Improving the house price and income debate

Please find below a guest post by fellow blogger, Cameron Murray. We are pleased to announce that Cam will be joining the MacroBusiness team later in the week.

While the RBA has warned of the risks of leveraging into the housing market on national television, they, and other analysts, have also presented a stable picture of the housing market, by estimating a house price to household income ratio of about 4x, and accompanying such analysis with statements like: “the ratio of housing prices to income has been reasonably flat for a number of years.”

Or, when he is at his best, Glenn Stevens can calm the nerves of recent home buyers with comments like this:

“The other thing I’ll say is that it’s quite often quoted very high ratios of price to income for Australia, but if you get the broadest measures, a country-wide price and a country-wide measure of income, the ratio it about 4 ½ and it hasn’t moved much either way for 10 years.”

I think I can safely say that most of Australia would disagree with this assessment of stability in the housing market or support from economic ‘fundamentals’. Indeed even the RBA’s own representations seem a little schizophrenic on the subject, with a recent report noting that the price-to-income ratio actually increased by 50% between 2001 and 2004.

Dwelling price growth significantly outpaced growth in household disposable income, with the nationwide dwelling price-to-income ratio rising from around 2½ in the mid 1990s to a little over 3 by 2001 and then to 4½ at its peak in early 2004.

Which is it Glenn? Did the ratio increase by 50% in that period, or hasn’t it moved much either way for ten years?

One reason for the clash between public views on housing and the ‘stability stance’ we see out of the RBA is that the RBA grossly overestimates household incomes.

I have examined the data used by the RBA and other analysts from the National Accounts (Table 14), and tried to replicate their method and reconcile the differences with ABS household survey data, which more accurately reflects household income available for current consumption. It is possible, and I have shown my results in shown in the table below.

ABS household survey data shows that at the beginning of 2010, the average household income was $88,113 before tax and $74,360 after tax. This closely reconciles with my own household income estimates from the National Accounts data in 2010 (within 1.3%). Unfortunately due to the need to estimate the total number of households between census years, this method has quite a large margin for error.

Given the average national dwelling price at that time was $447,994 and the median about $415,000, we are definitely in an uncomfortable range of price-to-income ratios, with 5.0x in average terms using before tax income data, and around 6.0x in after tax terms. In terms of median incomes and dwelling prices, the ratio is probably closer to 5.6x before tax, and 6.8x in after tax income (as recently estimated by fellow blogger Leith van Onselen).

While I don’t believe household income and house price comparisons are the best indicator of the state of the housing market (preferring comparisons of rents to incomes and yields to other rates of return in the economy), it does seem that we can use the national accounts data to give a decent regular estimate of household incomes for those who wish to use them for analysis.  Maybe the RBA should try it sometime.

Also important to note when comparing incomes to prices is that the debt service ratio, measured as interest payment against incomes, can be misleading.  Since this measure is also published by the RBA, I assume they rely upon it in some way.

Below is the household finances graph from the RBA chart pack (available here). We can see that, following the declines in interest rates at the end of 2008, household interest payments have settled at around 12% of disposable income. Note again that the RBA disposable income measure is probably overestimated (there is no specific note about the treatment of imputed rents), meaning the both measures are probably underestimated. But in any case the trends over time still hold.

What we need to consider here is that the interest paid graph shows what might be called a ‘debt-service’ ratio (although not in the true sense which would cover principle repayments). In regard to the surging household debt the RBA notes that the “…structural decline in interest rates has facilitated the increase in household debt ratios because it reduced debt-servicing costs”.

That is true, but would only explain an increase in debt that accompanied flat interest payments as a proportion of income, not increasing interest payments (as I have explain in detail here).

What is also overlooked is that at lower interest rates the difference between the payment of just the interest on debt, and the repayment of interest and principle (to actually reduce the loan balance over a fixed period), greatly increases. For the same interest payment, a high debt balance with a low interest rate is more difficult to repay than a low debt balance with a high interest rate.

The table below shows the amount of debt that a household with an income of $75,000 could service with 20% of their income ($15,000pa) at different interest rates. While a halving of interest rates means the household could double the loan amount and pay the same interest payment, the loan they could actually repay over 30 years increases by far less (as shown in the right hand column).

