RBA Rates Decision & Roy Morgan Unemployment

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The RBA’s decision not to reduce rates this month caught most pundits by surprise—including me. Given the international and local data, I thought they’d err on the side of caution and cut rates.

As I always note when asked to call what the RBA will do next, this is a call on how another body will respond to what they perceive as the economic data and the direction their model of the economy predicts the actual economy will move in. That’s closer to picking which cockroach is going to walk out of a circle first in a Changi prison gambling den than it is to economic forecasting per se (which is dubious enough activity in itself). So making a wrong guess about what the RBA will do is not the same as making a wrong economic forecast; you’re just making a different forecast of the future than is the RBA.

The RBA’s explanation for its decision shows that it is making a rosy call of both the current data and the direction in which the Australian economy is headed.

Information on the Australian economy continues to suggest growth close to trend… the unemployment rate increased slightly in mid year, though it has been steady over recent months… In underlying terms, inflation is around 2½ per cent… the Bank expects inflation to be in the 2–3 per cent range.

Credit growth remains modest, though there has been a slight increase in demand for credit by businesses. Housing prices showed some sign of stabilising at the end of 2011, after having declined for most of the year. The exchange rate has risen further, even though the terms of trade have started to decline … With growth expected to be close to trend and inflation close to target, the Board judged that the setting of monetary policy was appropriate for the moment.

As the Sydney Morning Herald editorialised, the RBA message was that the future looks good:

MOVE right along folks. Nothing to see here. By keeping interest rates on hold this week, the Reserve Bank is sending a subconscious message to borrowers: the economy is doing reasonably well. There is no need to panic…

Although we in NSW seem bogged Eeyore-like in our sad and dank little corner of the forest, glumly chewing our thistles day after day, perhaps we really ought to cheer up. Gloom is not just miserable in itself. When it comes to the economy, it’s dangerous.

This is not the take that the majority of economic pundits have on the data—and for once, I’m with the majority. Normally the majority is bullish (because they have a Neoclassical perspective on the economy that largely ignores credit, and thinks the economy always returns to equilibrium) and I’m bearish (because I have a “Post Keynesian” perspective that sees credit as the key motive economic force, and believes the economy is always in disequilibrium).

The majority of economic pundits lined up with me for a change because there was a range of data that implied the economy was stalling. Firstly, unemployment has been trending up, and the “steady over recent months” phenomenon that the RBA referred to above was entirely due to a fall in the participation rate. Had this remained at the November level, the ABS unemployment rate would have jumped to 5.6% last month.

Figure 1

And that’s the good news: as was widely reported, employment fell by almost 30,000 last month, so that net job growth in 2011 was zero—the worst outcome in 20 years.

Secondly, a broader measure of unemployment maintained by Roy Morgan Research hit 10.3 percent—5 percent above the ABS figure. The ABS treats someone who has worked for one hour in the previous two weeks as employed, a definition that Roy Morgan rightly rejects:

“Surely if someone is not working, is looking for work and considers themselves to be unemployed, then they should be considered unemployed regardless of whether they happen to have done a couple of hours work here and there during the month?”

The ludicrous official definition of unemployment is a classic case of bureaucracies (including the United Nations International Labor Organization in this case) eliminating a problem by redefining it rather than solving it. Many people have criticised this definition (including Peter Brain from the National Institute for Economic and Industry Research, who found that over a dozen official redefinitions of unemployment had all reduced the recorded level); since the late 1990s, Roy Morgan has gone one better and conducted a monthly survey using a definition of unemployment that actually makes sense:

” According to the ABS definition, a person who has worked for one hour or more for payment or someone who has worked without pay in a family business, is considered employed regardless of whether they consider themselves employed or not.

The ABS definition also details that if a respondent is not actively looking for work (ie: applying for work, answering job advertisements, being registered with Centre-link or tendering for work), they are not considered to be unemployed.

The Roy Morgan survey, in contrast, defines any respondent who is not employed full or part-time and who is looking for paid employment as being unemployed. ” (Roy Morgan, September 2011)

Roy Morgan’s definition therefore necessarily records a higher level of unemployment than the ABS—and they are also a more legitimate measure of real unemployment. However their results are also more volatile, since their sample is smaller than the ABS’s, and the results are not seasonally adjusted.

