Tag Archives: debt

Why deficits are bad

There have been many posts here on the blog arguing that government debt and deficits should not be feared, at least not in countries with their own free-floating currency and without foreign currency public debt*. In doing so, I have never discussed the reasons people may have for holding a contrary view. But I have now come across a rather disturbing theory on the news site Alter.net.

It may be that there are some who would like to see an end to government deficits because they adhere to the Chicago school of economics and scoff that Keynes was thoroughly discredited by the stagflation of the 1970s. There may be others who challenge supporters of government spending with a simple question: if too much debt was the cause of the financial crisis, how could more debt be the answer? (Of course, regular readers of the blog will know the answer to this one: the debt build-up before the crisis was private sector debt and for the private sector to reduce debt by saving again, the government must run a deficit**). Still others may think that deficits cause recessions (rather than recessions causing deficits).

But the theory offered by Alter.net is simpler still. Perhaps people think national debt is bad because it actually means a bad economy. Literally. They just do not understand the meaning of the words.

The evidence offered goes back to a US presidential debate from 1992. In the debate, an audience member asks the candidates the following question:

How has the national debt personally affected each of your lives. And if it hasn’t, how can you honestly find a cure for the economic problems of the common people if you have no experience in what’s ailing them?

If you watch the resulting exchange here, it quickly becomes clear that, in the questioner’s mind, “national debt” is in fact synonymous with “recession”. National debt doesn’t cause unemployment, it is unemployment!

Of course that clip is almost 20 years old and it is America, not Australia. But it still worries me. Could it be that part of the reason that it is so hard to have a rational debate about debt and deficits is that some (or even many) of the voting public do not understand what the debate is about? I hope not!

* So the eurozone is a different matter altogether!

** Either that or run a current account surplus…which is still something we have not achieved in Australia.

S&P being silly again

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The debt rating agency Standard and Poor’s (S&P) has placed their rating of the US on negative outlook. What this means is that they are giving advance warning that they may downgrade their rating of the US from its current AAA level (the highest possible rating). Their actions were motivated by concern about “very large budget deficits and rising government indebtedness”.

To me this shows that S&P do not have a good enough understanding of macroeconomics to be in the business of providing sovereign ratings. How can I doubt such an experienced and reputable organisation as S&P? Well, keep in mind that this is the same agency which maintained investment grade ratings for the likes of Bear Stearns, Lehman Brothers and AIG right up to the point where these firms were on the brink of collapse (while it was only Lehman that actually failed, that was only because the other two were bailed out). Likewise, it is the same agency which assigned investment grade ratings to sub-prime CDOs and other structured securities many of which only ended up returning cents in the dollar to investors during the global financial crisis.

Of course many commentators are very nervous about the growth in US government debt (notably, the bond market seems far more sanguine) and typically assert, with little justification, that growing government debt will lead inevitably to one or more of:

a failure of the government to be able to meet its debt obligations,
rising inflation as the government seeks to deflate away its debt (and interest rates will rise in anticipation of this future inflation), and
a collapse of the currency as the government seeks to devalue its way out of the problem.

Before considering how likely these consequences really are, it is important to emphasise that while there is a widespread tendency to label all of these as a form of “default” by the government it is only the first of the three, a failure of the government to make its payment obligations, that the S&P rating reflects.

In fact, I do not consider any of the three consequences above to be inevitable. The quick and easy counter is to point to Japan. As its government debt swelled to 100% of gross domestic product (GDP) and beyond, it never missed a payment, would have loved to generate a bit of inflation but consistently failed year after year and, while its currency has its ups and downs, the Yen remains one of the world’s solid currencies. While I certainly do not think that the US should aspire to repeat Japan’s experience over the last couple of decades (I would hope for a better recovery for them), this point should at least dent the simplistic assumption that default, inflation or currency collapse follow rising government debt as night follows day.

Since it is only a true default that is relevant for the S&P rating, it is worth considering more specifically how likely it is that the US government will be unable to honour its debt obligations. Regular readers of the blog will know that I regularly make the point at the heart of the “modern monetary theory” school of macroeconomics, namely that in a country where the government is the monopoly issuer of a free-floating currency, the government cannot run out of money. If your reaction to that is “of course they can print money, but that would be inflationary!”, ask yourself why that did not happen in Japan and then remind yourself that even if it did happen, it is not relevant to the S&P rating.

There is one important caveat to this monopoly issuer of the currency argument. While it certainly establishes that the US government will never be forced to default on its debt, it is still possible that it could choose to default. This choice could come about in a dysfunctional kind of way since the US imposes various constraints on itself, in particularly a congress legislated ceiling on the level of debt the government may issue. So it is possible that a failure of congress to agree to loosen these self-imposed constraints could end up engineering a default. Now that is a more subtle scenario than the one that S&P is worried about, but since it is possible, it is worth considering how serious debt-servicing is becoming for the US government. To make a comparison over time meaningful, I will take the usual approach of looking at the numbers as a proportion of GDP. Taking the lead from a recent Business Insider piece*, the chart below shows US government interest payments as a share of GDP rather than the outright size of the debt. This has the advantage of taking interest rates into account as well: even if your debt is large, it is easier to meet your payment obligations if interest rates are low than if they are high.

