Late last year on SBS News, when Stan Grant asked me which way the RBA would move rates in 2008, I replied “Up, and then down”, Stan quipped “Spoken like a true economist–an even handed answer!”–to which I replied “More down than up”.
I expected the intial rate rises because of the RBA’s focus on the rate of inflation, and a subsequent fall, not because inflation would be heading down, but because the economy would be–and the RBA rate would be forced to follow it
That day seems to be imminent, with the “surprise” 1% fall in retail sales, and the first signs of a tapering in credit demand as well. The RBA is now no longer focusing exclusively on inflation, but also on an apparently stalling economy. All market economists have now joined with me in expecting a rate cut this month–despite inflation still being above the RBA’s target range.
Until last month’s surprise announcement by the National Bank, it seemed that the only thing that wouldn’t be heading down was the mortgage rate. Now, especially after Wizard’s pre-emptive cut on Sunday, it’s fairly certain that all lenders will pass on Tuesday’s expected RBA cut. But there are good reasons why this is unlikely to be the case for subsequent cuts.
The idea that there is some stable relationship between the RBA rate and the mortgage rate is a furphy. When the RBA attempted to manage the economy by trying to control the money supply, the gap between the average mortgage rate and the RBA’s overnight rate fluctuated wildly between minus 5.5 percent and plus 2.5 (see Figure 1).
Figure 1
Margin between average mortgage rate and the RBA Rate
After the RBA abandoned targetting the money supply, and instead adopted a policy of trying to control short term interest rates, a stable relationship of sorts did develop. The gap settled down to about 4 percent, once the economy recovered from the 1990s recession.
This was roughly equal to the historical average gap between the rate banks charge for loans and the rate they offered for deposits–and banks, after all, make their money out of the spread between loan and deposit rates. Interest rate targetting “worked” because it controlled the banks’ costs of funds–as is evident from Figure 2, which shows that the 90 day bank bill rate has been very stable relative to the RBA rate since 1990 (though even this link is breaking down now–the margin between bank bill rates and the RBA rate is an indicator of how much banks trust each other, and they trust each other rather less now than in the recent past).
Figure 2
Margin between 90 Day Bank Bill and RBA Rate
The gap between mortgage and the RBA rate plunged from 4 percent in 1994 to 1.8 percent by mid 1997, as competition over market share broke out between banks and the new wave of non-bank securitised lenders.
It should now painfully obvious to everyone that this was not necessarily a good thing.
Those lower margins were driven primarily by lowering lending standards, rather than efficiencies, or the much-hyped wonders of competition. It therefore stands to reason that the margin will now rise, as the worst excesses of subprime and “low doc” lending are being driven from the market by the credit crunch.
The margin has already risen to 2.35 percent, as banks have increased mortgage rates above and beyond the RBA’s recent rate rises. But even that margin is still a long way short of the 4 percent gap that applied before lending standard plummeted with deregulation–and even of the 3 percent margin that applied at the time of the Wallis Committee.
The odds are that this margin will rise back to at least 3 percent, and possibly even 4 percent, as the RBA is forced to cut rates as the economy falls into recession. So the RBA may have to reduce its rate to 2 percent to ensure a mortgage rate of no more than 6 percent.
The RBA’s dilemma is trivial compared to its US counterparts, however. US mortgage rates have risen in the last year, even though the Federal Reserve has reduced its rate from 5.25 to 2 percent (see Figures 3 and 4). The Federal Reserve has become almost impotent with respect to loan rates–and that impotency has got more extreme with time.
Figure 3
US Interest rates and the Federal Reserve rate
When the Fed cut its rate from 6.5% in 2001 to 1% in 2004, mortgage rates fell from 8.5% to 5.5%–so just over half of the rate cut was passed on to mortgagors. This time round, the Fed has cut its rate from 5.25% to 2%, only to see mortgage rates barely move–from 6.7% to 6.4%.
Much the same story applies to corporate borrowers. Aaa corporate bond rates now are the same as when the Federal Reserve rate was 3.5% higher. The US Fed can do something to restore the profitability of financial institutions–by increasing the gap between lending and borrowing rates–but it can do precious little to take the financial pressure off US householders and corporations.
The danger for banks of course, is that their long run profitability depends not just on the spread between loan and deposit rates, but on borrowers actually meeting their commitments. A profitable spread means nothing if your borrowers are sending you jingle mail rather than money.
Figure 4
US interest rates--the last 5 years
It thus appears that one other casualty of the Credit Crunch has been the capacity of Central Banks to
manipulate the market interest rate. They can still control the short term rates–things like 90 Day Bank Bills here, and the Prime Short Term Business Rate in the USA (see Figure 5)–that set the banks’ cost of funds. But they have lost their capacity to influence long term rates, the price that banks charge their lenders. The days of interest rate targetting by Central Banks may well be over.
Figure 5
US Interest rates minus the Reserve rate
The US Federal Reserve is starting to appreciate this, as official rate moves have done bugger all to reduce lending costs–in contrast to Australia’s record, where mortgage rates have until recently closely tracked movements in official rates (see Figure 6).
Figure 6
Mortgage rate margins above Central Bank rate, USA and Australia
But after this month’s compliance, lenders will start to use some of the future falls in the RBA rate
to restore their margins between loan and deposit rates. Imprudent lending drove the margin down to unsustainably low levels, and it has to rise in future to make responsible banking profitable once more.
