Debtwatch No. 40 November 2009: Have we dodged the Iceberg?

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Part 1: The USA

The most recent “unex­pect­ed­ly good” growth fig­ures for the USA appear to indi­cate that what will still be the worst down­turn since the Great Depres­sion is final­ly over.

How­ev­er this is not your usu­al down­turn. Not only is it acknowl­edged as the most severe since the Great Depres­sion, it has also evoked the most remark­able gov­ern­ment eco­nom­ic stim­u­lus ever seen. It would be bizarre if this had not had an effect on the data.

Whether a recov­ery is tru­ly under­way in the pri­vate sec­tor there­fore depends on how the econ­o­my is like­ly to per­form after the stim­u­lus is with­drawn.

The “reces­sion is over” reac­tion could be valid under two cir­cum­stances. Either:

  1. The fig­ures are very high even when the gov­ern­ment stim­u­lus is tak­en into account; or
  2. If the econ­o­my could be expect­ed to con­tin­ue grow­ing endoge­nous­ly after the stim­u­lus were with­drawn, even if the aggre­gate num­bers for this quar­ter were good only because the gov­ern­ment stim­u­lus was so large.

Let’s con­sid­er the first option. The growth rate on an annu­alised basis for the last quar­ter was 3.5%. The BEA’s decom­po­si­tion of this notes that 1.66% of the growth was due to increased motor vehi­cle out­put, which was pri­mar­i­ly dri­ven by  the gov­ern­men­t’s “Cash for Clunk­ers” pro­gram. Anoth­er 0.48% was due to the growth in gov­ern­ment expen­di­ture.

There are also some ele­ments of the fig­ures that sim­ply seem, in the orig­i­nal sense of the word, incred­i­ble. For exam­ple, ris­ing invest­ment levels—up 11.5%—were a major rea­son for the pos­i­tive read­ing. But all com­po­nents of this mea­sure were either tepid or negative—except for res­i­den­tial invest­ment, which was up a whop­ping 23.4%.

That just does­n’t tal­ly with the most depressed real estate mar­ket in his­to­ry; pos­si­bly this huge con­tri­bu­tion to aggre­gate invest­ment could be the result of a large move­ment from a very small base, where­as the sec­tor’s weight in the over­all cal­cu­la­tions of invest­ment has­n’t been revised down­wards to reflect its true con­tri­bu­tion today. Or it could be a prob­lem with the data sam­ple that will be revised sub­stan­tial­ly down­wards in lat­er esti­mates of GDP.

Either way, the prospect that a seri­ous reces­sion, which was caused by the burst­ing of a hous­ing bub­ble, which left an unprece­dent­ed stock of unsold exist­ing hous­es on the mar­ket, and which has led to an unprece­dent­ed unsold over-sup­ply of exist­ing hous­ing stock, has been end­ed by a revival in hous­ing invest­ment… is sim­ply incred­i­ble.

That leaves the sec­ond option—that even though the pos­i­tive fig­ure was the prod­uct of the gov­ern­ment stim­u­lus, when this is with­drawn the econ­o­my can be expect­ed to con­tin­ue grow­ing on its own.

Here trends in con­sumer income and non-res­i­den­tial invest­ment are the impor­tant issues. These would both need to be pos­i­tive (or at least turn­ing from lows) for the pri­vate sec­tor to resume growth in the next quar­ter with­out the need for stim­u­lus.

Con­sumer dis­pos­able income fell at a sub­stan­tial 3.4% annu­alised rate in the quar­ter, while fixed invest­ment expen­di­ture rose by an anaemic 2.3% and invest­ment in struc­tures fell by 2.5%.

It is thus like­ly that if the gov­ern­ment stim­u­lus were with­drawn, both these pri­vate sec­tor areas would show even more neg­a­tive fig­ures over this quar­ter.

How­ev­er, anoth­er way of look­ing at whether this is the end of the reces­sion is to look at the tim­ing of turn­ing points in the data and eco­nom­ic recov­er­ies (this requires attempt­ing to deduce the cycli­cal com­po­nents in the data from the trend). On this and the con­ven­tion­al set of indi­ca­tors, it looks like the “avoid­ed the ice­berg” call could be right. First­ly as the next graph indi­cates, dur­ing the reces­sion all fac­tors save gov­ern­ment spend­ing were below trend, and the two biggest fac­tors in the turn­around are a revival in invest­ment (dri­ving almost exclu­sive­ly by the “23.4% rise” in res­i­den­tial invest­ment!) and net exports.

