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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.
steve, any thoughts on glen stevens evidence to parliament. in particular re savings rates.
think it ties in with your excellent piece
http://www.rba.gov.au/monetary-policy/testimonies.html
I’ve just browsed it so far Mahaish; I intend writing a post on both Stevens and Bernanke next week.
and the buyer strike going on in retail land is going to feed into those second incomes that are required to maintain debt service,
and meanwhile the government keeps dreamin of a surplus,
its rome and i can hear voilins in the background
Thanks for this post as someone considering buying a house for the first time I found it very interesting – thanks.
In my ignorance however I wondered if the level of debt really does have to decrease? If more people are entering the housing market then leaving – which you would think reasonable given population growth in Australia – then surely the result of people (like potentially myself) increasing their debt by taking out a new loan for the first time will have a greater impact on the total debt then the number of people paying off their mortgages, so that aggregate debt in the economy can actually continue to grow indefinitely provided that there is an increasing number of new people taking out mortgages?
Population growth could cause aggregate mortgage debt to continue rising Emu,
But as I deconstruct in earlier posts, population growth in the past hasn’t been correlated with house prices because what’s far more important than the absolute growth of population is the change in the proportion of the population that takes out a mortgage.
Your effect could apply, but it would need an extremely strong reversal of trends for that to happen–ie a dramatic increase in population growth, and the new entrants having the readies to enter the market on arrival.
Looking at http://www.rba.gov.au/chart-pack/bond-issuance.html you can see that our governments are now stimulating our economy a lot, by borrowing for infrastructure. There seems to be a lot of focus on deficits, but without that borrowing, our state and federal governments would be running much larger deficit, and whether it is a deficit or borrowing for a nonproductive asset we still have to pay the interest on the bonds. This can’t last forever, the American states are proving that. Then it really gets tough.
Nice article Steve
The ‘Different Here’ blog had a great write up about The Block last week
http://www.differenthere.com/2011/08/real-estate-in-crisis-block-auction.html
Disaster for Nine and the RE industry
Steve Keen, I’ve been curious about something. When a bank processes the sale of an asset via its deposits and loans, it can generate spending by increasing the amount of debt in the system, but also by having debts paid down. When, say, person A buys asset B from person C and immediately sells an asset of the same price to C again, the amount of debt in the system remains stable, but two transactions have taken place. Doesn’t the “aggregate demand = income + change in debt” formula end up missing two spending transactions here? The proof that something is odd is in the following: if the two transactions are handled via separate accounts, i.e. both generate debt rather than one counteracting the other, the economy-wide debt is increased by twice the price of B, and spending would be said to have increased by that amount, but the same transactions have taken place as in the initial example.
I’m probably just misunderstanding this. I would appreciate any clarification on this topic (from anyone).
I had to log in just to say…oh my god, you guys have a show like “flip this house” over there? That marked the top of the housing bubble in the US. Like my story the other day about recognizing we were going to pop when a neighbor started talking about flipping houses. When the average person gets in on the easy money, it is game over. Ouch.
Dear Professor Keen; Television is like sausage casing: it’s there and something
needs to fill it. My proposal, now that housing, both here in the states and down
under are joining hands, is a new series based on the scrip based markets which
are developing in states like Argentina. These bear a striking resemblance to the
medieval fairs of Seville and Lyon, which would last for a month, and where the
operator issued a temporary scrip which was redeemed at the end of the fair. Gold
was not used as a currency, but only to settle the remaining claims at the end of the fair. On another note, Yves Smith over at Naked Capitalism has an absolutely
outstanding short interview with economic anthropologist David Graeber entitled:
“What is debt – An interview……. I know you are incredibly busy, but the 10 minutes max which this would take is DEFINITELY worth it. Hope you get the
chance, am awaiting DE 2 with great anticipation!
From now on all my future comments will start with a title. The purpose is to make it easier for readers to decide if they want to skip my comment or not.
Title: Clarification for LCTesla
I hope that the link below is helpful
http://en.wikipedia.org/wiki/Aggregate_demand#Debt
Steve,
With the rate of change of debt leading changes in asset prices, I was wondering if the data for accelerating/decelerating debt is available in time to make investment decisions based on this relationship? I understand that the data already suggests a large drop in asset prices, but the curves seem to fluctuate between positive and negative on a smaller scales with regular occurrence. Is it possible to make short term investment decisions using this method? If so, have you?