Figure 7
Australian interest rates
Figure 8
Margins above RBA rate of mortgages and 90 Day Bank Bills
Comments on the Data
The turnaround in credit growth seems to be underway. Though the monthly data is volatile, and subject to revision–last month’s preliminary figures of credit growth have been revised upwards, from 5 billion to 22 billion–there is clear evidence of a break from decades of debt growing faster than income, to debt growing more slowly than income.
Monthly change in private debt (business+household)
Though this is necessary in the long term to wean Australia off its debt dependence, in the medium term it will cause a substantial slowdown in the economy–and it will push the economy into a deep recession.
This is because aggregate demand is the sum of income plus change in debt. For the last decade, the latter factor has been adding to demand–and aggregate supply, asset prices, and our import bill have adjusted upwards to suit. But as the change in debt drops and ultimately turns negative, it will subtract from demand–and supply (read employment), asset prices and imports will follow it down.
Contribution that the annual change in debt makes to aggregate demand
It seems probable that the Debt to GDP ratio will peak at about 166% of GDP. If Australians decided to reduce their debt to income ratio by 10% each year–to get back to the 25% level that applied back in the 1960s (before this long-term speculative bubble took off)–it would take roughly 15 years to get there.
Australia's 45 year long debt bubble seems to be reaching a peak of 167% of GDP
Australia's Debt to GDP ratio--the long term view
September 2nd, 2008 at 1:02 pm
Hi Dr Keen,
I’ve been a close follower of your work, and agree with your general prognosis. However, I have a query regarding the chart “Contribution to change in demand”, which suggests at present debt formation contributes around 18% to ‘demand’.
I’m interested to know how transfer payments factor into this figure, which as I understand, do not constitute a contribution to GDP thus demand? I would imagine a large proportion (>50%) of the quantum of debt formation would be directed towards real-estate and other fixed asset ‘investment’.
Kind regards and sincere thanks for your blog
Mark
September 2nd, 2008 at 3:18 pm
Hi Mark,
I’m very careful to emphasise that my aggregate demand measure (GDP [or more properly GNI--I'll update that shortly] plus the change in demand) represents aggregate spending on both commodities and assets. So a fall in that measure will be absorbed by both commodity markets and asset markets–not just commodity markets in isolation.
Probably more than 50% of the addition to debt financed asset purchases, as you say; but then some of that in turn financed commodity purchases by the recipients, and this especially applies to business borrowing. So the change in debt finances both asset speculation and demand for goods and services.
When that source of demand evaporates, then “something’s gotta give” in both commodity and asset markets. In one sense it would be better if the latter copped it rather than the former; but as we know from the Great Depression, a collapse in asset prices tends to have a cascading effect upon commodity markets too.
It also amplifies the desire to reduce debt: if you hold debt and it finances assets that are rapidly depreciating, then this accelerates the desire to reduce debt–which you do by spending less, thus reducing commodity demand. It is what I christened “Fisher’s Paradox”, after Irving Fisher, the economist who first pointed it out in his “Debt deflation theory of Great Depressions”.
Cheers, Steve
September 2nd, 2008 at 5:11 pm
As a subscriber to your views I am disappointed that these topics are not more widely debated in the media and other blogs. You attract more attention by American writers than locals, which is a great pity.
I would suggest that there is a linkage of growth in money supply (especially credit) with the growth of cheap energy. Money represents claims on energy (and perhaps other scarce resources) consumed in creating stuff. Peak oil and peak North Sea oil may explain much of the US and UK troubles. Australia as a net energy exporter has a favoured position, for a while.
I would also suggest that the decline, when it comes, will not be gentle. Once it is no longer possible to play the Ponzi game of housing appreciation, many will prefer to rent. Landlords who require an economic return will force prices down and rents up. The US and elsewhere show us that a decline in house prices spreads the pain widely, and hurts banks, retailers and many other sectors in the process.
Perhaps it has already started.
September 2nd, 2008 at 9:43 pm
Considering that the dollar has dropped about 2% after the rate reduction, and had already dropped by a greater amount in anticipation, interest rates of 2% would seem to suggest a collapse in our currency.
“Landlords who require an economic return will force prices down and rents up.” dyork, rents may go up in the short term, but long term they are going down. It is an unfortunate fact of life that someone who doesn’t have a job, and there will be many, will find accommodation they can afford, even if that means sleeping in a tent or living with mum. The Great Depression increased the average age of marriage by about 2 years as people couldn’t afford to set up house together.
September 3rd, 2008 at 12:32 am
Dear Dr. Keen,
Concerning the “Change in Debt to Demand” graph, how is interest treated? Is interest considered to be “demand”? It’s now a significant component of personal expenditure, as you have indicated in earlier writings.
Concerning the debt graphs, how wide is the net cast to capture and count debt? I assume all regular financial institutions such as banks + their finance company subsidiaries, building societies and credit unions report to the RBA. What about store-based credit cards? What about “pay day lenders”?
I assume goods on account from merchants to commercial customers and other such invoices are not included, and it is only loans with agreed rates of interest you are counting.
Any other types of debt I’ve missed?
What about HECS?
Thanks very much for your writings. Very nice to have this on the internet.
September 3rd, 2008 at 12:49 am
Oops! I also wanted to comment on the past monthly debt increase figure, revised up from $5.6B to $22B.
This looked pretty good a month ago as part of a borrowing slowdown story, but now at $22B it seems scarcely credible as part of a turnaround in credit growth. It’s roughly $1,000 per person more debt for the population of Australia. In just ONE MONTH! That’s nominally $4k more debt for my family, assuming the dog didn’t use his credit card.
