD by accepting to give us loans in a$ as well. However the sale of our resources, and our food chain, has been continuous over my lifetime and i’m now 59 (buggar!. Somehoe Australians have believed that these foreigners just loved us and they keep sending us money. They don’t want a return on it. Well the bad news is now they do! A huge part of our CAD is repatriation of interest and dividends and the problem is now pretty well insolvable. It is part of the “Debt” story.
    I find it amazing that almost nobody realises we have this enormous international debt. Everyone I try to beat some sense into says “but we have no debt…just ask Johnny and Pete!!! They fixed it all!!!!”
    Anyway, the RBA publishes the figures for how much we owe internationally. However I can find no source for the Foreign ownership of our companmies and resources. I hoped someone might be able to help me.
    I forget who it was…but thanks for the noe on transfers to Chinese ownership. I’m sure it continues apace.

  5. The Outback Oracle says:

    Given our huge CAD and International debt, will Aus suffer a “Capital” crisis as the Global credit crunch tightens? It occurred to me this may well prove the trigger that sets in motion the events Steve outlines. Of course the solution currently proffered by Politicians and the MSM is to keep selling off the country at an increasing rate. Can we sell it fast enough? Have we got enough we actually own left to sell?
    I keep thinking about debt and the interaction of events, and pretty soon my brain feels like it has been through a blender! And i seem to be no wiser than when I started!!

  6. BrightSpark says:

    Firstly Bullturnedbear the big difference you cited in the effect of the CAD between the 1980’s and now I see as only one of the mechanisms in play. You describe only one type of private borrower, a corporation borrowing in foreign currency. There are also foreign currency debts taken on by Banks with the associated $As being loaned to home buyers and “investors” inflating the debt bubble and asset prices. Also there is an attitude around that the foreign currency interface is non consequential even though the exchange rate varies. We have been borrowing to purchase and consume both essentials and consumer goods from oversees because we are unable (even in a mining “boom”)to create sufficient wealth to pay for them. We are a mendicant society or have been for more than a generation,the last 33 years.

    We have discarded our technological capabilities and our economy now closely resembles that of a “developing” country including the debt. Our continued prosperity is dependent on our line of credit which appears to enable us (until now) to borrow to pay interest. I know the private debt is meant to be good, but surely our slide into mendicancy in spite of the fiscal diligence of successive governments proves this proposition to be fallacious. It matters little that the debt is “private” or “government” we will all have to pay.

    My argument is that the private nature of the debt is just one of many mechanisms which are in play and to understand the behavior of the system we must take every one of the mechanisms into account not just one. From my reading neoclassical economics seems to specify a limited set of factors to be to be considered and in a dogmatic doctrinaire manner ignores everything else. Surely all of these factors have some influence and we need to measure the extent of this influence before we can fully understand the system.

    Ken, Yes there is no profitability in local manufacturing particularly when we can take advantage of skilled Chinese workers being paid around $60 per week who are working in a heavily controlled communist economy. They produce consumer goods and more and more food for us at at very low prices. But still we can not afford to pay at these prices, we need to borrow, we may soon be begging. Now we get Chinese Engineers coming to Australia to be trained as Hair Dressers so that they can get Permanent Residency and jobs as Taxi Drivers.

  7. Bullturnedbear says:

    Hi Guys,

    You have misread me. Firstly I was saying that it is smart to sell assets that are over valued. Even if they are mines/farms/productive businesses. Because when the tough times come again (and they will) the mines, farm, etc will sell for much less. In some cases we will walk in and take them for nothing. That’s the extension of what Steve has been saying. All assets are presently over valued because of ballooning levels of debt. Secondly I was saying that when business, banks and individuals borrow and fail the debt is written off. The consequences of that failure will be far reaching and painful. But after the pain, the debt will be gone. As distinct from Government ballooning government debt.

    I still totally agree that the system of money/debt creation is flawed and ultimately must fail. The system creates the debt, but not the means to pay the interest on the debt.

    A factor I have taken heart from recently is that Australia has an enormous amount of infrastructure, land, resources and a small population. When either peak oil or debt deflation take hold we will suffer much less than Europe or America. That’s not to say that the transition to a steady state economy will not be extremely painful.

  8. BrightSpark says:

    Yes Bullturnedbear I take your point.