US federal government interest payments as a share of GDP

So the interest servicing position of the US government has actually improved of late and is certainly much better than it was in the 1980s and 1990s. So why is S&P reacting now? I would say it is because timing is not their strong suit (and they do not really understand what they are doing). Ahh, you say, but what happens when interest rates start going up? Since the US Federal Reserve controls short-term interest rates and of late, through its Quantitative Easing programs, has been playing around with longer-term interest rates as well, the US government is in a somewhat better position than a typical home-borrower, and interest rates will only start to rise once economic activity picks up again. Then the magic of automatic stabilisers come into play: tax receipts will rise as companies make more profit and more people are back at work, and unemployment benefits and other government expenditure will drop and the growth of government debt will slow or reverse.

So, there is no need for panic. Once again, the rating agencies are showing that we should not be paying too much attention to them. After all, as they all repeatedly said in hearings in the wake of the financial crisis, their ratings are just “opinions” and not always very useful ones at that.

Data Source: Federal Reserve of St Louis (“FRED” database).

* As Bill Mitchell, @ramanan and others have noted the Business Insider chart, while looking much the same as my chart, has the scale of the vertical axis out by a factor 10.

Where is debt headed now?

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There have been a lot of posts about debt on this blog and the chart comparing government and household debt, which appeared in two of those debt posts, has proved particularly popular in discussion forums focusing on Australian property prices. Since producing the chart, the Australian government stimulus spending has continued to work its way through the economy and has been pushing up the levels of government debt. While I would still argue, as I have done many times before, that we should not follow the likes of Barnaby Joyce in getting agitated about public debt, it does seem worth updating the chart to illustrate recent developments. The regions shaded red denote Labor party governments in power.

Australian Government and Household Debt (1976-2010)

As expected, government debt levels exhibit a marked up-swing (note that the government data includes Treasury projections to the end of the current financial year). What is striking, however, is that the levels of household debt have not yet fallen. While some of the weakness in the economies of countries like the US and the UK is attributed to consumers “deleveraging” (a fancy term for paying down debt rather than buying flat-screen televisions), Australian households are showing no signs yet of reducing their debt. And 90% of that debt is for housing.

While it may not be evident here, there is in fact a tight relationship between debt levels in different sectors of the economy. If I spend money then either I reduce my financial assets (drawing on my savings) or I increase my liabilities (borrow on my credit card or some other form of debt). Exactly the reverse is true of whomever I give my money to (let’s call them Joe for argument’s sake): Joe’s assets go up or his liabilities go down. Spending money is an example of a “zero sum game”. If I add the change to my net worth (assets minus liabilities) to the change of Joe’s net worth it adds to zero. My negative change offsets Joe’s positive change. Aggregating over the whole economy, the sum is still zero.

Now consider what happens if we divide the economy’s net financial worth into that of the government sector, the private sector and the foreign sector (which includes overseas governments). Any changes in net worth across all three have to add to zero. As a result, the change in the government position is the opposite of the change in the private sector and international positions combined. If the government debt is going up, debt must be going down somewhere else. Now we know the household sector is not reducing debt, but what if we look at the private sector overall, including businesses? A different picture emerges.

Australian Government and Private Sector Debt (1976-2010)

Taken as a whole, over the 12 months to the end of 2009, private sector debt fell by about 2.5% of GDP. This was almost as much as government sector debt rose (about 3% of GDP). The difference can be explained both by the role of the foreign sector as well as slight differences in data collection methods across different sectors. Keep in mind that chart includes the government debt projections out to June 2010, while the private sector debt data only extends to the end of January 2010.

Since household debt has continued to increase, what this means is that Australian businesses have in fact been reducing debt significantly. The reduction in non-household private sector debt over 2009 was almost 7% of GDP. Businesses appear far more concerned about their debt levels than home-buyers do. It will be very interesting to see what happens once the first time home buyers scheme is fully unwound.

Data sources:

Government debt to 2008: A history of public debt in Australia
Government debt for 2009: Reserve Bank of Australia – Series E10
Government debt for 2010: Australian Treasury – Budget Estimate

Private sector debt: Reserve Bank of Australia – Series D2

Gross Domestic Product: Australian Bureau of Statistics – Series 5206.0

Junk Charts #3 – US Business Lending

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Today’s “Chart of the Day” from Business Insider’s Clusterstock blog presents an alarming picture of the US economy viewed through the prism of bank business lending. The chart, which I have reproduced below, shows a precipitous collapse in lending*, described in dramatic language as “falling like a knife”. There is no doubt that the US economy remains in very poor health, but should we be getting as excited as Clusterstock?

Annual Change in US Commercial and Industrial Loans

Closer examination of the chart reveals that it is in fact quite misleading.

For a start, it makes the very common mistake of plotting a long series of data without adjusting for the fact that over time the value of the dollar has declined through inflation and the US economy has grown. As a result, more recent movements in the data take on an exaggerated scale.

Also, the chart shows annual changes without providing any sense of the base level of lending. Not only that, while attention is drawn to the US $300 billion annual decline in lending, the increase of close to US $300 billion just over a year earlier is ignored, when in fact the two largely offset one another. Certainly lending has declined, but rather than taking us into historically unprecedented territory, as the Clusterstock chart suggests, it actually means loan volumes are back to where they were in late 2007.

