The RBA has put rates up now on the belief that the financial crisis is behind us, and it has to return to its established role of controlling inflation.
That this decision was likely was flagged by the speech by Anthony Richards last week, which implied that the RBA, having ignored the house price bubble created by private credit growth in the preceding two decades, was worried about the renewal of the bubble initiated by the Government’s First Home Vendors Boost (I refuse to call it by its official name, since the money clearly went to the vendors, while the buyers copped only higher prices).
Needless to say I am all for trying to contain the house price bubble, which I regard as a disguised Ponzi scheme that has sucked Australian households into unsustainable debt levels. It is quite possible that the increase in interest rates (which is sure to be fully passed on by lenders and will add $20 a week to the servicing costs of a now commonplace $400,000 home loan), combined with the phasing out of the Vendors Boost, will be enough to prick the bubble–especially if it is followed by another rise next month.
But the RBA is doing this in the belief that the economy will return to normal after the recent mild recession–normal meaning growing at about 3% per annum in real terms, and faster than that as it rebounds from the recession.
Unfortunately “normal” in our post-War experience has also involved a return to a rising private debt to GDP ratio. Every recession has involved a fall in debt-driven demand, and every recovery has involved a return to debt rising faster than income. As the global financial crisis has made many people realise, this is simply a formula for avoiding a crisis now by having a bigger one in the future.
I doubt that the RBA appreciates this even today. It is still mired in a neoclassical way of thinking about the economy, which myopically ignores the impact of debt-driven demand on the economy. This is why it can put up rates now in the belief that this will merely fine tune the economy’s performance–reducing the likelihood of inflation in the future.
I think it is likely that the RBA will achieve far more than it intends. The last time the RBA put rates up to attempt to control an asset price bubble that was already out of hand was back in 1989. That exacerbated the economic downturn that was already in train as the debt bubble of the 1980s started to collapse. I expect the outcome of this rate rise will be similar: a downturn that is already in train as a debt bubble bursts will be made worse by this increase in rates at a time of greatly heightened financial fragility.
The problem this time is I believe far worse than 1990. Then the household sector had a relatively low level of debt–the mortgage debt to GDP ratio was a comparatively trivial 18 percent, compared to its now record level of 87.5%. It was therefore possible for the financial sector to lend willy-nilly to households, something neoclassical economists facilitated by their enthusiastic deregulation of the financial sector.
Who is there to lend to today? All sectors of the economy except the government are carrying record levels of debt. Thus while the Vendors Boost and other enticements encouraged some additional borrowing by the already massively leveraged household sector–and gave us a household debt to GDP ratio that now exceeds America’s–I simply can’t imagine who (apart from the government) the financial sector can now sell debt to.
As a result, I doubt that we will see any sustained acceleration in the debt to GDP ratio, with the consequence that the debt-financed component of aggregate demand will be anaemic at best. Since that has been the major source of growth in aggregate demand for many years now, I expect that economic growth will be substantially less than the RBA anticipates.
If so, just as it killed a dragon that wasn’t there by its inflation-fighting rate rises up until March of 2008, it may be taming a lion that is sound asleep with its rate rises now. If economic growth does in fact stay well below levels that reduce unemployment in the coming two years, then there will be very good grounds for revoking the independence that the RBA has had in setting monetary policy. We may as well hand it back to the politicians, if the alternative is to leave it with neoclassical economists who don’t understand the dynamics of our credit-driven economy.
If any one is interested in a comparison on the current corporate insolvency numbers to the insolvency numbers post 1987 I’ve recently released a Business Stress Report. Most had thought insolvency numbers were on the improve, having peaked last December to March but by my reckoning, and comparing to 1987, they are getting worse. The latest BSR revealed a significant increase in the cost of insolvencies with the following key findings:
• The cost of bad debts to Australian Banks in the quarter to June 2009 was $10.8 billion which is the highest ever recorded. That compares to an average of around $4.4 billion per year for the years 1995 to 2008.
• The number of companies entering some form of insolvency administration has topped the 10,000 mark for the first time.
• The new numbers reflect what happened to insolvency numbers after the 1987 Stock Market crash at which time the number and cost of bad debts did not peak for 4 years.
More detail at http://www.restructuringworks.com.au/business-stress-report.html
Cheers
Hi Steve,
.. and the markets will become euphoric thinking about green shoots. I find market movements and Bloomberg headlines funny these days.
Also higher interest rates are bad for employment because firms incur more interest charges and they allot a lesser amount to wages. Higher interest rates are bad as far as the distribution of wealth is concerned.
Actually I think the RBA does not really want you to walk
How much higher could the RBA raise interest rates (in the current economic meltdown)?
“How much higher could the RBA raise interest rates”
By as much as necessary to dissuade people from bidding up the price of existing housing stock it would seem. Strange policy objective for an institution chartered with the task of keeping inflation in check.
Here’s a question; has the RBA ever clearly enunciated its definition of what the “normal interest rate” actually is and on what basis it defines and justifies this? And what is an “emergency setting” in terms of existing Monetary policy and how is it defined?
