Bubble, Bubble, Toil and Trouble

The recent disclosure through a freedom of information request by The Australian on Treasury warnings about the risks of a housing market collapse have stirred the pot on house prices once again. I, and many others, have discussed this great debate regularly in recent times (a marker, perhaps, of Australia's obsession with house prices). For previous posts see here and here.

According to The Oz:

Phil Garton, the manager of Treasury's Macro Financial Linkages Unit, sent colleagues a draft paper on the rise in household debt, prospects for further growth in the debt-to-income ratio and the potential implications of slower household debt growth.

His email prompted an exchange with Steve Morling, currently the general manager of the Domestic Economy Division, who argued the paper should "make a bit more about the risks".

"The elephant in the room is house prices or more specifically the risk of a precipitous drop in them, perhaps from an external shock or perhaps from their own internal dynamics when affordability constraints or capacity debt levels see prices and expectations of house prices start to move in the opposite direction," Mr Morling wrote on June 15.

"(I) know there are very supportive fundamentals, but prices rose by 50-60 per cent in three to four years in the early part of this decade, with largely unchanged fundamentals, so they can have a life of their own.

"And given what's happened elsewhere I'm far less sanguine about this - and the interplay with debt - than in the past."

I'm happy to admit that I just don't know what the outcome will be. My position over recent years has been to focus on the concept of vulnerabilities, rather than the certainty of either boom or gloom.

I still think the most likely scenario is a gradual decline (maybe just in a real sense i.e. via inflation, rather than by a marked nominal decline) but with different results for different cities and definitely different results for different market segments i.e. high-end versus first home valuations. Unfortunately that's a moderate position that is not particularly exciting.

But if I had to have a bet, I must admit I find the arguments of the bubblistas (the doomers) more persuasive. That may be because I have been a bit of a negative vibe merchant over the years, especially after the financial crisis. But be warned although I thought the longer-term prospects for the Australian economy were good, I was surprised by the vigorous and quick return of the boom for Australia. We might be right in the long run, but a s a famous economist once said we may have passed away before that long-run comes around.
But not pretending to think that I have the answers is not necessarily a poor position. What it should encourage is a hedging of bets.

We are no doubt in a period of great uncertainty. For risk-takers this means that the time is ripe for gambling on either side of the debate.
For those wanting to gamble on a fall, one position to take would be to short the banks (meaning effectively selling borrowed bank shares in the hope that they will be of lesser value when you have to pay them back). In a fall, this would be a good strategy, not only because banks are so exposed to the housing sector, but indeed because any collapse of house prices might be directly related to problems associated with bank debt! That is to say that the banks overseas borrowing means they are vulnerable to global financial developments. (see David Llewellyn Smith's post a while ago here based on this story.)

According to Clancy Yeates from The Age, the Treasury advised the incoming Gillard govt that

"A key risk for the Australian economy is our reliance on short-term external debt, largely intermediated through the banking system ... Among Australian financial institutions there has been some shift away from short-term funding since the crisis, but exposure to financing risk remains significant.

''Among Australian financial institutions there has been some shift away from short-term funding since the crisis, but exposure to financing risk remains significant."

''Highly indebted households, together with high dwelling prices, further heighten the vulnerability of the economy to shocks. While household finances are in good shape overall, and arrears rates and other financial stress measures remain much lower than in the early 1990s, households are more exposed than previously to adverse shocks.''

There's a recent Goldman Sachs report called "A Study On Australian Housing: Uniquely Positioned Or A Bubble?" by Tim Toohey that I'd like to read but it's not freely available. Reports of the study are located here and here. According to this report overseas hedge funds are (were?) shorting Australian banks.

Toohey argues that the banks are 25-35 per cent overvalued. The main risk factor is Chinese growth, which would negatively affect our export earnings. Yeates argues that the Treasury advised the incoming government that  

the rise of India and China were providing a hefty boost to national income, but Australia's increasing exposure to commodity prices were a risk and presented their own dangers. The terms of trade - export prices relative to import prices - are now at record levels, but Treasury pointed out that this could change quickly.

''While the terms of trade may continue to surprise on the upside, there are also downside risks if the global supply of resources responds more quickly than expected or if international market volatility persists. And even if those downside risks do not materialise, it is sobering to reflect on the fact that we have not managed previous commodity booms well.''

China's withdrawal of stimulus also threatened to limit investment spending in the world's most populous country, posing ''particular risks'' to Australia's resources industry, it said. In an attempt to prepare the government for managing the resources boom, Treasury also reiterated predictions that mining's expansion would force other industries to give way, a challenge known as the ''two-speed economy''.