$12k more debt per capita, if maintained over a year.
How much longer can we keep this up? (I guess that is what this website is all about. And none of us know.)
September 4th, 2008 at 10:09 am
Ken I think you understate the drop in our dollar resulting from the change in sentiment on interest rates. The exchange rate with the USD was about 0.95-0.96 before the speculation on rate cuts started, so the drop vs the USD has actually been of the order of 12.5%. I am just trying to emphasise your take on the currency getting into trouble is exactly correct in my view. A drop in the Reserve Bank target rate to 2% will involve further massive falls in the A$.
) I think this is just a time lag. We are still flavour of the month (decade) because we are a commodity based currency with high interest rates. So there has been a ratcheting effect up on money flows and currency. In an environment of falling commodity prices and falling interest rates this ratchet is surely likely to work in reverse. The price rises now in the pipeline will be magnified by currency depreciation.
Now I am only talking about my industry here but I have spoken to quite a few importers and this seems fairly general. Our US$ FOB prices out of China have increased across the board by 20 to 30% (some by 100%)in the last 6 months. Add in a 12.5% fall in the currency and you can imagine what this is doing to our pricing.
Steve mentioned the Reserve is not in quite as big a pickle as the US Fed however (with some temerity
So I suspect, given time, the Reserve Bank is going to find itself in the pickle as the Fed or maybe even worse.
I hope Steve or someone can tell me I am wrong here….at the moment I feel like I have my head caught in a vice the is steadily getting tighter and tighter!
Thanks Steve, in the midst of the media hype and general stupidity that passes for Political and Economic commentary in this country I was wondering if i was wrong in thinking that lending rates were going to stay up in line with the Global droughtrather than fall just because the RBA dropped its target rate. It was calling into question my whole understanding of the fundamentals of Economics – limited as it may be!
September 4th, 2008 at 12:21 pm
Working in the finance industry, I have seen the growth in margins of late. Bankers have told me that they are increasing margins to Small to Medium Sized Enterprises (SMEs). The customers are being told to lump it. What the credit crisis has done is two fold. It has reduced competition, but secondly and more importantly, it has reminded bankers of the first thing they were taught. “There is no such thing as a risk free deal”. Any new recruit that ever wrote that on a credit submission was laughed at from here to Friday drinks.
This is very significant, because not only are banks being more cautious (lending less money) customers are also becoming more cautious because money costs more (when price rises, demand contracts).
Really though, all this is at the margin (pun intended). The real problem, I believe is with the international bond and swaps markets. The spreads are still rising, thus making the cost of investment/growth rise dramatically. If this reaches a tipping point. Successful large businesses will not be able to roll their bonds (thus becoming junk bonds). The investors will become more risk averse and successful companies will be forced to liquidate assets to survive. There will be no buyers though, because the bond markets will stop functioning meaning new buyers will not be able to raise capital/debt to complete the purchases.
I read recently that the bail out programs of the US Fed (swapping treasuries for impaired mortgage backed assets) has resulted in the degradation of their balance sheet to the point where the treasuries they hold as collateral for Federal Reserve notes is now down from 95% to 53.7%. The long term average is between 85% and 90%.
The bond holders of the world must be very very nervous. If the world’s assets keep falling in value the bond market will blow up and interest rates will skyrocket. That will be the cliff that ultimately ends the speculative bubble.
Everyone should keep taking steps to get out of debt.
September 4th, 2008 at 12:35 pm
Hi Steve,
Thanks very much for your analysis – love your work! Couple of questions:
1. My daughter is contemplating buying a house with her partner. With your arguments in mind I’m inclined to advise them to hold off to see if the prices come down. Now I’m not seeking your financial advice! I’m wondering,though, whether increasing female workforce participation over the last few decades has made couples more able to take on mortgage debt, giving them more money and thus bidding up house prices? If so, house prices might never return to their long-term trend levels after the bursting of the current bubble. Instead, they might return to some higher baseline level (but what?) reflecting contemporary workforce participation levels (ie contemporary borrowing capacity).
2. I’m a boomer who has just retired. The first thing I did with my super lump sum was to pay off my mortgage. I’m just one of a looming demographic bulge of retirees. To what extent is Australia’s excessive private indebtedness likely to be worked off by retirees like me paying off their mortgages, and maybe giving up their credit card habits, so that they can live inside their pensions? [Noting that this wouldn't change your fundamental proposition - lots of ageing boomers getting off debt would still spell decreased aggregate demand which would still spell recession.]
All the best,
Ian
September 4th, 2008 at 4:26 pm
As this bubble deflates I expect the deposit/mortgage margin to exceed 4% > Loan loss ratios will rise. New lending tighten. A recession > Rising unemployment. RBA OCR to fall substantially > AUD collapse. Stagflation. House sales volume will contract > very illiquid asset market.
Cheers
September 4th, 2008 at 8:39 pm
Outback Oracle, the reason for most of the decline in the Australian dollar over the last few months has been the decrease in borrowing. Banks had already dropped their deposit interest rates by at least half a percent due to them needing less funds. As a significant amount of the funding is obtained from overseas this also influences our exchange rates as their is less inflow of foreign funds.
September 5th, 2008 at 5:33 pm
Ian, I wondered also about the effect of women in the workforce but it really hasn’t made much difference as participation by men has decreased due I presume to earlier retirement and higher unemployment. Overall participation has only increased from about 60 to 65% in the last 25 years and will probably go back to near 60% in a recession. Increase in part time work would also be significant. See http://www.pc.gov.au/__data/assets/pdf_file/0008/60479/workforceparticipation.pdf for some figures.
