Back in April, Dr Oliver Marc Hartwich from the Centre for Independent Studies wrote an article in Fairfax on the worrying parallels between the UK and Australian economies and housing markets.
The current mood in Australia triggers eerie memories for me. I feel as if I have experienced this scenario before – not in Australia but in Britain.
I moved to London in 2004. The ”cool Britannia” euphoria had ebbed away during the Iraq War but, at least domestically, the country was still at ease with itself. Gordon Brown, the Chancellor, celebrated prudence as the guiding principle behind his fiscal policy. The City of London was rivalling New York as the world’s financial capital, and the British housing market was booming…
Britain was going through the longest period of growth in its history. However, the more I looked behind the facade of the growth phenomenon the more unreal it all looked…
Britain’s growth had been built on four pillars that were all unsustainable. First, strong migration, particularly from eastern Europe, had boosted nominal GDP. Second, rising house prices had eroded the savings culture. Third, the private sector had become dependent on the property market to finance its consumption. Fourth, public debt had risen almost every year despite a booming economy…
Since then the British economy has indeed demonstrated how unsustainable its foundations really were…
Australia is not Britain… But there are worrying parallels as well. Although Britain had experienced big swings in its housing market in the past, the British had bought into Gordon Brown’s creed that the era of booms and busts was officially over. Consequently, they could no longer imagine significant corrections in the housing market. But that did not stop the property crash in 2008.
In Australia, there is much debate about a potential housing market bubble. There is only agreement that property is expensive. Whether it is also too expensive is hotly disputed.
It is nevertheless surprising how fiercely some economists and analysts fight the notion of a housing bubble. They point to strong demand, artificially limited supply, and the preferential tax treatment for real estate to justify their view that Australian housing is not fundamentally overvalued and thus not heading towards a correction. Although their arguments have merit, the very same arguments were also used by British analysts before the British housing market went into free fall.
The most frightening parallel between pre-crisis Britain and Australia today is more fundamental. In both cases, there was a dominant understanding that the countries had found their steady and stable growth model. In Britain it was based on financial services and house prices, in Australia on minerals and China.
In a similar vein, Money Broker, Tullett Prebon, last month released a fascinating Strategy Note highlighting the precarious position of the UK economy following its debt binge over the 2000s. Again, the analysis provides worrying parallels for Australia, which has engaged in similar, albeit less extreme, levels of borrowing over the past decade.
Below are some of the key extracts and charts from the presentation, split into themes.
First, the Strategy Note provides a detailed overview of the increasing indebtedness and debt-dependency of the UK economy.
Over the past decade, the British economy has been critically dependent on private borrowing and public spending. Now that these drivers have disappeared – private borrowing has evaporated, and the era of massive public spending expansion is over the outlook for growth is exceptionally bleak…
During 1996-2002, aggregate public and private borrowing averaged 4.9% of GDP. Between 2003 and 2010, however, aggregate borrowing averaged 11.2% of GDP and, with the single exception of the 2008-09 crisis year (7.8%), annual borrowing never fell below 10.4%…
A key feature of the British economy since 2002 has been the emergence of long-term dependency on borrowing at least 10% of GDP, year after year.
Moreover, the overwhelming majority of this borrowing came from overseas… During the boom years, British banks customarily funded their domestic lending from international wholesale markets, a process which not only contributed to a massive escalation in gross external debt (from £1.9 trillion at the end of 1999 to £6.4 trillion by end-2008) but put the banking system into an immediate crisis when, in 2007, the supply of wholesale debt dried up virtually overnight.
Next, the Strategy Note provides insight into how the UK’s debt binge misallocated resources by spuring activity in the non-tradeables sector of the economy at the expense of the tradables sector.
The critical economic role played by debt is reflected in divergences between the performances of different business sectors… Over the past decade, borrowing has driven up output in financial services (+123%), construction (+27%) and real estate (+26%), whilst lavish public spending has propelled expansion in health (+35%), education (+27%) and public administration and defence (+22%)…
Real output in all other industries is now 5% lower than it was ten years ago.
Between them, real estate, finance, health, education, construction and public administration are six of Britain’s eight largest industries, and account for more than 58% of output…
Diminishing returns from debt:
A worrying aspect of the UK’s debt binge over the 2000s was that it was channelled toward non-productive activities, such as housing speculation and consumption. As a result, the UK economy received diminishing returns as its debt levels grew.
The following is my favourite part of the report and the section which, in my opinion, offers the greatest lessons for Australia.
Borrowing-addicted Britain gained ever less growth from each successive increase in debt… After 2000-01, and just as borrowing began to escalate, growth stagnated, showing no gains whatsoever over the preceding (1996-2001) period. Indeed, trend growth was a lot lower during 2002-08 (2.6%) than it had been in the earlier period (3.5%)…
The problems facing the UK today are the direct result of reckless consumption by individuals and government alike, the former funded by equally reckless lenders. Now, and although the public are not yet aware of it, the bill for this era of unheeding greed has turned up. To put it colloquially, many of the imported gadgets might already be in landfill, but the debt incurred to buy them remains.
