Debtwatch No. 25: How much worse can “It” get?

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Last month closed with some far from com­fort­ing news about the state of the US hous­ing mar­ket (sales and prices still falling), US finan­cial insti­tu­tions (Fan­nie Mae and Fred­die Mac in need of res­cue), Aus­tralian banks (NAB’s 90% write-down of its US CDO port­fo­lio). Then ABS fig­ures showed that retail sales had fall­en “unex­pect­ed­ly” by one per­cent in June. The recent ral­ly in stock mar­kets came to a sud­den end, and after a brief peri­od of renewed con­fi­dence, the ques­tion “how much worse can “It” get?” is once again doing the rounds.

My answer is: a lot worse. The empir­i­cal grounds for this assess­ment are:

  • The ratio of asset prices to con­sumer prices–or the infla­tion-adjust­ed asset price index;
  • The ratio of pri­vate debt to GDP; and
  • Japan

In short, glob­al asset mar­kets have a lot fur­ther to fall, and a seri­ous recession–the worst we have expe­ri­enced since the Great Depression–is inevitable. Let’s first look at what the recent drop in retail sales implies for the econ­o­my.

An “unexpected” fall in retail sales

Retail sales fell sharply in June, tak­ing most eco­nom­ic com­men­ta­tors by sur­prise. Even peren­ni­al opti­mists, such as Shane Oliv­er, were forced to con­sid­er that the odds of a reces­sion were “at least 40 per­cent”.

In real­i­ty, the fall in retail sales was inevitable. Spend­ing in Aus­tralia has been dri­ven by the biggest debt bub­ble in our his­to­ry, and when that bub­ble peaked, spend­ing had to fall. Since house­holds had tak­en on a far larg­er share of debt than busi­ness dur­ing this bub­ble, the impact was bound to be seen first in retail sales, rather than invest­ment spend­ing, as I point­ed out in Novem­ber 2006:

If house­holds reduce their debt lev­els smooth­ly, they will have less dis­pos­able income to spend and retail sales will slump. If bank­rupt­cies become wide­spread, the sales down­turn will be over­laid with a finan­cial cri­sis.” (Debt­watch, Novem­ber 2006, p. 18;


The sud­den­ness of the turn­around is also no sur­prise, when you look at the data from a finan­cial point of view. Just as your per­son­al spend­ing each year is the sum of your net income plus the change in your debt, aggre­gate spend­ing for the econ­o­my is the sum of GDP plus the change in debt. As debt ris­es, the con­tri­bu­tion made to spend­ing by any change in debt also ris­es. Pri­vate debt–and house­hold debt in particular–has risen so much in Aus­tralia that, at its peak, the change in debt was respon­si­ble for almost 20 per­cent of aggre­gate demand.


As is obvi­ous in Fig­ure 1, debt’s con­tri­bu­tion peaked at the end of 2007, and it has been falling ever since. The month­ly fig­ures make this even more obvi­ous (Fig­ure 1 records change in debt over a whole year). The month­ly increase in total pri­vate debt peaked at $30 bil­lion in mid-2007, and trend­ed up to $27 bil­lion by the end of 2007. It has since fall­en to a mere $5 bil­lion in the month of June (see Table 1 and Fig­ure 2).

Table 1

Fig­ure 2

At some point, it will turn neg­a­tive, and change in debt will there­fore sub­stract from aggre­gate demand rather than adding to it. Giv­en that at its peak, debt financed almost 20 per­cent of demand, even sta­bil­is­ing debt at its cur­rent level–$1.85 tril­lion, com­pared to a GDP of $1.1 trillion–would result in a 20 per­cent fall in aggre­gate demand.

This hit will be felt by both asset and com­mod­i­ty mar­kets: asset prices will fall, as will out­put and employ­ment. The gov­ern­men­t’s attempts to counter this–by run­ning a deficit rather than a surplus–will ini­tial­ly be swamped by the sheer scale of the turn­around in debt-financed spend­ing. Even if the gov­ern­ment runs a deficit of A$20 billion–the same scale as this year’s intend­ed surplus–it will make up for less than a tenth of the fall in debt-financed spend­ing.

The cur­rent “cred­it crunch” is, there­fore, only the first act in a long-drawn out process of reduc­ing debt lev­els. The sec­ond act will be “the reces­sion we can’t avoid”. That recession–which will affect most of the OECD, since all major OECD nations bar France have suf­fered a sim­i­lar blowout in pri­vate debt levels–will only add to the cur­rent decline in asset prices.

The USA: Double Bubble

While the Dow has fall­en sub­stan­tial­ly in the last year, its infla­tion-adjust­ed val­ue is still three times its long-term aver­age, and more than 4 times its aver­age pri­or to the start of this bub­ble.  Even if the index falls mere­ly to its long term aver­age, it still has anoth­er 62% to go (in real terms)  from its cur­rent lev­el. If it reverts to its pre-bub­ble aver­age, it has anoth­er 73% to go.

Fig­ure 3

If those fig­ures seem ludi­crous­ly pes­simistic and unre­al­is­tic to you, take a look below at the CPI-adjust­ed Nikkei–which fell 82% from its peak at the end of 1989 to its low in 2003. At the time, most com­men­ta­tors blamed Japan’s Bub­ble Econ­o­my and sub­se­quent finan­cial cri­sis on the opaque and anti-com­pet­i­tive nature of its finan­cial sys­tem. We were assured that noth­ing so ridicu­lous could hap­pen in the trans­par­ent, com­pet­i­tive and well-reg­u­lat­ed US finan­cial sys­tem.

