Friday, July 23, 2010

Three Graphs and a Silly Question: Debt and Housing

The latest speech from the Reserve Bank Governor Glenn Stevens, entitled Some Longer-run Consequences of the Financial Crisis contained the following excellent table.

Stevens argues that there are three main lasting international legacies. The first is the "fiscal burden" of the crisis involving both financial sector bailouts and discretionary fiscal stimulus. In relation to the bailouts he argues:
Note that this is not necessarily a permanent burden since, if carried out successfully, the ownership stake can be sold again in due course. In fact about 70 per cent of the funds invested by the United States in banks have been repaid, and the US Government expects to make an overall profit from these capital injections.2 Nonetheless for a period of time governments are carrying a little more debt than otherwise as a result of the provision of support to the banking system.
In relation to fiscal stimulus:
while there was a lot of national variation, for some countries this spending was quite significant relative to the normal pace of annual growth in GDP. To the extent that the packages had measures that increased spending for a finite period but not permanently, the result is a rise in debt of a finite magnitude, but not an ever-escalating path of debt.
Debt ratios, he suggests are being exacerbated by the magnitude of the crisis and the anaemic recovery in Europe and the United States.
According to the IMF, for the group of advanced economies in the G-20, the ratio of public debt to GDP will rise by almost 40 percentage points from its 2008 level by 2015. Fiscal stimulus and financial support packages will account for about 12 percentage points of this. Close to 20 percentage points are accounted for by the effects of the recessions and sluggish recoveries. Another 7 percentage points comes from the unfavourable dynamics of economic growth rates being so much lower than interest rates for a couple of years
... the major countries generally are going to have significantly higher public debt relative to GDP after the crisis than before, and the debt ratios will continue to rise for several more years.
This was largely unavoidable. ... Generally speaking, the public balance sheet has played the role of a temporary shock absorber as private balance sheets contracted.
... At present that additional cost is, in some countries, reduced compared with what it might have been due to the low level of interest rates on government debt that we see. Moreover had the debt not been taken on it could well be that the economic outcomes would have been much worse, so increasing fiscal and other costs. Nonetheless this lasting debt servicing burden is a real cost.
A fairly balanced position from out Governor.

The second long-term implication is the increased role of government in the financial sector.
the intervention was broader than just a temporary period of public ownership – as massive an event as that has been. Take guarantees. Once the Irish Government guaranteed its banks, governments all over the world felt bound to follow suit in some form or other – expanding or (as in our case) introducing deposit insurance, and guaranteeing wholesale obligations (for a fee). The feeling was probably most acute in countries whose citizens could shift funds to a bank guaranteed by a neighbouring country without much effort.
Stevens acknowledges the fact that governments simply must shore up the financial sector in a crisis. The consequences of not doing so are too catastrophic to contemplate. The question for the future is how do governments shape the system so they do not have to make such forceful interventions in the future.

So some central banks, like their governments, have found themselves in very unusual terrain. It is terrain: in which the relationship between the central bank and the government is subtly changed; where the distinction between fiscal and monetary policy is less clear; from which it may be hard to exit in the near term; and a side effect of which may be wastage, over time, in some elements of market capability.
The third implication is the changing regulatory agenda:
In a nutshell, what regulators are pushing toward is a global banking system characterised by more capital and lower leverage, bigger holdings of liquid assets and undertaking less maturity transformation. It is hoped that this system will display greater resilience to adverse developments than the one that grew up during the 1990s and 2000s.
The implication is that the costs of intermediation - the role played by banks in bring borrowers and lenders together - will rise, which in turn will have broader economic effects. The first, Stevens contends, is lower growth and possibly less lending. Stevens observations on the potential impact of regulatory changes are worth quoting at length.

First, I think we ought to be wary of the assumption of a mechanical relationship between credit and GDP. ... did the steady rise in leverage over many years actually help growth by all that much? Some would argue that its biggest effects were to help asset values rise, and to increase risk in the banking system, without doing all that much for growth and certainly not much for the sustainability of growth in major countries. Some gradual decline in the ratio of credit to GDP over a number of years, relative to some (unobservable) baseline, without large scale losses in output may be difficult to achieve but I don’t think we should assume it is impossible.
Secondly ... we have to remember that there is a potential benefit on offer too: a global financial system that is more stable and therefore less likely to be a source of adverse shocks to the global economy in the future. ...
Thirdly, however, the reforms do need to be carefully calibrated with an eye to potential unintended consequences. One such consequence, obviously, would be unnecessarily to crimp growth if the reforms are not well designed and/or implementation not well handled.
Another could be that very restrictive regulation on one part of the financial sector could easily result in some activities migrating to the unregulated or less regulated parts of the system. Financiers will be very inventive in working out how to do this. If the general market conditions are conducive to risk taking and rising leverage ... people will ultimately find a way to do it. Of course while ever the unregulated or less-regulated entities could be allowed to fail without endangering the financial system or the economy, caveat emptor could apply and we could view this tendency simply as lessening any undue cost to the economy of stronger regulation of banks. But if such behaviour went on long enough, and the exposures in the unregulated sector grew large enough, policymakers could, at some point, once again face difficult choices.
In the discussion afterwards, Stevens gave short shrift to one question.