Figure 2

Overall however, Roy Morgan’s figures are a more accurate indicator of the level of unemployment than the ABS’s, and also as a harbinger of where the ABS data may move in the future. The current gap between the two measures is the highest it has ever been—over 5 percent, when the average gap has been about 2.5 percent—and this implies that the next move in the ABS figures could be substantially upwards. Gary Morgan warned that the economy is a lot weaker than the RBA seems to think:

“Today’s Roy Morgan unemployment estimates strongly support anecdotal evidence of continuing job losses throughout Australia. Just in the past week we have been told that Westpac has announced 550 jobs to go; ANZ is axing 130 jobs; Holden will cut 200 jobs at its Adelaide plant; Toyota will cut 350 jobs in Melbourne; Reckitt Benckiser (maker of Mortein & Dettol) is to retrench 200 jobs at its Sydney operations; defence firm Thales shedding 50 jobs in Bendigo — these are just the most prominent examples of job losses occurring in the Australian economy!

“Economists and politicians are wrong to talk about a ‘tight’ labour market in Australia driving wage pressures. Wage demands (inflation) at the moment are being driven by unions — a small minority of the Australian workforce — not by a tight labour market with workers changing jobs to secure better wages and conditions. Today’s Roy Morgan employment estimates show why inflation in Australia is contained, and will remain contained — at its meeting next Tuesday the RBA must drop interest rates by at least 0.5% and probably more.”

Figure 3


If Gary Morgan is right, the RBA’s rosy forecast for the future will be shown to be in error. The primary source of that error will be not merely misplaced optimism, but reliance upon neoclassical economic models about the economy that ignore the role of credit just at the moment that decelerating credit is finally setting in in earnest in Australia, after being delayed by the First Home Vendors Boost.

Figure 4

The First Home Vendors Boost was the sole cause of the reversal of deleveraging in Australia after the crisis began, with the growth in mortgages more than offsetting the reduction in debt by the business sector.

Figure 5

With that artificial stimulus to credit growth over, credit growth is now decelerating in Australia, and causing unemployment to rise despite the offsetting impact of the resources boom.

Figure 6

Mortgage debt is now decelerating strongly, and taking house prices down with it.

Figure 7

From its comment that “Housing prices showed some sign of stabilising at the end of 2011”, the RBA appears to be buying the RPData spin that a one month upwards blip in their data series after 11 months of decline signals a bottom to the housing market. However a simple comparison of house prices here to those in Japan and the USA after their bubble economies burst makes it hard to argue that “Australia is different”.

Figure 8

Of course, at this stage it is too early to tell whether we’ll follow the long slow decline of Japanese prices, or the sudden fall that marked the USA. But by the end of 2012, Australia’s house price decline profile should be apparent.

Figure 9

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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74 Responses to RBA Rates Decision & Roy Morgan Unemployment

  1. glubilee says:

    As to Aus housing markets, consider trend in US…imagine what young adult employment does to household unemployment. Over 20 percent of young men in US are now living with parents,this number has doubled in the last decade or so. And youngsters in US are most debt distressed folks, without buying a house, they are drowning to student loan debt, that cannot be discharged via bankruptcy typically. What does this do to our future housing market, economy, household formation. Rents up for now, I think due a temp one time shift away for people wanting to live in houses/buy houses in suburbs and instead live in apt complexes that are in convenient neighborhoods. Once housing supply has aught up to historic shift in type of demand, rents will decrease again.


  2. koonyeow says:

    Title: Lecturing Birds on Flying

    @ Lyonwiss February 12, 2012 at 10:57 pm

    I think that Pablo Triana will agree with you too.


  3. clive says:

    “so as long as american spending power is maintained in its sovereign currency and it is willing to run an external deficit with the rest of the world, foreigners have no choice but to accumilate dollar assetts thus maintaining the demand for the dollar

    the americans still have the largest economy in the world and
    americans have to pay their taxes in greenbacks, and if foreigners want to do business with americans they have to do business in greenbacks.”

    Putting aside the current kaos in the in the EU. Would it be true to say that one of the biggest threats to American supremacy is changes to the common currency, the Euro, as that would allow what you say to occur? It would appear a common central bank with the ability to ‘print’ could be deleterious to the US.

    Wasn’t Iran trading oil in Euros already?

  4. RJ says:

    The euro is no threat at all to the US dollar.

