Pettis on the European Crisis

From China Financial Markets Newsletter

Michael Pettis 

Seven steps to crisis

Step 1. The German savings rate rises. 

Thanks to the labor reforms, German wage growth dropped sharply, and with it the household income share of Germany’s GDP. As the household income share declined, and because the household savings rate remained flat, the household consumption share also declined. 

Because most consumption is household consumption, and Berlin did nothing to counteract the decline in household consumption, for example by increasing social spending, the total consumption share of GDP in Germany also declined during this period 

All goods and services produced by an economy (i.e. GDP) are by definition either consumed or saved. As Germans consumed a smaller share of all the goods and services they produced, by definition they saved a larger share. Germany’s saving rate, in other words, rose.

Note that Germany’s savings rate rose not because German households decided to become thriftier but rather because the growth in wages and overall income, and therefore in consumption, was suppressed by the Hartz reforms. 

Step 2. Weak consumption growth in Germany lowers private sector investment.  

Businesses expand production capacity usually because they expect demand for their product to grow. As consumption growth lagged, however, German businesses responded by reducing their investment growth rate to below the GDP growth rate.
When investment is equal to savings, everything that is produced is purchased either for consumption or investment purposes. The demand generated by investment absorbs all the goods and services that an economy has produced but has not consumed. In Germany however savings rose faster than planned investment. 

Step 3. As German savings began to grow faster than GDP, and planned German investment more slowly, there were four different ways in which the German economy could adjust: it could run a current account surplus, unemployment could rise, public sector investment could rise, or something could set off a rise in consumption faster than the rise in GDP. 

It could run a current account surplus. Germany could sell to foreigners the excess of goods and services it produced at home but could not sell in Germany. In that case Germany would also export the excess of savings over investment, and so run a capital account deficit. The value of the current account surplus would be identical to the value of the capital account deficit, with excess German saving financing the purchase by foreigners of excess German production. 

Unemployment could rise. German businesses could respond to growing inventories by cutting back production and firing workers. This would cause the total production of goods and services to drop. Total consumption would also drop as unemployed workers reduce their consumption, but because unemployed workers must still consume, the total production of goods and services would drop faster than total consumption, or, put differently, the savings share of GDP would drop. Rising unemployment, in other words, reduces the savings rate, not because consumption rises faster than GDP but rather because consumption declines more slowly than GDP.  

Public sector investment could rise. The German government could borrow the excess savings and invest it in ways that increase German productivity. Higher government investment would counterbalance higher savings and the decline in private sector investment so that German savings would no longer exceed German investment. 

A consumption boom could be set off. German investors could use excess German savings to buy assets like stocks or real estate. As asset prices rise, and the owners of these assets see their wealth rise, two things can happen. First, the “wealth effect” can cause Germans to increase their consumption faster than their income increases. Second, rising asset prices can cause them to increase their investment, especially in real estate. The first effect causes the savings share of GDP to drop and the second causes the investment share to rise, either of which retains the balance between savings and investment. 

Step 4. In fact Germany ran current account surpluses and capital account deficits, mainly with other European countries.  

For policy reasons Berlin and local German governments did not absorb the excess savings by borrowing and investing them locally. 

During this time European financial authorities were encouraging a convergence in interest rates among very different European countries with very different interest-rate histories, creating a sharp division between some countries, such as Germany, in which inflation had been low and interest rates historically low, and other countries in which inflation had been high and interest rates historically high, too. In the former the real cost of this available German capital was high, while in the latter, which we will call “Spain” in the rest of this essay, the real cost of this available German capital was low. 

Every economy consists of business and household entities with a wide range of risk appetites and optimism about the future, ranging from recklessness to prudence. When real interest rates are very low or negative in a growing economy, because of the diversity among businesses and households in their appetite for risk, inevitably some of them will borrow more than they otherwise would have in order to consume or invest more than might have been prudent. If we assume that Spain has exactly the same distribution of risk-seeking borrowers as Germany, and exactly the same distribution of reckless agents as Germany, and we offer Spanish and German borrowers equal access to capital, but at high real rates to the Germans and at low or negative real rates to the Spanish, most of the excess German savings will flow to Spanish borrowers and very little will flow to German borrowers. The difference between the two countries, in other words, is not in the distribution of reckless behavior but in the divergence in real interest costs. 

Some commentators have argued, bizarrely enough, that the causality is backwards, and that in fact all of the countries that we represent by Spain embarked on ill-advised consumption binges that occurred only coincidentally at the same time as Germany implemented the Hartz reforms. It was the subsequent collapse in Spanish savings rates, these commentators say, that caused them to wrest capital away from German investors, and the surge in their consumption that caused them to scoop up German tradable goods. It was Spain “pulling” capital and tradable goods out of Germany, in other words, and not Germany who was “pushing” capital and tradable goods into Spain. In the former case, however, Spanish borrowers could only have pulled capital out of Germany by forcing up interest rates, and by pulling tradable goods out of Germany, Spain would have also forced up the growth in German wages. The fact that European interest rates declined sharply during this period, and German wage growth decelerated sharply, would be extraordinarily counter-intuitive at best.  

Step 5.  “Spain” must accommodate the German current account surplus and the corresponding capital account deficit.  

Spain had been importing moderate amounts of foreign capital before all of this happened, but after the Hartz reforms, the distortions in Germany were so great that the amount of excess German savings pouring into Spain in a matter of 3-5 years increased by 20-30 percentage points of Spain’s GDP. Spain’s corresponding current account deficit also soared to among the highest levels in its history. Just as Germany’s soaring current account surpluses and capital account deficits reflected a rising excess of German savings over German investment, the soaring current account deficits and capital account surpluses in Spain had to accommodate a rising excess of Spanish investment over Spanish savings. These are automatic consequences of net capital inflows.  

There are four ways this could happen: Spain’s productive investments could rise, its non-productive investments could rise, Spanish unemployment could rise, or the Spanish consumption share of GDP could rise. 

Spain’s productive investments could rise. More available capital at lower interest rates increases the amount of productive investments in Spain, which causes Spanish demand for investment-related goods and services to rise, including for tradable and non-tradable goods and services. As unemployed workers are put to work, part of this demand is met by rising supply, but unless unemployment in Spain is extremely high, much of it must be supplied from abroad. 

Its non-productive investments could rise. More available capital at lower interest rates also increases the amount of non-productive investments in Spain to the extent that investors are unable to distinguish between the two. There are three reasons why non-productive might rise.   

First, the rush of capital into Spain can cause GDP growth to rise, which can cause investors, including local governments, to overestimate future demand for infrastructure, and this is all the more likely when widespread corruption creates strong incentives to over-estimate future demand. 

Second, when cheap capital pours into a country it can cause soaring asset prices, and as real estate prices soar, they create speculative demand for real estate, which creates even more scope for non-productive investment. Third, as German tradable goods increasingly displace Spanish tradable goods, Spanish investment in capacity is increasingly unproductive. For all these reasons, as non-productive investment in Spain rises, as in the case of productive investment, it causes Spanish demand for investment-related goods and services to rise, including for tradable and nontradable goods and services.

Spanish unemployment could rise. As German tradable goods increasingly displace Spanish tradable goods, Spanish investment in capacity becomes increasingly unproductive and Spanish manufacturers have to fire workers. Rising unemployment causes the savings rate to decline (as explained above). Before the 2008-09 crisis, however, fired workers were quickly hired by the rapidly-growing non-tradable goods sector, so the effect of the German tradable goods sector on Spanish unemployment was minimal until the crisis, with its effect being a shift of workers out of the tradable goods sector into the services and non-tradable sectors. 

The Spanish consumption share of GDP could rise. More available capital at lower interest rates increases the amount of speculative investments in existing Spanish assets, such as stocks, bonds, and real estate. As their prices rise, Spanish households, especially those with greater risk appetites, believe they have become permanently wealthier, and they respond by expanding the consumption share of their income. They fund this increased consumption either by reducing their savings or by borrowing against their assets. This causes Spanish demand for consumption related goods and services to rise. As unemployed workers are put to work, part of this demand is met by rising supply, but unless unemployment in Spain is extremely high, eventually much of it must be supplied from abroad.  

In three of these cases (excluding the third, rising unemployment) as Spanish demand for investment-related and consumption-related goods and services rose faster than Spanish supply of either, it had to import them from abroad, but because it can only import tradable goods (and some tradable services), an automatic shift had to occur in Spanish employment. Workers were transferred from the tradable sector to the nontradable sector, so that demand for tradable goods rose even faster, and this was resolved effectively by importing these goods from Germany.  This is a simplification, and technically incorrect, but we will continue to use it over the rest of this essay. The goods that Spain imports as a consequence of the German capital “push” don’t have to be imported only from Germany. They can be imported from other countries, which simultaneously increase their imports from Germany, so that the rise in Spain’s current account deficit will be exactly matched by a rise in Germany’s current account surplus even if the two do not occur bilaterally.  

Step 6. As speculation and cheap capital causes markets to rise, the Spanish debt burden will automatically rise until speculative price increases and a rising debt burden reach their limits.  

The different ways described above in which Spain could have responded to the increase in capital imports each has a different impact on the Spanish debt burden.

Capital that flows into productive investments does not result in a rising debt burden because the capacity to service debt rises as quickly, or more quickly, than the debt servicing cost. 

Capital that flows into non-productive investments causes the debt burden to rise because there is no consequent increase in the capacity to service debt, even as there is an increase in the debt-servicing cost. 

Capital that finances the increase in consumption also causes the debt burden to rise because there is no consequent increase in the capacity to service debt while there is an increase in the debt-servicing cost. 

When debt-servicing costs rise faster than debt-servicing capacity, the growth in debt is unsustainable and it becomes increasingly necessary to roll debt over as principle and interest come due.  

Rising asset prices and rising debt are self-reinforcing, but neither is infinite, and both will eventually be forced to stop rising. There are many triggers for the reversal, which we do not need to get into here, but once it happens, market prices fall, and it becomes more difficult to roll over the debt. This occurred in 2009, and the consequence was that German capital stopped flowing into Spain. As a result Spanish governments, businesses and households could not service existing debt to Germany and they could no longer fund the domestic consumption and investment that had previously been funded by German savings.

Step 7. When something is unsustainable, eventually it will stop. 