Both shortcomings are addressed in the chart below, which shows the history of loan volumes themselves rather than annual changes and overlays a series scaled by the gross domestic product (GDP) of the US to represent lending in “2010 equivalent” dollars.

US Commercial and Industrial Loans

Changes in lending do provide a useful reading of an economy’s health. But, it is important to be careful when using annual changes to read its current state. The change from January 2009 to January 2010 is affected just as much by what happened a year ago as by what happened last month. Since monthly data is available, we can in fact look at changes over a shorter period. The charts below show monthly changes, which are probably a little too volatile, and quarterly changes which are probably the best compromise. Since these charts extend only over a five year period, it is not as important to adjust for changes in the value of the dollar and the size of the economy.

Monthly Changes in US Commercial and Industrial Loans

Quarterly Changes in US Commercial and Industrial Loans

Both of these charts reveal an economy that certainly remains unhealthy and lending volumes are still declining. However, the declines of the last couple of years evidently reflect an unwinding of the enormous increases of a few years earlier. So rather than fretting that lending is “falling like a knife”, we can take some comfort from the fact that the rate of decline is diminishing from the worst point of the third quarter of 2009. The moral of the story is that charts can mislead as easily as words and should always be treated with caution.

* The data is sourced from the St Louis Fed “FRED” economic database.

Blame Greece’s Debt Crisis on the Euro

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The shadow finance minister, Barnaby Joyce, has been waxing hysterical of late about Australia’s “unsustainable” public debt. This is not a new line to take in Australian politics. Last year when the then leader of the opposition, Malcolm Turnbull, began attacking the government’s stimulus package, I argued in “Park the Debt Truck” that there was very little reason to be worried about Australia’s public debt.

This phobia of government debt is not unique to Australia. In the US, national debt is one of the primary bug-bears of the “Tea Party movement” that emerged in 2009. Widespread concern about government borrowing is helped along by the sort of simplistic fear-mongering evident in the so-called “debt clock” (and yes, I am aggrieved to say, there is an Australian version of the debt clock).

The catalyst for the current focus on sovereign debt is the crisis faced by Greece. Stimulus spending to combat the economic fall-out of the global financial crisis has led to significant growth in government debt around the world, prompting fears that Spain, Portugal, Ireland or even the United Kingdom or the United States will be the “next Greece”. This week, Business Insider published what it dubbed “the real list of countries on the verge of sovereign default”. Sourcing its information from a Credit Suisse paper via the FT Alphaville blog, they rank United States government debt as riskier than Estonian debt. That alone should raise eyebrows and suggests that Credit Suisse needs to join Barnaby Joyce in some remedial lessons in economics.

The basis of Credit Suisse’s sovereign risk ranking is mysterious. It supposedly takes into account, amongst other things, the market pricing of credit default swaps (CDS). However, they are clearly not listening too closely to the market, otherwise Argentina would be at the top of their list and the United States at the bottom (the chart below shows the actual Credit Suisse ranking). Of course, the market is not always right: just look at the tech bubble or the US housing bubble. Indeed, I know of one person working in the markets who refers to sovereign credit default swaps as a device for “taking money from stupid people and giving it to smart people”, so perhaps Credit Suisse are right not to put too much weight on these prices.

Credit Suisse Sovereign Risk Ranking*

It would appear that Credit Suisse is primarily concerned about the amount of public debt each country has (although if this was the sole criterion, Italy would rank above Greece).

Many who fret about the risk of government debt appeal to an analogy with a household budget. Just as you and I should not live beyond our means and put more on the credit card than we can afford to repay, so the government should not spend more than it earns in the form of tax. This analogy is simple and compelling. However, just as H. L. Mencken once wrote, “For every problem, there is one solution which is simple, neat and wrong,” this analogy is simple neat and wrong. The circumstances of the government are fundamentally different from yours or mine.

In “How Money Works” I explained the difference between money which derives its value from being convertible to something else, such as gold or US dollars, and “fiat money” for which there is no convertibility commitment. As I wrote in that post,

However, in a country with fiat money, the central bank makes no convertibility commitments…It has monopoly power in the creation of currency. So, the government simply cannot run out of money.

The United States, United Kingdom and Australia are all examples of countries with fiat money with floating exchange rates. None of these countries can ever be forced into default. Contrary to the alarmists, none of these countries are reliant on China (or anywhere else) for their money. Here is a simple thought experiment: when China “lends” the US government money by buying Treasury bonds, where does that money come from to buy the bonds? From US dollar mines by the Yangtzee river? No. All of the money comes from China taking US dollars as payment for their exports. So China is “lending” the US government money that was all created in the United States in the first place. While any of these countries could decide for political reasons not to repay their debt, that is extremely unlikely in current circumstances. So the United States, United Kingdom and Australia and indeed many other countries with fiat money and free-floating exchange rates should all be considered to pose an extremely remote risk of sovereign default.

But what about Greece? Unfortunately for the Greek government, ever since they joined the European monetary union and adopted the euro as their currency, they lost the power to create their own money. While the US government cannot run out of dollars, the Greek government certainly can run out of euros. To make matters worse, they are subject to the tight controls of the Growth and Stability Pact as part of the Maastricht Treaty which severely restricts their ability to use the sorts of stimulus measures Australia, the United States and others have turned to in the face of economic downturn. In fact, their national debt levels are already well over the Pact maximum of 60% of their gross domestic product.