The Sunday Sermon:
http://www.guardian.co.uk/technology/2011/aug/26/eric-schmidt-chairman-google-education
hey centreline,
in our case the government havings 10′s of billions of dollars of cumilative deficits flowing through the forward estimates and a central bank with 475 basis points to play with in terms of the inter bank support rate,
has propped things up, and our irrational exuberance has lasted a little longer than one would have expected,
you guys have congressional budgetary surply grid lock, and the fed has virtualy nowhere to go in terms of interest rates, except may be to bring down rates on longer term maturities, whcih funnily enough might have an impact on mortgage rates in your country,
once we get to zero or near zero interbank support rate in this country, then the jig is up,
we are not there yet, but we may be on the way
Mr Keen
I qoute Glenn Stevens “I’m sorry but job losses are just the reality’
Massive pressure will be apply by the thug unions to slash interest rates, I wonder if Glenn Stevens will get a dirty shovel at his front door?
I hope Glenn Stevens stands firm he will be under great political pressure by all the left wing thugs to slash interest rates.
Mr Glenn Stevens is the best central banker in the world he understands that rising interest rates can actually help the economy.
More savers and pensioners have higher cashflow from interest payments and actually spend the windfall.
Mr Keen we must clean the financial system out, before we blow it up like Mr Greenspan in the USA.
No pain, no gain your walk in the Snowy Mountains is a good example?
You must realise that a carbon tax and higher electricity costs are causing job losses?
Mr Market reacts to a policy before the event as any good trader knows so job losses will happen before the tax is even on the table.
All those extreme greenies don’t care as long as their job is safe and not involved in manufacturing that uses massive expensive electricity.
Greenies will be sitting in some inner city trendy coffee shop, talking about how their so wonderful because we are all saving the planet.
Give me a break some poor soul is losing their job and house because of their narrow minded policy.
Chopping block will be a new government if a early election is forced on these delusional labor/Green leaders.
Hi LCTesla,
When I make that calculation I’m focusing on the change in bank debt, which creates money by creating matching deposits. The same doesn’t apply to a non-bank lender–where debt is created but not additional money.
Hi Bob,
It is quite possibly useful for medium term speculation, though I seriously doubt it would work for high frequency trading. A colleague and I are working on refining the measure. As it happens, my current formula had an unnecessary limitation to the amount of data shown which I’ve now removed. I’ll be posting updated charts on the Australian (& maybe US) Mortgage accelerator later today.
Hi Steve
First, *full disclosure. I work in the Real Estate business and get to see the market week to week.
You make some compelling points and I’m in agreement that real estate prices will retreat.
While the auction of the block overall failed, lets not forget that within a week they’ve all sold. That’s hardly a failure.
My question to you is about your prediction of a 40% decline over the next 15 years. Your point about the absence of growing debt levels means falling asset prices is a good one.
Yet ‘The Market’ has many different components. The price falls in Manhattan have been very different from Los Vegas in the US.
Which areas are you predicting the smallest/ largest price falls to take place?
While I can see many outer suburban housing estates and the 1st home buyers/ Families the inhabit them to see heavy price falls on their assets, I’m not so sure that will be the case for many key inner city suburbs (*excluding new apartments).
Good suburbs with extremely low debt levels seem to be able to drastically cut supply when the market settles or retreats. If your argument also rests on baby boomers ‘cashing out’ at the same time, then I could see part of this thinking.
While different markets are connected, I think your debt level argument will be more relevant in some locations than others.
Either way, your contrarian views are fascinating to read.
Probably the best that can be said about The Block’s relevance to the current state of house prices is that prices are no longer going up at an alarming rate. In this market you can’t flip like what was happening a few years ago, obviously.
Apart from that though, not much can be drawn from the result, and all the houses sold in the end, for what seems pretty decent prices (even if at a loss give the flip aspect).
As a first home buyer, I’d like to see house prices tank, that’s my bias. But even though prices have come off a little, there is no sign of the tanking, no sign that prices are about to plummet — even if you accept the logic of Steve’s debt analysis, which I do.
In my view, it will need a catalyst like increasing unemployment etc, while if China does continue strongly, this might give a soft landing to the de-leveraging. Seems that you have to have forced sales before prices really drop hard.
So it could that Steve is right regarding the importance of private debt, but that his predictions about how big an impact it will have could be off the mark.
