Macro 101 – Credit effects

In my previous post I talked about the sectoral balance equation which is fundamental to understanding how an economy functions at a macro level.  The function is also useful to understand the likely high-level economic outcomes of  monetary and fiscal policy changes made by a government.

If a government is running a surplus budget then they are taxing more than they are spending. This means that the private sector will be paying more money to the government than they are receiving. Unless the export sector is providing the offsetting value ( a positive trade balance ) then the private sector will be getting poorer and will have to take on debt to maintain the same standard of living in the absence of price deflation.

That debt is what I want to talk about today.

Private sector debt is something that seems to be ignored by many economists. I have no idea why because it is an important measure of a number of things at a macroeconomic level. As I said above,  using the sectoral equation approach you can see that it can tell you when government taxation/spending levels are not appropriate  to support maintaining a standard of living given the terms of trade of the economy. From a financial stability perspective debt can be an early warning that the private sector is overly investing in a non-productive asset class which may require changes in the economic policy framework to counteract.

One of the major issues with a high private sector debt burden is that it reduces the private sectors ability to invest and therefore contribute to an increase in the productive capacity of the economy. If the debt associated with non-productive investments is allowed to grow unabated then the productivity of the economy will decline as the capital available for productive investment diminishes.

In Australia the private debt level has become so large that the banks can no longer fund it domestically within the regulatory framework. This now leaves the economy open to a foreign funding liquidity risk, something that flared up during the GFC and is very likely to happen again given the on-going troubles in Europe.

However what is less understood by most economists is the effect of the rate of change of debt issuance on the economy. Loans create deposits which can be used to pay down existing debt or used to purchase goods and services. When they are used to purchase goods and services they add to the overall economy by creating economic activity (resource utilisation).  This has a flow-on effect of creating jobs and creating economic growth.

But make no mistake, continual debt issuance is unsustainable without offsetting productive economic improvements. So if that credit is being invested in non-productive enterprises then there will come a time when the private sector simply cannot and/or will not take on additional credit because the underlying real economy cannot support it.

When this occurs then the effects we mentioned above works in reverse.  The fall in credit issuance creates less deposits, which drives less economic activity. This has a flow-on effect of  destroying jobs and making the economy weaker.

And this is where my concern lies with Australia today.

As I noted recently Victorians has started de-mortgaging for the first time in data’s history. I have been unable to find the same dataset for the other states, because none of them seem to freely publish mortgage discharge data. However by looking at long term trends in mortgage issuance you can see an emerging pattern of slowing credit issuance and what I see as the first hint of deleveraging. I suspect that demographics is also playing its part.  The chart below is for Queensland.

This is why the NAB’s latest survey of attitudes to house prices is so worrying to me. As Australians fall out of love with houses, they fall out of love with debt.  Without some spectacular growth in the terms of trade to offset the decline in credit issuance I would expect to see exactly what the Unconventional Economist outlined earlier this week.

When house prices rise, [households] feel richer, which spurs consumer confidence, spending and employment growth. A positive feedback loop can develop whereby households take on more debt, causing housing values to rise further and the process of confidence, spending and employment growth to repeat.

But home values and debt levels can only rise so far and, sooner or later, the process of debt feeding asset prices feeding confidence, consumer spending and employment growth goes into reverse (i.e. deleveraging). House prices stop rising (or fall) and highly-indebted households begin to reduce their spending and repay debt. Sectors reliant on consumer spending contract and unemployment rises. Consumer confidence falls, leading to further frugality, house price reductions and job losses.

As I have said many times before “housing speculation is the slow death of the economy”. What I am seeing now is some very worrying trends that have far wider consequences than just a small drop in house prices. Let us all hope that the China bulls are correct.


  1. First of all, congrats on the new supersite!

    A quick query… I kind of get the “loans create deposits” thesis, but wondered whether you might be able to explain it in a bit more detail?

    I’m guessing it all ties in with fractional reserve banking and one party’s asset being another party’s liability, but perhaps a layman-esque description would help, particularly when most people probably think that the relationship is the other way around; ie. that deposits create loans.

    Cheers 🙂

  2. Hi Sam,

    >I’m guessing it all ties in with fractional reserve banking and one party’s asset being another party’s liability

    Yes this is basically correct. A loan creates a deposit and a liability.

    We don’t actually have Fractional Reserve lendng in Australia, as the banks have no reserve requirements. They have capital requirements.

    I will actually be discussing the whole banking thing in part 3.

    • Hi DE,
      great post. Your thinking is very much aligned with Mitchell and Keen. Two very much unorthodox Oz economists. Is in it better that we start deleveraging sooner rather than later. Recently I was in US. US in comparison to OZ is a very cheap, yes alot do do with it is strong Oz dollar. Their housing, food, almost everything is much cheaper than here. Yes wages are bit lower there too. I wonder how competitive are we if we price ourselves out of the international markets where we have to compete. But at the same time we have to have relatively high wages in order to sustain very expensive housing. So when is Minsky moment meant to come, and do you believe that we will have debt deflation. I wana by my first house, I’ve been waiting for it for some 7 years now, and still no luck:)

  3. Delusional, I am very grateful for the posts you guys have been putting up.

    I have been trying to find the reserve ratio of our banks but can’t. APRA say it’s on their site but I can’t find it, just the capital adequacy ratio.