Like the other members of the monetary union, Greece is effectively operating on a gold standard only substituting euros for gold. In A Tract on Monetary Reform, John Maynard Keynes referred to the gold standard as a “barbarous relic” and the European Union is now learning how right he was. They adopted a common currency with an eye on the benefits of streamlining commerce between member countries, but without understanding the implications for times of economic crisis. The Union is now in a bind: do they allow Greece to fail, only to see Portugal, Spain and others tumble in its wake? Or do they ignore the rules of the Pact and bail Greece out, a course of action which would doubtless leave Ireland feeling that their fiscal austerity measures were an unnecessary hardship? In all likelihood, they will find a way to dress up a rescue package with all sorts of tough language and pretend that the union is as strong as ever. The fact remains, that the euro is the real reason Greece finds itself facing a debt crisis.

But what of Estonia being less risky than the United States? The Estonian kroon is pegged to the euro, so despite not yet being part of the European currency union, Estonia has chosen to give up sovereign control of its currency. As long it goes down this path, Estonian government debt has to be considered a far riskier proposition than US government debt. Clearly Credit Suisse’s sovereign risk analyst does not understand this. Little wonder it is lost on Barnaby Joyce.

* India, which ranks between Egypt and Italy, is not shown in the chart because no CDS data is provided. The “CDS spread” represents the annual cost of buying protection against an event of default. This cost is measured in basis points (1 basis point = 1/100th of a percentage point). For example, in the chart above, the CDS Spread for Australia is reported as 50 basis points (i.e. 0.5%). This means that to buy protection against default on $100 million of Australian government bonds would cost $500,000 each year. A typical credit default swap runs for five years.

The Mule on Mortgages

Deleveraging and Australian Property Prices

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car-small A few weeks ago, I had a preliminary look at Australian property prices. That post focused on rental yields and argued that the fact that property prices have consisently outpaced inflation over the last 10-15 years can be associated with a steady decline in rental yields which has been matched by a decline in real yields in other asset classes. What I did not address was the argument that debt deleveraging will lead to a collapse in property prices just as it has done in the US. That is the subject of today’s post.

The Bubble

The bubble argument is a compelling one. The chart below shows the growth in Sydney property prices over the last 24 years. Prices rose fairly consistently over this period at an annualised rate of almost 7%. Over this period, inflation averaged around 3% per annum, so property prices grew at a rate of approximately 4%. This means since 1985, the cost of a typical house has risen by a disconcerting 123% over and above inflation. Little wonder that many people see the property market as a bubble waiting to burst.

Sydney Property Prices (1985-2009)*

The fuel driving the property market has been the rapid growth in household debt, most of which has been in the form of mortgage debt. The next chart is taken from Park the Debt Truck!, a post which looks at trends in Government and household debt in Australia. The highlighted regions show the periods of Labor federal governments. Household debt began its upward trajectory during the Hawke and Keating years, but really gathered pace during the Howard years. With the help of continually extended first-time home-buyer grants, growth is yet to slow now that Rudd has come to power.

Govt and Household Debt

Government and Household Debt in Australia

This expansion of debt has been a key factor driving up property prices. Without the easy access to money, the pool of potential home-buyers would be far smaller and with less demand pressure, prices would not have risen so fast. A very similar pattern was evident in the US, but in late 2006 the process began to lose steam. Property prices faltered, debt became harder to obtain, borrowers began to default on their loans leading to foreclosure sales which put further downward pressure on prices. The bubble was bursting.

So far I am in agreement with the property bubble school of thought. Where I part ways is concluding that Australia will inevitably experience the same fate, resuting in a collapse in property prices, possibly in the range of 30 to 40%.

Deleveraging

Words can be powerful. Once you use the word “bubble” to describe price rises, it seems almost inevitable that the bubble must burst. Similarly, “reducing debt” sounds like a good thing, while “deleveraging” sounds like a far more ominous destructive process. But all deleveraging really means is debt reduction and it can happen in a number of ways:

borrowers use savings to gradually pay down debt
borrowers sell assets to pay down debt
borrowers default on their loan

When it comes to borrowers selling assets, in some cases this may be voluntary. But it may be that they are forced to sell. A good example is in the case of margin loans to purchase shares. If the share price falls, the lender will make “margin call”, requiring the borrower to repay some of the loan. Selling some or all of the shares may be the only way to raise the money required. When borrowers default on a secured loan (such as a mortgage), the lender will usually sell the asset securing the loan in an attempt to recover some of the money lent. In this situation the emphasis is usually on ensuring a speedy sale rather than maximising the sale price.

Forced sales are the ideal conditions for a price collapse, particularly if lenders have become reluctant to finance new borrowers. If debt reduction takes the form of gradual repayment, the pressure on prices is far less. There will certainly be less demand for assets than during a period of rapid debt increase, but this can simply result in neglible growth in asset prices for an extended period of time rather than a price collapse.