It maybe be that China is what makes us different. The good thing for the current first home buyer is that right now waiting and seeing does not mean you are suddenly priced out of the market.
Hi Edward,
Thanks for both the disclosure and the comment.
Yes they sold, but for, what, about $400,000 below cost? The initial purchase price of the wrecks averaged $900,000, they were apparently given an extra storey and restumpted for another $300,000 each, and then $100,000 was spent on them in renovations plus 2 months labour by the couples.
On where the market will fall on a regional basis, the measure is too crude for that; and you’re right that differences in debt levels between regions will play a role there too.
One inbuilt fallacy in aggregate house valuations though is that we value the entire housing stock at the last median price sale times all the available stock (roughly speaking). Of course that drastically overstates the actual value, another reason why I emphasise the first three letters when I talk about the “value” of assets.
Some interesting comments. Steve you pointed out that the debt accelerator is turning positive in the USA. That would fit in with Martin Armstrongs models that showed a turning point in June with house prices probably rising into 2012 ( From memory)but ultimately not bottoming until 2032. That is a 52 year rise from 1955 to 2007 and a decline of 25 years. All based on multiples of 8.6 year cycles. Our post war credit binge which has accelerated of late as your graphs show, I guess based on his model must have started in 1958?
I was intrigued by Sj commending Glen Stevens. Armstrong predicts based on his model that Stevens will raise interest rates. Of course Stevens is no better than any other Central Banker. He is just following the neo classical model as you say. Expand the money supply (some 170 odd percent between 20001 and 2010 I read somewhere) Well if yo do the sums that easily explains why a house that cost $200,000 ten years ago now costs $530,000.
I wish somebody with your clout and who appears on TV would explain what inflation really is to the masses. That is inflation is simply a function of the increase in the money supply. If you increase it by 10% per year as has been the case for 10 odd years now then ultimately prices have to increase by that amount. The CPI is not a measure if inflation. Rising prices of good and services are a RESULT of the inflation of the money supply. Early on the people love it because they see there house prices going up and think they are getting rich but later on that increase in money supply feeds it’s way into everything and the cost of food, power etc goes up. That of course is what we are seeing now. You could see the GFC coming and of course you would have seen the rising cost of living. He Reserve Bank is no better than any other Central Bank in this world. The name sounds very austere and conservative. In fact it is a very radical organization, witness how desperate Bernanke is getting with their Reserve Bank the Fed. When the mining boom finishes here how desperate is our Reserve Bank going to get?
Thanks Dudu,
But I’d better point out that I disagree with that definition of inflation: I stick with the change in CPI measure. One of the reasons for this is that an increase in the money supply can go along with a decline in its velocity of circulation. Another is that technological change can reduce the costs of production, and hence prices. I have always been a critic of the belief that inflation could simply be reduced to change in the money supply.
If people haven’t seen this interview in Der Spiegal with Paul Wolley founder of the wonderfully titled Centre for the Study of Capital Market Dysfunctionality at the LSE they should
http://www.spiegel.de/international/business/0,1518,782315,00.html
Woolley: The developments in recent weeks have made it quite clear that the markets don’t function properly. Things are spinning out of control and are potentially dangerous for society. Only a fraternity of academic high priests connected to the finance markets is still speaking of efficient markets. Still each market participant is pursuing their own selfish interests. The market isn’t reaching equilibrium — it’s falling into chaos.
SPIEGEL: You’ve compared the finance markets to a cancer. What do you mean by that?
Woolley: The finance sector can — and is — growing until it overwhelms the economy. In good years the US finance industry cashes in on more than 40 percent of all corporate profits. In bad years they are saved by the taxpayers. The agents are doing a devilishly good job of developing innovative, complicated new products that people can’t understand. It gives them the opportunity to earn excess returns and attract the best talent. While they are acting rationally, the result is a catastrophe…. I wanted to do something socially useful. We want to revolutionize the finance industry with our institute. You have to build into the models and the self interests of the banks and fund managers to which the most investors have delegated their investment decisions.
Two mainstream articles of interest.
http://smh.domain.com.au/real-estate-news/the-downside-of-government-handouts-for-property-20110826-1jcwn.html
http://www.smh.com.au/business/australians-want-greater-equality-in-wealth-share-20110828-1jgn6.html
* A study prepared by Empirica Research and the Harvard Business School.
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?