    As euro countries can not run large deficits as they are not monetary sovereign

    -Where does money come from. Answer. From debt. Either non Govt or Govt
    -How much debt can the non Govt take on. Answer. Only so much
    -What do people need money for. Answer. For consumption and esp as we age for savings. Money is needed for savings then an asset is needed (eg bonds) to invest this money in. Govt bonds release money then bonds drain this money if purchased by a non bank.

    We are currently worldwide very short of financial assets saved for retirement. So the need for debt is massive

  5. mahaish says:

    great insight lyonwiss on black scholes.

    the only thing i would say is that some of these products were designed to fail and people took bets on them failing.

    so its not totally correct to argue that they only new about the failure after the fact.

  6. TruthIsThereIsNoTruth says:

    Regarding financial engineering and the crisis

    Its true that ultimately it was due human greed, but there are theoretical lessons to be learnt as well. However these lessons are a long way from black scholes. In fact the lesson about black schole assumptions was learnt in 87. This time round the theoretical inadequacy of CDO pricing was the assumption behind default correlation, this was modelled as a constant small number, which was consistent with default history at the time. What it missed is the contagion effect, or the dependance of default correlation to economic conditions. If this was considered the consequences would be that the CDO price would show that these are not economically viable products and they would not receive AAA ratings. I personally believe that this is the reason it wasn’t considered. I can imagine the analysts having to come up with a model that made these products look attractive…

    Allainton, black scholes got a lot of traction academically and in practice due to the availability of closed form solution. Academics love it because the maths behind it is interesting and extendible, so they could produce research. Practitioners at the time liked it because of the computational efficiency of closed form pricing and really the lack of anything tractably better at the time. Things have changed since, the BS argument is at least 20 years old and only keeps being bashed out at some marginal academic institutions. Students are still taught it as a starting point to option pricing, but where it is taught properly BS is put in the correct historical context.

  7. clive says:

    RJ I agree, the point I was making is that should they head down one central bank model as some Europhiles have suggested and they were prepared to run deficits it’s probably a bigger player then the US. It seems every time Timmy G turns up there he seems to be encouraging them to do just that. Which if they did (I know unlikely) might not play out so well for the US.
    China already exports more into the EU than the US.

  8. RJ says:


    The US (and the world) would be MUCH better off not worse off with more Euro Govt debt financed by the ECB.

  9. joshua says:

    Dont know if this is one of Chris hurried articles as usual or whether Guy Debelle has realized the RBA is now irrelevant so better option is to side with the banks hoping that people dont realize this? http://www.smh.com.au/business/rba-backs-banks-over-higher-borrowing-costs-20120214-1t2ry.html

    The guys at Business Spectator have written something useful http://www.moneymorning.com.au/20120213/at-2-35pm-last-friday-the-rba-became-irrelevant.html. I must admit they are confusing me. one time they say stocks prices are 40% overvalued and a crash is imminent. Then they say market is heading for a highs since last April.

  10. joshua says:

    sorry that should be money morning!

  11. mahaish says:

    hi clive,

    the europeans have one central bank,

    but the problem is that the ECB is not prepared to act, or it argues the laws governing it prevent it from acting in the current crisis

    and infact national governments are sovereign in euros,

    that is domestic treasuries through their own central banks can theoretically create as many euro deposits as they like.

    thats how this whole euro problem came to light in that some if not all governments were in controvention of their maastreicht deficit ratios.

    the only way they could have been breaking the rules is by creating excess euro deposits in their domestic banking system

    and those excess euro deposits needed to be neutralised by the national central banks through bond issuance so that national interest rates match the interbank rate target set by ECB.

    and the rest is history.

    the fundamentsl problem is the single currency and the single interbank interest rate itself . its basically a de facto gold standard system, in that trade surplus nations accumilate euro’s while there is a euro drain from the deficit nations.
    which needs to be financed by the debt markets.

    recipe for disaster.

    and there is no single taxation power either, so you get the fiscal mess in greece as a consequence, since the euros value isnt driven by the taxation framework.

    think rj is right,

    the euros is toast, and the yanks have nothing to fear.unless the ECB is given the power firstly to neutralise the bond markets, and the euro zone is prepaired re draw the maastreicht guidlines.

    just as an aside, if you want to park your money right now on some US treasury assetts, you have to pay the fed. thats right you have to pay them not the other way around. so much is the demand for US government financial assetts.