To understand what form debt reduction will take, it is not enough to consider the amount of debt. The form of the debt is very important. Some of the key characteristics that will influence the outcome include:

the term of the loan (the length of time before it must be repaid)
repayment triggers (such as margin calls)
interest rates

Short-term loans can be very dangerous. In 2007, the non-bank lender RAMS learned this the hard way. It had relied heavily on very short-term funding (known as “extendible asset-backed commercial”) and back when the global financial crisis was simply known as a liquidity crisis, RAMS found itself unable to refinance this debt. It’s business collapsed and it was purchased by Westpac for a fraction of the price at which the company had been listed only months before.

The most common type of loan with repayment trigger is a margin loan. There is no doubt that a significant factor in the dramatic falls in the Australian sharemarket over 2008 was forced selling by investors who had used margin loans to purchase their shares. There are also other sorts of loan features than can be problematic for borrowers. Another one of the corporate victims of the financial crisis was Allco Finance. It turned out that they had a “market capitalisation clause” attached to their bank debt. This was like a margin call on the value of their own company and was an important factor in the collapse of the company.

Even if borrowers have long-term loans and are not forced to repay early, if they are unable to meet interest payments, they will be in trouble. A common feature of the US “sub-prime” mortgages at the root of the financial crisis was that interest rates were initially low but then “stepped up” a couple of years after the mortgage was originated. While the market was strong, this was not a problem due to the popular practice of “flipping” the property: selling it for a higher price before the interest rate increased. Once prices began to fall, the step-ups became a problem and mortgage delinquencies (falling behind in payments) and defaults began to rise. In some states, the phenomenon was exacerbated by laws that allowed borrowers to simply walk away from their property, leaving it to the lender, who had no further recourse to pursue the borrower for losses. On top of all this, rapidly rising unemployment put further stress on borrowers’ ability to service their mortgages.

So, how do Australian mortgages look on these criteria? The standard Australian mortgage is a 25-30 year mortgage with no repayment triggers. Most mortgages are variable rate and, despite the banks not passing through all the central bank rate cuts, mortgage rates are at historically low levels. In part due to the regulatory framework of the Uniform Consumer Credit Code (UCCC), lending standards in Australia have been fairly conservative compared to the US and elsewhere. The Australian equivalent of the sub-prime mortgages, so-called “low doc” or “non-conforming” mortgages, represent a much smaller proportion of the market. Many lenders cap loan-to-value ratios (LVR) at 95% and require the borrower to pay mortgage insurance for LVRs over 80%, which encourages many borrowers to keep their loans below 80% of the value of the property. Interest step-ups are rare. Mortgages are all full recourse.

The result is that while US mortgage foreclosure and delinquency rates have accelerated rapidly, they have only drifted up slightly in Australia. It is not easy to obtain consistent, comparable statistics. For example, deliquency data may be reported in terms of payments that are 30 days or more past due, 60 days or more or 90 days or more. Of course, figures for 30 days or more will always be higher than 90 days or more. Nevertheless, the difference in trends is clear in the chart below which shows recent delinquency rates for a variety of Australian and US mortgages both prime and otherwise. The highest delinquency rates for Australia are for the CBA 30 days+ low doc mortgages. Even so, delinquencies are lower even than for US prime agency mortgages 60 days+ past due.

Delinquency Rates (III) Delinquency Rates in Australia and the US**

All of this means that the foreclosure rate remains far lower in Australia than in the US. Combined with the fact that mortgage finance is still increasing, due largely to the ongoing first-time home-buyers grant, there has still been little pressure on Australian property prices. In fact, reports from RP Data-Rismark suggest prices are on the rise once more (although I will give more credence to the data from the Australian Bureau of Statistics which is to be released in August).

Once the support of the first-time home-buyers grant is removed, I do expect the property market to weaken. Prices are even likely to fall once more with the resulting reduction in demand. However, without a sustained rise in mortgage default rates, I expect deleveraging to take the form of an extended lacklustre period for the property market. Turnover is likely to be low as home-owners are reluctant to crystallise losses, in many cases convincing themselves that their house is “really” worth more. Even investors may content themselves reducing the size of their debt, continuing to earn rent and claim tax deductions on their interest payments.

The biggest risk that I see to the Australian property market is a sharp increase in unemployment which could trigger an increase in mortgage defaults. To date, forecasters have continued to be confounded by the slow increases in unemployment and now the Reserve Bank is even showing signs of optimism for the Australian economy.

Australian property prices have certainly grown rapidly over recent years. Driven by rapid debt expansion, prices have probably risen too far too fast. But, calling it a bubble does not mean it will burst, nor does using the term “deleveraging” mean that prices will inevitably follow the same pattern as the US. In the early 1990s, Australia fell into recession and the commercial property market almost brought down one of our major banks. Meanwhile, house prices in the United Kingdom collapsed. Despite all of this, in Australia, residential prices simply slowed their growth for a number of years. I strongly suspect we will see the same thing happen over the next few years.

* Source: Stapledon

** Source: Westpac, CBA, Fannie Mae, Bloomberg.

By the way, notice anything unusual in the picture at the top?

