Feature Stories | Nov 15 2006
By Greg Peel
When the bubble burst in Japan at the end of 1990, the Nikkei index had hit 40,000. In the following ten years it halved in value, to 20,000. In the first four years of this century, it more than halved again – to a low of 7,600 – before beginning a long-awaited recovery. Dr Steve Keen, Associate Professor of Economics and Finance at the University of Western Sydney, sees eerie parallels between Japan in the 80s and Australia today.
Former prime minister Paul Keating famous labelled the early nineties recession in Australia the “recession we had to have”. Dr Keen is convinced we are soon to hit the “recession we can’t avoid”.
“Private debt is by far the most important economic issue today”, says Dr Keen, “far more so than the rate of inflation – and that should be the focus of policy attention.”
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Inflation is an enigmatic beast. It could perhaps be called the cholesterol of an economy – for there is “good” inflation and “bad” inflation. Like most things economic, there is not always agreement as to which is really which, or at least to the extent of just how “good” or “bad” inflation is for an economy at any stage of a cycle.
To the average Australian, inflation is bad, as it means the prices of goods and services go up. On the other hand, low unemployment is good, because most everyone has a job. A “tight” labour market tends to force up wages, so if wages rise with rising prices, is that really a problem? Perhaps not on the surface.
Inflation implies, however, that the value of money is being eroded over time. It is thus not a good idea to keep your money under the mattress, as it will be worth less as each day goes by. The price of food, for example, will rise, but your mattress stash will still be the same.
Thus it’s better to spend that money now. It is not good economics to save it.
In fact, it actually pays to borrow money. The money you borrow now to spend now will be worth less in time. So if you want to buy a house, there’s no point in saving for one in an inflationary environment – your savings will be undermined. Better to borrow as much as you can afford, and let inflation work for you. If all goes well, the value of the house you buy now should also increase.
The matter of affording that house will come down to how much interest you have to pay. The lower the interest rate, the easier it is to service your loan on your current income. Thus the lower the interest rate, the more you can afford to borrow.
Another way to stay ahead of the erosion of the value of money through inflation is to invest in the stock market.
The Australian stock market has been booming of late because of the increased demand for Australian commodities, generated mostly by the industrial emergence of China. Commodity prices have risen, so resources companies have been able to charge more for their product. Price inflation has thus increased profit margins. This is good inflation.
But after a few years of dramatic economic growth, driven by the commodity boom, resources companies have found that everything they need to carry out their mining operations has also increased in price. Energy costs and equipment costs have increased, and due to a growing scarcity of mineworkers, so have wages. Cost inflation erodes profit margins. This is bad inflation.
It is the same in mining as for any business – expand or falter. Profits cannot continue to be increased in value if margins cannot continue to be increased. Thus in order to increase profits, businesses must start new projects, or acquire existing ones. One way to finance expansion is to raise equity capital. Another way is to borrow. If interest rates are low, borrowing seems an easy solution.
The Reserve Bank of Australia is a tenacious fighter of inflation. For many years it has targeted a “core” inflation comfort zone of 2-3%. A little bit of core inflation is a good thing, as it implies the economy is growing and profits are being made.
“Core” inflation differs from “headline” inflation by removing those elements that are subject to a lot of price volatility. If headline inflation were the sole measure, the inflation rate would jump around spasmodically and lead to a difficulty in picking the trend. That’s why the RBA is not concerned with the price of bananas. If a cyclone knocks out the banana crop one year, sending prices surging, the RBA knows a new crop will soon mature to bring the price back down again. No point in setting longer term economic policy on a blip in the banana price.
The price of petrol, too, has always been considered a headline inflation indicator, rather then a core one, as fluctuations in petrol prices are always transferred quickly to the pump, causing price volatility. However, the more recent secular shift in the oil price hits to the heart of core inflation when all manner of prices, petrol aside, need to be adjusted up to offset the entrenched added cost of fuel in the production and transport of goods.
If core inflation starts getting too high, this is bad. As costs rise, the risk is the economy will begin to slow down. Consumers cannot keep absorbing price rises forever, and profit margins must begin to give way. With no profits, the economy must quickly contract. The more inflation is allowed to run out of hand, the bigger the crunch will be, and the greater the ensuing hardship. When workers are laid off in numbers, an economic recession goes right to heart of the community.