As Spanish and other peripheral European debt rose to levels at which creditors were increasingly worried about funding further debt increases, and as the underlying economies were damaged as resources were misallocated as a result of asset price distortions, all it took was a trigger to set off a system breakdown. The US sub-prime crisis served as that trigger. Once creditors became sufficiently concerned about the adverse impact of US events on underlying liquidity, they began to raise interest rates, reduce maturities and otherwise transform liabilities in ways that were highly selfreinforcing, and in a very short period of time deficit countries found themselves unable to refinance their external borrowings. Without balancing inflows on the capital account, their deficits had to collapse.  

By definition a collapse in the current account deficit can occur either in the form of a drop in investment or a surge in savings. Investment dropped when creditors became unwilling to fund new investment and as stock and real estate prices collapsed, and the savings rate rose as Spanish households cut back on consumption. The net result was a sharp drop in demand and a corresponding surge in unemployment. 

After the crisis there were a limited number of ways Germany and Spain could adjust. Once the rest of Europe was no longer able to absorb the German surplus, and because Germany took no steps to rebalance domestic demand but instead maintained the existing distortions in which German workers and German households retained a small share of GDP, the export of German savings abroad meant that the full European surplus, perhaps the largest ever recorded as a share of global GDP, had to be absorbed abroad. 

In light of the June 23 Brexit vote, it might be worth noting that the British current account deficit, which had ranged between 1% and 3% for most of the previous decade, jumped 3.6% in 2008 and dropped back to its normal range over the next two years. Since then, as the European surplus has surged, the British deficit has climbed steadily to over 5% by 2015 and substantially higher in the first quarter of 2016. This requires one or both of two British consequences, rising unemployment or rising inequality.

Lessons 

It's not just the outflows we need to worry about but the initial inflows.

Capital flows require more management (i.e. restrictions and regulations) if we want to avoid the negative consequences of unproductive capital inflows. This in turn requires a realisation that the 'market' cares about profit not productivity. Profit can be made in remarkably unproductive ways.

It's not cultural propensities that should be the major explanatory variable for economic outcomes. Rather it is macroeconomic flows shaped by policy (ie. institutions) that are most important. Culture and path dependency will shape what are considered to be appropriate policies. In sum, institutions matter more than culture, although culture may shape what institutions are chosen and developed in the first place.

For Australia, a negative spiral might begin with an external reassessment of investment opportunities or a decline in employment. Given the highly indebted status of Australian households this would reduce consumption and lead to a reassessment of the housing market.

A housing price collapse in Australia would lead to a reassessment of debt, a collapse in consumption and rising unemployment, which would lead to further house price falls and so on.

Australia has avoided falling into this negative spiral through a combination of good luck and some good policy. However the rise in debt and the failure of authorities to regulate credit will soon be seen as remarkably poor policy.

The Fallacy of Composition: Return of Global Imbalances and the Possibilities of Trade War

Excess saving is a major problem for the global economy. Just like those painful colleagues who think that arriving early is always virtuous, many commentators and policy-makers see export surpluses as a sign of moral superiority.

Such a view of the world is wrong not only in an ethical sense, but also in a rational one. For every export surplus there must be a deficit. The virtue of the mercantilist must be matched by the supposed iniquity of the consumer. Unless we start trading with another planet, there is no other outcome.

This is a fallacy of composition - the belief that what is true for the part is true for the whole. Not every country can run a trade surplus and absent the willingness of some countries - particularly the Anglosphere countries - to run deficits the whole model would fall apart. 

The surplus countries need to adjust, just as much as the deficit countries if we to restore some sort of balance to the world economy. 

According to Brad Setser  

East Asia’s current account surplus—its excess of savings over investment—has recently amounted to about as large a share of world gross domestic product (GDP) as it did prior to the global financial crisis. In 2015, the region’s four major economies—China, Japan, South Korea, and Taiwan—along with the city states of Hong Kong and Singapore had a combined current account surplus of $700 billion. Their combined surplus significantly exceeded Europe’s surplus. No region of the world currently contributes more to the global glut in savings. Outward flows of capital from East Asia present a challenge to the world economy, and this problem may grow in the next few years. 

East Asia’s surplus is all the more remarkable because it has reemerged despite two factors that act to reduce it. China’s investment remains at historically high levels and Japan’s budget deficit is around 5 percent of GDP. Both high investment and large fiscal deficits absorb significant amounts of savings at home. These two surplus-reducing factors are overwhelmed, however, by East Asia’s extremely high rate of saving. At close to 40 percent of GDP, it appears to be at a record level relative to the size of the region’s economy. Without a reduction in the savings rate, there is a risk that East Asia’s already large surplus will increase. To control its bad-debt problem, China may reduce credit creation and investment. To control its government-debt problem, Japan may opt for fiscal consolidation. In either case, policies that reduce domestic risks could give rise to new global risks.

While before the crisis the net European surplus was low (i.e. European trade and financial interactions with the rest of the world), it has been growing since that time as austerity reduces consumption and as the export surplus countries have continued to repress consumption in the belief that export surpluses are virtuous. If only Greece could be more like Germany they argue. But as we pointed out at the beginning this isn't possible for every country. Germany doesn't have to become like Greece, but it does need to reduce its export surplus and export some of its demand to southern Europe.

The United States trade deficit is likely to become an important marker of the success or failure of Trump's Presidency and while the deficit on petroleum products has been reduced since the crisis due to the US oil boom, its deficit in other goods has grown rapidly.

As Setser points out, despite the high investment of East Asian economies, savings are still higher leading to current account surpluses. It is important to remember that the current account = savings - investment. A surplus means an excess of saving over investment and a deficit means not enough saving to fund investment. The latter is the case for Australia.

All of this leads to global imbalances as captured by the graph below,  On top are the surpluses, which include the East Asian and European surplus economies. Note that with the decline of oil prices, the oil exporting countries are now running deficits. The largest share of the deficit side of the equation is taken up by the Anglosphere economies - the United States, the United Kingdom, Canada and Australia.

East Asia is the major contributor to global surpluses, but the European surplus economies have also expanded theirs. This is exactly the opposite of what needs to happen in Europe. To help solve the crisis in Southern Europe will require the surplus countries to increase their consumption and lower their savings. They need to increase demand in their own economies rather than importing demand from southern Europe. This is all the more important given that monetary union has negated adjustment via the exchange rate. 

The major global problem, however, are the East Asian surpluses. This is partly because they are larger and partly because they affect the United States to a much greater extent. Setser contends: 

There is an urgent case for a strategy to reduce East Asia’s savings rate to a level that the region can more easily absorb internally. The adjustment should be centered on China, where exceptionally high levels of savings no longer serve the same purpose as during the country’s catch-up phase of economic development. In the past, high savings allowed China to finance high levels of domestic investment without drawing on potentially risky, reversible, cross-border capital flows. However, with the gains from high levels of investment now reduced, a national savings rate that still approaches 50 percent of output is simply too high to be absorbed effectively at home or abroad. China’s high savings rate increasingly implies either bubbles in credit and investment domestically or large capital surpluses that have to be exported and that add to global risks. 

Although China is the prime source of the savings glut, South Korea, Taiwan, and Japan also contribute. Savings rates of 35 percent of GDP in South Korea and Taiwan generate more capital than can be absorbed domestically. South Korea’s current account surplus is just under 8 percent of GDP, about the same share of its GDP as the surplus of Germany, the leading non-Asian contributor to the savings glut. Taiwan’s surplus is at an even higher 14 percent of GDP, although the effect is mitigated by Taiwan’s smaller economy. Japan’s surplus of 3 percent of GDP is comparable to that of the eurozone as a whole. 

Over the past few years, the nature of the policy challenge posed by East Asia’s external surplus has changed. The region’s surpluses are no longer maintained primarily through intervention in the foreign exchange market, with the result that moving toward floating currencies is no longer a sufficient policy response to Asia’s trade surplus. The traditional U.S. economic agenda in the region— aimed at liberalizing trade, investment, and exchange rates—also misses the threat that East Asia’s savings glut poses to global prosperity. U.S. economic diplomacy now needs to advance policies that lower national savings in East Asia directly. These include the use of fiscal policy to support an increase in household consumption and reforms in high-saving East Asian economies to strengthen the social safety net and thereby lower private savings.

Given that the 'savings glut' or global imbalances were a major factor in the global financial crisis we should all be worried by these developments. A Trump administration is unlikely to accept the United States' traditional role in soaking up these surpluses. This means that unless East Asian surplus countries reduce their savings (and surpluses) we can expect a Trump administration to focus on what the United States can do. The easiest 'solution' will be to impose new restrictive measures on East Asian trade. 

This means that either East Asia adjusts its policies or the United States will force adjustment through trade measures. This could lead to a trade war as nationalist sentiments awaken in the trade arena and the surplus countries maintain their belief in their moral superiority for running trade surpluses. 

Reasons to be cheerful? Trump, Globalisation and Australia

Yes, yes, dear, dear, perhaps next year
Or maybe even never
In which case...
Reasons to be cheerful, part 3 

- Ian Dury and the Blockheads 

One single observation can invalidate a general statement derived from millennia of confirmatory sightings of millions of white swans. All you need is one single (and, I am told, quite ugly) black bird.  

- Nassim Nicholas Taleb 

The best argument against democracy is a five-minute conversation with the average voter. 

- Winston S. Churchill

Can we all get along. 

- Rodney King

Introduction

It's likely that many disgruntled voters in the United States and progressive observers worldwide agree with Churchill's disdain for the popular preferences of the great unwashed. Democracy is messy. It can't produce optimal outcomes for all voters and given the multiple reasons why voters choose one candidate over another it may not produce optimal outcomes for the majority. But as Churchill said on another occasion: "Democracy is the worst form of government, except for all the others". It's all we've got and so the way it works - the way that popular preferences translate into optimal social outcomes - matters a lot. Pundits are arguing that a 'whitelash' led Trump to victory in the United States Presidential Election. Angry white Americans - at all income levels - came out to vote and elected a Republican President and majorities in both houses of Congress. While the Democrats had an establishment candidate, the Republicans had an anti-establishment, independent candidate who did not play by the rules of the game.