UPDATE: Thanks to Damien and mobastik for drawing my attention to this paper by Glenn Stevens of the Reserve Bank of Australia. It includes a chart comparing delinquency data for the US, UK, Canada and Australia. The data is attributed to APRA, the Canadian Bankers’ Association, Council of Mortgage Lenders (UK) and the FDIC. Since these bodies do not appear to make the data readily available, I have pinched the data from the chart and uploaded it to Swivel. It paints a very similar picture to the chart above.

Delinquency: US, UK, Canada and Australia Mortgage Delinquency Rates

Park the Debt Truck!

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About two months ago, I tried to bring some perspective to concerns about growing government debt in Australia. Last week the opposition has rolled out the “debt truck” to add to the hysteria about growing government debt, so I feel compelled to return to the subject for another attempt.

Last time I looked at net debt data going back to 1970. The data came from a chart in the Treasury paper “A history of public debt in Australia”. The paper also shows a history of gross debt and although I prefer to use net debt, the gross debt data goes back further, all the way to 1911 and so gives a longer historical perspective. As usual, I have posted the data on Swivel.

The alarmists like to trade in dollar figures, pointing to forecasts that gross government debt will peak in 2014 at $315 billion, which will be an all-time record. Of course, that ignores the effects of inflation, so it makes far more sense to look at the debt as a percentage of gross domestic product (GDP). Expressed this way, the 2014 forecast amounts to an expected 21% of GDP (while net debt will be 14%). As is evident in the charts below, this is about the same as in the years following the recession of the early 1990s and it is nowhere near levels in the more distant past. Immediately after World War II, gross debt reached an enormous 125% of GDP.

History of Government Debt

Figure 1 – Australian Government Debt (1911-2008)

If you are wondering about the shaded bands in these charts, they indicate periods of Labor Governments. The opposition is fond of saying that debt falls under Coalition governments and rises under Labor governments. Looking at the data, it is certainly true that government debt fell through both the Menzies and the Howard years (a pairing that would, I am sure, warm the cockles of our previous prime minister’s heart). Beyond that, the link is not so clear cut. What seems more apparent is that government debt fell during good economic times and rose during bad economic times and, moreover, the Coalition have not had a monopoly on good economic times nor Labor on bad. This pattern should not be the least bit surprising. When the economy booms, tax receipts rise and unemployment falls, reducing the cost of welfare payments and when it falters, the opposite occurs. As a result, the government tends to run fiscal surpluses in the good times, paying down their debt, and deficits in the bad times, increasing debt once more.

Recent History of Government Debt Figure 2 – Australian Government Debt (1960-2008)

What the debt demonisers fail to realise is that this counter-cyclical pattern of government spending is a good thing. The increase in welfare spending in troubled economic times helps boost economic activity, softening the impact of a slowdown, which is why welfare spending is often referred to as an “automatic stabiliser”. In more extreme downturns, such as the one we currently face, the government can supplement the automatic stabilisers with additional stimulus spending.

More importantly, government debt is very different from personal or business debt and is not something to be afraid of. In Australia, we have a currency that is not tied to other currencies, nor to gold or any other commodities. It is “fiat money”, effectively under the control of the government. Furthermore, all of the government’s debt is denominated in Australian dollars. This means that the government can, in fact, never run out of money, unlike individuals or businesses. So, any comparison between government debt and household debt is meaningless. Of course, in practice, governments should control their spending. If they kept increasing spending when the economy was strengthening, there would come a point where this spending would become inflationary. But this is a very different kind of constraint than I face on my spending! To dig deeper into the implications of fiat currency, monetary theory Bill Mitchell has a lot of material on the subject on his blog. A good place to start is his post on gold standard myths.

So, there is no substance to the fear that the opposition is trying to excite with their debt truck. Government debt is not what we should be worrying about. What is more concerning is private debt. Since individuals cannot issue new currency to repay their loans, excessive household debt can be a real concern. And, the chart below shows that there is something to be worried about. While the Coalition may be very proud of the record of government debt reduction during the Howard years, they should not be so happy about what happened to household debt under their watch (and you thought I was being easy on Howard before!). Instead of focusing on the possibility that government debt may reach 14% of GDP by 2014, perhaps the opposition’s debt truck should drive around the country alerting everyone to the fact that household debt is already over 100% of GDP.

Govt and Household Debt

Figure 3 – Household and Government Debt (1976-2008)

Of course, there are some commentators, such as Steve Keen, who are rightly concerned about the excessive levels of household debt. It is very likely that Australia and many other developed countries around the world will experience an extended period of private sector “deleveraging” (debt reduction). As long as consumers are saving rather than spending, this will translate to far lower economic growth than we have been used to in recent years.

To this point, I agree with Keen. Where I disagree is the extent to which this deleveraging will result in massive declines in Australian property prices. But that is a topic for another post, the long awaited sequel to my recent post on property prices.

UPDATE: for a Nobel Prize-winning perspective, here is Paul Krugman arguing that government deficits saved the world.

Australian Property Prices

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Property prices have always been a popular topic of conversation in Sydney, but the subject has become more contentious since the onslaught of the Global Financial Crisis. Views on prospects for Australian property prices range from the bleakly pessimistic to the wildly optimistic. Iconoclastic economist Dr Steve Keen is one of the more prominent pessimists and expects a fall in property prices of as much as 40%. At the other extreme, research firm BIS Shrapnel recently released forecasts that prices in capital cities will rise by almost 20% over the next three years. Of course, both sides have their critics. Macquarie Bank economist Rory Robertson is so convinced that Keen is wrong that he has offered a wager in which the loser will have to walk to the top of Mount Kosciusko wearing a t-shirt saying “I was hopelessly wrong on home prices! Ask me how”. Meanwhile, many dismiss the optimists as mere shills intent on talking up the market in the interests of their clients.

