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.