That is why the RBA is a tenacious fighter of inflation. That is why it keeps a wary eye on core inflation, the cost of goods and services, and the cost of wages. If the economy is growing rapidly, such that core inflation begins to get out of hand, it needs to be reined in to a more moderate and comfortable pace. As economic expansion is largely funded by credit, the easiest way to rein it in is to make credit more expensive. This is achieved by raising the interest rate.
Higher interest rates have the effect of slowing economic expansion as new projects, company acquisitions, factory building or store rollouts become costlier. But higher interest rates also have an immediate effect on those companies which have already borrowed money. If borrowing is extensive – in other words if that company is “highly geared” – then this will impact profit margins directly. There’s no point in raising margins because everyone is in the same boat, and won’t be able to pay more. Demand will slow.
The nature of business in a capitalist world is that companies will rise and fall. This is seen to be important to a healthy economy because the strong will survive and the weak will fail, providing ongoing efficiencies. When a business fails, there is hardship felt by those involved, but that was the risk undertaken. Business is after all a risk/reward game.
However, in a growing economy it is not only businesses that borrow money, but individuals. Average Australians borrow money for houses, cars, televisions; to buy investment property, or to invest in the stock market. Average Australians run a credit card. When interest rates rise, to stave off inflation rising in a growing economy, individuals are hit directly in the hip pocket.
As with companies, individuals are far better positioned to cope with rising interest rates if they are not too highly geared. If their mortgage cost is not too great a proportion of the income, then the adjustment is easily made. If they own at least the family’s second car, and their furniture and electronic goods, and if their credit card is constantly kept in check, then there’s not too much to be overly concerned about. Sure, there might be the odd sacrifice – that new frock perhaps – but so be it.
Unfortunately, twenty-first century Australians are not like that.
In 1975, inflation in Australia reached over 17%. This makes the RBA’s “comfort zone” seem a bit absurd by comparison. The key to seventies inflation were the OPEC oil shocks, which sent oil prices through the roof all of a sudden. While oil prices then were not much different, in real terms, to prices seen this year, the problem was this was a “supply shock”, where OPEC cut off supply, as opposed to the demand-driven price of today.
At the same time, interest rates were around 10%. It makes 6.25% look pretty cheap. But if rates were that high, why didn’t everyone go to the wall? The answer is because the ratio of Australian debt to GDP was only a third of what it is now.
In the runaway train that was the boom of the eighties, inflation was under 10%, but interest rates reached 17%. The stock market had quadrupled in the decade, and its crash in 1987 ushered in that recession we had to have, and began to send interest rates slowly back to historically low levels.
While the recession in the nineties was a tough time for the average Australian, the debt ratio was still only around half of what it is today.
The inflation rate and interest rate numbers are a lot lower by comparison today, so does that mean the increased level of debt is not so dangerous? No.
In the period 1988-1990, Australian mortgage rates rose from 13.5% to 17%, which is a 26% rise. That latest cycle of interest rises has seen mortgage rates rise from 6.05% to 7.8% – a rise of 29%. As Dr Keen points out, the current debt burden is more than 13% of GDP – the highest since the peak of the nineties recession.
Back then, the debt ratio was all about corporate excess. It was the decade of Robert Holmes a Court and Alan Bond. 10% of the 13% figure was corporate debt. Today, the corporate contribution is less than 5% (although it is turning around again).
This means most of the debt burden currently falls upon households.
“Fighting inflation and ignoring debt was a feasible policy choice when debt levels were ‘low’.” says Dr Keen, “But ever since then, the explosion in debt levels should have made debt at least as important an issue as inflation.
“Interest payments on mortgages account for twice as much of the GDP now as in 1990. The mortgage interest burden has doubled in just six years, from 3% in 2000 to 6% now. It has risen by over 15% since the 2004 election”.
“Official interest rates have risen 15% since 2000, but by far the major contribution to the increased repayment burden has been the increase in mortgage debt, which has risen a staggering 182% since 2000. The figures since the last election are 10.6% and 23.1% respectively, so even though official rates have been increased three times since then, rising debt has been more than twice as important as rising rates. Mortgage debt is now the largest component of private debt in Australia, having surpassed corporate debt in 2001.”
(Dr Keen’s comments were published on the Monday before the November rate rise on the Wednesday, so we have now had four interest rate rises since the election.)
Companies learnt their lesson in the recession of the nineties, and reduced their levels of debt significantly. When interest rates fell to historically low levels ten years later, companies still had long enough memories to know it was not a reason to go to town on borrowing once more.