It is also important to understand this relationship when comparing our household debt burden internationally. The RBA usually makes such comparisons without noting the importance that interest rates make to the burden of this debt on households. Given that mortgage rates vary between 7.5% in Australia to 2.5% in Switzerland and 3% in Germany and much of the EU (and noting the tax deductibility of mortgage interest in Netherlands), these differences are important.

I will finish this analysis by presenting two graphs.

First is a graph of the household occupancy rate. The reason to include this is that while household incomes may be still growing nicely, the number of people per dwelling has been increasing since late 2005, so in per capita terms incomes are not looking as good.

The second graph compares the growth in household incomes using each method with the ABS capital city price index. Of course, I have chosen an arbitrary baseline at June 2001, but I do note that mortgage interest rates then were the same then as they are now (indeed mortgage rates were about the same as now back in 1997 – see here), so the deviation observed could easily be interpreted as an overvaluation of housing.

What the graph mostly tells us is that there is a pretty solid reason so many people believe that house prices are historically high and are more likely to fall than rise in the near future, being supported only by our willingness to incur debt, and not our incomes.

Unconventional Economist
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  1. Congratulations to Cameron on becoming part of the MB blogging team. Although judging by this article perhaps Cameron’s time would be better spent as governor of the RBA judging by this and other articles 😉

    I agree that debt service on bigger and bigger mortgages is definitely a large factor in the current income to price ratio debate. I would love to see a graph comparing how much disposal income went toward servicing a mortgage perhaps over the past 20 years taking interest rates into account. In my opinion that would illustrate how badly Dutch disease has infected the average Australian mortgage holder and how we are paying more of our disposable incomes than ever before in the effort to own the roof over our head.
    Cam I think you neatly wrapped up the entirety of the housing bubble and the income to housing price ratio debate in the following:
    “What the graph mostly tells us is that there is a pretty solid reason so many people believe that house prices are historically high and are more likely to fall than rise in the near future, being supported only by our willingness to incur debt, and not our incomes.”

  2. I have zero confidence in the RBA. What do these guys know about anything, really? Just look at the Fed in the US for comparison. The Bernankster was saying in 2005 that sky-high house prices “largely reflect strong economic fundamentals” and that there is no housing bubble. And The Bernank is supposedly a genius with a PhD from MIT. Compare this feted member of the Chosen Race with poor ol’ Bible-totin’ Glenn, who has a Masters from some obscure college in Ontario. Help! Abandon ship. Glenn’s only talent is for looking serious and inscrutable, for displaying gravitas, and for sounding measured and dour — a Clown Governor for a country of clowns.

  3. The ‘hidden’ cost of housing affordability is the fact that when I bought my first home 40 years ago, the duration of the loan was 25 years. Today, Cameron matter-of-factly uses 30, and here in New Zealand I read in the Sunday papers that our banks ( your banks!) are extending the terms out to 50! I guess it takes pressure of the over indebted, but at what cost to the individual’s terminal net worth?

    • complicit or naive

      Banks decided to ‘steal’ another 5 years of labor for the most basic of essentials – shelter.
      Govt gets to partake of increased loan size in the form of extra stamp duty.
      MSM mantra – the sheeple are for fleecing.

  4. Great post – But the question isn’t really about whether Glenny was telling porkies to international investors and the domestic audience. We knew that already.
    Question is how to get Glenny to come clean and admit it. Maybe some MP can ask this question when Glenny faces them (under oath) at the next hearing.

    • sorry Mav, no MP will ever try to do or mention anything about housing affordability. The silence from them as the housing affordability crisis worsened is deafening. MP’s like all the other powers that be have a vested interest in maintaining the ponzi.

      as a previous bolgger here noted a few weeks ago and which still makes me laugh….the first rule of ponziclub is dont talk about ponziclub.

      • Politicians are populist beasts. I believe that Howard one said something along the lines of that housing affordability through price drops are things that only the opposition contemplates. Labor definitely showed that, making plenty of noises about over priced houses whilst in opposition then changing their tune with FHSAs and the now infamous FHOB, lessening of FIRB, and so on.