Trump isn't actually an anti-establishment President, but there is no doubt that his success was due to the perception that he would not be 'more of the same'. Trump's victory can't be seen as unequivocal support for a renewed conservative agenda, it's a vote against both the liberal and conservative elites. The Democrats had their chance to match the Republicans with their own anti-establishment candidate, but the Democratic Party hierarchy believed that Bernie Sanders could not win and that a Clinton candidacy would ensure the Presidency for the Democrats. Conventional thinking by the Democrat leadership has led to tough times for progressives. 

While those on the centre-left are wringing their hands and tensely running their fingers through their hair, beards or whatever, it's possible that the election of Donald Trump will open up a progressive path for policy reformers focused on the real problem of distribution rather than globalisation. But the path will have to beaten, it won't just open up as Trump fails to deliver what he promised or, perhaps worse, does deliver on some of his more repugnant promises. Trump's victory does not just contain lessons for Americans but for capitalist democracies everywhere. Australia has done better over the past 10 years than virtually any other capitalist democracy, yet disaffection is on the march. 

Globalisation

Trump's impact will be greatest on Americans but a substantial shift away from liberal internationalism will cause structural change in the global economy. It will alter the rules of the game and change what policies produce the best results. In a protectionist world, will economic liberalism in one country be viable, when that country won't be the United States? Will export enhancement be a viable strategy for developing countries? 

Minor restrictions on trade won't necessarily have the disastrous effects many liberal economists believe. Indeed, a shift to protectionism might stimulate growth in the United States. But the global financial fallout could be considerable if there were a major shift towards protectionism by the United States, which has acted as the sponge to soak up the surpluses of export enhancers everywhere. It would also create anxiety in financial markets. Restricted trade and open finance would be the exact opposite of what is required for growth and stability. Instead, the continuation of trade and investment globalisation will require greater regulation of short-term capital flows. A radical deglobalisation would cause chaos as countries returned to beggar-thy-neighbour policies in the attempt to develop new internally focused growth models. The whole structure could be mutually reinforcing reversing the trends towards globalisation since the 1970s. 

The real problem with globalisation is its destabilising financialisation component, spurred by the idea that capital everywhere must be free. The domestic problem of globalisation is the belief that globalisation means that public services have to be pared back, that taxes for the wealthy have to be lowered, that wages and conditions for low income workers have to be cut, that salaries for executives have to be increased, and that redistribution necessarily damages productivity. Blaming globalisation is a cop out for both the right and the left.

Globalisation has provided a simple explanation for the rise in inequality in developed countries. Both proponents and opponents of globalisation make such arguments. Proponents have argued that globalisation is a marker of a changed and constantly changing world, where the past goals of societies and governments to distribute the fruits of growth equitably are no longer possible or even desirable. Instead, the argument has been that garnering growth in a globalising economy requires governments to intervene less in market processes. Opponents argue that globalisation increases inequality and that better outcomes are only possible if countries take a step back from globalisation and liberal capitalism.

There can be no doubt that that governments face a multitude of domestic and global pressures and constraints. States and societies wanting to increase living standards have little choice but to engage with the global economy. However, the debate about globalisation and inequality obscures the most important variables in the determination of outcomes – government and societal choices. To understand the impact of globalisation on social outcomes, it is still necessary to focus on the impact of policy changes, rather than on globalisation as a stand-alone variable. The determination of the level of inequality in a society has more to do with domestic political struggles than with globalisation.

Globalisation is both a process and an ideology. It is not a thing that necessitates particular outcomes. There's no instruction book. Each capitalist democracy's relationship with the outside world produces different constraints and opportunities. While most countries have to adjust to the world ‘as it is’, the choice of adjustment strategy is shaped but not determined by globalisation processes. Varying responses and outcomes are always possible. As comparative politics makes clear some political systems produce dynamic capitalist economies with high levels of social equity, some don't. 

There are always choices to be made that have multiple trade offs. Societies that value egalitarianism, generally have more equal outcomes. The victory of Trump shows that even capitalist democracies that have a more laissez faire attitude to social outcomes still must find a way to make globalisation work for the people. In my 2009 book The Vulnerable Country I wrote: 

Ultimately, globalisation’s future will require domestic support in both liberal democracies and authoritarian regimes. This support will depend on globalisation producing more winners than losers or, at least, on the winners being able to convince the losers that they stand ultimately to benefit from short-term sacrifices to their welfare. Globalisation needs to be able to produce the goods – and the services. A liberal economic policy structure and support for globalisation is not set in stone. As the next few years will show, the imposition of more market-based regulation did not settle regulatory struggles for all time. The art of government will continue to involve trade-offs between economic and political pressures, and domestic and international arenas. The possibility remains that coalitions against globalisation and economic liberalism will emerge and that some groups within nation-states will continue to be amenable to protectionist rhetoric and policies. 

While the jury is still out on whether the world is entering a period of de-globalisation, we have clearly moved away from a world of advancing globalisation. The continuing impact of the global financial crisis has seen to that. Australia, however, is an outlier among the capitalist democracies as it continued to benefit from growth in China and Asia more widely. 

Australia 

What I got wrong in my book was the timing of events. As Keynes is reputed to have once said: 'The market can stay irrational longer than you can stay solvent'. If you're not right on time, you're not right. I accept that. Prediction is a difficult business.

Lots of variables intervened to continue the mining/housing/debt boom that began in the 1990s. The longer it has gone on, the more it has seemed that Australia is indestructible, that vulnerabilities can be dealt with by the existing policy framework. Australia has been lucky, but there's been some good policy as well. At the height of the crisis, the Rudd Labor government’s fiscal stimulus and the Reserve Bank of Australia’s lowering of interest rates each had a beneficial effect on the Australian economy, halting a downward spiral that otherwise might have led to a recession. The government’s haste to stimulate the economy, associated bureaucratic problems, and a general antipathy to government spending, led to intense criticism from the opposition and some commentators. Nevertheless, Australia did perform better than other countries during the key quarters of the crisis and before the Chinese stimulus helped to bolster investment and export growth. Australia clearly benefitted from the decoupling of Asia from the major advanced economies from 2009. 

There's no denying the sterling performance of the Australian economy in aggregate over the past 26 years. My argument is that the vulnerabilities that loomed large during the GFC have not gone away. Australia still remains vulnerable to the declining demand for resources and any future restrictions of the global supply of credit. And it still remains vulnerable to rising inequality, which was clearly a major factor in the rise of Donald Trump.

Australian policy-makers – both political and bureaucratic – have gambled that the distribution of opportunity, income and wealth is satisfactory, that the economy will continue to benefit from Chinese and broader Asian growth indefinitely, and that the economy will transition away from the mining boom with few policy innovations required apart from fiscal rectitude. They have also gambled that the build up in debt and property prices won't lead to a severe recession when the bubble bursts. 

Let's leave the gloom aside for a moment and consider what could go right?  

1. Australia gets lucky again and the household sector de-leverages gradually rather than savagely. 
2. China continues to grow rapidly. 
3. India and the United States (Africa?) embark on an infrastructure boom and revitalise Australia's resource sector. 
4. Disgruntled supporters don't reach a critical mass and they are marginalised by the centre parties and blamed for their plight. 
5. Some people get lucky because high house prices really are a 'new normal' and the desire for homeownership and property investment sparks a new innovative culture in Australia that leads to unimagined high tech exports? (Other people stay unlucky but are positively impacted by trickle down economics).

Maybe not that last one, but even if we do get lucky again, the problems of indebtedness and high property values will just push the problem forward and increase the leverage of the household sector, making the eventual adjustment even worse. 

Dealing with Disenchantment 

Even if I'm completely wrong and Australia continues its long boom indefinitely that won't solve the problem we started with: the attraction of voters to anti-establishment leaders and parties. This is a smaller problem in Australia than the United States, but we can expect a Trump effect, wherein dissident members of the major parties and independents are encouraged to speak out about race and welfare in a way that vilifies sections of society. It might not be pretty. 

The tragedy is that 26 years without an officially designated recession has left too many Australians behind. If it hasn't solved the problem of disaffection over the past 25 years, why do we think more of the same will do the job? Even with continuing growth, Australians will need to rearrange how the benefits of growth are distributed. In a recession, Australians will need to ensure that burdens are shared. 

While faith in democracy to produce the 'right' outcome has reached a new nadir amongst progressives everywhere, I still have faith in democracy to eventually get it right, or make things better, or at least to preserve gains already made. Eventually. 

If we lose our faith in democracy what are the authoritarian alternatives? For the left there's the idea of a 'right on' authoritarianism, with rules protecting the environment and the rights of the poor (as long as they're not damaging the environment). For the centre there's a government of rules limiting the discretion of elected governments to develop alternative policies. An independent monetary policy is a well accepted example and limiting fiscal discretion with unbreakable rules, is sometimes mooted. For the right there's a domination of nationalism and national security authoritarianism, restrictions on immigration, and the underlying belief in historical and racial hierarchies. 

Non-democratic outcomes are possible, which means that a major component of any progressive shift in capitalist democracies will require party and policy elites to engage with the disaffected, not write them off for their social views and actions. They will have to unite people on the basis of a shared solidarity, rather than divide them through vilification. 

Progressives will have to rebuild a coalition, uniting their cafe latte and fluoro bases. They will also have to build a new progressive business coalition, which realises that fairer and greener can be good for business. It will require balancing economic liberalisation with redistribution and improved equality of opportunity. Only the state can provide the resources for this to happen, which means abandoning the idea of a continuously smaller state.  

Centre-left parties will have to find new ways to distribute incomes, wealth and opportunities. They will also have to deal with the real concerns of many that immigration - both legal and illegal - is out of control, that multiculturalism is changing societal values for the worse, and that centre-left parties are just as beholden to financial and business interests as the centre-right. They'll also have to deal with the popular explanation that the root of their problems is globalisation. 

In Australia, the whole edifice can be built upon long-standing egalitarian ideals. While white Australia was an unfortunate component of Australia's egalitarian protectionist policy structure, racial exclusion can't be a part of a modern Australia. Australia is now unequivocally a multicultural country and so 'the people' are now a diverse bunch. Australians like to think of their country as an egalitarian one, so making that a key element of multiculturalism could help to smooth societal divisions. There is a great irony with the 'if you don't love Australia, leave' brigade, given that to not love a multicultural Australia is to not love Australia as it is now.

