Why -0.5% GDP won’t be the last of the tumultuous times ahead for Australia

When the results of the last quarter of GDP growth were released by the RBA, are we likely to see growth in the near future to even out the negative figure? That is the question plaguing economists as of late.

Having looked at various economic indicators it immediately becomes evident that there are certain relationships between debt sectors and price indices that cannot be ignored when considering what causes a bubble – in most parts of the western world that bubble occurs in asset markets. To say that America and Australia are not comparable due to the differences in population dynamics is something that needs to be proven either true or false.

Utilising the data viewer and CSV files available for download free of charge on the BIS Statistics Browser, I was able to graph the CPI-deflated housing price indices for both the U.S. (up to 2006 for illustrative purposes prior to the GFC), as well as the current data for Australia up to 2015. To do so I set the first year at 100 and used the difference between CPI and nominal HPI to calculate the CPI-deflated housing price index. While the household debt to GDP as an index is calculated by dividing the first year by itself and multiplying by 100 (all further consecutive years are divided by the base year). The result is shown in the following graphs:

us-household-debt-to-gdp-vs-cpi-deflated-hpi
What are you looking at? Notice that the CPI-deflated housing price index (HPI) accelerates in 2001 – especially in 2004 after subsidies utilised to reduce the impact of 9/11 on the economy as well as the dot-com bubble bursting.

Leading up to the GFC we notice that from 1998-2006 (an 8 year period) there is a divergence of the CPI-deflated housing price index (the rate at which the price of housing grows faster than inflation or “the cost of living”) from the household debt to GDP index (which compares the debt of households associated with expenditure on loans such as personal loans, car loans, credit card debt and mortgages). Laws pertaining to prudential lending regulations were changed by the housing and urban development secretary (HUD) in the United States in 2004; the purchase of subprime mortgages by the two largest government-sponsored-enterprise (GSE) companies (Fannie Mae and Freddie Mac) more than doubled from $81 billion in 2013 to $175 billion in 2004. At the time this equated to approximately 44% of the mortgage-backed securities market, in 2005 they paid $169 billion (33%) whilst in 2006 they paid $90 billion (20%) as stated in this HUD Washington Post article.

To buy this volume of mortgage-backed securities (MBS), there had to be enough mortgages to fill the market with securities in the first place, causing the lending standards to dive. Loans that required no income, no job or assets (NINJA loans) rose significantly during this period, where lending institutions (especially Countrywide, lead by Angelo Mozilo) gave non-recourse loans (loans where the asset is given back with no extra collateral or money necessary even if the market value of the asset decreases) to low-income earners. These MBS products were then placed in debt derivative products known as collateralized debt obligations (CDOs), which used “tranches” (layers) of mortgages and other loans (credit card debt, car loans, student loans i.e. asset-backed debt) based on the creditworthiness of the borrowers. Most loans at the time were mortgages and as such the CDOs that were comprised of mortgages were priced based on the creditworthiness of the borrowers.

In many instances, the rating agencies who were paid to rate the CDOs did not accurately rate the creditworthiness of the products, and as such, the companies that purchased the CDOs without looking at the mortgages inside them thought that they were highly reliable when, in fact, they weren’t. An example of which is the Abacus 2007 AC-1 synthetic CDO, which was filled with risky subprime loans yet was rated AAA (the highest possible rating of creditworthiness) as in this article about the Goldman Sachs Abacus fiasco.

US Household Debt to GDP Vs CPI Deflated HPI 2016.png
After the peak of the US CPI deflated HPI, we see that after it accelerated away from the household debt, it quickly moved back into line with the household debt to GDP, which in turn dramatically decreased housing prices as a result. The CPI-deflated HPI had historically tracked the household debt to GDP at an almost identical rate, both of which were growing exponentially even after inflation.

The excessive speculation due to financialisation of the American housing market in derivatives of MBS products, in essence, caused mortgage debt to accelerate at a faster rate than the household debt to GDP. These CDOs encouraged a combination of risky lending (in many cases unconscionable conduct) and various forms of fraud (fraudulent ratings acquired by using forged or missing creditworthiness documentation).

 

united-states-interest-rate
Previous low: the low reached in 2004 for interest rates evidently encouraged speculation on assets – primarily property as indicated by the CPI-deflated HPI, which then caused an oversupply of credit, leading the US Fed to raise rates between 2004-2006. Notice that the housing price index was growing faster than the household debt to GDP especially between 2004-2006, although once the interest rate got high enough and the CPI-deflated HPI flattened off and started coming down. 