If Britain’s economy has indeed become dependent upon annual debt increments exceeding 10% of GDP, why was there not at least some improvement in growth rates? The conundrum is one that asset managers term returns on capital employed – Great Britain plc has increased its capital (debt) base very markedly without generating any improvement at all in income growth. Why?
To understand the conundrum posed by a growing capital (debt) base and diminishing growth, we need to distinguish between two types of debt. These are termed ‘self-liquidating’ and ‘non-selfliquidating’ debt.
If the owner of a successful restaurant borrows to invest in additional seating space, the debt is selfliquidating because it will be serviced and paid off from the higher income that the expanded restaurant will generate. But borrowing to pay for a new car or a foreign holiday is non-selfliquidating, because it is a form of consumption which does not leverage the borrower’s income. Though the parallels are necessarily less than exact, the sharp fall in Britain’s return on capital reflects the fact that the overwhelming bulk of new borrowings have been non-self-liquidating…
Government has been guilty of over-consumption, and very little has been invested in self-liquidating projects such the improvement of the country’s road, rail, power or telecommunications infrastructure.
But the biggest problems have not been caused by government, but by individual borrowers.
The biggest single debt increment during the period between 2002 and 2009 was mortgage borrowing, which increased by £590bn between those years. Many borrowers saw this as investment, a view which was profoundly mistaken even though many policymakers and even bankers managed to delude themselves otherwise. As average property prices soared from £121,000 in 2002 to £197,000 in 2007 (a real terms increase of almost 70%), escalating mortgage debt looked like an investment, and a good one at that.
But to believe this was to overlook two critical points.
The first point that was generally misunderstood was that property prices, whilst realisable on an individual basis, are not realisable in the aggregate. Therefore, and as borrowers and lenders alike were to discover, property prices, far from being an absolute, are an example of ‘notional value’.
The second reason why the escalation in mortgages was not an investment was that a steadily diminishing proportion of new issuance was actually going into the purchase of homes – by 2007, only 35% was being used for this purpose, with the balance going into buy-to-let (BTL) (26%) and equity release (39%). Whilst BTL might have looked like an investment, the reality was that it was a low- or negative-return punt on property prices continuing to rise ad infinitum. Equity release, meanwhile, amounted to the direct leveraging of balance sheets into consumption.
That the property market could not go on rising indefinitely was demonstrated in dramatic fashion when average prices fell by 19% between 2007 (£197,000) and 2008 (£160,000). Despite this correction, property prices still look very exposed in terms of earnings multiples, which remain far above historic norms…
The harsh reality is that the overwhelming bulk of private borrowing during the Brown era was channelled into immediate consumption. ‘Spending like there was no tomorrow’ showed how the public had bought into the ‘easy money’ mentality of the ‘Brown bubble’, but individuals can hardly be criticised for this, since government itself had done precisely the same thing, increasing public spending by more than 50%, in real terms, between 1999-2000 and 2009-10.
The Strategy Note provides a bleak outlook for the UK economy.
In a nutshell, private credit has turned negative and is likely to remain subdued for an extended period. Home prices are still way overvalued, eliminating the prospect of a significant pick-up in mortgage borrowing. And with the Government committed to all but eliminating the budget deficit by 2015-16, the Government will be unable to fill the void in the economy left by the reduction in private sector credit.
Past dependence on substantial levels of annual incremental borrowing has put Britain into a high-debt, low-growth trap. Because growth was feeble even when fuelled by the continuous injection of debt-funded demand, the outlook, now that the country’s borrowing capacity has been maxed out, may be for extremely low economic growth. The collapse in private borrowing has dreadful implications for two of Britain’s eight biggest industries (real estate and construction) and may have adverse implications for a third (financial services).
Another three big sectors (health, education and public administration and defence) are necessarily ex-growth now that the expansion of public spending is over. Together, these six sectors account for 58% of the economy, which makes the delivery of aggregate growth very difficult, and perhaps impossible.
The UK is already showing unmistakeable signs of economic deterioration. Real incomes are declining, a trend to which individuals are leveraged by the high and increasing cost of such nondiscretionaries as food, fuel and utility bills. To make matters worse, interest rate rises seem inevitable, either for policy (inflation) reasons or because of bond market jitters. If the outlook is indeed for low growth, the government’s growth-dependant deficit reduction plan won’t work. And, if the plan were to come unstitched, sterling would come under severe pressure, exacerbating inflationary pressures and compounding the misgivings of international investors holding British debt.
Although Australia’s large resources sector and healthier public finances reduces the likelihood of a UK-style meltdown, these differences could lose relevance in the event that the Chinese economy experiences a hard landing.
Then Australia’s ‘miracle economy’ might suddenly look more like a mirage. And we will wish that we had the foresight to establish a sovereign wealth fund that saved some of the bounty from the mining boom for a rainy day.
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