My optimism about the possibilities of a progressive future for capitalist democracies is not just based on faith. There's a vast trove of historical evidence, showing how capitalist democracies have improved the lot of working people, children, women and men; how public spending has provided opportunities across societies, how feminism has advanced the position of women; how racism has been challenged in the public sphere; how the green movement has improved environmental outcomes. Some of these have taken a long time and many of them have a long way to go. But at a time of seeming progressive retreat it's important to remember past battles fought to produce the 'good society' and the battles ahead to keep what has been gained and to embark on new progressive measures. There's no success in isolation, both within societies and between states.  

History also shows us that radical parties don't generally control the process of policy change. Instead it is their impact on the mainstream parties that leads to breaks with the status quo. Think the historical adaptation of conservative parties to welfarism and workers rights over the late nineteenth and twentieth century. More recently, consider the impact of the green movement on mainstream environmental policies from the 1980s. The outcomes are never as pure as the radicals desire, but that is the nature of democracy: compromise. 

It is important to remember that not every democracy produces poor social outcomes like the United States. Maybe, just maybe, Trumpism in the United States and its equivalents in other capitalist democracies will open up the path for a new progressive policy structure that attempts to share the benefits and costs of capitalism through the democratic process.  

For that path to open up Trumpism must be seen to fail for its own faults not from some plot conspired by the liberal elites to hamstring his mandate. Managing a progressive coalition is going to more difficult in the United States, but they too have successful historical precedents during the Roosevelt and Kennedy/Johnson eras. The Clinton and Obama Presidencies made gains, but they also show that opportunities can be missed: Clinton's decisions to further liberalise the financial sector and cut welfare and Obama's willingness to bailout the financiers and leave homeowners to their own devices. Hopefully, Obamacare does not go down as a failed attempt to improve access to healthcare. 

It might take a while for Trump's shortcomings to become clear. Indeed it is likely that the election of Trump will provide an inflationary boost to the US economy as spending and tax initiatives boost animal spirits. I think we can dismiss the possibility of Trump becoming a small government conservative, regardless of the rhetoric. If Trump were to embark on an infrastructure program it would boost the US economy considerably. Progressives should support that. It's also likely that Trump will cut some regulations and go slow on the enforcement on others, stimulating business and investor confidence in the short-term. 

A more laissez faire approach to regulation will not be sustainable, however, especially in the financial sector. Finance needs more regulation, not less. It needs regulations to be enforced and it needs real penalties for criminal behaviour. Overall, it must aim to restrict the bubbling of asset prices and the growth in private debt to unstable levels. 

A pro-finance and a pro-business policy stance won't appease working and middle class desires for improving living standards and protection of their savings, which can only be achieved through higher wages for lower paid employment and limitations on the salary packages of executives, either through regulation or taxation. Given Trump's world view, it is likely pro-business will mean greater incentives for the wealthy and more discipline for the poor. 

Exhausted 'Solutions'

One of the major reasons for Trump's victory was that the political and economic establishment have presided over an era of stagnating and in many cases, declining living standards. Two past measures measures that have helped to augment household incomes over the past 40 years are no longer 'solutions'. The first strategy has been to put another parent to work. The second has been the expansion of debt. Increasing debt has helped households to maintain or boost consumption and to afford more expensive housing. Unless we move to three parent families or banks forgive all debts, these options are now virtually exhausted. Households can no doubt increase their debts for a while, especially if house prices keep increasing, but that's only a short-term solution. And one with worse consequences for economy and society down the line. 

These exhausted solutions apply to virtually all capitalist democracies. Including the United States. Trump will find that 'running' an economy is much harder than running a business, no matter how large. Eventually there will be another backlash, as people realise that right wing populism is worse than the centrist status quo; and that Donald Trump and the Republican Party will make the lot of the working and middle classes worse. This won't guarantee a progressive solution, but it will open up the path.

I have faith in a backlash to the whitelash because I don't believe everyone who voted for Trump is necessarily committed to Trumpism, racism or misogyny; they're committed to shaking things up. They're committed to sending a message to the political establishment that their privileging of the economic establishment at their expense, can no longer stand.

The problem is that they're wrong to believe that Trump can deliver with his advertised suite of 'policies'. Despite the political establishment berating the public for electing Trump, it is they who must change. If the establishment wants to maintain open economies then they will have to help build a new coalition in favour of openness and a fair distribution. This must be underpinned by real gains for the middle and working classes.  A new pragmatism among centrist politicians and economically liberal policy-makers must take hold.  

Conclusion

The fact that governments in Australia and elsewhere have abandoned attempts to increase equality is more important than any impact of globalisation. Globalisation as an ideological and political construction is important as a constraint, but also as a framework for policy-makers and economic interests to argue that egalitarian policies are no longer possible or desirable. Such aspects of globalisation are, of course, much more difficult to ‘measure’, but are no less important. Attempts to improve social outcomes have given way to attempts to explain inequality.

Scepticism should prevail about the contention that globalisation compels governments and societies to idly accept inequitable outcomes. It is even more doubtful that that the best response is to increase inequality by downgrading existing government efforts to improve social outcomes in the name of incentive and efficiency. 

Trump's victory and similar reactions throughout the capitalist democracies show that people are unhappy with the establishment's rhetoric about globalisation imperatives. While the populist right aims to gain support by blaming globalisation, the left should remain committed to a progressive or sustainable globalisation.

Alternative globalisation strategies are available for Australia: economic liberalism is not always the best strategy. For globalisation to continue in Australia and throughout the world, efforts must be made to ensure that globalisation creates benefits that are widely distributed. Just as the concept of globalisation is contested and multifaceted so are the choices available to citizens and governments.

The Stretched Rubber Band: Banks, Houses, Debt and Vulnerability in Australia

For a more recent, academic version of this paper see here.

[T]he crisis, when it comes, is likely to be prolonged and severe. The wretched Government has so many scraggy chickens, and when they come home to roost they will seem to come at the same time.

W. K. Hancock Australia 1930 (cited in Milne) 

It may well be that the classical theory represents the way we should like our economy to behave. But to assume that it actually does so is to assume our difficulties away.

 J. M Keynes The General Theory of Employment, Interest and Money 1935

Introduction

Financialisation - defined as "the increasing dominance of financial actors, markets, practices, measurements and narratives, at various scales, resulting in a structural transformation of economies, firms (including financial institutions), states and households" - has been a dominant element of the globalisation of the world economy since the 1970s. The origins of financialisation lie in the breakdown of the post-war world economy and the willingness of governments throughout the developed world – both Left and Right – to support financial liberalisation. (Block, Kuttner, O'Brien, Cerny, Strange, Helleiner)

Financialisation and its consequences have attracted considerable academic scrutiny (Martin, Epstein, Dore, Greenwood and Scharfstein, Hein, Palley, Stockhammer, Tabb, Fuller). The fallout from the global financial crisis clearly shows how financial excesses and instability can exacerbate inequality, damage economic activity and global trade, reduce consumption, and lead to an increase in reactions against globalisation and openness. The global financial crisis (GFC) has led to a considerable reduction in financial flows of all kinds and to increasing questions about the benefits of financialisation. However, while financial flows have declined substantially, total debt has not. Growing debt has domestic as well as international sources.

Moran and Payne argue that the 15 year period of growth from 1992 to 2007, known as 'the Great Moderation' were:

also years of the extraordinary cult of the financial markets: a period when the technical wizardry of market actors and regulators, supposedly operating a world beyond the mental capacities of either normal citizens or democratic politicians, removed decision-making to an arcane, technical environment. It was no coincidence that this was also the period of the cult of ‘light touch’ regulation; in other words, of the widely accepted belief that politics, in the guise of regulatory institutions, should play only a minimal role in the workings of the markets. 

Ironically, financialisation in the context of insufficient and ineffective regulation represents a key danger to the sustainability of global economic interconnection. The market meltdown of 2008 shows that faith in major financial players to regulate themselves and maintain the public interest was optimistic at best, and irresponsible and potentially catastrophic at worst. The crisis showed that financial market actors gave little thought or consideration to the systemic consequences of their risky behaviour. Some aspects of financial liberalisation have been beneficial, especially increased access to credit, but the flipside is the rise in debt. 

Finding a balance between the opportunities and vulnerabilities of financialisation is a problem for all countries. As Jorda et al point out: 

Mortgage credit on the balance sheets of banks has been the driving force behind the increasing financialization of advanced economies. In relation to GDP, non-mortgage bank lending to companies and households has remained stable, with virtually all of the increase in the size of the financial sector stemming from a boom in mortgage lending to households ... About two thirds of the business of banking today consists of the intermediation of savings to the household sector for the purchase of real estate.

Thus far, Australia has managed to avoid the financial problems experienced by other developed countries. A quarter of a century without a recession has been a remarkable performance for an economy seen to be in decline in the 1970s and 1980s.  Despite this, or indeed because of it, financial excesses have built up in the Australian economy. During this time Australia's house price index has increased around 150 per cent in real terms. Just like in other developed countries, these financial excesses are related to housing debt. It is one thing to point out the increase in private debt, but it is another thing to establish that this presents a systemic risk both internationally and domestically. Jorda et al find that in the post-war period "the growth of mortgage credit has important implications for the sources of financial fragility in advanced economies, and hence for macroeconomic policies." Slower growth rates follow in the aftermath of mortgage booms even if there was not a financial crisis. Jorda et al conclude that "Contemporary business cycles seem to be increasingly shaped by the dynamics of mortgage credit, with non-mortgage lending playing only a minor role."

Australian policy-makers and investors should note Hyman Minsky's financial instability hypothesis:

The first theorem of the financial instability hypothesis is that the economy has financing regimes under which it is stable, and financing regimes in which it is unstable. The second theorem of the financial instability hypothesis is that over periods of prolonged prosperity, the economy transits from financial relations that make for a stable system to financial relations that make for an unstable system. In particular, over a protracted period of good times, capitalist economies tend to move from a financial structure dominated by hedge finance units to a structure in which there is large weight to units engaged in speculative and Ponzi finance. 

Minsky highlights the dangers of what he calls Ponzi financing wherein "cash flows from operations are not sufficient to fulfill either the repayment of principal or the interest due on outstanding debts by their cash flows from operations". The only way to pay off principal or interest is to sell assets (hopefully at a profit) or borrow more (in the hope that asset prices will continue to grow). According to Minsky, a heightened emphasis on speculative and ponzi finance leads to a greater likelihood that the financial system becomes what he calls a "deviation amplifying system".