    I am concerned about the pre-collapse situation and for this the government/private nature question seems to be of minimal influence. Yes the system is very non linear and in post-collapse the difference may be greater, but what if the exchange rate free falls.

  9. Bullturnedbear says:

    Yes a free falling currency is likely and will make the debt serviceing situation much worse. On the flip side though a lower currency will be supportive of our primary producers/exporters.

    The thing that puzzles me out of all this, is why the bond market keeps functioning. Why would people keep endlessly lending to the USA, Europe, Australia, etc. I know that yields have risen. As a borrower, one should alway be concerned that one will get their principal back. How risky does it have to get before the bond market collapses. I thought it would have collapsed well and truly by now.

  10. Lord Kelvin says:

    I’m much less relaxed about the sale of assets than Bullturnedbear.

    Certainly, it makes excellent sense to sell an over-priced asset. With luck you can buy it back later. I remember that in the 1980s a Japanese real estate company ran into difficulties and dropped a six figure sum when it resold a development site in Surfers Paradise.

    One also recalls that Kerry Packer provided a bit of vendor finance to Alan Bond when the latter bought Ch9 from KP. KP said some wise things like all assets are for sale if someone wants to pay you too much, and also that Alan Bond only comes along once in your lifetime. (So you need to take advantage of it.)

    It was also earlier written that loans go bad so we’ll get out of jail by not paying them. This is not quite right. When Bond Corp failed, Australia’s overseas borrowings fell dramatically by about 10%! However it did result in creditors seizing assets. The Bond Corp brewerys ended up being overseas owned. So it’s not as if the nation just benefitted from a no obligation transfer of capital as a result of the failed loans. Some property changed hands too as a result.

    But these are isolated instances, and most assets once sold, stay sold. We seem to have pretty much lost our listed gold miners for example and they are not coming back. The Big Australian itself was about 40% Aust owned last time I heard. It is courageous to assume that even at today’s high values, mining assets and food assets are over-priced, given the increasing population and rising per capita consumption and the finite nature of high grade mineral deposits and good farming land.

    In the real estate and Ch9 examples I gave, the assets were resold in a weak market by distressed vendors. If the Australian mining assets are to be recouped in such a manner, it would probably imply that the Chinese Government itself would be in financial strife, as most Chinese companies seem to be govt owned or at least govt backed. How likely is that to occur?

    No, it seems to me that the progressive transfer of companies and their ongoing profit streams out of the country, just increases the tide we have to swim against. It is not a good thing. It is not even a neutral thing.

  11. BrightSpark says:

    Your statement about currency moves being supportive of “our” primary producers and exporters is interesting. They may be in Australia but more and more they are not “ours”.

    Lord Kelvin
    Just one observation, we are not just tangling with the “Chinese government” here, we are tangling with the Chinese Communist Government which is not shackled by the rules, theory and doctrine of Neo-Classical Economics. Instead they are using their knowledge of this to their advantage. How they will react post-collapse is an unknown quantity. I don’t think they will accept losses lightly.

  12. The Outback Oracle says:

    I thought BHP was only 16% Australian owned but it SEEMS I have that wrong and 40% is the number. I still cannot find any authority which has a number for Foreign ownership of resources but the Mayne report runs through a few major projects
    Rio is only 15% Australian owned.
    I do find it amazing inview of the fact that the repatriation of interest and dividends is now becoming an issue in the CAD that there are no official numbers on this nor any comments in the MSM. I suppose all modern Economists are part of the “deficits don’t matter brigade”. It took me about 6 years and the current US shakeout to convince my not-intellectually impaired son (a pretty smart Economist) that deficits did actually matter.

  13. Bullturnedbear says:

    Hi All,


    GDP for the last quarter was just announced in the US as an annualized rate if 3.3%. I checked and their annual economy is about $14 Trillion. Therefore $3.5 Trillion for the quarter. During that quarter though, the Government pumped $168 Billion into the economy via extra tax rebates and one off payments. $168B over $3.5T is 4.8%. Therefore their economy shrank by a massive amount if you excluded the Government pumping. Am I reading this correctly? No reports I have read have referred to this?

  14. The Outback Oracle says:

    Bullturnedbear….I hope you don’t mind. I took the liberty of posting your question on Itulip with appropriate credit to you. There are a lot of blokes with a lot of brains and technical expertise in there so hopefully someone will answer for us.