Faced with a debate like this, the only recourse for the Stubborn Mule is to look at the data. Fortunately, I have been able to get my hands on a rich set of data (and ideas) from University of New South Wales economist Dr Nigel Stapledon*. Stapledon has painstakingly assembled data on Australian property prices back to the 1880s and rental data back to the 1960s. This data underpins a detailed comparison of the Australian and US property markets in Stapledon’s forthcoming paper “Housing and the Global Financial Crisis: US versus Australia” in The Economic and Labour Relations Review, Sydney. By comparison, the House Price Indexes published by Australian Bureau of Statistics (ABS) commence in 1989.

A first glance at Stapledon’s index of Sydney property prices does indeed appear to show a meteoric trajectory that would inflame the passions of the pessimists.

Sydney House Price Index

Sydney House Price Index

Of course, asset prices tend to exhibit exponential growth, so it is far better to look at historical prices on a logarithmic scale. This reveals a striking trend. The growth of Sydney property prices has been remarkably consistent at around 9% per annum over the last 50 years.

Sydney House Price Index (log scale)

Sydney Property Prices (log scale)

Prices for Australia overall show a similar trend, with average prices over the six major capital cities growing at an average of 8.6% per annum since 1955.

Six Capital Cities

Australian Property Prices

What these charts do not take into account is the effect of inflation. Indeed, inflation varied significantly over the last 50 years, so adjusting for the effect of inflation shows that the trend in Sydney house prices has not been so stable. Booms such as those from 1987-1989 and 1997-2003 are made very clear in the chart below. But it is also evident that prices have failed to keep up with inflation over the last few years. Nevertheless, over the last 50 years, Sydney house prices have appreciated an average of 3.1% over inflation and that is before taking rental income into account.

Sydney House Price Index (inflation adjusted)

Sydney Prices (inflation adjusted)

One difficulty with long-run property price data is that fact that observations are typically based on median house prices, which does not take into account changes in the quality of houses. The median house in 2009 may be “better” than the median house in 1955 and changes in price may reflect this change in quality as well as price appreciation. Stapledon has attempted to take this into account by constructing an index for Australian house prices (six capital cities) that is adjusted for both inflation and standardised to “constant quality”. The trend in real prices, adjusted for quality over the period 1955-2009 has been an increase of 2.1% per annum over inflation. This compares to an increase of 2.7% per annum over inflation without adjusting for quality. So, at a national level, quality changes overstate the trend growth rate by 0.7%. While Stapledon has not constructed a quality-adjusted index for Sydney, assuming that the national trend applied would lead to the conclusion that Sydney house prices have a trend growth rate of 2.4% over inflation.

Six Capital Cities (quality adjusted) Australian Prices (quality and inflation adjusted)

Interesting though this historical exploration may be, the question we would like answered is where prices may head in the future.

One approach to the problem is to assume that growth in property values in real terms may change in the short term, but over the long term will revert to a long term trend. Enthusiasts of trend following may see some significance in the fact that Australian prices still appear to be above the longer run trend, while Sydney prices have already fallen below trend. Of course, depending on the time period used to determine the trend, very different conclusions may be reached. If I were to base the trend on the full history from the 1880s, the last 50 years would appear to be well above trend.

Another popular approach is to consider housing affordability. This approach either looks at ratios of house prices to income or ratios of housing servicing costs (whether interest or rent) to income. The assumption is that these ratios should be stable over time and if increases in house prices result in reduced affordability this indicates the prices can be expected to fall in the future. Stapledon is critical of this approach, arguing that:

while income is expected to be a major influence on prices, there is no theoretical reason for any fixed relationship between prices and income or between rents and income

Over time, people may change their priorities and place a greater or lesser importance on housing and, as a result, be prepared to spend a larger or smaller proportion of their income on housing. Stapledon argues that a better approach is to examine rental yield, which is the ratio of rents to prices. Since the property prices can be expected to keep pace with inflation (and, in fact, outpace inflation), rental yields should be comparable to real yields (i.e. yields over and above inflation) on other asset classes. The easiest real yields to observe are those of inflation-linked Government bonds. The Reserve Bank of Australia publishes historical data for inflation-linked real yields back to the late 1980s. The chart below compares these Government bond real yields to Stapledon’s history of rental yields. While the correlation is not perfect, both rental yields and real yields show a downward trend from the late 1980s/early 1990s which has only recently begun to reverse. Since rents have not fallen over this period, this provides an explanation for the strong growth in property prices over that period.

Rental Yields

Australian Rents and Inflation-Linked Bonds

So what could this approach tell us about property prices? Rental yields have already risen further than bond real yields, but certainly could go higher. What this means for prices does also depend on where rents themselves may be headed. The chart below shows the contribution of rents to consumer price inflation as published by the ABS. While the rate of growth in rents has slowed, history would suggest that rents are unlikely to go backwards. A cautious, but not overly pessimistic forecast could see rental increases falling to an annualised rate of 1% while rental yields could climb back to 4%. The combined effect would be a fall of 12%. Since prices have already fallen by 7% over the year to the end of March 2009, this would amount to a fall of almost 20%.

