The Chop­ping Block?

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Real­ity came to Real­ity TV in Aus­tralia last week, when 3 of the 4 prop­er­ties in the much-hyped “Flip that House” pro­gram The Block failed to sell at their nation­ally tele­vised auc­tion. A 400 per­son live audi­ence, watched by over 3 mil­lion TV view­ers, couldn’t entice more than one per­son to part with money rather than eye­balls. As the SMH observed:

What­ever the lure of a celebrity house, the would-be buy­ers in Fitzroy Town Hall were just as jit­tery as the would-be buy­ers at any other auc­tion in recent weeks. (“Auc­tion fail­ure shocks The Block”, SMH August 22)

The remain­ing three prop­er­ties sold in the week after the sale, but at a sub­stan­tial loss com­pared to the ini­tial pur­chase prices plus the sums expended on them by the 4 cou­ples in their 2 months of tele­vised ren­o­va­tions (and let’s not men­tion the adver­tis­ing bud­get).

So is the chop­ping of The Block a sign that the days of ever-ris­ing house prices are over? Not if you lis­ten to Chris Joye (“Property’s fine fore­cast”, Busi­ness Spec­ta­tor 25th August 2011). The median fore­cast of the “21 lead­ing mar­ket econ­o­mists” he polled was for 5% growth in nom­i­nal house prices per annum for the next ten years, which Chris notes would sug­gest “that they will likely be 55 per cent higher in 10 years’ time”.

Good luck with that. As Chris notes, my fore­cast wasn’t included, but it should be no sur­prise that I expect a fall in house prices of about 40% over the same time period.

I dif­fer with the 20 who pre­dicted pos­i­tive price growth for one sim­ple rea­son: I focus on the role of debt in dri­ving house prices. Hav­ing argued that debt drove prices up over the last 15 years, I now expect debt to drive them down again.

The mech­a­nism is simple—but it’s not part of con­ven­tional “Neo­clas­si­cal” eco­nom­ics, which is why Chris and his sur­veyed mar­ket econ­o­mists don’t con­sider it. Aggre­gate demand is the sum of income plus the change in debt, and this is spent on both goods and ser­vices and assets. There is thus a link between the change in debt and the level of asset prices (and the frac­tion sold, and the quan­tity pro­duced, but I’ll focus just on just house prices for now).

Going one step fur­ther, the change in aggre­gate demand is the change in income plus the accel­er­a­tion of debt. There is thus a link between the accel­er­a­tion of debt and the rate of change of house prices. If this rela­tion­ship is strong, then ris­ing house prices require that the rate of growth of debt rises over time.

So just how strong is the rela­tion­ship? Using the RBA’s data on mort­gage debt from 1992 till now (there was a break in the series in 1991) and the ABS House Price Index, the cor­re­la­tion between accel­er­at­ing mort­gage debt and the change in real house prices is 0.42 and highly significant—see Fig­ure 1.

Fig­ure 1: The Mort­gage Debt Accel­er­a­tor and change in real house prices

The accel­er­a­tion in mort­gage debt has been volatile, but on aver­age pos­i­tive. For two decades, mort­gage debt has accel­er­ated at 0.5% of GDP per annum. Can that con­tinue for the next ten years?

No way. That sus­tained accel­er­a­tion of debt has caused mort­gage debt to ris­ing dra­mat­i­cally, from less than 30% of house­hold dis­pos­able income in 1991, to a peak of 135% of dis­pos­able income early in 2011 (see Fig­ure 2).

Fig­ure 2: A 4.5 times increase in mort­gage debt com­pared to dis­pos­able income over 2 decades

That’s a 4.5-fold increase over 20 years, com­pared to the 50% fall in mort­gage rates across the same period.
Sim­ply pay­ing the inter­est on out­stand­ing mort­gage debt now con­sumes over 8% of house­hold dis­pos­able income, ver­sus 4% back in 1991—and less than 2% in the 1970s.