Read what Steve has written and decide if anyone should buy a property. Ask yourself if the increase in debt is sustainable (doesn’t look like it at the moment) and what will happen to prices if it isn’t. My prediction is someone who buys now will in 10 years time be lucky to get their money back. Bit unpleasant if the mortgage payments are twice what they would be paying in rent.
September 7th, 2008 at 7:58 pm
Hello Steve
Keep up the good work and thank you for being the only voice of reason on these matters.
I agree with Outback Oracle that the recent very rapid fall in the AUD’s value against most other currencies was a direct result of the anticipation of and one month later the actual 0.25% fall in RBA interest rate. As I see it speculation is the only mechanism capable of such a low time constant and rapid change. Ken’s claim that the drop was caused by reduced bank borrowing over the last few months can not be correct because there was a rise up to 97cents followed by a rapid fall following the RBA pronouncements in August. In any case foreign interest payment obligations and currency exchange obligations would be requiring the banks to borrow foreign funds to cover the CAD.
The 17% drop so far from $US 0.97 to $US 0.81 must be increasing the bank’s interest bill by quite a large amount. If the debt is 40% foreign and most likely in $US, the interest bill must be increased by 0.4 time 17% or 6.8%. In any case much more than the RBA 0.25% drop, with speculation in the system this is a very dangerous positive feedback loop. Add to this the effect on the banks’ balance sheets with 40% of their debt being increased by 17% (so far) although this is a second order effect with a longer time constant.
Do the banks have any alternative but to increase their rates? They must be hoping for a turn around in the dollar value. Can the speculators understand the feedback mechanism? Can the banks take a loss?
Also as I understand it the amount of the CAD which is not covered by private overseas asset purchases and borrowings must be covered by overseas bank borrowings. At a time when the banks have run out of acceptable borrowers this is further adding to the banks’ interest liabilities without increasing their cash flows. This must further increase the need for a larger margin. Also the CAD is still rising much faster than the GDP.
In any case will this reduction help the economy as intended? Surely the exchange rate drop will increase prices as most items on shop shelves, (particularly items for discretionary spending) are imported. This may reduce not increase business activity. The extra funds in the hands of borrowers may not compensate.
September 8th, 2008 at 11:46 am
The US Government has just taken control of the two largest Mortgage debt servicing businesses, Freddie Mac & Fannie Mae. The two have roughly 6 trillion of the US mortgage market. The estimates are 5% losses = $300B. These businesses have roughly $70 billion of risk capital = $230 billion of tax payer losses. Of the multitude of problems the deflating housing bubble is causing, Steve has identified one that is concerning the US Government ~ the loss of control of the mortgage margin, which is threatening to cause a house price deflation spiral.
September 8th, 2008 at 12:28 pm
The problem with arguments of change in the dollar being caused by interest rate changes is that a change of 17% in exchange rate is out of proportion to all previous effects of a 0.25% change in interest rates.
Most of our foreign debt is in Australian dollars which is one of the nicer aspects. Essentially foreign investors are taking the foreign exchange risk. There is some borrowing in foreign funds but either with hedging or a business model that makes exchange rate fluctuations irrelevant. Selling in $US provides a natural hedge.
The denomination of debt in AUD will be the cause of further problems, as the foreign exchange risk becomes obvious it will become harder to obtain funds and our dollar will fall. Banks can offset the risk by offering higher rates but then will require loans at higher rates. More likely borrowing will become more difficult.
September 8th, 2008 at 4:55 pm
The take over of Freddie and Fannie (F&F) is a sign that the US has problems that are very deep and getting worse. If the situation was at the bottom, the Government would not have needed to act. Also if F&F are that bad, the other Banks must be in a bad position as well. There will be no room left to bail out the other banks because F&F will now be the priority as the US will try to “get their money back” from propping up F&F. Also the bond holders of F&F Paper might be feeling better, but what of the paper issued by all the other US banks. Surely these holders will be feeling decidedly sick tonight.
I heard first hand today from a guy. His brother has just bought a Condo in Las Vegas for US$76,000. That same unit sold 4 years ago for US$260,000. All the banks must be losing capital by the day.
The US government has built a dam wall. How long will it hold up for? and how long will it take for the markets to realise that F&F is a sign that things are much worse than they thought and not a sign that “we will all be OK now”.
September 9th, 2008 at 4:42 pm
It has been obvious for sometime that the prime loans may be more of a problem than subprime. While the default rate is lower, the amount loaned is larger.
It is easy for the US government to guarantee the loans, they can just print the money, unfortunately money that will decline quickly in value. The euphoria isn’t going to last long.
September 9th, 2008 at 5:00 pm
As someone looking to buy their first home I am trying to get my head around this whole issue. Their seems to be alot of doomsday talk but it’s not translating to the mainstream property market (that I can see) in Oz.
Essentially, my read is that prime loans, although large, remain affordable because jobs and incomes have largely remained intact. Although I note today impending middle management cuts at ANZ. From what I have seen, most large corporates carry a lot of fat through middle management – people that are adding little value, but for whatever reason are seen as too important or to hard to get rid of.
Presumably, as business conditions deteriorate, the fat will be trimmed and highly geared property speculators will begin to sweat on their assets. I would imagine the boom towns of Brisbane and Perth are highliy susceptible to this as their workforce is largely transitory and contingent on the continued mining boom.