It shouldn't be too hard to realise that the growth of the property sector as an outlet for investment shares much of the characteristics of ponzi finance. Investors utilising negative gearing provisions in the tax code are not as concerned as they should be that their asset produces sufficient income to cover interest, let alone principal, and rely instead on continuing increases in prices. This enables them to sell when necessary and to utilise profits to continue the process of asset price inflation. The longer the process goes on, the more likely it is that instability gets built into the financial system.

Eventually, there is a point of inflection where assessments about future profits turn negative, revealing the precarious nature of the whole edifice. Minsky argues that his hypothesis

is a model of a capitalist economy which does not rely upon exogenous shocks to generate business cycles of varying severity. The hypothesis holds that business cycles of history are compounded out of (i) the internal dynamics of capitalist economies, and (ii) the system of interventions and regulations that are designed to keep the economy operating within reasonable bounds.

Nevertheless, it seems clear also that external events can play a big role in creating inflection points and in leading to shocks that undermine liquidity and confidence.

In this paper I argue that the financialisation of the Australian economy has led to a cascading series of vulnerabilities in the Australian financial system, beginning with the domination of banks in the financial system, the preponderance of the big four banks in the banking system, the weight of real estate in the balance sheets of the big four banks and the explosion of household debt. Ultimately, the fate of the Australian financial sector - and the fate of the share market and the wider economy - sits precariously on the precipice of over-inflated property markets and debt-ridden households. The debt-house-price-nexus in Australia is like a stretching rubber band. A stretched band can either be relaxed gradually or it can be stretched further until it breaks.

Achieving the aim of a balanced financial system requires policy-makers to note the vulnerabilities building up in the Australian financial system and to work to reduce them over time. I argue, however, that financial policy-makers have underestimated the financial vulnerabilities building up in Australia as evidenced by the slow take-up of macroprudential policies and their complacent statements about growing risks. There are three reasons for this sanguine attitude: the policy predilection for economic liberal regulation of the financial sector, Australia's growth record and the profit performance of the major Australian banks. Policy-makers appear to believe good fortune will continue indefinitely, but as good investment advisers should always note: past performance is no guarantee of future performance. This is especially the case when the good times have gone on so long and fragilities have built up within the property-finance nexus.

I begin by considering bank domination of the financial system and the Big Four domination of the banking sector. I then outline the preponderance of mortgages on banks balance sheets and the accompanying large rise in property prices. This is followed by an analysis of recent financial regulation, before considering some of the dominant interests pushing for increasing property prices. The reluctance of financial policy-makers to discourage excessive credit growth has been a key 'non-decision' helping to buoy prices. In this section I outline the need for macroprudential policies to moderate the growth of credit. The analysis then turns to the phenomenal growth of debt and how the rise in private debt has fuelled massive increases in house prices. I outline historical and cross sectional evidence that shows that countries with the largest expansion of household debt suffer the most severe recessions. While many countries have already experienced such negative consequences, Australia has seen a 25 year expansion of house prices and household debt. This evidence, however, provides cause for concern for Australia's economic future. Policy-makers, complicit in the expansion of credit, have misplaced their focus on the expansion of public debt and the need to cut public spending. The final section analyses the strange disappearance of any concern about the growth of foreign debt and the current account deficit. I conclude by stressing the very real possibility that Australia's debt fuelled house price expansion will lead to a severe recession in coming years.

Banks 

Australia has one of the world's most bank-dependent financial systems in the world. This dominant banking sector is itself dominated by the big four banks - the Commonwealth, the National Australia Bank, the Australia and New Zealand Banking Group and Westpac. According to David Richardson in The Rise and Rise of Big Banks,"the common ownership of the big four banks" has led to the possibility that banks can "boost profits by acting as a monopoly". Measuring bank concentration by considering the share of the top four banks in total banking assets shows Australia has the most concentrated sector in the world. Australia's ‘big four’ make up four of the eight most profitable banks in the world. According to the Reserve Bank of Australia (RBA), Australia's large banks' return on equity (after tax and minority interests) has recently replaced Canada as the highest in the world.

The big four's share has grown over time. In August 1991, banks accounted for 67.2 per cent of all lending and 77.6 of home loans, growing to 82.6 per cent of lending and 87.5 per cent of home loans by 2012. Since the mid-1980s banks (or more correctly ‘Authorised Deposit-taking Institutions’) have increased their share of the financial system from 50 per cent to 90 per cent. The big four banks are also preponderant in the Australian share market, accounting for about 25 per cent of the ASX 200. The Big Four Banks are also the Big Four shares, accounting for the four largest listings on the ASX. They also dominate in terms of profits. Their combined profits topped $30 billion in 2015. Wider financials accounted for about 48 per cent of the ASX 200 in November 2015, falling to 43 per cent in August 2016. As the Australian banks go, so goes the Australian economy. 

Despite their domination, Richardson's analysis found that "the cheapest of the big four banks was a good deal more expensive than many individual mutual banks, credit unions and building societies and was more expensive than the average of those institutions by 40 basis points." That's a lot of people not getting the best deal on their loans. According to Luci Ellis from the RBA

Back in the early 1980s, non-bank financial intermediaries were almost as important as banks. In contrast, nowadays the share of financial intermediation outside the prudentially regulated sectors is very small – the orange bars compared with the sum of the two blue bars [in the figure below] ... [B]anks have grown in importance because they are no longer being restrained by the tight restrictions of prior decades. The supposition of the debate in the 1990s had been that deregulation would make it harder for banks to compete with new entrants. The reality was that banks were being constrained by those regulations more than they were being shielded by them. Certainly that's the message of the non-banks during this period, many of which voted with their feet and became banks, just as a number of credit unions have done in recent years.

Houses

The RBA, while discussing the risks, doesn't seem too worried about these trends. In his statement accompanying the August 2016 monetary policy decision, the Governor Glenn Stevens said:

Supervisory measures have strengthened lending standards in the housing market. Separately, a number of lenders are also taking a more cautious attitude to lending in certain segments. The most recent information suggests that dwelling prices have been rising only moderately over the course of this year, with considerable supply of apartments scheduled to come on stream over the next couple of years, particularly in the eastern capital cities. Growth in lending for housing purposes has slowed a little this year. All this suggests that the likelihood of lower interest rates exacerbating risks in the housing market has diminished.

However, if we add another variable to our analysis - mortgage lending - then we also add another layer of vulnerability to the financial system and the wider economy. Australian banks have more mortgages on their books than any other developed country banking system. Residential mortgages account for over 60 per cent in Australia compared to around 30 per cent for the United States and 20 per cent for the United Kingdom. According to Jorda et al., this is a global phenomenon with the aggregate share of real estate lending in total bank lending expanding significantly since the 1990s. 

While house prices grew roughly in line with inflation in the 1980s, according to the RBA, from the 1990s until the mid 2000s strong housing price growth, associated with a a major rise in the debt-to-income ratio of Australian households, correlated with large increases in prices. As Stapledon points out:

In the period since Australia’s last recession, house prices have risen much more sharply than in any period in Australia’s history. That builds on a substantial rise in the preceding four decades which has cumulatively seen both house prices and rents rise significantly faster than incomes.

This has been a common experience in all developed countries with Germany and Italy the weakest in terms of prices rises and Australia as one of the strongest. Prices in most countries have diverged significantly from long-term averages and ratios to rents and income. This has especially been the case in Australia. A major difference between Australia and countries such as the United States and Netherlands is that prices and ratios have significantly corrected, while thus far Australia has avoided a decline.

While population growth and supply constraints have had an impact on prices, they are insufficient explanations. According to the ABS, "Australian population growth over the past ten years has averaged 1.7% annually, peaking at 2.2% in June 2008. For the past nine quarters the rate of growth has been slowing, with the March 2015 annual growth rate of 1.4% being only 0.1 percentage points above the September 2005 annual growth rate at the start of the period of analysis ... Over the past ten years dwelling transfers have tracked quite closely to population growth with movements in the number of transfers tending to exhibit a slight lag behind population growth. Currently the number of dwelling transfers is continuing to rise despite slowing population growth."

It is possible that there have been structural changes in Australian property markets - on both the supply and demand sides - that will lead to prices settling at a higher level, but history and comparative analysis suggests that prices will eventually fall and probably quite substantially. Even if price rises have been driven by supply constraints, the likelihood is that pressures to increase supply will overcome bottlenecks A historical and comparative analysis - one that is suspicious of claims of 'this time it's different' or 'new fundamentals' - tells us that there will be a reversion to the mean.  While the issue of when is a problem for those trying to time the market, this is less important for our analysis than the fact that it will eventually happen, with dire consequences.

A falling market, especially if accompanied by rising unemployment, could fall a long way, given the level of variance. But this isn't just a problem for highly leveraged households, it's also a problem for the banks. Falling prices will mean banks will have a growing number of loans on their books that involve negative equity for borrowers. Roy Morgan Research in late 2016 found that over 300,000 home borrowers had no real equity in their homes, which they argue:

represents a considerable risk, particularly if home values fall or households are hit by unemployment. In addition if home-loan rates rise, the problem would be likely to worsen as repayments would increase and home prices decline, with the potential to lower equity even further. Lower interest rates on the other hand have the potential to increase home equity through increased home values and by giving borrowers the opportunity to pay down the principle at a faster rate.

If the latter scenario encourages more lending (and of course more debt) then the problem is only pushed down the line, making adjustment even more severe when interest rates eventually rise again.
Falling prices will discourage investors, which will lead to lower prices. Lower prices will lead to lower lending and an increase in problem loans. Given  the importance of the banks, their decline will negatively impact the share market and the overall economy. The dislocation caused by a decline in the property market could be part of a negative spiral that engulfs the Australian economy.

It's not just domestic investors that helped to inflate the property market, foreign investors are important too. Foreign investment in both commercial and residential real estate has grown rapidly in recent years, with China playing a growing role. Approvals for new residential construction have been concentrated in the apartment market in Sydney and Melbourne. Another risk is that foreigners may reduce their purchases of Australian real estate. Indeed, there is some recent evidence that this is already happening. The RBA notes in its April 2016 Financial Stability Review:

if a significant subset of buyers reduce their demand sharply, this can weigh on housing prices, and Chinese buyers are no exception to this given their growing importance in segments of the Australian market.