The role of net exports is unusu­al (though unre­mark­able), but the turn­around in invest­ment is a sign of recov­ery that has occurred in all pre­vi­ous recessions—as the next chart indi­cates.

How­ev­er there is anoth­er fac­tor that has­n’t yet been considered—the role of cred­it. Dur­ing post-War reces­sion, cred­it growth has dropped well below trend, and the recov­ery has involved ris­ing debt lev­els. This is not the sign of a healthy economy—far from it—but this is how the US econ­o­my has “recov­ered” from every pre­vi­ous post-WWII reces­sion.

Not this time it appears: if this is a recov­ery, then it’s a high­ly unusu­al one because cred­it growth is still well below trend—and, in fact, neg­a­tive: Amer­i­ca is delever­ag­ing.

We there­fore have the strange com­bi­na­tion that one accept­ed “lead­ing indi­ca­tor” of recovery—a turn­around in investment—appears to have occurred, while anoth­er less favoured indicator—the trend in cred­it growth—is still point­ing at reces­sion.

I apol­o­gise for get­ting some­what geeky here, but this is one issue that a sim­ple check of charts can’t decide—we have to delve deep­er to work out which of these two con­tra­dic­to­ry indi­ca­tors to take more seri­ous­ly. So the next two tables get slight­ly more tech­ni­cal and look at the cor­re­la­tions over time between changes in the com­po­nents of GDP and cred­it and changes in real GDP.

Here the data favours debt growth as the lead­ing indi­ca­tor to watch. Invest­ment is strong­ly cor­re­lat­ed with GDP, but that’s hard­ly sur­pris­ing since it con­sti­tutes a major and volatile com­po­nent of GDP. Just as with consumption—the larg­er but less volatile major component—its cor­re­la­tion is high­est when coin­ci­dent with GDP. It is not a lead­ing indi­ca­tor.

The two best lead­ing indi­ca­tors are debt, and gov­ern­ment spending—with the for­mer stronger than the lat­ter. Gov­ern­ment spend­ing a year ahead of GDP is a good indi­ca­tor of which way GDP will go—something which sup­ports the Char­tal­ist approach to macro­eco­nom­ics and under­mines con­ven­tion­al “neo­clas­si­cal” eco­nom­ic think­ing. But changes in debt are a stronger indi­ca­tor still, and have a stronger effect clos­er to the actu­al move­ments in GDP.

The pre­vi­ous cor­re­la­tions cov­ered the whole post-WWII peri­od (from 1952 till now), but there has clear­ly been struc­tur­al change in the US econ­o­my over that time—especially the relo­ca­tion of pro­duc­tion to off­shore low-wage coun­tries, the growth of the FIRE sec­tor with the econ­o­my’s increas­ing depen­dence on debt, and the shift in eco­nom­ic pol­i­cy from a “Key­ne­sian” ori­en­ta­tion to a “Neo­clas­si­cal” one (pri­or to this cri­sis) in the mid-1970s. So the next two tables repeat the above cor­re­la­tions, but just with data from 1990.

These rein­force the argu­ment that move­ments in debt mat­ter as an indi­ca­tor of whether we’re out of the reces­sion or not—and the answer is no. It also appears that the influ­ence of gov­ern­ment spend­ing on eco­nom­ic per­for­mance weak­ened while neo­clas­si­cals were in charge (and behav­ing as neoclassicals—rather than “Born Again Key­ne­sians” as they are now).

So I don’t believe that this quar­ter of growth for the USA implies it has dodged the ice­berg. Instead a patch-up job has been done on the dam­age, but the USS is still tak­ing on water as the pri­vate sec­tor delever­ages.

Part 2: Australia

The Aus­tralian result of only one neg­a­tive quar­ter of growth, fol­lowed by a return to pos­i­tive growth is the best in the OECD. This was dri­ven by:

  1. The dra­mat­ic pos­i­tive impact on house­hold bud­gets from the cut in inter­est rates by 4%, which reduced debt ser­vice from 15.4% to 10.3% of dis­pos­able income;
  2. A stim­u­lus pack­age that was equiv­a­lent to 2.5% of GDP, the largest such pack­age in the OECD;
  3. Aus­trali­a’s unusu­al posi­tion as a com­mod­i­ty producer—so that we ben­e­fit­ed from Chi­na’s huge stim­u­lus pack­age and recent stock­pil­ing of com­modi­ties; and
  4. The entice­ment to house­holds to take on addi­tion­al mort­gage debt that goes by the name of the First Home Buy­ers Boost.