Both the warnings about housing and the view of risks associated with China show that there is substantial disagreement between Treasury and the Reserve Bank of Australia about future economic prospects. While the Governor, Glenn Stevens, is more circumspect, Ric Battellino has long been a boomer. In a recent address he points out just how bad the US housing market is at the moment. (For a longer analysis of Battellino's views see my previous post).

Compare this to the situation in Asia, where house prices are rising reflecting strong economic growth and some bubble action.

Dwelling prices in the Australian house market have been expanding rapidly in recent years, although there was significant growth before this index series from Battellino starts.

Battellino is a housing market bull based on the under-supply theory.

Investment in new dwellings has increased over the past year, though growth in the number of dwellings is still falling short of growth of the population. As a result, rental markets are tightening, with vacancy rates falling and rents rising at a solid pace. At the same time, however, households now seem to be less inclined to increase their gearing in order to trade up to better housing. Auction clearance rates have fallen back to around long-run average levels and house prices have been relatively flat over recent months. This is in keeping with the more financially conservative approach that Australian households have taken recently. These trends are probably most pronounced here in Perth, which is going through a period of adjustment after the euphoria of 2006 and 2007.

Anyone wanting a counter-argument to this should read Leith van Onselen's excellent case for an Australian housing market bubble (especially the section on supply-side arguments). It's hard to go past this analysis.

Especially interesting is the argument for why housing investment is a elaborate Ponzi scheme based on this fabulous graph from the RBA itself (via Leith's blog).

The divergence between house prices and rental yields means that real yields from housing have been falling rapidly and that any gain must be made through capital gains. In other words you must sell your investment property at a higher price to make the investment worthwhile because income is was less than you could get from putting your money in a term deposit.

The graph is from a 2008 article (speech) called "Some Observations on the Cost of Housing in Australia". The author, Anthony Richards, Head of Economic Analysis Department, argued: 

One clear fact is that in the 35 years since 1972, nationwide house prices have risen significantly faster than average household incomes, house-building construction costs, and average rents. Most of the increase in real house prices occurred in two episodes, in the late 1980s boom and the subsequent boom in the late 1990s and into this decade. Growth in prices has been broad-based across the different states and territories. The run-up in prices is likely to mostly reflect an increase in the price of land. 

The increase in housing prices has been a mixed blessing for Australians. At one level, rising housing prices have made many people feel wealthier and have contributed to higher levels of consumer spending than might otherwise have occurred. But they have also resulted in concerns about housing affordability.

The difference in views reflects the fact that housing is not just an asset but also a consumption item. When housing is thought of purely as a consumption item, it would seem that in aggregate we would be better off if its price were lower. Because we all need to consume some level of housing services, either rented or purchased, a higher level of housing prices and rents allows less spending on other items.

But housing is also a long-lived asset, and there are distributional aspects to changes in housing prices and rents. Renters will be worse off when housing prices rise whereas those who own rental property will be better off. Owner-occupiers may be largely unaffected, since they can be thought of as being ‘hedged’ against increases in the cost of housing. There are also generational differences. Younger people who have not yet bought homes will be hurt by higher housing prices. Older owner-occupiers may benefit from an increase in prices if they are intending to extract part of the increased value of their homes. Of course, if older people pass on some of their increased wealth to younger relatives, the gains and losses of these two age groups will be reduced. Indeed, the biggest difference may be between those who benefit from transfers from older relatives and those who do not. Both home ownership and ownership of rental property tend to rise with incomes (Graph 2), so it is lower income households that tend to suffer from rising housing prices and higher income households that tend to gain. (my emphases)

So we can see that there are multiple interests at stake here and it might be the fact that you are now even more confused! But remember a bit of confusion, is probably better than misplaced certainty (unless of course you are a gambler).

For me, as I argued in The Vulnerable Country, debt is the big worry. Not public debt, but private debt and particularly household debt. See my earlier posts on debt. The question I ask myself is just how indebted we can be over the long-run. What level of debt is unsustainable?

Household debt as a percentage of household disposable income is a key variable to watch as are mortgage defaults (which are still very low). A major crisis in the world economy that affects Chinese demand would require a reassessment of my moderate fall story. If house prices fall it'll probably be due to some external shock although it is possible that a price precipitous fall is possible based on the sectors own dynamics as the Treasury memo argues.