Now this question should worry a few people given that it shows just how ignorant people in financial companies can be about the countries they have an interest in. At least he got to ask the Governor a question and is now 'informed'.

The answer shows that the RBA is not really worried about debt at all - either public or private (household). Although the Governor is less sanguine than some in the RBA about growing household debt even further.  

Two other graphs both support and question the governor's benign outlook on public and private debt respectively. The first is from Peter Martin's excellent economics blog.  It's original source is from a Treasury analysis of Public Debt in Australia, which I have covered a while ago here and here.

But while the RBA is not particularly worried about household debt or about the housing market, others continue to warn that Australia's house prices are bubbling. According to the Economist:

House prices in Australia rose by 20% in the year to the end of the first quarter, faster than the 13.5% recorded in the 12 months to late 2009. More concerning, however, is our analysis of “fair value” in housing, which is based on comparing the current ratio of house prices to rents with its long-term average. By this measure Australian property is the most overvalued of any of the 20 countries we track. A frothy property market was one of the reasons for the Reserve Bank of Australia raising interest rates six times between October and May. Since then, the bank has become more sanguine about the state of the market. It cited “some signs that the earlier buoyancy in the housing market was easing” when keeping interest rates on hold in June.

For those wanting a more 'balanced' view of the prospects for Australian housing see Rory Robertson, "Extreme predictions on house prices will continue to be wrong". Robertson argues:
Average prices could rise a bit further or fall a bit over the coming year, but they will not collapse, as happened in the US and Japan.
Claims that there is a "bubble" in Australian housing markets don't stand up to serious scrutiny.
Investment legend Jeremy Grantham sees a bubble based on his calculation that housing trades near 7.5 times family income today versus about 3.5 times in earlier times.
Prices supposedly are around twice what they "should be". And "sooner or later" they will return to the "normal" multiple of family income.
Don't bet on it. For starters, the Reserve Bank estimates Australia's price-to-income ratio is near five times income, not seven times, removing any need for home prices to fall that first 30 per cent.
The step up in Australian house prices and housing debt relative to incomes over the past decade and a half was largely a function of the sharp drops in average inflation and interest rates delivered by the early-1990s recession.
These downshifts in inflation and interest rates are structural rather than cyclical. So don't expect the price-to-income ratio ever to return to three times, a level typical in Australia's long gone, bad old days of high inflation.
The recent 30 per cent drop in US house prices is a very poor guide to what might happen here.
Why? Well, because Australian and US housing and mortgage markets are like chalk and cheese. The relative strength of our economy -- 5 per cent unemployment here versus near 10 per cent there -- is part of the story.
More importantly, we have carefully supervised banks and mortgage markets that offer only "full recourse" loans. Australians know they cannot "walk away" from their mortgages without serious financial penalty. There is no "jingle mail" here.
And our home lenders generally hold their loans for the full term, so take very seriously the need to assess whether any would-be borrower is a "good risk" or not.
For those who worry that the level of Australia's mortgage debt is simply "too high", the Reserve Bank has estimated that three-quarters of all mortgage debt is held by the top 40 per cent of income earners.
Home ownership has been steady near 70 per cent for decades, yet the home ownership rate for households with heads aged under 35 years is just 40 per cent, down from 50 per cent in the late 1980s.
The bad news is that young people are finding it harder to buy where they want to live.
The good news is that -- contrary to some claims -- not everyone is overgeared. Some 60 per cent of younger households -- many with steady jobs and good incomes -- do not have a mortgage at all.
According to Robertson we should not worry about simplistic debt to income ratios and should not forget high immigration and chronic under supply of new housing.

Having won his bet with Steve Keen (an easy target) Robertson is feeling reasonably sure of himself:
Australian home prices are relatively high in part because, rather than "spreading out" across our continent, most of us choose to compete to live on the same best-located bits of ground near the beach.
With housing, you get what you pay for.

I'm not so sure.

1 comment:

Please be civil ...