Steve – I just can’t see the rationale for people/business choosing to reduce debt levels to some long term average unless this is dictated to us through exogenous factors (like we lose our job). Our behaviour is context specific. I don’t see why people today will decide debt levels of 50 years ago or 100 years ago are more sensible than say debt levels 10 years ago.
Are you suggesting that a correction in debt levels in line with long term averages will be somehow an automatic response?
September 9th, 2008 at 7:33 pm
hyper I’m in a similar situation to you. Trying to work out how long to stay out of the property market till I buy.
My understanding of Steve’s theory is that the ratio of debt to GDP has been increasing since the last depression and that this is eventually unsustainable. As asset prices increase people borrow larger and larger sums to purchase the same assets. Eventually the price of the assets becomes such that no one wants to buy them anymore and people start saying show me the money and there isn’t any, just more debt. At this point the worth of the assets crumbles. It’s like pass the parcel, make sure you aren’t the one holding the parcel when the music stops. Apparently this has happened twice in the last 100 years already.
That’s the best I can do and I may be completely wrong but that’s how I’ve read it.
September 10th, 2008 at 1:29 am
hyperproductive,
The illusion of wealth from a credit induced binge is very convincing. In 1929, smart people literally thought the fundamentals had changed – the “Goldilocks” economy was well and truly kicking back then. People were gearing up on margin loans to buy stocks and asset prices rose precipitously. Wage growth stagnated, the wealth gap rose and this needed to be replaced with credit growth. In the 20’s, people started purchasing larger items (cars, radios) on credit. In many ways, it is similar to what has been going on here of late – its just that this time instead of just getting drunk at a party one night we have been shooting up on heroine for 20 years.
Why did sentiment change and stay for a long time during the 30’s? There are lots of theories why. There are lots of theories why it can be averted and it is different this time. Maybe debt levels can keep going up indefinitely. I doubt it though – but conceded there is a chance it could actually be different this time.
There were lots of things that “could never happen” just two years ago: Bear Sterns, Fannie Mae, Freddie Mac, Indy Bank, Rams, Babcock and Brown, Opes Prime and numerous other “events” that were “not going to happen” are no surprise to some people. I won’t be surprised by peoples debt levels being reduced after we get through the bursting of this mother of all bubbles.
September 10th, 2008 at 10:02 am
Hi Emil, I definitely think that a big deflation could happen, I just wonder why Steve is so convinced it will. Is he suggesting there is some automatic stablising forces which will return debt levels to some long term average?
As I indicated, my read is that it is partially driven by sentiment and by the strength of the job market. Obviously levels of debt and the job market are intertwined – but I can’t see why debt levels would stabalise at a long term average as opposed to at levels seen 5 or 10 years ago?
September 10th, 2008 at 11:37 am
hyperproductive, the problem is that our jobs and incomes are financed to a significant extent by growth in debt. When someone sells a property at profit (and that profit is funded through debt) they tend to spend it, pushing money into the economy as well as generating revenue for the real estate industry through fees and government through stamp duty.
It is all coming to an end. The previous owners of the unit I’m renting made a loss, so they will be spending less. The NSW government is in a mess due to lower stamp duty returns so they will be cutting spending.
As to debt returning to previous levels, the reason is that there is no point in borrowing for assets that decline in price and banks will shortly become very scared of loaning money without adequate deposits. Especially when rent is half the cost.
September 10th, 2008 at 1:11 pm
Hyperproductive
I tend to agree with Steve that deflation in house prices is inevitable. This is because a scenario where prices neither fall nor rise is not possible. Not possible because prices have only risen because of expectation of the continuing rise. For some time now people have paid the high prices because they and their lenders anticipate a time in the future when the asset values largely exceeds the current values. Investors have done this encouraged and subsidised by the government which has allowed losses to be offset against other income for taxation purposes.
In engineering we would call this positive rate or differential feedback. This works on the way up and it works on the way down. It is avoided in engineering design because is causes crashes.
The trouble is that just as this positive feedback caused a rise it makes the status quo only meta stable at best like a car with no brakes at the top of a hill a small push will send it running down the hill.
A negativly “geared” investment property which is loosing in cash flow terms and not appreciating becomes a big and bigger problem as prices start to fall.
The prices have topped out (in engineering terms reached the limit) because prices became unafordable and this would have happened sooner or later even without the interest rate increases.
People also borrowed to invest in shares as well as real estate. This was done on the advice of financial advisers and banks (my bank sent me a free watch suggesting that I could leave work early). This further increased the feedback effect (we say increased the loop gain in engineering).
It happened in the 1930’s and it is happening now. Did somebody make comments about failing to learn from history?
September 10th, 2008 at 1:32 pm
Some observations.
The nationalisation of Freddie & Fannie seems to have lowered mortgages about 0.5% in the USA.
The average USA house is heading toward AUD$180,000-$240,000 mortgage rates are roughly 5.9%
The average UK house is presently AUD$300,000 and is predicted to be AUD$230,000 in a few years mortage rates are 7.0%
The REIV published AUD$640,000 as the median Melbourne house auction result last weekend and private sale average was AUD$440,000 mortgage rates are 9.0%
September 10th, 2008 at 3:12 pm
hyperproductive,
I understand where you are coming from and it is a good question. I believe that there are a lot of forces that will ultimately reduce out debt levels. I believe this because it seems to be a consistent pattern. Others don’t believe it will occur because central banks will ultimately be able to control the business cycle and control the situation. Ultimately I believe that the market will dictate the direction of things and the behaviour of the market is not so easy to control when things get wildly unstable as they are now.