    An Australian lecturer got back to me and said Labor dumped reserve ratio’s in the late 80’s. Why did they switch?

    Keen pointed out recently (or Leith) I can’t remember which, that Commonwealth Bank is still lending up to 97%.

    Would you be able to explain to us how we can work out what it will take to put our big banks into real trouble in your view? (And therefore get an idea of a margin of safety or something?)

    Leith was saying how he would like to see minimum of 30% deposits or something, can that be achieved under the current system or does the capital adequacy ratio not permit that type of specification. I couldn’t work the formula back to a reserve ratio.

    Cheers 🙂

    • G’day David. My preference would be for:
      1) Requiring minimum deposits of, say, 15% (85% LVR) when a cash deposit is used and 50% when non-cash collateral (e.g. another property) is used in place of a cash deposit;
      2) Placing limits on the ratio of debt service to income for housing lending, which would reduce the likelihood of borrower default and limit highly-leveraged property purchases. For example, a 30% limit would permit a household with a gross income of $100,000 to borrow a maximum of $428,500 at a 7% interest rate, whereas a 40% limit would permit the same household to borrow a maximum of $571,500 at a 7% interest rate; and
      3) Placing limits on the amount of loans that can be extended against short-term funding sources, such as at-call deposits, and term deposits and wholesale funding with less than 12 months term-to-maturity. These types of measures: reduce the tendency of lenders to rely on short-term or unstable funding markets to support rapid lending growth; reduces the likelihood of experiencing a liquidity crisis like Australia’s banks experienced during the GFC; and reduces the overall amount of leverage in the financial system.

      Cheers Leith

  4. Hi David,

    >I have been trying to find the reserve ratio of our banks but can’t. APRA say it’s on their site but I can’t find it, just the capital adequacy ratio.

    The reserve ratio for Australian banks is 0%. They have a capital requirement.

    You can read a little bit about these requirements from a previous post from our Deep T

    Where he talks about how banks are doing their best to c*ck it up for the rest of us.

    I am going to do another post in macroeconomics 101, where I actually talk about all of these things.

    So just give me another couple of days.


  5. Thanks Leith & Delusional.

    After reading Deep T’s post you mention I get the feeling we are in the middle of The Hurt Locker…although maybe its more like Speed because we are all on the bus, its wired and ready to blow, so we just keep the pedal to the floor and hope that someone will just magically diffuse it. Except you guys are actually looking at how its wired so are probably quite close to knowing which wire we should snip.

    Leith I want to add your three suggestions to the Finance page “to do list”

    But I am just not sure how to word it so it shows we are being responsible. Maybe it just means saying “we are going to progressively decrease maximum LVR down to 85%” then cite commonwealth example of 97%. (and 50% for non-cash). Because obviously if the PM said, “right, in 12 months time the banks maximum LVR for cash is 85%, and 50% for non-cash, debt service to income ratio will be a max of 30% and no ADI can have more than 5% of funds from short term sources”, Mr Smith may choke on his morning cereal.

    The limit on short term funding deposits seems critical too.

    Going bush for 2 weeks Monday. When I get back will start putting it together. It would be good to know the counter arguments that will sprout so I can address them. Not too long ago when Keen was being interviewed by the ABC, the reporter had a firm and crystallized opinion that any increase in the size of deposits needed by first home buyers will make it much harder for them to get into their first home..:)

    If something happened and property prices went down, we could just tighten the screws along the way. But if we start tightening the screws before it goes down, I guess controlling the rate is the important thing? Hopefully whoever is standing behind Abbot and Gillard with their knives, have been reading these blogs..:)

    • G’day David. I’m happy to help you with the wording and provide links to reputable literature on these issues. The Bank for International Settlements (the Central Banks’ bank), which oversees the Basel bank capital adequacy requirements, has published a lot of papers on these measures, known as MacroPrudential tools.

      Australia effectively used these types of measures to control credit prior to the big relaxation of credit standards in the mid-1990s following the entry of the non-bank lenders. That is, the banks would only lend 80% LVR and an amount that could be repaid using 30% of a borrower’s income. Offshore borrowing by the banks was also very small back then.

      Now the banks will lend 95% plus and an amount that, after loan repayments, leaves households with just enough money to ensure that they stay above the Henderson poverty line, with much of the funds coming from offshore.

      Combined with Australia’s restrictive land use policies, this is why Australia is experiencing one giant housing bubble?

      Email me if you need help with any of this stuff.

      Cheers Leith

  6. DE, you say in your second para. “Unless the export sector is providing the offsetting value ( a positive trade balance ) then the private sector will be getting poorer and will have to take on debt to maintain the same standard of living.” This would be true if the prices of goods and services remained the same. But if productivity improved, there would be a greater quantity of goods and services for sale and prices would have to come down. This could maintain, or even improve, standards of living without the need for debt.

  7. Alex you are correct, that is what comes from writing blogs at midnight.

    I am glad someone is checking my work. The sentence should read

    “Unless the export sector is providing the offsetting value ( a positive trade balance ) then the private sector will be getting poorer and will have to take on debt to maintain the same standard of living in the absence of price deflation.”

    I will adjust it in the post.

    Thanks Again.