  15. Keith says:

    Hi Steve,
    Thanks for your comments.
    I have just noted your comments about superannuation, and being 100% in cash. I was similarly in 100% in the cash option of my fund, but then I tried find out what ‘cash’ meant. The fund’s website informed that the cash option was composed money market securities. I attempted to correspond with my fund to find out what this meant, but I was never favoured with an answer. Given the times in which we now live, this seemed like a pretty clear signal to move to another fund that could give me answers.


  16. BrightSpark says:

    Consider also that in the same quarter the US ran a Current Account Deficit of $180 Billion. That is they imported another $180 Billion worth of goods that they did not pay for (about the same per capita as us). If you take this into account the shrinkage is even more. Any “growth” that they have had has been borrowed! Or perhaps recent “growth” (in the US and here) has always been an illusion.

    I have the same concern, the “interest only” option in my super fund could be “third tranche” CDOs for all I know! This Could be worse than the “growth” option! I do not know and I cant find out what IS going on! How can we find out?

  17. Steve Keen says:

    Interesting observation about the size and timing of the US $168 billion stimulus package being all and more than the measured growth in GDP for the quarter. I can’t confirm your intuition, but it is feasibly correct–and that casts a very different light on the surprise result.

    On super, I checked and the same applies to me–my 100% cash is a range of money market instruments.

    I expect there is “no cause for alarm” here–I certainly hope so. The notional definition of cash here should mean “highly liquid instruments” at the very least, and that should include things like 90 Day Bank Bills rather than CDOs.

    But I would be delighted if one of you could spare the time to grill your super fund and find out what their cash portfolio actually is right now.

  18. The Outback Oracle says:

    Anyway folks…there is no problem…I watched Alan Kohler last night on the ABC news…we’re rolling in it (I presume he meant cash but bulls..t might be closer to correct) The CAD was down from 16 Billion for Q2 to $12.8B…whoopeebloodydo!!
    How can anyone with any brain whatsoever, let alone one with (presumably) some Economic training, think that is good?

  19. The Outback Oracle says:

    Bullturnedbear I see Steve has intervened and given his opinion on your observation. What itulip feedback i got was the same as Steve’s opinion. (naturally enough)

  20. Keith says:

    Brightspark, Steve,

    Sorry this is a late reply, so might not be read.
    After the above, I was able track down, via the AGEST (my old super fund) website, that the ‘cash’ option was invested in “Macquarie Treasury Plus Fund”
    and “Macquarie True Index Cash Fund”. Amazingly, since I looked this up, the super fund website page has been changed to reflect the fact that the Treasury Plus fund is no longer used in the cash option…
    I was able to access the PDS for these products at the Macquarie website.
    The PDS for True Index fund listed risks of concern to me, like “swap counterparty risk”, “liquidity risk”, “spread risk”, etc.
    I wondered if these risk were generic to other offerings, but they are not.
    In each case the PDS correctly points out that Macquarie is only the manager of the fund, and any deposits you place in the fund are not a liability of the Macquarie Bank.

    Having just read about the implosion/bailout of AIG and Lehman, the above risks become pretty pertinent. As an example of some of the fall-out of the Lehman bust, one of the oldest money market funds in the US has just lost $785 million in Lehman debt paper that suddenly became worthless. As to why they were holding such paper was probably due to the securitization morass that is the US financial system. In any case money market funds are supposed to be safe.

    I don’t want to worry anyone unduly, but if you don’t know what you own in terms of your super holdings, I think you should take resolute steps to find out.

    Let me know if I can be of any assistance.

  21. Anton says:


    Your research into the AGEST cash fund sends alarm bells to me as I am with AGEST and have just read the Macquarie PDS which in effect says “no care, no responsibility”
    I moved across to the cash fund about 6 months ago thinking it was 100% safe. I suppose nowadays nothing is safe
    Keith, have you campared any other cash funds?

  22. SEO Training says:

    A very interesting and predictive post. I read an article in the Fin Review last week that predicted 2.8 million mortgage defaults in the USA in the next 12 months. That is very, very scary indeed.

    It wouldn’t surprise me if Russia, Iran, or North Korea take advantage of this crisis and the upcoming US election to launch some sort of attack or grab for territory.

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