        For instance, according to the most recent HILDA survey, (from memory) only about 28% of people rent. Most, note only most, of the rest of the 72% are lulled into a false sense of wealth by rising house prices (the real cognitive dissonance comes from those that are both celebrating how much their house has risen in value and are upgrading).

        What politician is going to risk pissing off up to 72% of his electorate by directly moving to lower house prices? I am hoping the that current crop of incompetents in Canberra (in all major parties) simply sit idly by whilst the current house price deflation runs its course instead of, once again, kicking the housing can down the road, but who knows…

      • Well, this RBA blooper should be publicised – the annual Demographia survey did that job quite well. But I don’t think we can wait until the next one comes out.
        Re international investors who fund our banks via overseas wholesale funding, are probably already well aware of this fact, but keep investing because they know the government will rescue our banks. i.e. moral hazard.

  5. Cam,

    Thank you so much, and welcome to the MB team.

    You have a nice, clear writing style that conveys the essence of the subject matter without losing the novice along the way (no reflection intended on the style of the other MB contributors).

    Without doubt the most important takeaway from this article is the one that you knowingly highlighted:

    “….a high debt balance with a low interest rate is more difficult to repay than a low debt balance with a high interest rate.”

    For those who simply want to put a roof over their family’s head, this is the message that must be made to resonate.

    Yet, all of the forces-that-be seek constantly to portray the opposite –
    “low interest rates, and ever-increasing house prices are good for you”.

    High interest rates are bad – but high prices (more debt) is good.

    The bloke who can get the “Higher interest rate – Lower debt” argument out into the mainstream should be in line for some sort of Nobel prize.

    Regrettably, whilst this state of affairs would be great for the genuine homebuyer, it would be anathema to those who see housing purely as a quick and easy route to capital-gain riches.

    So, what hope of it gaining traction, then 🙂

    At the risk of appearing to be a picky bastard though, the word is “principal”…not “principle”.

    “Principle” seems to be in pretty short supply in the housing market, whereas “Principal” (until recent times) has been abundant 🙂

    Thanks again.

    • Absolutely agree with this statement. I often tell older people that use the argument “I bought when interest rates were 15%+” that they bought at the best time and I don’t feel sorry for them in the slightest. In fact if it wasn’t for luck I tell them I marvel at their reading of the economic indicators. Its also what I tell young people when they say “interest rates have never been this low – time to buy!”

      When buying at higher interest rates prices normally have adjusted to where the marginal buyer can afford to pay per month on their mortgage. Additionally principal payments at a higher interest rate have a much more measured impact on future interest payments than at a lower rate. And you had the upside of any future interest rate decreases should you have survived. Plus it rewards savers as well.

  6. Something I’ve read in a number of places and I think even quoted by C.J is that there has been a “structural decline in interest rates”

    But I’m curious, why is this “structural”? As the above very well outlines, we have more debt, and therefore we generally are more sensitive to interest rates, but that’s all a bit circular because it’s the low interest rates that allowed more debt, and according to the linked graph as well as the ones above, interest rates were lowered before the debt binge got out of control…

    Also I’m wondering whether low interest rates encourage banks to loosen their credit criteria to drive profits from volume of loans, or is it really just the difference between the OCR and/or international credit rates that drive their profits, such that they will not lower LVRs or other protections?

    • Cameron, thanks for the quote:

      “For the same interest payment, a high debt balance with a low interest rate is more difficult to repay than a low debt balance with a high interest rate.”

      Its a key issue and as tone points out, calling rates falling as a ‘structural change’ is silly. What does it ‘structural’ mean? Its a made up term with no signifigance.

      The “structure” in place is since 1970s has come from Governments spending too much and printing money and the mass wave of private credit fuelled by articicially low interest rates (set by the RBA and other central rates) that has flooded the economy.

      As Cameron notes, this has meant we have the opposite of what we had under Keating (low private debt, high interest rates).

      We now have large private debt and low interst rates. This is because they cant have high interest rates as it will crush those in high debt. So Stevens and the RBA cannot raise rates and will not. If this is what CJ calls a ‘strucutral’ decline…then structural must also mean precarious and temporary.