    so much for all those predicting the hyper inflationary demise of the greenback

  12. centerline says:

    It is not about the sovereigns and soveriegn debt. It is about the banks. All of these banking institutions are interconnected via counterparty exposure relative to both private debts AND sovereign debts – much of which exists out of sight in the shadow banking system – in a space where banking liquidity is only by suspension of normal practice (mark to market), ongoing central bank intervention, and recursive gains obtained almost entirely by expanding leverage (i.e. rehypothecation). You cant simply decouple Euro woes from Greenback problems and vice versa and everyone knows it. Just take a look at the Greek drama. The reality is that facade is very thin and cannot be allowed to break (until it is time for it to be broken). The PRIVATE banking system has no allegiance to any country and this is who is in the drivers seat.

    Regarding the EU, I agree it is toast. Regarding the fate of the USD… who knows. This is a tough one. But, fat lady hasn’t even warmed up yet – so I wouldn’t place bets either way (I would hedge though).

  13. RickW says:

    MF Global was not too big to fail. The background to its failure is not unusual in terms of the practices within financial businesses. If you can watch the series of congressional hearings on the demise without getting ill then it is instructive in how greed overrides the prudence you would hope the minders of your money display:

    No one knows how the risks are spread but given Goldman Sachs are now directly in charge of Greece and Italy it is certain that GS stand to lose a bundle when these countries default.

    Also I expect the politicians will have a much higher hurdle with regard to what is too big to fail next time around.

  14. mahaish says:

    “It is not about the sovereigns and soveriegn debt. It is about the banks. All of these banking institutions are interconnected via counterparty exposure relative to both private debts AND sovereign debts”

    well yes it is centreline,

    about sovereign debt in non sovereign framework.

    but you have a point since those excess euro deposits ended up in either domestic national banks, or german and french banks where the liquidity swaps occured.

  15. mahaish says:

    actually i should add that my first post was inaccurate in that not only did the excess deposits occure in the domestic banking systems, but also in export power houses like germany, which presented them with a sterilisation problem as well.

  16. GG says:

    you really need to sit down with Alan Kohler and give him a good lesson! There he is today on Business Spectator making the discovery that our problem is debt because of high land prices, but then trying to say it’s because excessive regulation, etc, etc.

    Hasn’t he ever read your stuff on the high correlation between mortgage finance acceleration and land price?

  17. Steve Hummel says:

    This whole mess is about the survival of the current financial system……not the people who happen to reside in its various countries. If it was about the survival of the individuals there the governments would have simultaneously bailed out both the Banks AND the people with $50k/family every 6 mos. with 75% of that mandated to reduce personal /business debt and then rinse and repeat until everyone had like 50% equity in their homes and their other debts were paid off. This would have saved the Banks from their bad loans and hair cutted their income at the same time, and of course given the consumer a huge breath of fresh air which they haven’t been given since the American Homestead Act expropriated Native Indian lands. ?

    You want the economy to run on all cylinders and protect it from recession/depression give the consumer money, enough money to at least liquidate production as it comes to the market, and do it in perpetuity. There are a few other things that need to be watched and/or regulated/banned, but its all much simpler than its usually made out to be.

  18. Steve Keen says:

    Yes, I know. I deal with the editors there, who know my work rather better than does Alan.

  19. taddles says:

    One day we WILL see one of Steve’s analyses in mainstream media but let’s all hope it’s as a forewarning and not a post mortem of a housing bubble crash.

    I’ve just bought a beautiful, large seaside property for half the price of 3 years ago and cheaper than 6 years ago. That’s cheap enough for me and I bought for old-fashioned reasons of having a place to call home. The banks are refusing mortgage business in this town so values are realisitic.

  20. Amotzza says:

    Taddles, If you want to buy some more seaside or farming property let me know. As we all know it takes 2 to tango – in regard approx $2M+ property it took me 1 year to sell a Toorak Victoria property 1/3 below bank valuation and I have had another Mornington Peninsula property on the market for over 1 year – the interest and flow of money has really slowed.

  21. Endless says:

    Interesting Taddles,

    Despite falls in house prices this doesn’t mean buying a home now is necessarily a bad move, for at least the reason you suggest — to have a place to call home. If house prices continue to fall then at least if you sell in a few years the rest of the market will have also fallen so you purchasing power will be roughly the same for another home — assuming of course equity hasn’t been completely eroded.