The first two fac­tors alone result­ed in a 9% increase in housh­old dis­pos­able income over the year from June 2008 to 2009—an unheard of devel­op­ment in boom times, let alone dur­ing an eco­nom­ic cri­sis. As Ger­ard Minack put it in his Dow­nun­der Dai­ly on Octo­ber 9th, “If that’s reces­sion, bring it on!”

As a result of this pol­i­cy-dri­ven paradox—rising dis­pos­able income in a recession—Australia will not record a fall in real out­put on an annu­al basis in 2009, a result that is in stark con­trast to out­comes in the rest of the OECD.

So fast and mas­sive gov­ern­ment action—by both its Trea­sury and Cen­tral Bank wings—averted a reces­sion in the face of an unprece­dent­ed finan­cial cri­sis.

This is a wel­come outcome—and one that con­tra­dicts one of the lat­est fads that dom­i­nat­ed eco­nom­ics pri­or to the GFC, “ratio­nal expec­ta­tions macro­eco­nom­ics”, which argued that the gov­ern­ment could­n’t affect real out­put. As I not­ed in an ear­li­er post, though neo­clas­si­cal­ly-trained econ­o­mists drove the pol­i­cy response, they did so as “Born Again Key­ne­sians”, and if their res­cue does work, then it con­tra­dicts neo­clas­si­cal eco­nom­ics just as much as the GFC’s very exis­tence did in the first place.

Also as not­ed in that post, the only school of eco­nom­ic thought that could be vin­di­cat­ed by this out­come is the Post Key­ne­sian “Char­tal­ist” group, which argues that any macro­eco­nom­ic down­turn can be avert­ed by suf­fi­cient­ly strong gov­ern­ment action.

The ques­tion for the future is what the econ­o­my is like­ly to do after the spe­cial fac­tors that turned it into a com­par­a­tive boom for Aus­tralian house­holds and exporters are unwound.

Already the RBA has start­ed to reverse the first fac­tor above, by rais­ing inter­est rates by 0.25% at its Octo­ber meet­ing, flag­ging that it will do as much or more on Mel­bourne Cup day, and imply­ing that the reserve rate could be as high as 5–6% by the end of 2010. If the RBA fol­lowed that plan of action, then the debt ser­vic­ing costs for house­holds would rise to over 15 per­cent of house­hold dis­pos­able income. This would reverse more than half of the improve­ment to dis­pos­able incomes engi­neered by gov­ern­ment pol­i­cy dur­ing the GFC.

More­over, this increase in debt ser­vic­ing costs would come on top of the removal of the First Home Buy­ers Boost (FHBB)—which I pre­fer to call the First Home Ven­dors Boost.

Pri­or to that fool­ish pol­i­cy, Aus­tralian house­holds were deleveraging—reducing their debt lev­els. Thanks to it, they increased their debt lev­els so that the ratio of mort­gage debt to GDP in Aus­tralia is now at an all-time record, and exceeds the lev­el in the USA (though not the UK). in mid-2008, the mort­gage debt to GDP ratio peaked at 84.9%, and it then fell to 84.2% by the end of 2008. Under the influ­ence of the FHOB, that ratio stopped falling and is now 88.4%—an all-time record, and five times the lev­el that applied in 1989.

This gov­ern­ment-induced $50 bil­lion increase in mort­gage debt has been a major fac­tor in dri­ving the econ­o­my upward, despite the GFC. The take­up of the boost is tru­ly staggering—from a nation­wide total of 121 in Octo­ber 2008, to 5,385 the next month, and a peak of 20,389 in June 2009. The total enticed into tak­ing out a mort­gage will sure­ly exceed 200,000 by the end of December—and rep­re­sent more than one per­cent of the Aus­tralian pop­u­la­tion.

How did the Gov­ern­ment get such a fab­u­lous “mul­ti­pli­er” out of its Boost—put in $1.5 bil­lion, get $50 bil­lion addi­tion­al spend­ing on hous­ing (at $7000 per recip­i­ent, times rough­ly 200,000 recip­i­ents by the time the Boost ends—there were 171,000 recip­i­ents as of the end of Sep­tem­ber 2009)? Because the recip­i­ents of the grants used the $7,000 to get an addi­tion­al $40,000-$50,000 in finance from their mort­gage lender, and then hand­ed this over to the First Home Ven­dor (FHV) in a gross­ly inflat­ed sale price.

