Rescuing the Economy or the Bubble?

Oct19
by Steve Keen on October 19, 2008 at 11:01 am

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Many elements of the recently announced package are justified. When the economy is about to go into a debt-induced recession, government spending both boosts demand, and provides the private sector with cash flow needed to meet its debt repayment commitments.

Equally vital was the guarantee of all bank deposits. A run on the banks would be disastrous, and this guarantee ensures that this will not happen.

But yet another increase to the First Home Buyers Grant???

Is this because, um, house prices are, like, maybe too low?

Oh please, some reality here: the root cause of this crisis is excessive debt that drove house and share prices to unsustainable levels. Times appeared rosy as the house (and stockmarket) bubble continued, but this was only because borrowed money was adding to demand.

No-one worried about this when it was easy to flog a house for a higher price. But unfortunately, this game had to come to an end, because debt servicing became prohibitive as house prices rapidly outstripped incomes. The bubble burst first in the USA, and the carnage it has wreaked there should warn us all that asset price bubbles are dangerous.

And how does the Australian government respond? By providing yet another stimulus on the demand side.

A collapsing housing bubble may be a scary prospect, but the more it is inflated, the scarier the final bust. And Australia’s, on any measure, is bigger than America’s.

A simple comparison of the ABS Established House Price Index (ABS 641601 and 641603) to the CPI shows just how large the Australian house price bubble is (see Figure One).

Figure One

Figure One: House Prices vs the CPI

House Prices vs the CPI

Since 1987–hardly a time when Australian house prices were low by historical standards–house prices have increased two and a half times as fast as consumer prices (see Figure Two). Median incomes have fared little better than the CPI, so that houses are 60 percent less affordable now than in 1987.

Figure Two

Ratio of House Prices to the CPI

Ratio of House Prices to the CPI

That’s also true even when we take into account lower interest rates. Yes, rates are about half what they were in 1987 (see Figure Three); but debt is six times larger as a percentage of household disposable income than it was then (see Figure Four)–so that merely paying the interest on outstanding mortgage debt consumes 13 cents in the household dollar, versus a mere 3.5 cents back in 1987.

Figure Three

Mortgage rates and payments

Mortgage rates and payments

Figure Four

Mortgage debt to disposable income

Mortgage debt to disposable income

Increasing the amount of money that first home buyers can slap down on a home may help those who can’t afford to get into the market do so–great. It will also increase competition for houses, and potentially sustain the Great Australian Housing Price Bubble. 

Not great. As the USA shows us, the pain of a bursting house price bubble can be pretty immense–especially since it’s fuelled by excessive levels of debt.

But that pain will only get worse if the bubble is driven any higher. The higher up you are when you fall off a mountain, the more it hurts when you hit the ground. The Australian house price mountain, on any measure, is substantially higher than the USA’s was when it began its long, painful descent (see Figure Five).

Boosting the First Home Buyers Grant is a mistake, just as it was when Howard did it. It will merely delay the day of reckoning.

Figure Five

Australian vs US Housing Bubble

Australian vs US Housing Bubble