    The opposite was true, of course, for the family home buyer and seller in the up and up market: you may have made so much money on paper, but if you were looking for a another property to buy arguably it had gone up a similar percentage.

    It is refreshing to think of buying a house as somewhere to live rather than a place to brag about or to make squillions off.

    It’s the property investor market which is really interesting, at what point do investors decide that running a loss for tax reasons just doesn’t add up it if capital gains are disappearing.

  22. taddles says:

    Exactly Endless, buying now does not suppose a return to the old technical high. It does mean for sure that I didn’t pay that which is real comfort.

    The flood of real estate media spin also includes that the elderly should oblige by “downsizing” which is euphemism for “dying a bit”. I have upsized substantially and have every facility imaginable. Already I am receiving enquiries to slice my block into little pieces to build the jail cells AKA apartments that developers dream.

    Amotzza, no need for more. One nice house is enough.

  23. foxbat101 says:

    Working out of debt
    An update of our research on the efforts of developed countries to work out from under a massive overhang of debt shows how uneven progress has been. US households have made the greatest gains so far.
    JANUARY 2012 • Karen Croxson, Susan Lund, and Charles Roxburgh
    Source: McKinsey Global Institute

    In This Article
    Sidebar: Deleveraging: Where are we now?
    Sidebar Exhibit
    Exhibit 1: Although the debt ratio of US households remains high, they may be halfway through the deleveraging process.
    Exhibit 2: In the United States, household deleveraging may have only a few more years to go, while in Spain and the United Kingdom it has just begun.
    Exhibit 3: If forbearance is factored in, up to 14 percent of UK mortgages could be in difficulty—identical to the percentage of US mortgages in difficulty today.
    Exhibit 4: Signi?cant public-sector deleveraging typically occurs after GDP growth rebounds.
    About the authors
    Comments (11)
    The deleveraging process that began in 2008 is proving to be long and painful. Historical experience, particularly post–World War II debt reduction episodes, which the McKinsey Global Institute reviewed in a report two years ago, suggested this would be the case.1 And the eurozone’s debt crisis is just the latest demonstration of how toxic the consequences can be when countries have too much debt and too little growth.
    We recently took another look forward and back—at the relevant lessons from history about how governments can support economic recovery amid deleveraging and at the signposts business leaders can watch to see where economies are in that process. We reviewed the experience of the United States, the United Kingdom, and Spain in depth, but the signals should be relevant for any country that’s deleveraging.

    Toggle Sidebar

    Deleveraging: Where are we now?

    Back to top
    Overall, the deleveraging process has only just begun. During the past two and a half years, the ratio of debt to GDP, driven by rising government debt, has actually grown in the aggregate in the world’s ten largest developed economies (for more, see sidebar, “Deleveraging: Where are we now?”). Private-sector debt has fallen, however, which is in line with historical experience: overextended households and corporations typically lead the deleveraging process; governments begin to reduce their debts later, once they have supported the economy into recovery.
    Different countries, different paths

    In the United States, the United Kingdom, and Spain, all of which experienced significant credit bubbles before the financial crisis of 2008, households have been reducing their debt at different speeds. The most significant reduction occurred among US households. Let’s review each country in turn.
    The United States: Light at the end of the tunnel
    Household debt outstanding has fallen by $584 billion (4 percent) from the end of 2008 through the second quarter of 2011 in the United States. Defaults account for about 70 and 80 percent of the decrease in mortgage debt and consumer credit, respectively. A majority of the defaults reflect financial distress: overextended homeowners who lost jobs during the recession or faced medical emergencies found that they could not afford to keep up with debt payments. It is estimated that up to 35 percent of the defaults resulted from strategic decisions by households to walk away from their homes, since they owed far more than their properties were worth. This option is more available in the United States than in other countries, because in 11 of the 50 states—including hard-hit Arizona and California—mortgages are nonrecourse loans, so lenders cannot pursue the other assets or income of borrowers who default. Even in recourse states, US banks historically have rarely pursued borrowers.
    Historical precedent suggests that US households could be up to halfway through the deleveraging process, with one to two years of further debt reduction ahead. We base this estimate partly on the long-term trend line for the ratio of household debt to disposable income. Americans have constantly increased their debt levels over the past 60 years, reflecting the development of mortgage markets, consumer credit, student loans, and other forms of credit. But after 2000, the ratio of household debt to income soared, exceeding the trend line by about 30 percentage points at the peak (Exhibit 1). As of the second quarter of 2011, this ratio had fallen by 11 percent from the peak; at the current rate of deleveraging, it would return to trend by mid-2013. Faster growth of disposable income would, of course, speed this process.