Wall street financed cheap credit. This money found its way all over the globe and there was a rise in shadow lending on money (think Rams, Aussie, etc). Banks were forced to follow suit, credit got cheaper, lending practices deteriorated. It was one big party on the way up. Real estate never falls, so why not lend to people who can’t afford it – there is no risk in the loan if the assets always appreciate. Just like tech stocks never fell during the mid 90’s, all sorts of reasons as to why the fundamentals had changed and things were different this time were concocted – some of them very convincing. The reality of the boom was cheap dollars in bullish hands.
When the tide turns, equity prices will start declining (we are starting to see that). Does a bank then want to lend you 105% of the value of an asset with rising unemployment, less banking competition and falling asset prices? The answer is almost definitely not. They are going to want you to have some money in the game and proof that you can pay it back. We will revert back to 20% down with stringent criteria regarding serviceability of the debt. This will crush housing and is almost inevitable. Access to cheap and easy credit will dry up and will be reinforced by falling values. Who wants to lend to people who are going to invest in falling asset prices and have reduced ability to pay back the loans? That would be a recipe for disaster. So, as you can see, the same rationale for why people were all too willing to lend on the way up will be exactly the same rationale for why they will tighten up on the way down. Then there will be the psychological change regarding debt. As things turn, people will learn that being in debt is to be avoided at all costs. This will also affect our debt levels, as people scramble to reduce their debt load.
September 10th, 2008 at 3:32 pm
I would be interested in the capital relationships between SME’s – house prices – mortgage debt.
Large public listed corporates have relatively well understood market capitalizations – debt – GDP ratios.
The SME’s could be the black swans in all of this.
September 10th, 2008 at 4:54 pm
It would be interesting to know the ratios & links between SME’s – House prices – mortgage debt – SME working capital.
SME’s could be the Black swan.
SME’s are not scrutinised like the publicly listed ASX businesses for market capitalization – debt/equity – revenues – margins – GDP.
September 11th, 2008 at 10:13 am
Peter W
This is just one SME! I have posted this earlier in the thread but every day the situation gets worse! We are importers from China of outdoor recreation goods. Inflation is happening so fast we cannot keep up with it. We cannot change our prices at a rate to keep pace with the ninflation.
We put out forward Order prices in June which are current till January. Since then we have had FOB USD FOB China price increases of about 10% (on top of the about average 30% in the 9 months prior). We then put out a price list as at Aug 1. The change in the dollar has already increased out Landed costs by more than 20% since then. So, prices rising slower than out inventory replacement cost equals a squeeze on our Working capital…….are we feeling it day to day??? You bet your sweet life! And we will still have to pay the damned income tax on money that we are not making! We’re squuezed! And I’m one of the few that was aware of all this coming!
Cheers
September 11th, 2008 at 10:15 am
BTW
For August turnover was down but our GP was way up! We are selling older stock at the new prices. If GP is based on replacement cost…we are dead!!!
September 11th, 2008 at 2:04 pm
Hi Emil, and others.
Your arguments seems to be that the upswing is sentiment driven, the downswing is sentiment driven so the downswing will equal the upswing.
Playing devils advocate, on the upswing there were lots of people that made lots of cash and got out at the right time. Not everyone will be losers out of this.
So whats stopping the people who won on the upswing (bought low, sold high, held cash and rented) buffering the falls, so long as they maintain their jobs?
Getting back to my question, why is Steve so confident debt levels will recede to a long term average as opposed to some other level? Of course there are businesses who have relied on the artificial advantage of manufacturing overseas, selling local (such as the outback oracle), cheap debt etc but there are lots of businesses that will benefit from a lower dollar, imported inflation and rising debt costs. Not every business/person got caught up in the irrational exuberance…
I don’t question the need for a correction, or that there will be a correction. I just question that the correction will return debt levels to their historic average?
September 11th, 2008 at 5:39 pm
Debt ratios will return to historical averages because the return on assets declines when asset prices rise faster than asset income generation. Debt growth faster than asset income generation growth has infated asset prices and lowered the return on asset to the point that there is no profit margin between the cost of debt and the return on asset, especially property.
September 11th, 2008 at 6:26 pm
Hyperproductive…I’m just curious…did you mean to be obtuse and insulting or was it by accident or am I just sensitive?
I was just trying to provide an insight into one business. FYI I am not overborrowed, nor have I ever been caught up in irrational exuberance. My comment was in support of the idea that working capital is shrinking in SME’s,
I spent many years as a farmer getting the raw end of the pineapple from the artificial settings in this economy.
I used to manufacture here too! I was driven out of it by all the normal things, like Government interference, artifiicial real estate values, wrong settings for the A$ etc…
I live simply, have a nice and successful family, drive a snall car.
So why the insults?
September 11th, 2008 at 10:27 pm
hyperproductive and outback oracle,
I (am hoping) that hyperproductive was not trying to insult you. Possibly using your story as an example but I don’t think hyper meant any mailce.
You have to play the game within the rules set – buying cheap imports from overseas and selling for a profit here makes plain economic sense. If someone can do something better than you for cheaper, you should always be encouraged to go down that path. The current global situation is what it is – it may change, but business owners who are now selling instead of manufacturing are doing that for a reason. I don’t think it is irrational or exuberant. Knowing when to change tact and what is coming will prove prudent no doubt – but that is a different matter.