Individuals, on the other hand, had no such memory. Generation X hit adulthood just in time to combine a “must have now” philosophy with easy monetary policy. These are the so-called “aspirants” – tertiary-educated, technology savvy, gainfully employed, and ready to enjoy the trappings of wealth. There is no waiting around for Generation X. And no there is no substitute for size. For them it is the McMansion, the four-wheel-drive Sherman tank, the wide-screen TV, and private school education for the kids. Armani for him, Dolce & Gabana for her.
There is also an inherent need to keep up with the Joneses.
As Dr Keen states: “Rising debt is not a problem; what is of concern is the ratio of debt to income, and the debt service burden this generates. Here we are in uncharted territory. The private debt to GDP ratio is now 144.5% – the highest it has ever been.”
This number cannot keep growing, for if it did eventually all disposable income would be needed to service debt. Interest alone on mortgages (before principal is paid) accounts for 39% of household disposable income, compared to 19% in 1990 when mortgage rates reached 17%.
Anecdotal accounts suggest that one way the “mortgage belt” is coping with consecutive mortgage rate rises is to stop paying the principal on their loans and maintain only the interest rate payments until the heat is off. Interest only loans were popular during the housing boom, as were no deposit and low documentation loans, because house prices were rising rapidly. There was little thought given to owning the house ultimately – rather, selling out at a profit was the goal.
But this also pushed prices up for people just wanting to own their own home, so the attitude became “get in now or miss out”. There was no problem with stretching the mortgage, as the value of the house would rise.
The problem now is that house prices have fallen from their peak in the most populous centres of the country, and are likely soon to top out in the most economically strong. If mortgagees are unable to keep up the interest payments on their homes, let alone principal payments, they could be forced to sell at a loss or worse, be foreclosed. There is already evidence to suggest that “mortgagee sales” have increased dramatically.
Yet evidence also suggests that while credit levels in Australia are no longer growing at as rapid a pace as they were earlier this year, they are still growing. The mortgage to debt ratio is still rising. Says Dr Keen:
“It appears that the price of credit has little or no impact on the demand for it. A borrowing binge only comes to an end when its adverse consequences can no longer be avoided. Then, when a slump follows a debt bubble, as in 1990, no amount of rate reductions can encourage borrowers to borrow. If interest rates are the RBA’s only policy weapon, then on the issue of private debt, it appears impotent.
“The RBA nonetheless seems intent upon raising rates, in the belief that inflation has reached dangerous levels, and increasing interest rates will restrain it. I expect much of their thinking is underwritten by “general equilibrium” economic models, in which interest rate increases restrain inflation by (a) making savings more attractive than spending; (b) reducing the incentive to invest; and (c) reducing growth in the money supply, thereby reducing the rate of growth of money relative to goods.”
By focusing on inflation and not debt, Dr Keen believes the RBA is “winning the last war”. There is no doubt higher interest rates will eventually curb inflation, but this will come about through a chain reaction of bankruptcies, not by any smooth adjustment. The RBA may be “slaying the David of inflation”, says Dr Keen, “while leaving the Goliath of debt alive”.
It was noted earlier that in the seventies, inflation was much higher than interest rates. In other words, real interest rates were negative. The debt to GDP ratio dropped in the seventies not because debt was repaid, but because inflation eroded the real burden of debt. When debt reaches excessive levels, “this may actually be a good thing”, notes Dr Keen.
This is what Japan came to realise in the nineties.
Prior to 1990, Japan was experiencing an economic boom that had seen Japanese incomes, which had being surging since the end of World War II, exceed those of the US. The Nikkei index was at 40,000, compared to 16,000 today. The property boom was so extreme that the land value of the Imperial Palace in Tokyo – ten square kilometres – exceeded that of the state of California.
Japan subsequently fell into depression from 1990 to 2005. Dr Keen notes that “commentators of all political and economic persuasions are in rare unanimity” that the debt accumulated during the ‘Bubble Economy’ was the root cause.
So how does Australia compare today to Japan in 1990?
There may be some differences in statistical measures, warns Dr Keen, but the level of debt that led to crisis in Japan is about 40% BELOW the level that currently prevails in Australia.
Dr Keen also notes quickly that debt financing plays much greater role in Japan than it does in Australia or the US, which is one probable reason for Japan’s greater sensitivity, but there is little doubting this is a frightening comparison.
While Japan was suffering through depression, Australia’s economy boomed, and Australians enjoyed apparent wealth of which their parents and grandparents had only dreamed. But was this wealth real?