    Back to top
    We came to a similar conclusion when we compared the experiences of US households with those of households in Sweden and Finland in the 1990s. During that decade, these Nordic countries endured similar banking crises, recessions, and deleveraging. In both, the ratio of household debt to income declined by roughly 30 percent from its peak. As Exhibit 2 indicates, the United States is closely tracking the Swedish experience, and the picture looks even better considering that clearing the backlog of mortgages already in the foreclosure pipeline could reduce US household debt ratios by an additional six percentage points.

    Back to top
    As for the debt service ratio of US households, it’s now down to 11.5 percent—well below the peak of 14.0 percent, in the third quarter of 2007, and lower than it was even at the start of the bubble, in 2000. Given current low interest rates, this metric may overstate the sustainability of current US household debt levels, but it provides another indication that they are moving in the right direction.
    Nonetheless, after US consumers finish deleveraging, they probably won’t be as powerful an engine of global growth as they were before the crisis. That’s because home equity loans and cash-out refinancing, which from 2003 to 2007 let US consumers extract $2.2 trillion of equity from their homes—an amount more than twice the size of the US fiscal-stimulus package—will not be available. The refinancing era is over: housing prices have declined, the equity in residential real estate has fallen severely, and lending standards are tighter. Excluding the impact of home equity extraction, real consumption growth in the pre-crisis years would have been around 2 percent per annum—similar to the annualized rate in the third quarter of 2011.
    The United Kingdom: Debt has only just begun to fall
    Three years after the start of the financial crisis, UK households have deleveraged only slightly, with the ratio of debt to disposable income falling from 156 percent in the fourth quarter of 2008 to 146 percent in second quarter of 2011. This ratio remains significantly higher than that of US households at the bubble’s peak. Moreover, the outstanding stock of household debt has fallen by less than 1 percent. Residential mortgages have continued to grow in the United Kingdom, albeit at a much slower pace than they did before 2008, and this has offset some of the £25 billion decline in consumer credit.
    Still, many UK residential mortgages may be in trouble. The Bank of England estimates that up to 12 percent of them may be in some kind of forbearance process, and an additional 2 percent are delinquent— similar to the 14 percent of US mortgages that are in arrears, have been restructured, or are now in the foreclosure pipeline (Exhibit 3). This process of quiet forbearance in the United Kingdom, combined with record-low interest rates, may be masking significant dangers ahead. Some 23 percent of UK households report that they are already “somewhat” or “heavily” burdened in paying off unsecured debt.2 Indeed, the debt payments of UK households are one-third higher than those of their US counterparts—and 10 percent higher than they were in 2000, before the bubble. This statistic is particularly problematic because at least two-thirds of UK mortgages have variable interest rates, which expose borrowers to the potential for soaring debt payments should interest rates rise.

    Back to top
    Given the minimal amount of deleveraging among UK households, they do not appear to be following Sweden or Finland on the path of significant, rapid deleveraging. Extrapolating the recent pace of UK household deleveraging, we find that the ratio of household debt to disposable income would not return to its long-term trend until 2020. Alternatively, it’s possible that developments in UK home prices, interest rates, and GDP growth will cause households to reduce debt slowly over the next several years, to levels that are more sustainable but still higher than historic trends. Overall, the United Kingdom needs to steer a difficult course that reduces household debt steadily, but at a pace that doesn’t stifle growth in consumption, which remains the critical driver of UK GDP.
    Spain: The long unwinding road
    Since the credit crisis first broke, Spain’s ratio of household debt to disposable income has fallen by 4 percent and the outstanding stock of household debt by just 1 percent. As in the United Kingdom, home mortgages and other forms of credit have continued to grow while consumer credit has fallen sharply.
    Spain’s mortgage default rate climbed following the crisis but remains relatively low, at approximately 2.5 percent, thanks to low interest rates. The number of mortgages in forbearance has also risen since the crisis broke, however. And more trouble may lie ahead. Almost half of the households in the lowest-income quintile face debt payments representing more than 40 percent of their income, compared with slightly less than 20 percent for low-income US households. Meanwhile, the unemployment rate in Spain is now 21.5 percent, up from 9 percent in 2006. For now, households continue to make payments to avoid the country’s conservative recourse laws, which allow lenders to go after borrowers’ assets and income for a long period.
    In Spain, unlike most other developed economies, the corporate sector’s debt levels have risen sharply over the past decade. A significant drop in interest rates after the country joined the eurozone, in 1999, unleashed a run-up in real-estate spending and an enormous expansion in corporate debt. Today, Spanish corporations hold twice as much debt relative to national output as do US companies, and six times as much as German companies. Debt reduction in the corporate sector may weigh on growth in the years to come.
    Signposts for recovery