What is irrational is the fact that we have been able to do this for so long. What is irrational is that we have been given credit to consume with as opposed to produce with. Every time this happens it ends in tears. As soon as the average Joe thinks that credit can replace wages you know that trouble is brewing and is only a matter of time. The illusion will last for a while as it will artificially stimulate the economy. People “feel” wealthy, so they take on more debt and speculation goes up. Creditors lend because asset prices are rising and people are spending. Some people have trouble repaying, but no problem, there is always more credit on offer to pay debt or consume with so there are no problems with debt growth – there is always someone there to loan just that little bit more. I started getting nervous about the economy when I started seeing signs with cars on them going up saying “tomorrows dream today” – the connotation being that if you can’t afford it, don’t worry, we are in the business of making all your dreams come true not matter what the circumstances. How do things look during this time? Couldn’t be better. Business is booming because the money is flowing and the bulls just can’t fathom that anything could be wrong. Debt is just how “things work these days” – why would it ever change?
At some point, people start to realize that maybe they are in too much debt. Perhaps asset prices can’t still keep going up. Look at what has happened in the USA. There is a full blown credit crunch going on and this is before any signs of a real economic slowdown! People were unable to pay their debt and there was barely a hint of unemployment. This should be a huge warning sign – people are in way too much debt that they clearly can’t manage and problems are starting even before there is a lack of demand or slowing of the economy (if you believe their GDP numbers). As asset prices fall, people tighten up and stop spending which leads to job losses and a self reinforcing feedback cycle. Who wants to lend against that backdrop? Where is the growth in credit going to come from? Unless the government just hands out money, how is the situation going to correct itself? I can’t believe that people are thinking the credit crunch is nearing the end – it is literally only just starting. Wait until unemployment doubles or triples and people are still under mountains of debt.
So, why will people reduce their debt levels? They won’t have a choice. Lenders won’t be as aggressive lending and people won’t want to take on as much debt on depreciating assets.
Many people argue that it won’t happen as the governments won’t let it. They might be right, but I think the market is a lot more powerful force than a government, and the market will dictate what ultimately happens. It appears to me the market is slowing starting to appreciate the reality of the situation going forward and it doesn’t like what it sees.
September 11th, 2008 at 11:52 pm
It’s interesting to note that in the most recent months UK lending figures only 33,000 mortgages were financed. In Australia the most recent ABS data was 50,000 mortgages. The UK population is roughly 3.3 larger than Australia.
The UK is also in a credit crunch.
Why would lenders offer finance to borrowers with even 25% down if the lenders believe asset prices will drop 25%? Isn’t this roughly the same as 100% finance ~ i.e very risky.
September 12th, 2008 at 12:45 am
In general I support the view that easily available western debt has resulted in a compound growth of asset values that will ultimately see a severe downward correction in value. The only issue I am not certain of is the impact of China and other developing economies such as India etc on mitigating this correction… Your article is silent on this issue. Popular opinion is that the Aust economy and to some degree the global economy will be largely insulated from possible recession as these developing nations and their massive populations grow and consume… I’d be interested to know your view regarding China & India’s capacity to insulate us from financial ruin?
September 12th, 2008 at 9:37 am
Smokey3,
China and India have been exceptional growth stories. I think a lot of their growth has been stimulated by growing their exports to the west. China has been buying a lot of US debt, the US uses this for consumption and purchases cheap Chinese goods and the process repeats. As the big western economies stagnate, you would think that the Chinese economy would also take a hit because the stimulus they need from the west wont be as pronounced.
This does appear to be the case. Manufacturing in China has contracted two months in a row (although it is hard to tell what impact forced shutdowns over the Olympics had). Anecdotal evidence is that things in China are slowing down. They also had a speculative bubble in their real estate and stock market. If you look at the Shanghai index, it is down around 60% and falling still.
It will keep growing, but during a global economic collapse, I don’t see them paying top dollar for commodities and the competition for raw resources between their companies won’t be as frantic.
The market seems to think this is the case. Commodities have collapsed lately along with the Shanghai index. This all points to a severe contraction.
So where does this leave Australia once the mining boom is over and we are still left with the highest debt levels in the world as well as the highest house prices? I’ve always thought that Australia will be the last to fall, but when it does, it will fall twice as hard. I hope that this won’t be the case and that China and India will recover quickly or be able to move forward on their own. I know Peter Schiff who was interviewed with Steve Keen on Dateline the other night thinks this way but personally, I am skeptical. Time will tell.
September 12th, 2008 at 10:30 am
Thanks Emil and a great summary of the way of things!
Smokey I have been forced to contemplate a lot the question you pose re whether we might be the exception. The crisis that I have felt has been coming for a long time, has been postponed for,,,well,,,let’s call it “a long time”. We keep up our living standard by increasing the rate at which we both borrow internationally and continue to sell our resources, including our manufacturing base, food chain and mineral resources. The CAD has not declined through this greatest boom of all time,so it looks like it doesn’t matter how big the boom is we will just continue spend more than we earn and borrow to borrow.
The National tolerance for the sell-out of the nation has far exceeded my expectations. As per earlier in this thread the Chinese are more than willing buyers.
It’s just a question of for how long the illusion can be kept in place. If anyone has an opinion non timing, I am all ears! Let’s say I am sort of “short” property and am nervous the inflation will happen before the “shake-out”
On that note I see Gotliebsen had a number of $129 Billion for Bank refinancings from overseas sources for the next 12 months. Presuming that is reliable, how the heck are they going to refinance $129 Billion in the midst of the current financial meltdown? And what will the interest rates be?
September 12th, 2008 at 10:36 am
Hyperproductive
In relation to your postulation about the swing up and down being equal there are two matters of relevance.