Fig­ure 3: A four­fold increase in mort­gage ser­vic­ing vosts since 1980

The sit­u­a­tion is worse when debt repay­ment is taken into account. The cost of pay­ing a 25 year vari­able rate mort­gage on the aver­age First Home Loan has risen from 45% of Aver­age Weekly Earn­ings (AWE) in 1991 to 63% now—and it peaked at 74% of AWE before the “unex­pected” Global Finan­cial Cri­sis forced the RBA to dras­ti­cally cut rates in 2008.

Fig­ure 4: It now takes 2/3rds of the aver­age wage to become a First Home Buyer

Chris real­is­ti­cally observes that house­hold lever­age can’t rise any fur­ther, but implies that this is neu­tral for house prices. But sta­bil­is­ing debt is not neu­tral for house prices: since debt lev­els have risen till now, a sta­ble debt level in the future means decel­er­at­ing debt and falling house prices. Fig­ure 5 shows that the decel­er­a­tion (on an annual basis) began in Octo­ber 2010, and it has gath­ered pace since.

Fig­ure 5: Mort­gage debt decel­er­at­ing

If rather than sta­bil­is­ing debt, Aus­tralian house­holds start to reduce their debt as US house­holds have done (see Fig­ure 6), then house prices would need to defy the grav­ity of decel­er­at­ing debt to keep ris­ing at the 5% nom­i­nal rate (roughly a 2% real rate) that Chris Joye pre­dicts for the next decade.

Fig­ure 6: Mort­gage debt in the USA is now falling

Of course, this is Aus­tralia, where the world is upside down: maybe “this place is dif­fer­ent”?

It will need to be, if the US post-Bub­ble expe­ri­ence is any­thing to go by. The rela­tion­ship between mort­gage debt accel­er­a­tion and change in house prices has held up through the ups and the downs of the US mar­ket since 1986 (with a cor­re­la­tion of 0.78)—see Fig­ure 7. The US expe­ri­ence since 2006 shows what is likely to hap­pen here as the debt bub­ble that fed the hous­ing bub­ble finally comes to an end.

Fig­ure 7: Debt accel­er­a­tion deter­mines change in US house prices

The final retort to the argu­ment that house prices will crash here as they have else­where is that there hasn’t been a bub­ble here, so a crash can’t hap­pen. Chris acknowl­edges that house prices have risen faster than dis­pos­able income per house­hold in Aus­tralia, but attrib­utes that to ratio­nal rather than bub­ble fac­tors:

By way of his­tor­i­cal con­text, dis­pos­able income on a per house­hold basis has aver­aged a healthy 5.8 per cent per annum over the last 10 years, and 4.9 per cent per annum over the past 18 years.

Yet for a range of rea­sons that I have explained many times before – includ­ing the once-off, 40 per cent plus reduc­tion in nom­i­nal inter­est rates over the 1980 to 2011 period – his­tor­i­cal house price appre­ci­a­tion has con­sis­tently out­per­formed dis­pos­able income growth.

For exam­ple, we esti­mate that between 1982 and 2011 median Aus­tralian house prices rose at a 7.7 per cent com­pound annual growth rate. (“Property’s fine fore­cast”, Busi­ness Spec­ta­tor 25th August 2011)

Firstly, as noted ear­lier, a 40% fall in inter­est rates can’t explain the 4.5-fold increase in the house­hold debt to income ratio. Sec­ondly, the argu­ment that debt lev­els have risen because inter­est rates have fallen can’t explain why debt lev­els were much lower in the 1960s when inter­est rates were also lower than today. If house­holds responded ratio­nally to the fall in rates by increas­ing debt lev­els in the 1990s, why didn’t they respond ratio­nally to the increase in rates dur­ing the 70s by reduc­ing debt lev­els?

Mort­gage debt almost dou­bled as a per­cent­age of house­hold dis­pos­able income from the mid-1970s till the early 1990s, even though inter­est rates (adjusted for infla­tion) increased from minus 4% to over 10% across that period. The debt ratio also increased from 75% to over 120% between 2001 and 2008, when real mort­gage rates rose from 0.5% to 6.4% (see Fig­ure 8).