    Paring debt and laying a foundation for sustainable long-term growth should take place simultaneously, difficult as that may seem. For economies facing this dual challenge today, a review of history offers key lessons. Three historical episodes of deleveraging are particularly relevant: those of Finland and Sweden in the 1990s and of South Korea after the 1997 financial crisis. All these countries followed a similar path: bank deregulation (or lax regulation) led to a credit boom, which in turn fueled real-estate and other asset bubbles. When they collapsed, these economies fell into deep recession, and debt levels fell.
    In all three countries, growth was essential for completing a five- to seven-year-long deleveraging process. Although the private sector may start to reduce debt even as GDP contracts, significant public-sector deleveraging, absent a sovereign default, typically occurs only when GDP growth rebounds, in the later years of deleveraging (Exhibit 4). That’s true because the primary factor causing public deficits to rise after a banking crisis is declining tax revenue, followed by an increase in automatic stabilizer payments, such as unemployment benefits.3 A rebound of economic growth in most deleveraging episodes allows countries to grow out of their debts, as the rate of GDP growth exceeds the rate of credit growth.

    Back to top
    No two deleveraging economies are the same, of course. As relatively small economies deleveraging in times of strong global economic expansion, Finland, South Korea, and Sweden could rely on exports to make a substantial contribution to growth. Today’s deleveraging economies are larger and face more difficult circumstances. Still, historical experience suggests five questions that business and government leaders should consider as they evaluate where today’s deleveraging economies are heading and what policy priorities to emphasize.
    1. Is the banking system stable?
    In Finland and Sweden, banks were recapitalized and some were nationalized. In South Korea, some banks were merged and some were shuttered, and foreign investors for the first time got the right to become majority investors in financial institutions. The decisive resolution of bad loans was critical to kick-start lending in the economic- rebound phase of deleveraging.
    The financial sectors in today’s deleveraging economies began to deleverage significantly in 2009, and US banks have accomplished the most in that effort. Even so, banks will generally need to raise significant amounts of additional capital in the years ahead to comply with Basel III and national regulations. In most European countries, business demand for credit has fallen amid slow growth. The supply of credit, to date, has not been severely constrained. A continuation of the eurozone crisis, however, poses a risk of a significant credit contraction in 2012 if banks are forced to reduce lending in the face of funding constraints. Such a forced deleveraging would significantly damage the region’s ability to escape recession.
    2. Are structural reforms in place?
    In the 1990s, each of the crisis countries embarked on a program of structural reform. For Finland and Sweden, accession to the European Union led to greater economies of scale and higher direct investment. Deregulation in specific industry sectors—for example, retailing—also played an important role.4 South Korea followed a remarkably similar course as it restructured its large corporate conglomerates, or chaebol, and opened its economy wider to foreign investment. These reforms unleashed growth by increasing competition within the economy and pushing companies to raise their productivity.
    Today’s troubled economies need reforms tailored to the circumstances of each country. The United States, for instance, ought to streamline and accelerate regulatory approvals for business investment, particularly by foreign companies. The United Kingdom should revise its planning and zoning rules to enable the expansion of successful high-growth cities and to accelerate home building. Spain should drastically simplify business regulations to ease the formation of new companies, help improve productivity by promoting the creation of larger ones, and reform labor laws.5 Such structural changes are particularly important for Spain because the fiscal constraints now buffeting the European Union mean that the country cannot continue to boost its public debt to stimulate the economy. Moreover, as part of the eurozone, Spain does not have the option of currency depreciation to stimulate export growth.
    3. Have exports surged?
    In Sweden and Finland, exports grew by 10 and 9.4 percent a year, respectively, between 1994 and 1998, when growth rebounded in the later years of deleveraging. This boom was aided by strong export-oriented companies and the significant currency devaluations that occurred during the crisis (34 percent in Sweden from 1991 to 1993). South Korea’s 50 percent devaluation of the won, in 1997, helped the nation boost its share of exports in electronics and automobiles.
