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

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.
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  • ferb

    Funny thing i got told today.

    Appar­ently, the min­ing tax is what will be the down­fall of Perth realestate prices, unless Ruddy does a back­flip, then all will be hunky dory!!

    A group of friends of mine all sure that $620k is a rea­son­able price to pay for a 4/2 in Kings­ley, and 10% should con­tinue to grow annu­ally for years.

    On that math, in 4 yrs, some idiot is going to pay 900k!!. mmm either every­one is employed by the min­ing sec­tor and earns 150k or the min­i­mum wage has increased $40/hr…still an idiot.

    I am sure my friends are silently wor­ried, as per the inten­sity of the min­ing tax debate. Deep down though, they all recog­nise the redicu­lous math, and are sit­ting with there fin­gers on the trig­ger to sell.

    It’s when every­one comes to the real­i­sa­tion that things have plateaued that the attemped mass sell off wil begin, espe­cially when the baby boomers think it’s time to cash in and down­size, which ever comes first.

  • bur­rah

    “hey bur­rah,
    i look at man­ag­ing our resources as a yield man­age­ment prob­lem.
    mar­ket posi­tion and rel­a­tive scarecity deter­mines pric­ing.
    what is our future mar­ket posi­tion,
    my guess is there is sev­eral times global demand for our resource exports than avail­able sup­ply. so we have a finite resource in global terms, over the next 50 years or longer.

    so if the min­ers want to take their bat and ball and go home, well i say make my day.”

    Excel­lent analy­sis and quit per­sua­sive for resource nationalism.Only prob­lem, RN is a washout every where it’s been tried, wit­ness Zim­babwe and Venezuela.
    Because of this gov­ern­ments have come to believe that whole­sale nation­al­i­sa­tion is not con­ducive to their inter­ests and have instead moved towards impos­ing more puni­tive roy­al­ties and taxes.
    It is not only in Aus­tralia that these moves are being made, last month the Niger­ian gov­ern­ment passed the Petro­leum Indus­try Bill, which attempts to reform the lucra­tive oil-sec­tor by allow­ing the gov­ern­ment to bring down the prof­its of for­eign com­pa­nies and impose more strin­gent taxes and roy­al­ties.
    Evo Morales, the pres­i­dent of Bolivia, is at the fore­front of a change in the atti­tude among devel­op­ing-world lead­ers toward foreign–or, more specif­i­cally, Western–mining com­pa­nies. His coun­try owns half the world’s deposits of lithium, which could be hugely lucra­tive if devel­oped. But his gov­ern­ment is reluc­tant to let West­ern com­pa­nies in.
    An excel­lent case study of the sit­u­a­tion in Bolivia is here. It shows the moves and counter moves amongst the var­i­ous actors. So far it’s not look­ing good for Bolivia.
    The prob­lem is that these are all forms of social­ism. Social­ism is an excel­lent sys­tem which works bril­liantly until you run out of other peo­ples money, then it is a washout, as Mag­gie was wont to observe.
    In ancient times social­ism was known as human (espe­cially vir­gin) sac­ri­fice, where cer­tain groups were sac­ri­ficed for the greater good.
    The present day des­ig­nated vir­gins, for­eign invest­ment, unlike their pre­de­ces­sors are noto­ri­ously reluc­tant to sac­ri­fice them­selves for the com­mon good. At the first sign of car­nal intent by gov­ern­ment, they are likely to bolt.
    Or as you so suc­cinctly put it:
    “so if the min­ers want to take their bat and ball and go home, well i say make my day”

  • Philip

    NAB in chase for big­ger share of mort­gages and deposits

    Good to see that the NAB wants to increase its expo­sure to mort­gages.

  • ferb

    Re: NAB in Chase for mort­gages

    Check out one of the replies.

    Price drop? I don’t think so. (1) Neg­a­tive gear­ing, (2) Tax-Free cap­i­tal gains on own home, (3) 50% reduc­tion in CGT for prop­er­ties owned for longer than 12 months,(4) Hous­ing Short­age — they ain’t mak­ing any more land close to our CBDs, (5) China led resources boom — good for prices in WA & QLD, (6) Low inter­est rates still — despite recent rises, (7) Low unem­ploy­ment, (8) High lev­els of immi­gra­tion about to go much higher due to resources boom, (9) Money print­ing by many coun­tries around the world due to the GCC is low­er­ing the value of cash and thus increas­ing assets, (10) Infla­tion — that silent assas­sin that the RBA is try­ing to curb lurks in the back­ground and over long peri­ods of time inflates asset prices, (11) Aus­tralian prop­erty still much cheaper than in China, and wealthy Chi­nese are look­ing at Aus­tralian prop­erty as a good place to park their cash”