I ask because these terms are used liberally by the RBA and the fourth estate but no one seems to know exactly what they really mean.
Interest rates are determined by supply and demand. RBA probably is just following the international market.
Steve,
Great site, and very timely response to the interest rate decision by the RBA.
Do you have any record of the development of upfront payments during the buildup of the bubble? Recently I read some report stating that the banks are relatively secure because of the recourse loans.
My first guess at the future: the aussies will try to do it better than the US and give money directly to the debtors. Currently a lot of people are fearing inflation in the US. As it always has been, the outcome is totally different from what has been expected. Maybe the greatest bout of inflation will hit Australia first — a country loved by investors for its resource richness.
A comparison of the bubble evolution against equity requirements or similar stuff would be quite useful, too, I guess.
Cinquero@10
“Maybe the greatest bout of inflation will hit Australia first — a country loved by investors for its resource richness.”
Some detailed explanation of the mechanism involved and the timing will be appreciated.
Cinquero, let’s just concentrate on the buying power of the $A.
I find it hard to believe that something as dumb as neoclassical economics still has any hold at all in our Reserve Banks and our Universities.
Surely not Keynes, nor Marx (with his “analayse capitalism” hat on), nor even Adam Smith would have ignored the impacts of excessive credit and subsequent over-indebtedness on the economy. How can all this knowledge be lost? Where did these idiot neoclassicals come from? Why are they able to persist and to hold on to the levers of power when they are so clearly wrong and clearly in denial of the empirical evidence?
It frustrates the be-jingoes out of me.
I’m confused, isn’t one of our main economic problems that we borrow too much money, and our house prices are way over inflated due to that easy money? With that in mind, what’s wrong with today’s RBA rate increase, doesn’t that make it slightly more discouraging to borrow as much?
I thought we were trying to prick the housing bubble.
“Why are they able to persist and to hold on to the levers of power when they are so clearly wrong and clearly in denial of the empirical evidence?”
In my view they have gotten away with it for so long because the rising tide of the baby boom has created unprecedentedly benign economic conditions from 1949-2007. The level of growth seen during this time leads to a bad case of confirmation bias of neo-classical theories.
Until recently debt has been sustainable because this massive bulge of people kept spending more and more. We only need to be patient and the academic fraud steve and others have been debunking will be laid bare.
“I thought we were trying to prick the housing bubble.”
That’s been part of the RBA’s “explanation” for this rise, since there’s precious little evidence that inflation is on the rise.
The problem is that RBA interest rate hikes affects the cost of all cash rate linked lending, not just that used for housing.
So business, especially if trade exposed, is experiencing the worse of all possible worlds; a sluggish local and international economy, rising borrowing costs and a loss of international competitiveness.
And all because the RBA is trying to use the very blunt instrument of monetary policy to achieve an objective much better suited to well targeted fiscal policy; namely avoiding the housing bubble.
Definitely worth a cross-post, Bill Mitchell’s take on today’s events:
http://bilbo.economicoutlook.net/blog/?p=5294
Dear Steve and all,
I understand that this blog is mostly interested in the interface between finances and macroeconomics and that my request will probably be a bit of a distraction, but I would like to know how do you guys view the effects of this interest raise (and potentially others following soon) on employment and wages.
Steve already made some observations regarding unemployment in the next two years. Can anyone offer any additional details?
The RBA press release was very vague (ominously so, I would add)
STATEMENT BY GLENN STEVENS, GOVERNOR
MONETARY POLICY
http://www.rba.gov.au/MediaReleases/2009/mr-09-23.html
Although interest rate rises will place quite some pressure on mortgagee incomes, something else will need to operate in tandem with rate rises to precipitate a steep decline in home prices. Perhaps that factor will be the imminent insolvency of CIT, or the destruction of more capital due to the collapse of US option ARM or ALT A loan portfolios or even commercial property lending portfolios. I’m sure you know that level of US option ARM and Alt A loan resets will rise from November 2009 and keep escalating until they peak in mid-2011 resulting in yet more loan losses. In fact the losses are quite predictable and are likely to result in just over a trillion more dollars being lost.
As we are a capital importing country we are vulnerable to these potential shocks or an even greater shock such as the collapse of demand for treasuries which will force sharp US rates rises and raise inflation. There are so many risks that that housing looks like a lousy bet because things could get seriously ugly over the next 12 months.
However, I don’t believe that the US will allow that to happen. There is no political will to cut spending and stop printing money. They are intent on sweeping the problem into the next government’s term and will keep stimulating until they threaten the solvency of their currency. Bear in mind also that unlike Argentina or Brazil the lenders to the US are the ones who bear the foreign exchange risk. As unlikely as it appears, it is even possible (although not probable) that the US may grow or inflate its way out of its debt trap. I believe that they will try after all there is no other politically expedient way out for them.
However, in the short-term, with the US Federal Reserve keeping interest rates at close to zero I can’t see any dramatic rate rise here. That’s not to say that rates here can’t rise by up to 2 per cent.
It’s hard to forsee where we go from here. I don’t envy any economist having to call the next 12 months.