Fuelling growing wealth has been growing debt. Global interest rates have reached historically low levels since the late nineties, when excessive money printing by the US government was deemed necessary to kick start the economy out of the Asian currency crisis, then the LTCM hedge fund collapse, and then the tech-wreck.
Inflation, too, fell to low levels, but as the effects of easy monetary policy have flowed through the economy it has been rising slowly ever since. The CPI is only one measure of inflation. Another is an increase in the monetary supply. Many an economist would argue that inflation has actually been much higher than price inflation measures suggest, for some time now. And this is the really “bad” inflation. Just look at Zimbabwe.
Most of the borrowing in Australia has been done by wage-earning households, and not by the excessively wealthy. The average Australian has been living it up on credit. Wealth has now transferred to financial institutions – the lenders. This was okay when house prices were rising, but they have now fallen in the most populous centres. It might be okay so far for those invested in the stock market, but only if the stock market keeps rising.
Dr Keen suggests it is the average Australian who has now “done an Alan Bond”. They have financed a speculative bubble whose unwinding must ultimately impact negatively on the economy.
After three rate rises this year, the RBA now has hinted (in its quarterly statement this week) that it will sit back and watch what happens. Its hope, clearly, is that this last bit of pain is enough to put a brake on things, without tipping the economy over the edge. Recently the RBA has been perplexed, because despite no noticeable increase in productivity, employment is still growing, and despite higher interest rates, credit is still growing.
Japan experienced a similar puzzle, notes Dr Keen. Debt continued to accumulate even after the bubble had burst. Dr Keen is not so perplexed, however, as he points out that in Japan “the momentum of debt commitments overwhelmed the ability of borrowers to finance debt”. What this meant is that unpaid interest had to be capitalised into increased debt.
The data would appear perplexing, says Dr Keen, if conventional economic theories are assumed. However, if one considers the “Financial Instability Hypothesis”, developed by post-Keynesian economist Hyman Minsky, the data make “eminent sense”.
The hypothesis argues that markets tend to develop “euphoric expectations” that lead to investors taking on excessive debt during booms. (It is not hard to see where this hypothesis might be applied to Australia.) When expectations aren’t fulfilled (for example, housing prices fall) they find themselves having to pay debt down in depressed conditions.
“As a result, the level of debt tends to ratchet up over a series of booms and slumps – a process that can lead to a ‘debt deflation’ if high levels of debt coincide with falling prices.”
Dr Keen’s work involves modelling this hypothesis. He notes that:
“…as with the actual economy, a boom (rising employment) occurs just before the debt to output ratio reaches its minimum in any given cycle, while the peak in the debt ratio occurs well after a slump (marked by falling employment) has commenced. Also, as with the Australian data, the lag between the start of the slump and the peak of the debt ratio grows over time, as the system gets closer to a debt-induced breakdown: the lag starts at 6 years, and blows out to 9 years in the final cycle before breakdown. In the final cycle, debt explodes as soon as a downturn begins and the economy collapses.”
The good news is that economic collapse can be avoided when the model is set up to avoid “debt deflation”. The bad news is this is not what we see in the Australian data.
While the RBA watches the economic data closely, looking for any signs of increasing inflation that might trigger the need for yet another interest rate, I’ll leave it to Dr Keen to conclude:
“Debt has reached unsustainable levels, and whether its reduction is done smoothly or abruptly, economic growth has to slow in the meantime. 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.
“A recession may have already started in the domestic economy, with only the China/India export boom masking the phenomenon. Certainly the NSW economy, like the global-warming affected weather itself, is in the doldrums.
“In this situation, doing anything – like increasing interest rates to ‘contain inflation’, or increasing subsidies to home buyers (as happened in 1991 with the doubling of the First Home Buyers’ grant) – will be worse than doing nothing at all.
“Paul Keating’s most famous aphorism, ‘the recession we had to have’, gave the 1990s recession an apt moniker. I fear that whatever policy is followed, the next recession will be will be known as ‘the recession we can’t avoid'”.
Speaking on ABC radio last week, shortly after the RBA raised interest rates, Dr Keen suggested that this recession is one to two years away.
Source: Monthly Debt Report November 2006, “The Recession We Can’t Avoid”; Dr Steven Keen, Associate Professor of Economics & Finance, University of Western Sydney. Report kindly provided by Dr Keen. Charts republished with permission. The full report is available at www.debunkingeconomics.com.