  • Banks.
    We read every day that Banks are on the com­pete for deposit monies They will pay for new cus­tomers, not their own (what’s new, this has been going on as long as bank­ing existed)top inter­est for Term Deposits. They adver­tise (try google T.D.) sub­sid­uary com­pa­nies Me Bank U Bank etc at 6.2. ( 6 months) Go to one of the Big 4 with the com­pe­ti­tion quotes and you get a straight answer “We can do this today for 5.575%” how­ever we can ring trea­suty at H.O. and see if wee can bet­ter that offer) At the end of the day the exer­cise is only aimed at get­ting “new” busi­ness not main­tain­ing the cash that they already have.

    They have not changed a bit even if they are short of liq­uid­ity it is not appa­rant in their atti­tude.

    One would think a les­son would have been learned from this World Wide Bank­ing deba­cle a les­son that they stuffed up and more of the same will not cor­rect this gigan­tic stuff up.

    Cash Cap­i­tal is scarce- no doubt of that-Secu­ri­tised equity used as Cap­i­tal is suss, though some bet­ter than oth­ers, how­ever it is with oblig­a­tion or risk.
    Why, then are we tak­ing these bankers seri­ously when their behav­iour does not match their needs or do they really belive their own B.S. as the ANZ’s Cheif Econ­o­mist relly doesn’t believ e that Australia’s hous­ing prices are unnaford­able.

    He states that sup­ply is out­strip­ping demand because of the hous­ing short­age. Hello, where has he been or bet­ter still where have we been when try­ing to fig­ure it out.

    ferb, I for one copped out, Sold, put the money in the bank at 6% and know tha I am bet­ter off than wor­ry­ing about the spend­ing of every cent. I intend to stay that way as long as it’s bet­ter than own­ing for the sake of it. I want real return and my home should be regarded as shel­ter (an essen­tial part of liv­ing) not an Invest­ment.
    There should be no sub­si­dies whatsover for Cap­i­tal Gains tax, neg­a­tive gear­ing, or inter­est rate sub­sidy — zero then we may look at pro­duc­tive enter­prises to make money enough to buy our own home–

    WOW! would’nt that be great!

  • ferb

    oh man, the baby boomers are sure fired up to milk every last cent they can, at any cost, includ­ing there kids, aka Amer­i­can style.

    This says every­thing about the atti­tude towards house prices, for one would never enter this arrange­ment if one thought the price would drop, or…would they?!

    In the case of the sub­primes, as the val­ues of the prop­er­ties dropped, some peo­ple could not refi­nance, hence they were hurt. But com­par­a­tively, in the case of the reverse mort­gage, the bur­den will fall on the gov­ern­ment ”

    I hope the banks are ready to suck up the dif­fer­en­tial in the long term?

  • ned

    Hi all,

    I just saw this paper from the IMF on the benefits/drawbacks of a CB rais­ing the infla­tion tar­gets. It is con­soder­ing ta move to 4% from the cur­rent 2%. The effects would obvi­ously be more extreme for a higher tar­get (I remem­ber 7% men­tioned ear­lier in this con­ver­sa­tion). Well worth a read con­sid­er­ing the dis­cus­sion that has just taken place.

  • ak


    I think that this is one of the best pieces:

    The defin­i­tive study on the rela­tion­ship between infla­tion and eco­nomic growth was pub­lished in 2000 by the IMF itself, enti­tled “Thresh­old Effects in the Rela­tion­ship Between Infla­tion and Growth”. The pri­mary con­clu­sion is that higher infla­tion in the indus­tri­al­ized world begins to impede eco­nomic growth when infla­tion is not far from
    2%. Of the five spec­i­fied mod­els in the IMF paper, three sug­gested the opti­mal infla­tion rate is 1%, one sug­gested a 2% tar­get, and one sug­gested a 3% tar­get. These find­ings are hardly a ring­ing endorse­ment for a higher infla­tion tar­get dur­ing nor­mal eco­nomic con­di­tions, let alone a shift all of the way to 4%.
    The five spec­i­fi­ca­tions then cal­cu­late what the eco­nomic cost would be to shift from a 2% to a 4% infla­tion tar­get. All five spec­i­fi­ca­tions cal­cu­late an annual eco­nomic sac­ri­fice of 0.25–0.50% for the indus­trial world. Fur­ther, a higher aver­age infla­tion rate tends to trans­late into more volatile infla­tion, with addi­tional unac­counted for eco­nomic costs.”