The RBA argues that several factors may instigate a reduction in housing demand, including "a sharp economic slowdown in China that lowers Chinese households' income and wealth." A falling yuan would lower their purchasing power. Slowing growth in China would hurt other countries in the region as well, lessening their capacity to invest in Australian property. It's also possible that Chinese government will further tighten capital controls. Finally, the RBA countenances the possibility of "a domestic policy action or other event that lessens Australia's appeal or accessibility as a migration destination, including for study purposes."  Just two months earlier in its February Statement the RBA argued: "In the period ahead, dwelling investment seems likely to be supported by continued strong demand from foreign buyers. Information from the Bank's liaison suggests that foreign buyers tend to have long-term motivations for investment and may be relatively unconcerned about temporary fluctuations in housing price growth." Things can change quickly, obviously. Foreign investment has played a significant role in inflating prices and, in its absence, will play a part in eventually spiking the bubble.

Weak Regulation 

Monetary authorities and government have played a supportive role in the build up in systemic risks related to household debt. Such a position shows a profound faith in the finance sector to take responsibility for the stability of the overall financial system, despite the evidence from other countries and from history.  On the way down, they will have a different set of choices in front of them, many of which will involve crisis management. There are macroprudential policies (MPs) and measures available and in use around the world that could have been used to limit vulnerabilities and build resilience in the system by restricting excessive credit growth and moderating the pace of asset price inflation, in the first place. Financial policy-makers have reluctantly resorted to MPs because of the clear build up of vulnerabilities in the Australian financial system related to debt and house prices.

The reticence of policy-makers and commentators is due to the belief that these measures would involve a return to the restrictive policy framework that characterised Australian finance before the liberalisation of the 1980s. According to former RBA Board member, Warwick McKibbin:

When listing the suggested interventions usually contained in a macroprudential policy portfolio, the list looks somewhat familiar to those who were around the policy debates of the 1960s in Australia. It took many decades to remove these types of inefficient interventions in financial markets that for many decades had distorted the allocation of capital and retarded the potential growth rate of the Australian economy.

In broad terms, Claussen argues MPs aim to "to reduce systemic risks arising from “excessive” financial pro-cyclicality and from interconnections and other “cross-sectional” factors". Measures include:

capital adequacy ratios (time-varying); contingent capital requirements; requirements for higher quality capital on balance sheets; explicit limits on credit growth; varying reserve requirements; caps on loan-to-valuation ratios; and dynamic provisioning.

According to McDonald, MPs aim "(i) to create a buffer (or safety net) so that banks do not suffer overly heavy losses during downturns; and (ii) to restrict the build-up of financial imbalances and thereby reduce the risk of a large correction in house prices". He finds that Loan-to-value (LTV) and debt-to-income (DTI) limits can be very effective "when credit is expanding quickly and when house prices are high relative to income". MP controls aim to restrict the growth of lending, especially to risky borrowers with little existing capital. Restrictive measures force these borrowers to save before they can borrow and reduce turnover in markets. Akinci and Olmstead-Rumsey, argue that there have been few studies of the effectiveness or otherwise of MPs. They create "a new set of indexes of macroprudential policies in 57 advanced and emerging countries covering the period from 2000:Q1 to 2013:Q4". They find that:

macroprudential policy variables exert a statistically significant negative effect on bank credit growth and house price inflation. ... Targeted policies, which are specifically intended to limit the growth of credit in a certain sector, seem to be more effective. 

Much of the growth in the literature on, and receptivity to, MP has been a result of the assessment that there was a need "to go beyond a purely micro-based approach to financial regulation and supervision". Microprudential policies aim to regulate individual firms. Both microprudential and MP regulators use prudential policy measures such as buffers and balance sheet restrictions but "microprudential policy adjusts capital based on individual institutions’ risks, while macroprudential policy adjusts overall levels of capital based on the financial cycle and systemic relevance to guard against systemic risk buildup." Obviously effective MPs will make the job of microprudential regulators easier. The aim of microprudential oversight is to examine the ability of individual firms to cope with exogenous shocks and they do not "incorporate endogenous risk and the interconnectedness with the rest of the system". It is important to note, Minsky's insight that the financial system does not require an exogenous shock for the system to become unstable.

However, any change in policy creates negative reactions and policy-makers and advocates of MP need to be aware of this. Itai Agur and Sunil Sharma point out that:

For regulation to be truly effective it has to be designed with an understanding of the regulatory structure, and the possible interventions by financial and political players that could distort the enforcement of the rules. Taking account of the political economy of regulation is likely to be especially important for macro-prudential policy ... The devastation caused and the costs imposed by the global financial crisis suggest that the system of oversight must be designed to prevent the emergence of systemic threats because once a system-wide meltdown starts it is hard to control due to the complexity of the system, the struggle of managing expectations under stress, and the challenges of coordinating and implementing policy through multiple agencies.

Chair of the Federal Reserve Janet Yellen supports the use of MP to target financial stability rather than monetary policy, but argues that policy-makers have to be aware of the potential for risks to appear outside of regulated sectors, the potential to miss emerging risks and  "the potential for such policy steps to be delayed or to lack public support."

This has certainly been the case in Australia. MP could have been used earlier on in the boom and to a much greater extent. The RBA Governor, Glenn Stevens, has been sceptical about the sustainability and effectiveness of MP regulations, describing them in 2014 as "dreaded" measures and the "latest fad". Given his role as Chair of the Council of Financial Regulators, it is not surprising that Australia has been slow to take up MP measures. Eventually, however, the CFR and another of its members, the Australian Prudential Regulatory Authority (APRA) realised that additional measures were required because the RBA needed to lower interest rates for the benefit of the wider economy. Alternative measures were required to counteract the stimulatory effect of lower interest rates on growth of credit and house price inflation.

In late 2014, APRA outlined new regulatory measures to "reinforce sound residential mortgage lending practices". APRA wrote to all ADIs stating:

In the context of historically low interest rates, high levels of household debt, strong competition in the housing market and accelerating credit growth, APRA has indicated it will be further increasing the level of supervisory oversight on mortgage lending ... At this point in time, APRA does not propose to introduce across-the-board increases in capital requirements, or caps on particular types of loans  However, APRA has flagged to ADIs that it will be paying particular attention to specific areas of prudential concern. These include:

• higher risk mortgage lending — for example, high loan-to-income loans, high loan-to-valuation (LVR) loans, interest-only loans to owner occupiers, and loans with very long terms;
• strong growth in lending to property investors — portfolio growth materially above a threshold of 10 per cent will be an important risk indicator for APRA supervisors in considering the need for further action;
• loan affordability tests for new borrowers — in APRA’s view, these should incorporate an interest rate buffer of at least 2 per cent above the loan product rate, and a floor lending rate of at least 7 per cent, when assessing borrowers’ ability to service their loans. Good practice would be to maintain a buffer and floor rate comfortably above these levels.

In mid-2015, APRA raised interest rates for property investors by around 25 basis points. Overall the regulatory action by the CFC in relation to banks, mortgages and house prices have been on the soft side with 'jawboning' a major component of 'action'. Head of APRA, Wayne Byers noted in a 2015 speech that APRA has stepped up its 'examination' of lending practices since 2011:

• in 2011 and again in 2014, we sought assurances from the Boards of the larger authorised deposit-taking institutions (ADIs) that they were actively monitoring their housing lending portfolios and credit standards; 
• in 2013, we commenced more detailed information collections from the larger ADIs on a range of housing loan risk metrics; 
• in 2014, we stress-tested the 13 largest ADIs against two scenarios involving a significant housing market downturn; 
• also in 2014, we issued a Prudential Practice Guide on sound risk management practices for residential mortgage lending;
• at the end of last year, we wrote to all ADIs about the need to maintain sound lending standards, and established some benchmarks against which we would consider the need for further supervisory actions.

Two conceptions guiding policy are, firstly. that Australia remains "a long way from the poor practices that led to problems elsewhere in the world", and, secondly, that because it is in a bank's interest to scrutinise the heightened risk environment they will effectively regulate themselves. Strangely, Byers contends that, "APRA can’t stop or prevent cycles in prices, or change the broader environment in which lenders lend". However, "to ensure the banking system is resilient to whatever conditions might eventuate in the future", it might just be necessary to resist excessive cycles in prices and slow the rise in debt.

Byers, told the House of Representatives economics committee in March 2015 "we are targeting those [banks] that are pursuing the most aggressive lending strategies and to the extent there is extra capital imposed, that will be imposed on those housing portfolios where the risks are." More recently, Byers outlined that he had no plans to change the 10 per cent threshold arguing that it had slowed investor lending. However, as the RBA points out, "Following the introduction of an interest rate differential between housing loans to investors and owner-occupiers in mid-2015, a number of borrowers have changed the purpose of their existing loan; the net value of switching of loan purpose from investor to owner-occupier is estimated to have been $41 billion over the period of July 2015 to May 2016 of which $1.1 billion occurred in May.

The initially dismissive attitude of policy-makers to MP has to be seen within the context of the faith in the benefits of Australian financial liberalisation and in economic liberalism as a guiding framework for policy. However, there are also considerable political interests supporting the debt-asset price inflation nexus.

The Politico-Housing Complex

Another problem in dealing with the rise of house prices in Australia is the development of a politico-housing complex in Australia, wherein policy is adapted to keep property prices buoyant. David Llewellyn-Smith argues that:

At all levels of government and regulatory enforcement, real estate rules supreme. At the Federal level it guarantees and protects too-big-to-fail banks, drives rampant population growth and shields legal loopholes for criminal property activity. Regulators are only nominally independent from this, offering further uber-generous banking supports, little or no transparency as they endorse gaming of international rules that would impinge on property rent seekers. At the state and local levels it is planning restrictions, supply side bottlenecks, developer kickbacks and demand side stimulus measures. All are designed, in one way or another, to keep property prices high. Australian civil society is not much better. While it agonises over global warming, asylum seekers and aboriginal fates, it gorges itself on the property ponzi, forcing its children into levels of debt servitude far beyond prudence and their parent’s experience ... The non-government sector is paltry and ineffectual while the lobbies that drive property interests hold privileged seats at the policy table.