Firstly, as Steve points out, at this time, the magnitude of the swing up and its associated debt levels has been so great that it is unprecedented in the history of fiat money. An equal swing down is going to take us down a long way!
Secondly, my (too long) experience of life tells me that the swing up is relatively slow; the fall is precipitous. Without going back to Steve’s data here, let’s say this period of “up” is 20 years. The whole thing will unwind over say one or two years.
IMHO
September 12th, 2008 at 11:57 am
The rough maths behind why house prices are not sustainable at 7.5 X wages.
Maximum rent 30% of wages (taxes, petrol, food etc will take roughly 70%)
1/(7.5/0.3) = 4% gross rental yield
Net yield will be ~70% of gross yield = 2.8%
Wage (rental) growth 4%
Total house return = 4 + 2.8 = 6.8%
Debt costs = 9%
Bank deposits = 7%
Prices at 7.5 X wages = -2.2% compound return
September 12th, 2008 at 3:39 pm
I dunno Peter….you just don’t get it do you!
Real Estate always goes up at 10% per year average, so a bit of negative return and increase in debt doesn’t matter. And…all the gain is tax free!!! Just ask any Real estate agent or Property Consultant.
A few years ago my son and I did a small DCF analysis on Sydney property. Given the leverage you can get on property, the cosseted interest rates, and the tax free status of gains, if you got a 3% REAL appreciation in the house price, the equivalent return required in a 100% equity investment elsewhere (say in some productive enterprise like a factory) was about 26%. The rate varies a little with inflation rates, tax rates etc but the order of magnitude stays the same.
Anyone wonder why Australians overinvest in houses?
September 12th, 2008 at 4:44 pm
The main OECD nations nationalise their mortgage banking systems because my maths is roughly right. The USA did it last weekend and the UK is having the political discussion at present.
The missing 3% p.a. has to come from somewhere! Nations will choose… wages growth, eliminate deposit/mortgage margin (nationalise the debt), house price correction.
September 12th, 2008 at 5:25 pm
Peter
We sold our house recently and there was a bit of negotiation with the Bank. Let’s just say we are a good risk! However our Banking Manager was quite frank and explicit. The Mortgatge was being held by the Reserve Bank.
I remember the report of it happening about the time of the Bear Stearns crisis.
Again i am only speaking from memeory but essentlally I think this particular (one of the big 4) Bank was leveraged some 40X.
So, correct me if I am wrong, the mortgsges have already been nationaised here in Aus to try to prevent bank failure.
September 12th, 2008 at 10:19 pm
The RBA allowed something like a 1 year repo on the failed RAMS portfolio undewriting ~ $5 – $10 billion. It would be several orders of magnitude larger if the entire mortgage debt was nationalised ~ $1 trillion. The USA just did 1/2 of it ~ $5 trillion(US). It will make business real tough for all the deposit funded banks to make a competitive loan.
September 13th, 2008 at 2:20 am
Peter, you seem to know a bit. We are with Westpac and the mortgage was being held by the Reserve bank? Definitely!
September 13th, 2008 at 11:59 am
I’m not sure nationalising mortgage lending is good public policy. Individuals get the benefit of the nations AAA credit rating but should that be extended to businesses as well (negative gearing rental property)?. What about all the other businesses that will be excluded AAA credit price, including all the recent infrastructure privatisation. Surely power ports roads etc are equally important to a functioning economy!
September 13th, 2008 at 2:25 pm
Asset shifting from public > private > public balance sheets shifts costs & benefits in ways that are probably undesirable and seems to be somewhat cyclical. We change Govenment, they clear the national balance sheet, we wreck our own private balance sheets, we want to transfer it back. Do we wreck the national balance sheet again? Frankly it would be better if we all priced ‘risk’ appropriately. Those who don’t should fail. These are commercial transactions. If you don’t save enough and you over borrow to aquire an asset at inflated prices and recieve insufficient cashflow to amortise and own it, and that recipe fails for you, why reward the behaviour? Moral hazard!
September 15th, 2008 at 8:54 am
Hey Emil, Oracle, definitely no malice intended.
It was more a stream of conscience, i didn’t mean to imply the Oracle was caught up ‘irrational exhuberance etc’.
I’d personally like to see a big readjustment in currency valuations so that nations can compete on an equal footing. I agree it is ‘rational’ to to go make something cheaper where you can, but to me, it should be cheaper because someone can do it better/smarter, not because someone can do it in a country whose currency is worth peanunts – and the peoples wages reflect this. To me, that is artifical comparative advantage.
September 26th, 2008 at 10:58 pm
Debt to GDP is not 170%. GDP is about $1000 billion. Australia’s foreign debt was about $500 billion before our dollar dropped.
The Reserve Bank holds most of Australia’s foreign debt. The Current Account Deficit puts Australian dollars on the world market that no one wants. These dollars are mopped up by the Reserve. Yes, apart from the Aus dollar at 98 cents: being caused by currency speculators waiting for the $US to bottom.
So the Reserve sets the price of $Aus, like goldilocks, not too high nor too low, according to the economic circumstances.
Reserve banks borrow printed money from each other. Currency swaps were only stopped as it made blatantly obvious that Reserves were printing money to lend to each other. Debt is not a problem: mopping up debt with printed money possibly could be.
We could have a 15 year Japanese bubble, yet.
The best contribution for the esoteric elite e.g. (Steve Keen) to make, is to put the plain truth on public record.
What does it achieve by testing out the general public. Even if they have informal expertise, their thinking will never make a difference in contributing to a better world.
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