    Even if exports alone cannot spur a broad recovery, they will be important contributors to economic growth in today’s deleveraging economies. In this fragile environment, policy makers must resist protectionism. Bilateral trade agreements, such as those recently passed by the United States, can help. Salvaging what we can from the Doha round of trade talks will be important. Service exports, including the “hidden” ones that foreign students and tourists generate, can be a key component of export growth in the United Kingdom and the United States.
    4. Is private investment rising?
    Another important factor that boosted growth in Finland, South Korea, and Sweden was the rapid expansion of investment. In Sweden, it rose by 9.7 percent annually during the economic rebound that began in 1994. Accession to the European Union was part of the impetus. Something similar happened in South Korea after 1998 as barriers to foreign direct investment fell. These soaring inflows helped offset slower private-consumption growth as households deleveraged.
    Given the current very low interest rates in the United Kingdom and the United States, there is no better time to embark upon investments. Those for infrastructure represent an important enabler, and today there are ample opportunities to renew the aging energy and transportation networks in those countries. With public funding limited, the private sector can play an important role in providing equity capital, if pricing and regulatory structures enable companies to earn a fair return.
    5. Has the housing market stabilized?
    During the three historical episodes discussed here, the housing market stabilized and began to expand again as the economy rebounded. In the Nordic countries, equity markets also rebounded strongly at the start of the recovery. This development provided additional support for a sustainable rate of consumption growth by further increasing the “wealth effect” on household balance sheets.
    In the United States, new housing starts remain at roughly one-third of their long-term average levels, and home prices have continued to decline in many parts of the country through 2011. Without price stabilization and an uptick in housing starts, a stronger recovery of GDP will be difficult,6 since residential real-estate construction alone contributed 4 to 5 percent of GDP in the United States before the housing bubble. Housing also spurs consumer demand for durable goods such as appliances and furnishings and therefore boosts the sale and manufacture of these products.
    At a time when the economic recovery is sputtering, the eurozone crisis threatens to accelerate, and trust in business and the financial sector is at a low point, it may be tempting for senior executives to hunker down and wait out macroeconomic conditions that seem beyond anyone’s control. That approach would be a mistake. Business leaders who understand the signposts, and support government leaders trying to establish the preconditions for growth, can make a difference to their own and the global economy.

    About the Authors
    Karen Croxson, a fellow of the McKinsey Global Institute (MGI), is based in McKinsey’s London office; Susan Lund is director of research at MGI and a principal in the Washington, DC, office; Charles Roxburgh is a director of MGI and a director in the London office.

    The authors wish to thank Toos Daruvala and James Manyika for their thoughtful input, as well as Albert Bollard and Dennis Bron for their contributions to the research supporting this article.
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    1 The full report, Debt and deleveraging: The global credit bubble and its economic consequences (January 2010), is available online at mckinsey.com/mgi.
    2 NMG Consulting survey (2010) of UK households.
    3 See Fiscal Monitor: Navigating the Fiscal Challenges Ahead, International Monetary Fund, May 2010.
    4 See Kalle Bengtsson, Claes Ekström, and Diana Farrell, “Sweden’s growth paradox,” mckinseyquarterly.com, June 2006; and Sweden’s Economic Performance: Recent Developments, Current Priorities (May 2006), available online at mckinsey.com/mgi.
    5A Growth Agenda for Spain, McKinsey & Company and FEDEA, 2010.
    6 In 2010, residential real-estate investment accounted for just 2.3 percent of GDP, compared with 4.4 percent in 2000, before the housing-bubble years. Personal consumption on furniture and other household durables added about 2 percent to growth in 2000.
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  24. foxbat101 says:

    Hi Steve i noticed this paper on a site, hope it does not cause you a problem posting it on your blog.
    Peter ps.it appears to be on the same train of thought as yourself

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