      Australia can lower its rates when the economy begins to slow after the last cash injenction given by the Keynes Governments of the world, but every time we try to ratchet up our debt levels and kick start the economy..the high our debt load becomes.

      You simply cannot have debt repayment, high savings and strong economic growth unless you are having massive productivity imrovedments.

      The Austrians have warmed about a financial crisis such as this (the fiscal crisis caused by the gold standard not preventing excessive soverien debt and monetary crisis caused by artificially low rates).

      A free market and gold standard would have not allowed problems of this size to form.

      • “Australia can lower its rates when the economy begins to slow after the last cash injenction given by the Keynes Governments of the world, but every time we try to ratchet up our debt levels and kick start the economy..the high our debt load becomes.”

        Indeed, this would suggest that the change in interest rates is cyclical (which I would take to mean as the opposite of structural).

        Looking at the timing of the shift in interest rates it seems they were lowed as a response to the “recession we had to have”. If this had the necessary stimulatory effect, and this stimulus was based upon debt, then this would be the expected outcome. And looking further down the track, I would then expect that as inflation drives rates higher again (albeit slowly), then people, or consumers as perhaps we’re now referred to as, will start to deleverage, which will then serve to take the constriction off rates, and thus they will be able to rise again.

        Therefore, the lower rates are cyclical, not structural. I would say though that the length of the cycle would be considerably longer than a seasonal cycle. Looking at the linked graph of interest rates would suggest that the length of the cycle is about 20 years. Unfortunately this cycle was interrupted by the GFC and the sudden drop in rates, which we have not yet made up for, has prolonged it somewhat. Perhaps that time frame makes sense given standard loan is 30 years, and as pointed out by Janet above, it used to be 25 years.

        • Well, continuing with the inflation targeting argument for the so-called “structural shift”, the RBA starting the inflation band targeting in 1993, right after Keating’s “recession we had to have”.

          I believe I had read Chris Joye directly stating the the “structural shift”, as he calls it, was due to the advent of inflation band targeting from the RBA.

          The OCR is fairly cyclical, as the RBA’s inflation mandate and employment mandate, as well as protecting the currency, all generally go hand in hand. The big question, though, is what would the RBA do if inflation remains above their target band (thanks, say, to mining and QE3) but unemployment spikes as the whole non-mining sector continues to struggle?

    • Wish there were “Agree” buttons for the quotes about the quality of the article and welcoming Cam Murray to the MB team. Glad he didn’t give up blogging when he said he would!

      About the “structural change to lower interest rates”, they are referring to inflation targeting by the central banks which should keep the inflation well in the target band. Hopefully, this will stop the high inflationary events before they begin, such as seen in the 70s/80s and thus preventing the higher interest rate spikes.

      • I thought containing inflation has always been one of the main jobs of the RBA?

        If so they basically were doing it either very badly, had other bigger problems or could not contain it during those periods. But in either case, they were raising rates to those levels in order to do the same thing, ergo, given similar conditions, or without the current constraints, rates would and could get to similar levels..

        Or perhaps you’re suggesting the targeted band has changed? In this case it’s just a policy decision, rather than sound economic theory, that sets the band, which therefore says that it’s cycle is based around the length of central banker’s careers or the term of board member’s positions. Actually does anyone know where the 2 – 3 % band comes from? Is it an objective target?

        • +1 – yes Cameron, that is the key….how they managed to let the housing bubble boom without the CPI sending warnings signals was the most devious of tricks

    • ‘Structural’ as in rearanging the speadsheet to massage and ignore inflation, using words like ‘core’. Otherwise we would need 7 or 8% base rate to balance inflation. For eg, how is it that housing, food, petrol, utility bills etc etc can double in around 7 or 8 years with only 2.5% or so inflation? Oh, I know, computers and TV’s are cheaper.

  7. rational investor

    Cam, Leith,
    On the topic of fudged figures…

    I check the apm Saturday auction results for Melbourne every Sunday on the age website.