Yeah, right.

Fig­ure 4

The sto­ry for the US hous­ing mar­ket is lit­tle bet­ter. The index has already fall­en 23% from its peak in 2006. A rever­sion to the long term mean implies a fur­ther 38% fall in the aver­age house price in Amer­i­ca; while rever­sion to the pre-Bub­ble mean implies a fur­ther 41% fall.

Write­downs by US finan­cial insti­tu­tions cer­tain­ly haven’t yet fac­tored in that degree of pos­si­ble fall in hous­ing val­ues, and as Wil­son Sy point­ed out recent­ly in two bril­liant research papers (1 2), the banks’ “stress test” mod­el­ling great­ly under­em­pha­sis­es the impact of such asset price falls on their finan­cial via­bil­i­ty. House price falls in the USA are far from over, and like­wise “unex­pect­ed” write­downs by US finan­cial insti­tu­tions.

Fig­ure 5

Over­all, if US mar­kets fall back to their pre-Bub­ble lev­els, the stock mar­ket will plunge about 80% from its peak (much the same degree of fall as applied in Japan) and the hous­ing mar­ket will fall 55% (rather more than hap­pened in Japan, where aver­age house prices fell 44%–but less than Tokyo, where they fell over 70%).

The unique fea­ture of this US asset bub­ble is that it affects both stocks and hous­es. There have been three Stock Mar­ket Bub­bles in the USA in the last cen­tu­ry: the “usu­al sus­pects” of the 1920s and 1980’s, but also one that does­n’t nor­mal­ly rate a men­tion: a ’60s Bub­ble that peaked in 1966, and was fol­lowed by a slump that only end­ed in mid-1982 (see Fig­ure 6).

As Fig­ure 6 indi­cates, this dual bub­ble has no prece­dent. Not only is it a bub­ble in both asset mar­kets, both bub­bles dwarf any­thing pre­vi­ous­ly expe­ri­enced. Even the great Roar­ing Twen­ties stock mar­ket bub­ble bare­ly pokes its head above the long term aver­age, com­pared to the 2000s Stock Mar­ket bubble–and in the 1920s, as Fig­ure 6 shows, the hous­ing mar­ket was rel­a­tive­ly under­val­ued. The over­val­u­a­tion of today’s hous­ing mar­ket far exceeds the now com­par­a­tive­ly minor bub­ble when Keat­ing (Charles, not Paul) was on the loose in the USA.

Fig­ure 6

While the Aus­tralian Stock Mar­ket is not as severe­ly over­val­ued as the Amer­i­can, it is still sub­stan­tial­ly over its long term trend. Even after the recent falls, the infla­tion-adjust­ed All Ordi­nar­ies Index exceeds its lev­el before Black Tues­day in 1987. It has anoth­er 30% to go before it will have revert­ed to the mean of the last 25 years (see Fig­ure 7).

Fig­ure 7

The prog­no­sis for the Aus­tralian hous­ing mar­ket is sub­stan­tial­ly worse. Even on short term data–covering only the last 22 years–the mar­ket could fall 40% if it revert­ed to the mean, and 50% if it revert­ed to the pre-bub­ble mean. Nigel Sta­ple­don’s research into long term house prices in Australia–which is not shown here–implies an even greater poten­tial for a fall in house prices.

Fig­ure 8

Of course, such talk can seem non­sen­si­cal and alarmist. Espe­cial­ly if you ignore what hap­pened in Japan.

Japan: the world’s most recent debt-deflation

Japan clear­ly under­went a debt-defla­tion after its “Bub­ble Econ­o­my” spec­tac­u­lar­ly burst in 1990. In its after­math, house prices across Japan fell on aver­age by 42%, and by over 70% in Tokyo (though they have since recov­ered slight­ly).

Fig­ure 9

Fig­ure 10

What has hap­pened there can hap­pen in Aus­tralia, the USA, and the rest of the OECD–especially since our Bub­bles, while small­er than the Tokyo bub­ble, are larg­er than that for Japan as a whole (see Fig­ure 11).

Fig­ure 11

The killer behind the Bubble: Debt

The lev­el of over­val­u­a­tion of asset mar­kets reflects the unprece­dent­ed scale of pri­vate debt, both here and in America–since the vast bulk of that debt was under­tak­en to finance “Ponzi” spec­u­la­tion on shares and hous­ing. This is the rea­son that this reces­sion will be so severe–as will the asset mar­ket bust.

Every “recov­ery” from a debt-induced reces­sion since 1970 has involved resump­tion in the ten­den­cy for debt to grow faster than GDP (see Fig­ure 12, where the once seem­ing­ly major debt cri­sis of the late 80s is now just a pim­ple on the upward trend of the debt ratio to its cur­rent unprece­dent­ed lev­el).

Yet today the debt to GDP ratio is more than twice that of the Great Depres­sion. It is sim­ply can­not go any high­er. Who else, after all, can banks lend to, now that they have exhaust­ed the “sub­prime” mar­ket?

The only way for the debt to GDP ratio now is down (unless we’re unlucky enough to expe­ri­ence defla­tion, in which case the ratio will rise fur­ther, as in the Great Depres­sion), and as it heads down, so will out­put and employ­ment. A seri­ous reces­sion is inevitable.

Wel­come to “the reces­sion we can’t avoid”.

Fig­ure 12

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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.