Deleveraging returns

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Mar­ket econ­o­mists have spent the past few months search­ing each major data release for con­fir­ma­tion of their hope that the econ­o­my is return­ing to growth and that a ‘sus­tain­able recov­ery’ is under­way.

Most cur­rent­ly argue that the fun­da­men­tals in Aus­tralia are good – low unem­ploy­ment, a strong recov­ery in equi­ty mar­kets (notwith­stand­ing the 14 per cent sell-off in the past month), a sig­nif­i­cant num­ber of com­pa­nies’ results beat­ing expec­ta­tions and so on.

The same econ­o­mists and com­men­ta­tors (none of whom actu­al­ly saw the GFC com­ing) then argue that if the recov­ery from the GFC is derailed, it will be because of an exter­nal shock – a Chi­na-led com­modi­ties slump, the sov­er­eign debt cri­sis, or an abrupt car­ry trade rever­sal when the Fed starts rais­ing rates (though the recent slump in the $A implies this is tak­ing place now with­out the Fed’s assis­tance).

What these analy­ses over­look is the inter­nal indi­ca­tor which enabled me (and hand­ful of oth­er non-ortho­dox econ­o­mists) to antic­i­pate the GFC in the first place: the ratio of debt to GDP, and its rate of change. On this indi­ca­tor, even if none of these oth­er ‘shocks’ even­tu­ate, Aus­tralia still faces either a reces­sion, or a return to the unsus­tain­able trends that set the stage for the GFC.

To under­stand why, we need to think back to the ear­ly 1980s when the Hawke/Keating gov­ern­ment allowed for­eign banks to flood into Aus­tralia, and when “Bondy” and “Ska­cy” were regard­ed as nation­al heroes—rather than as the Ponzi mer­chants that sub­se­quent events proved them to be. This pub­lic embrace of Ponzi finance gave offi­cial back­ing for what was in real­i­ty a debt-dri­ven eco­nom­ic sys­tem, rather than one based on real eco­nom­ic growth.

Ris­ing debt became increas­ing­ly impor­tant for sus­tain­ing eco­nom­ic activ­i­ty, and a cul­ture of addic­tion to cred­it began that last­ed (despite major dis­rup­tions such as the late-1980s inter­est rate blow-outs and the ear­ly 1990s reces­sion) until 2008. Aus­tralians became increas­ing­ly com­fort­able with high lev­els of mort­gage debt, because house prices were also ris­ing; but their ‘com­fort’ result­ed from increas­es in asset prices that were them­selves caused by even larg­er increas­es in debt.

That process came to an abrupt halt as 2007 came to an end, and the sud­den with­draw­al of debt-financed spend­ing is what real­ly caused the GFC, both here and over­seas.

Aus­tralia then side­stepped the start of the GFC part­ly by fair means—a huge gov­ern­ment stim­u­lus, sub­stan­tial inter­est rate cuts and a Chi­na-led export boost—and part­ly by foul—enticing house­holds back into mort­gage debt via the First Home Ven­dors Boost.

This gov­ern­ment pol­i­cy tem­porar­i­ly reignit­ed the debt cul­ture, but the con­tin­u­ing GFC (and a series of RBA rate ris­es) has final­ly con­vinced Aus­tralian house­holds to return to the pre-FHVB ten­den­cy to delever—mostly through a sharp decline in own­er-occu­pi­er bor­row­ing, as I dis­cussed last week in “Mort­gage Finance Fal­ters” (the data in these charts does­n’t yet reflect the sub­stan­tial drop-off in own­er-occu­pi­er mort­gage debt; this may be because these aggre­gate debt fig­ures aren’t sea­son­al­ly adjust­ed, where­as the ABS data on new finance for hous­ing is sea­son­al­ly adjust­ed).

Small busi­ness bor­row­ing has also seen dra­mat­ic declines. In fact, only one major group of bor­row­ers – hous­ing investors – con­tin­ues to lever­age up, based on cur­rent data.

But even they seem to be reach­ing a plateau at about 25% of GDP—and as might be expect­ed, the increase in investor mort­gage debt was trig­gered by the FHVB. Pri­or to its intro­duc­tion, investor mort­gage debt was trend­ing down from 25.6% of GDP towards 24.75%. It then start­ed to rise as the FHVB-inspired bub­ble took off, and hits its new peak of 26.2% in March 2010.

Wide­spread delever­ag­ing is there­fore the ele­phant in the room for econ­o­mists hop­ing to find evi­dence of ‘sus­tain­able growth’ in com­pa­ny reports, and mar­gin­al changes to the unem­ploy­ment data. If delever­ag­ing gath­er pace, then unem­ploy­ment will rise; if instead debt lev­els rise, then unem­ploy­ment will fall, but based on an unsus­tain­able trend in debt to income.

In the chart below I have used RBA data to demon­strate why this is so (the source files are D02Hist, G07Hist, and G12Hist, which them­selves repack­age ABS data). The key rea­son is that the more Aus­tralians bor­row in rela­tion to incomes, the greater is the pro­por­tion of aggre­gate demand that is sim­ply recy­cling of debt cap­i­tal. While this caus­es a boom as debt lev­els rise, this process also works in reverse.

I cal­cu­late the pro­por­tion of aggre­gate demand that is debt-financed by divid­ing the annu­al increase in debt by the sum of GDP plus that change in debt. From con­tribut­ing noth­ing to aggre­gate demand at the end of the ear­ly 1990s reces­sion, debt-financed demand rose steadi­ly to hit a peak of around 19 per cent of demand in 2008.

Now, as pri­vate delever­ag­ing gath­ers pace, aggre­gate demand is plung­ing, mean­ing that near­ly a fifth of Aus­trali­a’s ‘income’ is in jeop­ardy because Aus­tralians are no longer will­ing to bor­row to fund the addi­tion­al spend­ing. The First Home Ven­dors Boost—which caused the turn­around in pri­vate delever­ag­ing that is evi­dent in the data for 2009—and the increase in gov­ern­ment debt stopped the debt con­tri­bu­tion from turn­ing neg­a­tive (as it did in the USA). Con­tin­u­a­tion of that trend is unlike­ly this year—and even if it did con­tin­ue, we would be bas­ing our con­tin­ued pros­per­i­ty on a return to the debt-induced growth that caused the GFC in the first place.

The final, dis­turb­ing aspect of the chart below is how close­ly unem­ploy­ment cor­re­lates with debt-fund­ed demand changes: since 1980, the debt con­tri­bu­tion to aggre­gate demand explains 90% of the lev­el of unem­ploy­ment.

While cor­re­la­tion does not prove causation—and there are more causal fac­tors than just the change in debt—in this instance the causal mech­a­nism that would lead to reces­sion and high unem­ploy­ment is so sim­ple that only a neo­clas­si­cal econ­o­mist could con­test it. Our econ­o­my is demand-dri­ven; as debt’s con­tri­bu­tion to demand falls, aggre­gate demand slumps, and the num­ber of jobs that can be sup­port­ed by aggre­gate demand will also fall.

The odds are that Aus­tralia is head­ed for a very painful delever­ag­ing-induced reces­sion. We can only hope that the prob­lem is not ampli­fied by the “exter­nal shocks” from the still-extant GFC.

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About Steve Keen

I am Professor of Economics and Head of Economics, History and Politics at Kingston University London, and a long time critic of conventional economic thought. As well as attacking mainstream thought in Debunking Economics, I am also developing an alternative dynamic approach to economic modelling. The key issue I am tackling here is the prospect for a debt-deflation on the back of the enormous private debts accumulated globally, and our very low rate of inflation.