In early 2010 I wrote at Business Spectator that I did not think that the time had yet come for the reckoning of the Great Australian Housing Bubble. My rationale was simple. Although the bubble had been obvious for a decade and more, it was equally clear that authorities had the wherewithal to bail it out if trouble came.
And so it has proven to be. The commodity super-cycle came and went and housing eased and then boomed again.
In 2011, I coined the phrase “politico-housing complex” to define the extraordinary capture of policy at all levels of government by the bubble, its ideologies and its interests. Again I did so because it was obvious that nobody gave a hoot that the bubble was in the process of crowding out the entire economy bar resources. Not only that, that authorities were hell-bent on propping up the bubble no matter how perverse policy became.
Since that time I’ve repeatedly fought for policies that would either back-fill the bubble or see it deflate slowly. Any other outcome will be a terrible trial for the country and make no sense in terms of public policy. The mining tax was one such policy, a Son of Wallis inquiry with teeth was another. Myriad policy remedies for a lower dollar, increased competitiveness, raised productivity, the rescue of manufacturing, on the list goes, all have been directed at correcting this one giant imbalance.
All have been ignored, trashed, botched and discarded.
Well…this week, for me, we passed some kind of invisible tipping point. I no longer think that Australia has the resources to sustain the bubble into the future, nor does the politico-housing complex have the brains to pull off such a deft act indefinitely. Right now, the complex is marching the nation towards its doom.
Hitting the limits
The key event this week was the ratings agency Standard and Poors (S&P) putting a hard cap on Australia’s net debt levels at 30% of GDP to sustain the AAA rating. To understand why this is so vital you must first understand how the Australian economy works.
Our economy is a unique combination of the pre and post-modern, with no modern in between. We earn commodity income like cave men trading stones then borrow against it in offshore markets using hyper-real credit instruments, and tip that debt into houses. This asset inflation underpins the entire services and consumption economy, which barely exports anything and has terrible productivity and so can’t raise its own income. The kicker is that because commodity exports are capital not labour intensive, it is only through the second step of leveraging and asset inflation that domestic economic activity is produced.
It was not always thus. We used to have a much higher component of modern industries that were more labour intensive, tradable sectors that generated domestic economic activity and productivity growth without the need for debt. But after years of double Dutch disease and a radical over-concentration of ownership in all sectors, these are largely gone and in their place the credit and housing bubble has become the domestic economy.
You might ask why that matters. So long as we can keep borrowing overseas then we can keep on keeping on. We’re solvent so what’s the issue? That’s true, to a point.
But there are two problems with the system. Households are leveraged to the hilt and really can’t borrow any more, nor do they want to.
Second, our banks are also leveraged to the hilt. They’ve used every trick in the book to squeeze more mortgages out of astonishingly thin capital bases. Their first reckoning came in the GFC when they were bailed out by public guarantees to their debts and the banks have been trading on the public balance sheet for free ever since.
That bring us back to S&P. Its 30% of GDP cap for net public debt is very low in comparison to other AAA nations. But the reason it’s so low is that the Budget supports the banks’ enormous offshore debts via the guarantees. It is not the banks’ prudence or metrics that let’s them borrow at low enough rates in global markets to keep pumping up housing to keep the domestic economy ticking, it’s the clean public balance sheet, and S&P is exactly right to insist that it remains ship shape.
That’s the first reason why I see Australia running out of ammunition to support the credit and housing economic model. Here is a chart of our net public debt:
Net public debt is currently at just above 20% of GDP (including Future Fund assets). More importantly, look at the 2009/10 parabola that took it from -5% to 15%. That’s what a recession does to public debt via stimulus and falling tax revenues, as well as automatic stabilisers like rising unemployment benefits. At all levels of government, in the past six years we have spent a net $320 billion just to keep the economy growing below trend, despite the greatest commodity boom in the nation’s history.
At a 30% ratio the AAA rating goes. I spoke with S&P sovereign analyst Craig Michaels yesterday and asked him how hard is the cap, especially in the circumstances of a recession. He said that they might offer some flexibility when the chips were down, to the extent that the ratio temporarily blew out to 31% or 32%, depending whether or not the external vulnerability was getting better or worse. In other words, it’s a hard cap. Very hard.
In the next few years the public debt to GDP ratio is going to get worse by a couple of percentage points as the terms of trade keep falling and government growth forecasts miss. As a result, we’re more likely than not going to enter the next recession with roughly half of the fiscal firepower used in 2009/10 to rescue the economy.
So, the downgrade is coming. And it’s going to hurt. The moment the AAA is lost, the guarantees ensure that bank’s ratings will be cut too and their cost of funds will rise at a time when fiscal policy is severely constrained and growth hard to come by. That unfortunate combination brings us to the second reason that the politico-housing complex passed a tipping point this week.
Australia’s financial system is once again off the leash and expanding its offshore borrowing:
Worse, much if it is short term debt:
And, the ratio of offshore private borrowing to GDP is headed back to its GFC highs:
All of these ratios are set to worsen swiftly as credit growth has begun to accelerate for housing and business, as we saw yesterday in the credit aggregates.