Soos and Egan also point out the significance of "a cabal of vested interests", whom they argue includes, "highly leveraged banks, the real estate and developer lobbies, media companies reliant on property advertising revenue, federal and state governments supporting the banking sector and housing markets with public funds, and of course, homeowners and investors who reason that steep housing price inflation improves their financial well being." The property market is an important source of revenue for state and local governments, meaning that a decline in the market will lead to budgetary shortfalls. Just over half of state and local government taxation revenue was property related. There are two broad categories: "taxes on immovable properties which includes the following subcategories: land tax, rates and other, and taxes on financial and capital transactions which includes: financial institutions transaction taxes, government borrowing guarantee levies, stamp duty on conveyances and other stamp duties." In recent years, property taxes have been growing at a faster rate than other taxes reinforcing the dependence of local and state governments.

It might be the case, however, that the biggest impediment is cultural. The continuation of the edifice is built upon a culture of property speculation and a popular belief in the safety, or better, of housing investment. The longer the show continues, the more the belief in the "safe as houses" mentality dominates public discourse. Obviously, given the years without a major correction the claims have historical truth. Many people have made large sums of money buying and selling real estate and many others want a piece of that action. The more people who want to get in on the investment ponzi, the more prices rise and the greater the impact of the eventual fall. The debate over housing affordability is often mentioned as a problem for younger people, but that is soon ignored as home 'owners' and investors celebrate the wisdom of their purchases. 

It's clear that there are many interests supporting the maintenance of high house prices in Australia. These interests have helped to limit the development of MP controls. The problem is that the boom will eventually end and because the economy is so leveraged to real estate, its end will have serious consequences. The resistance to MP can be seen in this light because their explicit aim is to get banks to tighten up on lending. The consequence should be less upward pressure on house prices, at least in lower market segments.

Policy-makers know this and will try to shore up prices. Eventually, they will fail. The Rudd government liberalised foreign investment in real estate in 2009 and then tightened up again in 2010. In early 2009, the government did not want a fall in property prices. By 2010, the government was more relaxed as fiscal stimulus in Australia and China helped keep the economy buoyant while the United States and much of Europe went into deep recession. The Turnbull government will also be tempted to act and, given the Coalition's victory in the 2016 election, it won't be able to blame changes to negative gearing rules that might have happened under a Shorten Labor government.

An end to the radical deviation of house prices from their long-term average relationships to inflation, income and rents and the related need for households to deleverage will cause significant pain for Australians. A reversion to mean, however, will have other beneficial consequences. Eventually. While it sounds heretical in the Australian context, constantly increasing house prices are not good for society as whole and for most buyers and sellers it constitutes wealth illusion. If you sell a house in an inflated market, you probably still have to buy one in that same market. The only real beneficiaries are those who downsize or move to an area of lower house prices. But even then if the general price level of houses was lower, even those sellers would be able to buy a relatively cheaper house when they downgraded.

Of course, for investors the major aim is capital gain, which means that fewer houses are available for owner-occupiers. Over the past 10 years this has been an incredibly lucrative investment strategy: tax breaks and capital gains. According to Core Logic,  the median selling price for houses Australia wide increased by an average of 51% over the past decade, and 44% for apartments.It also means that a huge component of 'investment' in the country is focused on what effectively is a ponzi scheme, rather than productive investment in future productivity enhancing businesses and infrastructure. Investors are 'encouraged' by negative gearing to make a loss on their investment. Not a particularly sound investment strategy overall. Income earned by the asset - through rents - are thus less important to the investor than capital gains.

Even if the worst of the risks do not come to pass, Michael Janda highlights the macroeconomic problems associated with an excessive focus on property speculation.

The home lending fetish results in underinvestment in new businesses, research and expansion, and an over-reliance on foreign capital which can easily evaporate in a crisis. It also creates a higher cost of doing business because of inflated land prices, and because workers' wages need to be high enough for them to also afford inflated housing costs, making Australian firms globally uncompetitive. If (or, perhaps more accurately, when) this results in an Australian recession the banks will have to be bailed out through central bank loans.

In a recent study, Chakraborty et al, "find evidence that an increase in housing prices leads to a decrease in commercial lending." They also show that

the decrease in lending translates to a real effect, as it leads to a decrease in the investments of firms that have a relationship with the affected banks. The premise underlying this crowding-out behavior is that banks are constrained in raising new capital or selling their loans, and so when highly profitable lending opportunities arise in one sector (mortgage lending), they choose to pursue them by cutting their lending in another sector (commercial lending).

Cecchetti and Kharroubi have written two important papers analysing the impact of the growth of finance. In a 2012 paper the authors concluded that financial sector growth "is good only up to a point, after which it becomes a drag on growth. They also show that "a fast-growing financial sector is detrimental to aggregate productivity growth".  In a later paper they argue that:

financial booms are not, in general, growth-enhancing, likely because the financial sector competes with the rest of the economy for resources. Second, using sectoral data, we examine the distributional nature of this effect and find that credit booms harm what we normally think of as the engines for growth – those that are more R&D intensive.

Put it all Together and What Do You Get: Debt

Associated with this excessive focus on the property sector is the rise and rise of household debt in Australia. This has been a general trend in developed economies. Jorda et al. utilise new data sets to show that:

after an initial period of financial deepening in the late 19th century the average level of the credit-to-GDP ratio in advanced economies reached a plateau of about 50%–60% around 1900. Subsequently, with the notable exception of the deep contraction seen in bank lending in the Great Depression and World War II, the ratio broadly remained in this range until the 1970s. The trend then broke: the three decades that followed were marked by a sharp increase in the volume of bank credit relative to GDP. Bank lending on average roughly doubled relative to GDP between 1980 and 2009 as average bank credit to GDP increased from 62% in 1980 to 118% in 2010.

Fernandez and Aalbers argue that "[h]ousing finance represents both an asset and a liability". On the asset side of the equation "housing plays a critical role as collateral for debt. The rising share of housing finance in overall financial assets demonstrates the pivotal role of the built environment in the expansive phase of finance of the last three decades". On the liability side a global pool of liquid assets, that they call a "wall of money", requires investment opportunities. There are four sources for these funds. Firstly. there are funds from institutional investors, which includes pension funds, insurance companies and sovereign wealth funds; secondly, funds created by the trade surplus countries, thirdly from loose monetary policy; and finally from the rise in corporate savings from accumulated profits. The general move towards higher private debt levels shows that policy would need to fight against the potential for expansion of debt. This, of course would have been an overt challenge to the orthodoxy of financial liberalisation. No organised grouping opposed the direction of policy or the creation of housing debt. And as argued above this meant that those with the most to gain had the loudest voice.

The problem is not just asset price inflation and debt expansion on the way up, it is also the consequences on the way down. Lansing and Glick, in a study of the debt build up in industrial countries, report that:

countries experiencing the largest increases in household leverage before the crisis tended to experience the most severe recessions, where severity is measured by the percentage decline in real consumption from the second quarter of 2008 to the first quarter of 2009. Consumption fell most sharply in Ireland (-6.7%) and Denmark (-6.3%), both of which saw huge increases in household leverage prior to the crisis. Consumption was flat or fell only slightly in Germany, Austria, Belgium, and France, which were among the countries that saw the smallest increases in household leverage before the crisis. Overall, the data suggest that recession severity in a given country reflects the degree to which prior growth was driven by an unsustainable borrowing trend. Of course, other factors besides leverage could have influenced the post-crisis consumption pattern. These include actions taken by policymakers in the respective countries to mitigate the economic fallout from the financial crisis.

Not only is the expansion of household debt eventually associated with significant declines in household consumption, but there is evidence to show that it leads to banking crises. Citing work by Jorda, Schularick and Taylor and Reinhardt and Rogoff, the authors of House of Debt, Atif Mian and Amir Sufi contend that we must understand the association of the expansion of private debt with both recessions and banking crises. Jorda et al. considered over 200 recessions between 1870 and 2008 (thus missing the fallout from the GFC) They find that:

first, financial-crisis recessions are more painful than normal recessions; second, the credit-intensity of the expansion phase is closely associated with the severity of the recession phase for both types of recessions. More precisely, we show that a stronger increase in financial leverage, measured by the rate of change of bank credit relative to GDP in the prior boom, tends to correlate with a deeper subsequent downturn.

Mian and Sufi argue that the international and US evidence is clear: "Economic disasters are almost always preceded by a large increase in household debt. The two are linked by "collapses in spending". The problem is that there are many alternative views that consider the rise in household debt to be a "sideshow". These views include the "fundamentals view", which highlights the role of major shocks to the economy in the form of political crises, natural disasters or a major change in expectations. Mian and Sufi point out that most of the severe recessions were preceded by such events. Fundamentalists don't see the rise in debt as a causal mechanism. The "animal spirits" view proposes that recessions are caused by a rise in irrational expectations about future price growth. The "banking view" sees the problem in terms of declining access to credit. The crisis can be fixed by encouraging banks to start lending again to households. The banking view was heavily supported in the aftermath of the GFC. President George W. Bush's administration was an enthusiastic supporter.

Australia has thus far not required an explanation as to why the build up in debt has been followed by a collapse in spending. It hasn't happened here. Yet. There are many warning signs and Australia has experienced all the initial conditions for an eventual debt derived collapse in consumption. As the figures below show, household debt has been on an almost continuous rise in Australia since the early 1990s. The big advantage for Australian households has been the lowering of interest rates, which has reduced the amount of interest paid since the late 2000s, increasing disposable income and making leveraged households increasingly dependent on low interest rates. An increase in interest rates will increase the debt service burden once again. It is also possible that a wider economic crisis will force deleveraging before that time. Meanwhile, low interest rates will encourage households and investors to take on more debt.

Household debt is at unprecedented levels in Australia. It is now growing again after a short period of consolidation and it is possible, likely even, that the 'rubber band' of debt will stretch a bit further. Of course this will exacerbate problems down the line. Across the economy, debt service in relation to profits has also been relatively low because of the decline in interest rates. This is likely to remain the case for some time and those keen for a continuation of high house prices (spurred by increasing leverage) will hope that the Reserve Bank lowers rates even further.

So why can't this whole debt-fuelled property extravaganza go on for longer? Why isn't it possible that 'this time it is different'? The question to ponder is what level of debt as a percentage of disposable income would be possible? Could Australia go to 250 per cent? And if it did where would it go from there? To 300 per cent? 400 per cent? The Netherlands and Denmark show that debt as a percentage of income can go much higher than currently experienced by Australia.