The FHV then took this addi­tion­al cash and lever­aged it into an addi­tion­al $200,000 or so for their next house pur­chase. So the FHVB caused a bub­ble, not mere­ly in the sub-$500,000 price range that most First Home Buy­ers inhab­it, but right up to the $1 mil­lion range that accounts for more than 90% of Aus­tralian hous­ing. The lever­age on the FHBB was not mere­ly sev­en to one, but clos­er to 50:1 giv­en this flow-on effect.

With this gov­ern­ment-engi­neered mort­gage debt spree, it’s no won­der that the Aus­tralian house price bub­ble, which had begun to deflate in late 2008, has tak­en off once more. It’s rather apt that my walk to Kosciuszko (as a result of Rory Robert­son’s bet with me) will start from Par­lia­ment House, since there’s no doubt about Par­lia­men­t’s role in keep­ing this Ponzi Scheme alive.

The impact on Aus­trali­a’s finan­cial posi­tion was dra­mat­ic and will, in the long run, be very, very bad. It has encour­aged us to go back to the same unsus­tain­able trend of ris­ing debt to income lev­els that caused the GFC in the first place. It has also engi­neered an unnat­u­ral­ly fast return to ris­ing debt lev­els: in the 1990s reces­sion, it took 29 months to go from “peak debt” (85.34% of GDP in Feb­ru­ary 1991) to “trough debt” (79.14% in July 1993). This time it has tak­en just 14 months (from 164.8%in March 2008 to 158.84% in May 2009).

After the 1990s reces­sion, debt lev­els took off in the Great Aussie Mort­gage Bub­ble, ris­ing from 85% to almost 165% of GDP in just 15 years. If we are to get out of this cri­sis the same way we escaped from “The Reces­sion We Had To Have”, then debt lev­els would need to con­tin­ue ris­ing rel­a­tive to GDP. Which rais­es the ques­tion, “Who Are You Going To Lend To?” Both house­holds and busi­ness­es are car­ry­ing more debt than in any pre­vi­ous reces­sion, and the busi­ness sec­tor is still deleveraging—only house­holds are tak­ing on more debt.

All these fac­tors lead me to expect that 2010 will be a bad year for the Aus­tralian econ­o­my:

  • The com­bi­na­tion of the RBA’s rate ris­es and the end­ing of the First Home Buy­ers Boost will in all like­li­hood prick the house price bub­ble inspired by the Boost in the first place—and lead as many as 175,000 house­holds to be very angry that they were enticed into this spec­u­la­tive bub­ble in the first place. If this hap­pens, there is lit­tle prospect of mak­ing the House Price Souf­fle rise twice by yet anoth­er fool­ish entice­ment into debt.
  • The polit­i­cal pres­sure on the gov­ern­ment may lead it to unwind its stim­u­lus, which will remove a key prop from the econ­o­my; and
  • Delever­ag­ing, which has been the loom­ing prob­lem that gov­ern­ment pol­i­cy (espe­cial­ly the First Home Ven­dors Grant) has sim­ply delayed, will kick in as it has in the USA. The most like­ly man­i­fes­ta­tion would be a decline in dis­cre­tionary con­sump­tion and non-min­ing invest­ment.

I there­fore expect that the RBA won’t get to com­plete its intend­ed pro­gram of rais­ing inter­est rates, but will be forced to go into reverse in 2010 as it was in 2008. It should­n’t be for­got­ten that the RBA was still rais­ing rates in mid-2008 to fight infla­tion. They did­n’t see the GFC com­ing, and I believe that they’re mak­ing a sim­i­lar mis­take this time—believing that it’s all behind us when the spe­cial fac­tors that min­imised the impact are ter­mi­nat­ing.

So no I don’t believe we have dodged the iceberg—we’ve mere­ly pushed it below the sur­face, from where it will rise again to dent out eco­nom­ic hull once more. And all the while the neo­clas­si­cal econ­o­mists who did­n’t realise they were in an ice field in the first place are busi­ly rear­rang­ing the deckchairs on the Titan­ic.

Table One

Table Two

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