Wow! Just read Anthony Richards paper. For richards underlying demand is the sum:
Demand due to natural growth of the population;
Demand due to trends in household size (i.e. the number of people per dwelling);
Demand for new houses that replace houses that have been demolished; and
Demand for second or vacant homes (presumably holiday homes.)
He doesn’t make a single mention on the demand for housing caused by speculative activity fed by negative gearing. Housing is treated entirely as consumption good. How ridiculous? I’ll bet that around 40-50% of fixed homes are purchased by investors. Surely that group imposes a strong risk to price as it needs to make an economic return form a pretty inflated investment that cannot generate an adequate return for the capital deployed. I would love to know the metrics behind the risk from the negatively geared crowd
It is sad that the analysis does recognise the demand for housing as a means of speculation, tax avoidance and the role that this has played in lifting home prices to such unsustainable levels.
Alright so… first post – been following Keen’s stuff (and your comments) for about 8months now – you’re a gutsy man Steve and I reckon there’s even a fair swag of the neo-classicals that would secretly admire your conviction in the face of everything.
However, starting to get a little edgy about the economic future of our country – I’m in my mid twenties and have been crawling around powerstations all year to put some money aside, so I have savings and no debt. I’ve always been the person that gets suspicious when bandwagons are a little too easy to jump on and a little to full of plebs – hence I haven’t bought a house and didn’t put any $’s in shares. So… rate rises may be a good thing for my savings but I am starting to realise that as a ‘saver’, i’m actually an ‘investor’ in a fiat currency and i’m starting to get a little nervous about my investment (ie. I have no faith in the drunken sailors at the helm of this ship).
My question is: Since we all seem a little ahead-of-the-curve how do we prepare for and profit from what’s going to happen? Bullturnedbear – I feel we’re on similar wavelengths from reading your posts (the bits I understand) so your advice in particular would be appreciated. I’ve been leaning towards currency trading but it’s hard to get advice I can trust off the internet.
I realise this post has been very ‘take’ and no ‘give’ to the community but with time I hope to change that.
regards,
don
Btw – I’ve travelled through Argentina and those guys are still hurting from their 1999-2002 crisis. hopefully something similar doesn’t happen here.
Government panders to the voters by artificially pumping the housing prices, Reserve Bank panders to bank shareholders by handing them some guaranteed profit and the middle Australian mortgage holders do the work and pick up the tab.
Everything is exactly as it should be!
Why are you always moaning Steve?
I actually see this as a good thing (even though I have a mortgage myself) because it’s a good thing for the nation as a whole.
*leans in close, speaking with slight whisper, Robert Gottliebsen style* …and I’ll tell you why.
It proves that either the Reserve Bank is truly independent of the government, or the pair of them have a very smooth “good cop / bad cop” routine going. Now we have the ratbag, good-for-nothing NSW Government putting up posters all over Sydney offering 50% discount on stamp duty, so the Reserve Bank turns around and whacks up interest rates to balance it out. The interest rise bumps up bank profits, and coincidently the Federal Government taxes those profits and the NSW government get to watch the tax they could have taken being slurped up by the Feds instead. Round and round. What a fun game to play!
“When the people find they can vote themselves money, that will herald the end of the republic.” — Benjamin Franklin.
The job of the RBA is to convince the people of Australia that perpetual motion is impossible, and hopefully keep the Republic in a functional state. We could of course, use gold as our currency and get exactly the same effect the old, boring and reliable way, but that would be too easy.
By the way, if the NSW government wants a great method of lifting housing prices, perhaps they should consider making Sydney an attractive place to live? You know, with industry and stuff. Might I suggest hiring Jeff Kennett?
I cannot agree that the Reserve Bank got it wrong. If debt is the problem, and like Steve I am convinced it is, then we should not encourage more debt by low interest rates.
In my area, unit prices have probably gone up at least 20%, if not more in the last few months. Too many people are being sucked into buying units at ridiculous prices.
Therefore raise interest rates to discourage borrowing and let China mitigate any slowdown we experience with their purchases of our commodities.
Interest rates are only a small part of the solution to discourage excessive borrowing and also to make housing affordable. The following steps should also be taken
1.
Thanks for that Steve. You summerised the last 2 hours of my thoughts. I totally agree with you, nobody see’s the problems that you continue to highlight. What do you think the exchange rate will do though? I think that 10 year Treaury yields will fall hugely, but am unsure what the AUD will do. On one side you have deflationary credit which will be supportive, and on the other hand you have the potential for a reversal of hot money if rates do not rise as expected. What do you think?
Thank you
Stuart
I must have hit the wrong key. To continue, the required steps in my opinion.
1. Abolish first home owners grant completely
2. Abolish negative gearing
3. Relax zoning to ensure plenty of cheap land available for housing
4. Increase property taxes on unimproved value of land to discourage hoarding of land. This can replace stamp duty on land transactions to reduce costs for buying and selling of land
5. Abolish concessional treatment of capital gains
I am sure many other steps can also be taken. But I believe these would be very good first steps to reduce overall debt in households and the economy that we can have proper balanced growth after a period of adjustment
Regards
David