    So did these “sci­en­tists” pre­dict the GFC if their model was so accu­rate? So what went wrong? Not enough ratio­nal expec­ta­tions?

    To me this is as good as the phlo­gis­ton the­ory. This is my defin­i­tive view.

  • ned


    The Aus­trian school mod­els pre­dicted the GFC, would you clas­sify their the­o­ries as phlo­gis­ton as well? I sus­pect so. A theory’s pre­dic­tive abil­i­ties are one aspect to accep­tance, but it has to fit into real­ity. The dan­gers of a high infla­tion envi­ron­ment are clear. This “If you build it they will come” men­tal­ity to high infla­tion rate tar­get­ing “Change the rate and peo­ple will adjust and accept it” won’t work in the real world. Just the same as phol­gis­ton, and all bad ideas it is a dogma that attempts to twist real­ity to con­form to it.

  • ak


    The prob­lems which I have with the Aus­trian the­ory are dif­fer­ent — let’s leave this for another dis­cus­sion. I am not aware of any Aus­trian “mod­els” — they have a the­o­ret­i­cal frame­work which indeed pre­dicted the insta­bil­ity because for them infla­tion is sim­ply the change in broad money.

    I was refer­ring to the neo­clas­si­cal mod­els employed by the IMF to “prove” that infla­tion tar­get­ting is the best way to fine-tune the econ­omy.

    How can you inte­grate a dif­fer­en­i­tal equa­tion from time t=now to t=now+10 years to get a value of a para­me­ter for t=now? This can be only achieved if you make cer­tain oner­ous assump­tions like ratio­nal behav­iour of the agents (the per­fect knowl­edge of the future out­come). Oth­er­wise all you get is chaos. I can assure you that eco­nom­ics is the only “sci­ence” where this kind of rub­bish is in use. Nobody who has a slight­est idea how the real feed­back sys­tems work would ever attempt that. Can you imag­ine an elec­tronic engi­neer doing that? I can­not. We can only assume that the state of the sys­tem at t=now affects the state at t=now+delta (delta greater than 0) and then model the sys­tem step-by-step. That’s why I think that the Steve’s approach is right. 

    Jay For­rester and Wynne God­ley laid foun­da­tions of that approach.

    But this kind of mod­el­ling is not used often in the neo­clas­si­cal world. Even the TRYM model is a set of triv­ial sec­ond order damp­ened oscil­la­tors anchored to long-term equi­lib­rium val­ues.

    The whole NAIRU con­cept is based on the expec­ta­tions about the future infla­tion.

    Can it be right?

    There is no proof that CPI infla­tion tar­get­ting at 2–3% over the cycle actu­ally pre­vents other nasty effects like asset price infla­tion (bub­bles). There is also no proof that 5–10% infla­tion can­not be kept in check so that there is no hyper­in­fla­tion. There are fis­cal tools avail­able to remove the excess liq­uid­ity from the sys­tem the only prob­lem is that peo­ple can be eas­ily manip­u­lated to reject them. It is all good if peo­ple have to spend extra 20% of the income on the inter­ests as one may pre­tend that this is the “mar­ket” what sets them. If taxes are to be increased by 20% every­one will protest. What is the dif­fer­ence?

    Nobody has proven any long-term adverse effects of mod­er­ate CPI infla­tion with­out using the the­o­ret­i­cal frame­work which has been com­pletly dis­cred­ited by the GFC (but is still in use).

  • ferb

    Inter­est­ing read­ing in the online news­pa­pers this morn­ing.

    Mel­bourne — don’t know if they are arthur or marthur, appa­rantly an abun­dance of sup­ply is nothin to worry about

    Demand is greater than in NY — well i’ve lived in NY and what a load of…

    Seems they need to fig­ure out another way to arti­fi­cially keep the prices up.…yeh lets have reform so to stop the down­ward spi­ral!

    Well infla­tions up…

    or wait…is it?

  • shy­lam­orales

    great stuff!

  • Neeraj Kulka­rni

    Cash flow equiv­a­lent at coun­try level: if we look at house hold debt, and debt to gdp ratio Switzer­land is high­est ranked. But you I read some­where men­tion­ing that swizz econ­omy is not in trou­ble because the invest­ments are in assets that gen­er­ate CASH FLOW and are not in assets that are spec­u­la­tive. Thus despite high debt, swiss econ­omy is not in trou­ble. My ques­tion is what para­me­ters one can use to esti­mate cash­flow equiv­a­lent at coun­try level? is it about “tax col­lec­tion” amount? is it about aggre­gate per­sonal income of all cit­i­zens? what apareme­ter can give good idea of cash­flow at the coun­try level?