    Being a slow Sunday I decided to run their data through a spreadsheet to confirm their median, clearance and total sales numbers. See below:

    Actual Reported Difference
    Median 597000 608500 1.89%
    Total Sales $46,583,500.00 55185500 15.59%
    Total Properties 159 182 12.64%
    Clearance 54% 51.00%

    I note the following:
    Calculated Median price almost 2% lower than reported
    Clearance Rate is higher
    Total Sales is a lot lower..

    All figures were copied from the reported results.

    I guess that APM unlike Chris Joye does not have enough PhD’s employed…

  8. I don’t believe household income and house price comparisons are the best indicator of the state of the housing market (preferring comparisons of rents to incomes and yields to other rates of return in the economy)

    I’ve been wondering for a while why you economics types don’t focus on this more. As a layperson, it seems like the important bit to me.

    • As another lay person, I would suggest that this is because the 2 measures mentioned relate solely to the investor, whereas income to price relate to owner occupiers. I would say that that both are equally important as these are the 2 constituents of the market..

      it may also be interesting to close that gap by also including a ‘rent to interest over time’ comparison which should give us an idea about the relative benefit of renting vs buying. It should also tell us the reliance upon, as well as the relative risk of negative gearing that an investor will need to take on board. Surely as the gap widens an investor takes on more risk of the necessary capital gain coming to bear. In fact I would be very interested in seeing such a graph!

  9. “For the same interest payment, a high debt balance with a low interest rate is more difficult to repay than a low debt balance with a high interest rate.”

    We should all just keep writing this over and over in various places on the internet…

  10. It does seem Cameron should be Governor of the RBA!

    regarding the variance in the price/income ratio – could it be Glenn rounded up from 8 years. If so, he might be right based on your last graph.

    As for the under estimation argument…I’m not sure I fully understand? Are you saying that because it is 6x under one measure and the RBA is using a measure that says 4.5x that the RBA is underestimating the problem? They are different measures! Thats like saying 6 rupees is worth more than 4.5 dollars?

  11. expectations deflated

    In support of the observation about debt repayment capacity, it is interesting to look at how real and nominal mortgage interest rates have developed over the last 40 years or so.

    Doing some crude analysis (taking RBA F5 for mortgage rates, deducting ABS CPI – probably wrong, but I am not a statistician and it does the job), shows that real interest rates peaked towards the end of the early 90s recession, while nominal rates were at their highest in the late 80s.

    Save for some GST related oddities in 2000-1, real rates have been in a narrow range of ca. 4-6% for the last 12 years or so (after declining markedly prior to that). Nominal rates have fluctuated a bit more (6-10%).

    These are both structural shifts from the 80s when both nominal and real rates were higher, and from the 70s when nominal rates were high, but inflation was higher still, meaning that real rates were negative for much of the decade. A great time to have been a prudent borrower (although I understand mortgage availability was restricted at that time relative to now).

    Mortgage borrowers (and lenders) generally do their ability to pay analysis off nominal rates and current income. In those circumstances, inflation is the borrower’s friend as it “eats away” at the principal and naturally grows their repayment capacity(as wages, in general, grow with inflation+).

    Further, high nominal interest rates cap leverage as people will limit their debt servicing obligation to a fixed % of their post tax income. You get a triple bonus if those high nominal rates you borrowed at initially are reduced during the term of your loan (ie anyone who borrowed to purchase in the late 80s/early 90s (read: the BB generation) got a few free kicks: 1. not overly leveraged initially due to high rates, 2. interest rates then went down during the 90s, slashing your mortgage bills, 3. new suckers coming in to the market could pay more for exactly the same house due to the lower rate environment, making you flush with paper capital gains).

    Low inflation has led to lower nominal rates. This has meant that people now borrow more (as they continue to apply the same debt servicing ratio – “I want to spend x% of my post-tax income on mortgage repayment”, irrespective of nominal interest rates), and the de-levering benefit of inflation on the principal is now greatly diminished. Interest rates also offer hyberbolic effects. The change in debt servicing from 15% to 12% interest rates is not the same as from 8% to 5%.

    Couple that with anemic economic and salary growth (other than for one sector of the economy), and you have the recipe for the current malaise.