When the next recession comes globally, in my view in 2016, the Australian financial system is very likely going to find itself locked out of global markets once more and if current trends persist its vulnerability to the event will be not dissimilar to 2008. The Reserve Bank of Australia (RBA) will be called upon again to provide an abundance of liquidity, and it will, but more importantly, this time around it will have a lot less ammunition to cut rates and absorb the financial system’s higher funding costs, only 1-1.5% of rate cuts left in its holster versus the 4.25% of cuts deployed in the GFC. As it cuts rates banks will be caught between the need to fatten margins to offset rising bad debts and to lower interest rates for clients to prevent the debts going bad in the first place.
That has the makings of a credit crunch.
In short, we’ll face a situation in which both fiscal and monetary policy is impaired and the Great Australian Housing Bubble, neh, the Great Australian Credit Bubble, all thirty years worth of it, will be pressed up against a bed of nails.
No way out?
Is there anything that can be done to dodge this fate? There was. We needed to improve our competitiveness to restore growth in tradable sectors while keeping the boot on credit.
The RBA was doing magnificently through 2010/11. The last chart above shows you the wonderful disleveraging it was managing, taking full advantage of the serendipity of the mining boom. Had it persisted with a policy of repairing structural imbalances by cutting interest rates and installing macroprudential policy to control credit, I believe it would have pulled off the near impossible, the soft-landing of a genuinely huge housing bubble.
Alas, it did not. It squandered our good fortune by opting to kick the growth can via a renewed house price boom in the name of a few new houses. Thus the dollar has remained far too high, tradables have been hollowed out further, and our external vulnerability is growing once more.
Is it too late to turn back? Perhaps not and I reckon the high dollar will force macroprudential. But when it finally comes it is more likely as not to only slow the build up of imbalances, not reverse them. It’s probably still a better option than raising rates but it’s no longer a cure.
On the fiscal side there are many things that could be done. In a kind of mashed-up fashion, like its wearing boxing gloves during micro-surgery, the Abbott Government is doing many of them. Repairing competitiveness is one of its policy touchstones but its efforts are extraordinarily blundering. Attacking unions while supporting rentier businesses won’t improve productivity. Directing tax reform at supporting rentier businesses instead of productivity gains won’t do it either. Budget repair that protects rentiers at all levels while hammering the vulnerable will make income growth worse. A mad dash for Keynsian road spending and asset-recycling without precise analysis will produce economic activity for its own sake but no lasting productivity dividend, as well as make the debt burden worse. Hugely expensive and ill-considered reforms like the PPL and the Medicare co-payment are simple wastes of money. Ignoring fiscal remedies for the high dollar while pumping population growth only weighs on competitiveness further as the nation slowly chokes on its own good fortune.
Yes, there is a way out, but the Government’s efforts are so ham-fisted that even if it sees the exit it is careening head first into the wall beside it.
How does it play out?
So, how does the crisis play out? I don’t know. It may not happen at all. China may keep the pedal to the metal against its own interests long enough for some other act of serendipity to appear. But if it does happen, and the risk is more real this week than ever before, then it will come in the form of a rolling current account crisis, perhaps like that of the United States but more likely a little slower.
Over the next year, and probably sooner rather than later, monetary authorities are going to have to tighten mortgage lending. Housing and increasingly banks (and non-banks) are out of control. The bubble is obvious enough that RBA and APRA credibility is now on the line. I reckon they’ll use macroprundential to do it because in the circumstances of the mining capex cliff rate rises will risk recession. Either way, they will be forced to slow housing one way or another and we’ll likely enter the next global crisis with stalled and falling asset prices.
At first, our banks will appear to be OK. Rising bad debts will be absorbed by rate cuts, automatic stabilisers and a little fiscal stimulus. We’ll also have the ongoing ramp up of LNG exports to support headline growth, even though income growth tanks with global commodity prices and China going ex-growth.
Renewed housing stimulus is very likely. It is cheap, popular and easy. House price falls will be reversed temporarily. And besides, there is nothing else! Even so, unemployment will rise to 8%.
But, a year or more post-crisis, with growth still weak, budget repair will become a pressing priority and the fiscal screws will tighten even as the economy fails to sustain a rebound. It is then that the AAA ratings will be stripped and Australia find itself with no room left for public spending, interest rates at rock bottom with the banks’ cost of funds stubbornly high and rising, house prices still sliding and unemployment getting higher still.
Some form of very expensive bank bailout will probably become necessary. The most likely scenario being a nationalisation of the Lender’s Mortgage Insurers, which will enable the government to channel tens of billions of dollars to the banking system on the quiet as it pays out premiums on dud loans hand over fist. Think of the US bailout of AIG for a comparison.
We will enter a long shakeout of falling house prices, massive budget deficits, fiscal austerity and the chase for export-led growth. The great blessing will be a dollar trading at 50 cents and rising Asian growth that will continue to support commodities, education and toursim.
The event will be of greater scale than the 1990 recession, and will probably be compared with the 1890s crash. Unemployment is going to run well into double figures.
What I am describing here, really, is the end of a thirty year delusion. It’s called various things in various places. The US and UK know it as “financialisation”. In Australia we call it the Pitchford thesis: that private sector debt is irrelevant in economic calculus. It’ll die out without any real recompense or accountability, as is the Australian way, and be replaced with an older wisdom, that current account deficits really do matter, in the long run.
Of course I could well be wrong. Probably even! Something may come along once more and our famous good fortune bail us out again. This is futurism not science. All I can do is point out that this is the path that the politico-housing complex has put our feet upon.