The problem with the index coming down was that housing financing was primarily provided by using home equity (the difference between what the property was considered to be worth by bank appraisals and the liabilities on the property), which then meant that the liquidity for future purchases had dried up, devaluing the assets further and causing the insurance bonds in the form of MBS products and CDOs to fail. One thing becomes blindingly obvious is that since 2010 where interest rates sat at 0.25%, the US has entered into another bubble.

 

If we 0bserve the comparative chart for Australia, we can see that the same government stimulus expenditure in the housing market in the form of the first home buyers grant has quickly pushed the CPI-deflated housing price index away from the household debt to GDP ratio which it tracked steadily until the time of the GFC, when the CPI-deflated HPI dropped heavily over a very short period of time, leaving borrowers above their maximum LVR threshold (triggering technical defaults), as well as putting millions of Americans out of work.

With any kind of media-based research, we see that the Australian media portrays the prudential regulation of Australia’s banks as being very sound, as well as the fact that we have vastly different population dynamics, our CPI-deflated HPI and household debt to GDP charts should look vastly different right? Wrong:

aus-household-debt-to-gdp-vs-cpi-deflated-hpi
Notice anything similar to the US chart circa 2006? The CPI-deflated HPI skyrocketed after 2007, and while the market seemed about to crash in 2010/2011, the Australian government’s introduction of the first home buyers grant, the last oomph of the mining boom and (as will become evident with the US data further on in this article), lowered interest rates have propped up the market.

Notice now how closely the CPI-deflated HPI moves in tune with the cash rate set by the RBA in the following chart. Once the RBA thought they had “thwarted the GFC”, they began raising rates again, which then produced results similar to those in the US, with the household debt to GDP decreasing slightly, and the CPI-deflated HPI looking likely to drop rapidly. The RBA then began to lower interest rates further to ensure that the same drop that happened in the US did not happen here. They have been cutting interest rates ever since, while both wage growth and GDP growth have stalled. To make matters worse, the federal government have started funnelling government debt into the first home buyers grant, further skewing the data.

 

australia-interest-rate
Interest rates reacting to crisis; the GFC resulted in quantitative easing which has arguably created a larger bubble than existed prior to the high-interest rates relative to the current day.

Notice that Australia started raising rates after the GFC? The RBA were the only national reserve bank in the world to raise rates following the GFC, with the results being a tumultuous period of time, as we were uncertain as to whether or not we were going to go into a full-blown recession.

 

 

CPI Deflated Aus HPI.png
The figures never lie but liars can figure: the correlation between the CPI-deflated HPI and an exponential growth trend is 94.5%

One of the most interesting figures of note is a comparison between the CPI-deflated HPI and a purely exponential trendline; this means that the housing prices have grown exponentially faster than the rest of the economy and in fact exponentially faster than wage growth. It has since slowed interestingly with quarterly data that I will update this post in the near future once the last quarter worth of data is released on the BIS website.

So what does this all mean for the Australian economy? Return to surplus by 2021? The probability of a return to surplus of Australia by 2021 is almost 0, with further government debt piling up, in fact, becoming increasingly more likely as the banks slowly start to figure out what they should have known in 2009. Relaxing lending standards and decreasing interest rates will almost certainly result in a housing bubble when the rates have to inevitably come back up. The main reason that Treasurer Scott Morrison is pushing for surplus is that the Liberal Party created a mandate for themselves in the 2013 election, however, their policy has, in fact, shifted the debt from the public sector onto private businesses as well as households, as private debt is almost always inversely proportional to public (government) debt. My outlook is quite bearish on the Australian market due to the fact that we now no longer have:

  1. A mining boom.
  2. Government surplus.
  3. Manageable household debt to GDP.
  4. High interest rates.

For this reason, we are not even remotely close to being able to get ourselves out of the rut we are in. Wage growth is stagnant yet housing prices are climbing rapidly. We have the highest household debt to GDP in the world, matched only by Switzerland at 125.2% of GDP, and we are heavily reliant on China for our exports. Hopefully, people such as Saul Eslake who credit the avoidance of a technical recession to a government surplus look more heavily into the contribution of tax subsidised property speculation and the contribution of mortgage debt to the overall outlook of the economy which primarily considers public (government debt). They should also credit sheer dumb luck that created a mining boom into the calculations that applaud the Howard era for its “forward thinking”. Their skewing of public opinion towards thinking that public debt is always bad and that low-interest rates are always good should definitely have a spotlight shone on it, as it flies in the face of rationality and common economic sense.