    People have borrowed too much, and the structural reduction in inflation has contributed to the problem. With inflation lower, you actually need to work harder (ie earn more) to pay down your home loan – never a pleasant task – and the game of not paying off your loan but using the equity build to trade ever up is now looking old hat.

    Inflation (and higher interest rates) used to be a natural protection for people from their own stupidity and the greedy mortgage banker. Now, its absence will hurt them both.

  12. Nice work Cam

    Interest rates have a fair way to fall here which provides some cushion for those late to the market. However the capital value of assets will decline quicker as they are doing right now in Melbourne (finally). Not good for wannabe investors or the younger folk swallowing the BS served up by the property spruikers.

    I’m glad you showed the occupancy per household graph – it reflects the inevitable supply of housing stock for rent and for sale – a clear negative effect on the price of houses.

    With the ageing demographic of the population and the start of the “pill effect” upon us (10 to 12 years to come), we have a long way to unwind this bubble.

    40% in my view – probably over a 3 to 4 year period, the damage will come early but will linger for a decade or more as people’s mind set towards property will turn 180 degrees, if not permanently (current generation – I reckon this will linger for 20 years to sort out the mess in the western world … which by default engulfs the third world).

    Australia is the most over valued country in the world – plain and simple. And then by some …

    • All I can say is that I feel really sorry for young people starting households in this day and age. Unfortunately the system and what you need to know about economics has exploded and for the average person it is hard to decide what action to take. Our financial system is overly complicated now where even economic “experts” can’t get consensus about what people should do for their future. The media, property lobby, government and anyone with authority is telling them low interest rates and grants are great for affordability and they should buy asap. Not that interest rates are low and therefore your slaving away to pay the mortgage will not dent the interest as much as your parents.

  13. It will be good to get Cameron Murray’s capacity for research and analysis added to the already good Macrobusiness team. This is a good post, and fits well with the focus of the “Unconventional Economist” in particular. Just keep the “supply doesn’t matter” controversy in the background, please, Cameron.

    I strongly agree with the people who “liked” THIS:

    “For the same interest payment, a high debt balance with a low interest rate is more difficult to repay than a low debt balance with a high interest rate.”

    Someone had to put it this clearly eventually. Well done for being “that man”, Cameron.

    One massive irony that exists in the world economy today, is that the (comparatively few) people who enjoy low house prices thanks to the existence of a free market in their city’s land market, are now also enjoying low interest rates courtesy of “monetary easing”. Those Germans and Swiss, and those Southern and heartland US States, will be on a continual win relative to their idiotic distorted-land-market economic competition.

    “Discretionary Income” or WHAT…..??? Then the idiot “anti sprawl” crowd will wet its pants because all these people will be buying V8’s and spa pools and generally “living unsustainably”……

  14. There is a lot of irony in the difference between the world’s “anti sprawl” cities with inflated housing costs, and the ones with low housing costs and high “discretionary incomes”. The latter, tend to spend their high “discretionary income” on things that are “less sustainable”. But the “anti sprawl” activists fail to indentify the differences in outcomes between cities, as the result of “discretionary incomes”. Instead, they wallow in hubris about how “successful” their urban growth constraints have been. Never mind that fossil fuel use is down, in their “model” cities, because there is simply less discretionary income for people to spend on it, or because more people are outright jobless.

    “Future proofing” urban economies by imposing heavy de facto taxes on them, is like voluntarily selecting for one’s own Darwinistic demise. It is the cities WITHOUT the taxes, and with the high discretionary incomes and the currently “unsustainable” lifestyles, that will still be standing if and when the oil runs out or whatever Ecopalypse takes your fancy. The “Smart Growth” cities are the ones that will have died off first. The “live free or die” cities, will have modified their lifestyles as they HAD to, AND will have had the money to do it with.

  15. Cameron. A good article; I suggest you contact the Housing Industry Association and ask them what the “Household income” is? I think you will find they will quote you a figure of around $135k

  16. Well, it depends also measures can be taken at home because this happens in different parts of the world and we must try to creear or take steps to ensure that people have access to credit.