Rent CPI

Rent Inflation (Quarterly)

This is certainly a significant drop, but still half the fall that Keen expects to see. For prices to fall by 40%, even assuming rents remain unchanged rather than growing by 1%, it would be necessary for real yields to rise to 5.8%, which exceeds the record level since 1960 of 5.4%. On this basis, I find it hard to be as pessimistic as Keen. Indeed, the latest data from RP Data-Rismark International suggests that prices are once again on the rise. The next ABS release is a little over a month away, so it will be interesting to see whether they see the same recovery.

The relationship between rental yields and real yields is an interesting one, but ultimately does not provide definitive predictions, but rather an indication of a range of outcomes that would be precedented historically. Of course, as Nassim Taleb has emphasised, unprecedented “black swans” can occur so history does not allow us to rule out more extreme events. Furthermore, nothing here addresses the question why prices in the US have fallen so dramatically and yet Australian prices could suffer far milder falls. That is the primary focus of Stapledon’s paper and is a topic I may return to in a future post, but this one is long enough already!

UPDATE: In this post I noted that the historical data shows a marked shift in behaviour from the mid-1950s without providing any explanation as to the cause of this shift. Needless to say this is a subject Stapledon has given some serious consideration, and I will quote from his doctorate, “Long term housing prices in Australia and some economic perspectives”:

From a longer term view, a key observation is the clear shift in direction in house prices and rents from circa the mid 1950s. House prices, in particular, jumped significantly, best illustrated by the rise in the price to income ratio from about one: one to about 4:1 in the 2000s. Looking at demand and supply variables…indicates that this shift in direction cannot be adequately explained in terms of the demand variables of income and household growth. Supply side factors appear to be more crucial and there is a substantial literature emerging in the US emphasising the importance of supply side variables and specifically the propensity to regulate to constrain supply. The evidence presented in this thesis of the lift in the cost of fringe land in the major urban areas provides prima facie evidence that supply factors have been a significant factor explaining the upward trajectory in house prices in Australia since the mid 1950s.

* I would like to thank Dr Stapledon for generously making his data available to me.

UPDATE: finally, I have published the post on why I don’t think Australia’s property market will experience the same fate as the US market.

http://unsworks.unsw.edu.au/vital/access/manager/Repository/unsworks:1435

Pinching Debt Data

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Regular readers of the Mule will know that I am a bit of a data-mining junkie. Whenever I come across an interesting chart I start Googling for the underlying data. But, even with well-honed Google skills, it’s not always possible to find the data. Sometimes it is simply not publically available. I ran into just this problem recently. The recent Australian Federal budget triggered countless alarmist opinion pieces despairing that Australia would be “mired in debt” and this prompted me to do some research of my own. In the process, I came across a handy primer on the subject entitled “A history of public debt in Australia”. Written by a number of Australian Treasury employees in the Budget Policy Division, it included the chart below which shows the history of net Government debt (combining Commonwealth and State debt) over almost 40 years. The chart also includes forecasts for the next few years.

Debt History - Original (v2)

Australian Government Net Debt to Gross Domestic Product

While the paper is clearly quite recent (it has no publication date), the forecasts pre-date those included in the May budget, so I was interested in updating the chart with the latest Treasury forecasts. The underlying data does not appear to be published online and, since I do not work with the authors in the Budget Policy Division, I had to resort to special measures. I turned to a handy (and free, open source) little piece of software I have used a number of times to pinch data from charts. The software is called Engauge Digitizer and it allows you to import an image of a chart and extract the underlying data.

Engauge Digitizer Screenshot

For charts with points or curve segments, Engauge generally does a great job of automatically finding the data. For a column chart like the one I had found, the process is a little bit more manual, but with a bit of clicking on the tips of each of the columns in the image, I had my data. The chart below shows the data I obtained. One indication of the accuracy of the results is that the authors of the history paper noted that net debt had averaged 5.7% of gross domestic product (GDP) since 1970. Satisfyingly, the average of my extracted data over this period was also 5.7%.

Australian Government Net Debt to GDP (imported data)

Having obtained the data, I was then able to replace the forecasts with the more recent Treasury figures included in Budget Paper No. 1.

Debt History - New Forecasts (v2)

Australian Government Net Debt to GDP (updated forecasts)

For the alarmists who are worried about this growing debt, it is useful to put these forecasts in a global perspective. The chart below puts these Treasury forecasts alongside IMF forecasts for a number of other developed countries.

World Debt Forecasts

Global Debt to GDP Forecasts

Compared to the rest of the developed world, the global financial crisis is still not looking quite so scary for Australia. When it comes to the United Kingdom, rating agency Standard and Poor’s is even more pessimistic than the IMF and is concerned that their net debt could reach 100% of GDP and have accordingly changed the credit rating outlook for the UK to negative.

UPDATE: For anyone interested in getting hold of the data without resorting to scraping it from the images, I have uploaded it to Swivel. This dataset includes the most recent Treasury forecasts.