Fig­ure 8: Mort­gage debt rose before real inter­est rates fell

Rather than changes in debt lev­els reflect­ing ratio­nal, equi­lib­rium responses to changes in inter­est rates, the growth in mort­gage debt was the fuel for a Ponzi Scheme that has pro­pelled house prices far faster than incomes have risen.

Bubbles upon Bubbles

There have been 3 big bub­bles in Aus­tralian hous­ing in the last 50 years, all dri­ven by accel­er­at­ing lev­els of pri­vate debt: the late-60s to early 70s bub­ble focused on Syd­ney; the 1988 bub­ble when the 2nd incar­na­tion of the First Home Ven­dors Scheme trans­ferred spec­u­la­tion from the busted stock mar­ket into hous­ing; and our cur­rent one since 1997, which has been dri­ven by accel­er­at­ing mort­gage debt and gov­ern­ment policy—by both Lib­eral and Labor—with the First Home Ven­dors Scheme being used to give the econ­omy a sharp stim­u­lus to avoid reces­sion.

Fig­ure 9: Bub­bles upon bub­bles in Aus­tralian hous­ing

These bub­bles have been built on each other only because the debt has con­tin­ued to accel­er­ate. But now that Aus­tralia has reached a mort­gage debt to GDP ratio that exceeds the worst ever expe­ri­enced in the USA (see Fig­ure 10), the days of accel­er­at­ing mort­gage debt are over—and so are the days of prices ris­ing faster than incomes.

Fig­ure 10: Mort­gage debt grew faster in Aus­tralia than in the USA

Even to sim­ply elim­i­nate the impact of the last bub­ble that began in 1997, prices would need to fall 40 per­cent (com­pared to incomes) from their cur­rent lev­els. Aus­tralia is now start­ing to expe­ri­ence the same process of debt delever­ag­ing and falling house prices that Amer­ica has been mired in for the last five years. The one sav­ing grace we have is China—so long as China con­tin­ues to grow and drive demand and prices for our raw mate­ri­als. But as recent eco­nomic data has indi­cated, even China may not be enough to stop unem­ploy­ment ris­ing in Aus­tralia, now that Australia’s debt dri­ven love affair with house prices is on The Chop­ping Block.

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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  • suvikasb

    Another good one Prof.
    One aspect you haven’t touched on is the length­en­ing of the mort­gage period over the last few decades. A 30 yr is stan­dard in the US now, and even here, in India, I am see­ing more of 20 yr. This, cou­pled with the reduc­tion in inter­est rates, have made ‘ser­vic­ing’ of mort­gage eas­ier — to my mind.
    Your thoughts?

  • Hi Suvikasb,

    I thought I had replied to this, but it looks like the post was lost. Yes, this drift in the length of a mort­gage has also been a facet of recent bubbles–the most obvi­ous being the intro­duc­tion of 99 year mort­gages at the peak of the Japan bub­ble.

  • alain­ton

    Heres a UK mort­gage you could be pay­ing off when your 105

    Hal­i­fax is one lender that does not spec­ify a max­i­mum age. It offers one of the most inter­est­ing – or alarm­ing – deals, depend­ing on your point of view: the Retire­ment Home Plan is aimed at retired peo­ple but is not an equity release prod­uct. It’s nor­mally only avail­able to those over 65, and with a max­i­mum term of 40 years you could still be mak­ing pay­ments if you live to 100. This deal only requires the cus­tomer to pay inter­est each month.

    When they die, the prop­erty is sold and the mort­gage repaid out of the pro­ceeds. Those tak­ing out this deal can bor­row up to 75% of their home’s value. Hal­i­fax says they can use the raised cap­i­tal for almost any pur­pose – a new kitchen, a hol­i­day home, etc. And if you have a repay­ment mort­gage with another lender, the bank says you can remort­gage to this plan “and take advan­tage of a lower, inter­est-only, monthly pay­ment”.

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