As a percentage of GDP, however, Australia currently has the highest level of debt in the developed world. To avoid a crisis policy-makers need to engineer gradual deleveraging across the household sector to restore balance to the economy: a 'soft landing' Paul Keating might have called it were he still in charge of policy. The danger is that this change in direction might create a point of inflection that leads to a downward spiral. The 'solution' is to not let debt build up to unsustainable levels in the first place.

Australia hasn't yet had a housing crisis and so net wealth has held up reasonably well. The point to note, however, is that if asset prices were to fall, liabilities would not. The positive wealth effects of rising asset prices will suddenly turn negative as households with negative equity on their houses feel poorer even if they don't have to sell into a falling market.

The buildup of debt is not just an Australian phenomenon and is not just tied to houses. Debt, both public and private, domestic and foreign, has been on the increase since financial liberalisation began in the 1970s and 1980s. The IMF recently reported

The global gross debt of the nonfinancial sector has more than doubled in nominal terms since the turn of the century, reaching $152 trillion in 2015. About two-thirds of this debt consists of liabilities of the private sector. Although there is no consensus about how much is too much, current debt levels, at 225 percent of world GDP, are at an all-time high.

In the lead up to the GFC private debt increased by 35 per cent of GDP in the advanced economies, with the IMP noting that Australia along with Canada and Singapore have continued to rapidly accumulate private debt. But the major problem may lie in emerging economies with debt expanding significantly in recent years. 

While public debt has increased around the world in the aftermath of the GFC, with private sector deleveraging matched by increased public debt, especially in the United States and Europe. As the IMF notes "public debt declined across all country groups up to 2007".

Australia has maintained a relatively low level of public debt. Despite the deterioration of revenues after the crisis and the Coalition government’s rhetoric of a ‘debt emergency’, Australia’s public debt is comparatively and historically low. In 2015, according to the IMF, Australia’s general government net debt was 17.9 per cent of GDP, compared to 80.6 per cent for the United States and 80.7 per cent for the United Kingdom. The worst countries were Greece with a net debt of 176.6 per cent of GDP, Japan with 128.1 per cent and Portugal with 121.3 per cent. Norway, which like Australia benefitted from the boom in resource prices, has a positive balance of 278.3 per cent of GDP. Norway has managed to redistribute the benefits of its resource base to current and future generations of Norwegians and it shows what might have been possible for Australia to achieve with effective taxation of its 80 per cent foreign owned resource sector. 

In a speech in August 2016, Treasurer Scott Morrison highlighted the relatively poor position of Australia in terms of external debt and our relatively good performance on the public debt front. However, instead of drawing the conclusion that private debt (both foreign and domestic) is a problem, he argued that private debt is "supported by real assets and is in productive enterprises". Given the amount of private foreign debt going into property, this assessment depends on the property sector remaining buoyant and a perception that Australians buying and selling houses to each other is productive for Australia's future economic output. While in the United States in October, Morrison argued that inflated prices in Australia are mostly due to supply constraints.

unlike many overheated real estate markets in the US in the past, our real estate asset prices have predominantly been underpinned by genuine under supply. In addition, unlike in the US, borrowers cannot just walk away from loans and throw their keys in the door. Our lending model is based on full recourse financing, with low doc loans a very small component of our housing credit market. This puts the necessary tension in the chord to hold our real estate markets together.

This low level of low-doc loans is correct according to the official data, but recent reports show that large percentages of loans can be characterised as "liar loans". According to UBS:

an anonymous survey of more than 1200 Australians who have taken out a residential mortgage over the past two years ... has uncovered an epidemic of “liar loans” despite tougher lending standards imposed by the banks. The study found 28 per cent of mortgagors said their application was “not factually accurate”. Only 72 per cent said their loan application was “completely factual and accurate”, 21 per cent said they were “mostly factual and accurate”, 5 per cent said they were “partially factual and accurate”, while 2 per cent “would rather not say”.

Morrison's concern is that foreign liabilities make it difficult for Australia to fund public debt.

we have less head room for Government debt than other advanced economies that fund their own debt, and ... ratings agencies tend to be very focussed on Australia’s deficit and debt position. All Australian Governments must therefore be more conscious of our collective debt position. Just because rates are low, doesn’t mean the money is free – you still have to pay it back. To arrest our debt we must restore the budget to balance.

The figure below shows the breakdown of Australian foreign debt into public and private components. Foreign public debt has grown significantly since going into negative territory in  2006-07.

Despite Morrison's contention that our foreign liabilities are a problem for funding deficits, foreign debt has largely disappeared from public and policy concern. In the 1996 election campaign the Howard-led Coalition paraded a debt truck decrying the rise in foreign debt during Labor's 13 year tenure of office. In 1996 net foreign debt was 36.1 per cent of GDP, up from negligible levels in the early 1980s. In 2007 at the end of the Coalition's tenure of government it was 49.3 per cent. In March 2016, it was 63.1 per cent of GDP.

A significant amount of foreign debt has been recycled by the banks through to households, with funds ending up in the property market. One prominent economic journalist argues that 

Banks own the foreign debt, not households. Our high level of household debt is an economic vulnerability, making us exposed to any downturn in house prices or steep rise in joblessness. But it's not part of the foreign debt story. 

Such a simplistic view of financial interconnection is surprising given the obviousness of the interdependence between the two. This complacent approach is the general tenor of analyses from policy-makers, economic commentators and academics. Depository corporations in Australia have increased their gross external liabilities since the early 2000s. Offshore funding has gone from about 30 per cent of GDP in 2000 to over 50 per cent in 2016.

Right of centre economists focus on public debt and others assume that because foreign debt has not been a problem in recent years it won't be a problem going forward. They might be right for a while, but normal circumstances are not what we are worried about here. High levels of foreign debt have been associated with particularly bleak periods of Australian economic history. Before the 1980s, the highest foreign debt levels were recorded during the depressions of the 1890s and 1930s. Foreign liabilities built up in more prosperous times exacerbated the severity of subsequent downturns. The 1890s bust, following the boom in the 1880s, left Australia in a perilous position that was a major spur for Federation. According to Belkar, Cockerell and Kent:

Large inflows of capital in the 1870s and 1880s pushed up net foreign liabilities to very high levels (over 150 per cent of GDP). These inflows helped to fuel substantial growth in lending by financial institutions, much of it finding its way into the property market. The collapse of property prices in the early 1890s coincided with more than half of the trading banks of note issue suspending payments (with around 60 per cent of these eventually closing their doors permanently) and a large number of non-bank financial institutions failing. Deposits in many of these trading banks were effectively frozen for years, with the government enforcing reconstruction of these institutions. Most deposits were repaid between 1893 and 1901, but in some cases deposits did not get repaid until as late as 1918. Not surprisingly, overseas investors took flight during the 1890s, and their full confidence was not restored until the 1910s. 

Debt built up again after World War I and led to another situation where dire external events exacerbated domestic vulnerabilities. Contrary to the earlier crisis, the banks were in reasonable shape before the worst of the Depression hit and net foreign liabilities as a percentage of GDP were much lower. Nevertheless, Australia’s terms of trade deteriorated by 39 per cent between 1929 and 1933, after falling by 20 per cent between 1925 and 1929. Increased recourse to foreign borrowing in the late 1920s accompanied the decline of Australian exports. McLean argues that the debt crisis of this period "had its origins in the war-related borrowings of the federal government some of which was foreign debt. But the borrowing programs of the the state governments during the 1920s considerably augmented the total debt outstanding." According to Meredith and Dyster public debt during this period was high – about 128 per cent of GDP. 

Although new inflows of capital stopped, there was significantly less capital flight. Belkar et al note that a key feature of this crisis was the "lengths to which the Australian Government went to avoid default, especially on debt held by foreigners". Australia felt the Great Depression acutely because access to long-term borrowings, necessary to service existing debts, was substantially restricted. Rolling over debt was no longer possible after the crash of 1929. Unemployment reached never before seen levels and governments were unable to find a way out of the downward spiral of despair. Ultimately it was war that allowed Australia to leave the Depression behind. 

Do these past crises hold any lessons for today's Australia? Clearly, Australia has an unprecedented level of private debt, some of which is foreign derived. Unlike the 1930s crisis, today's level of public debt is less worrisome. There are some other factors mitigating the severity of current debt levels in Australia. One is the fact that much of the foreign debt held today is denominated in Australian dollars or is hedged; another is that Australia has increased its level of equity investments overseas meaning that foreign liabilities are taken up almost entirely by debt. Nevertheless, Australia’s ability to service its debt is dependent on the willingness of foreigners to continue lending. In normal times this shouldn't be a problem. In a time of global financial restriction it just might be. If global credit tightens up severely, the flow on effects will also create a serious financial crisis in Australia. 

Another major policy concern of the 1980s and 1990s was the current account deficit (CAD). Like foreign debt, it too has disappeared from public concern. The current account is a component of the balance of payments (BoP), which is a statistical measure of Australia’s transactions with the rest of the world. The Australian Bureau of Statistics explains the BoP as ‘a system of consolidated accounts in which the accounting entity is the Australian economy and the entries refer to economic transactions between residents of Australia and residents of the rest of the world (non-residents)’. These transactions include both trade and financial flows. The BoP is made up of a set of double entry accounts – on one side a current account and on the other a capital and financial account, which statistically must be in balance. The financial and capital account is made up of ‘capital transactions, such as capital transfers, and financial transactions involving Australian claims on, and liabilities to, non-residents’. The current account is made up of exports and imports of goods and services, income earned and paid overseas, and transfers such as international aid, family payments from overseas and gifts (both incoming and outgoing). A CAD occurs when there is a trade deficit or a net income deficit (or both). Put another way, a CAD measures the amount of foreign savings Australia draws on foreign savings to fund that portion of national investment that is not funded by domestic national savings’. 

By far the largest component of the CAD is the net income deficit, which includes interest to foreign lenders and dividends to foreign shareholders. Australian policy-makers seemed to have reconciled themselves to a higher CAD. Both political parties now believe that nothing directly should be done about foreign debt or the CAD) and both have effectively accepted the ‘consenting adults’ view – the idea that as long as debt is between private businesses with the aim of creating economic activity it should not be the focus of deliberate government policy. Despite this lack of concern, the question remains: what level of CAD would be a problem? What level of foreign funding for the CAD is sustainable? The answer is, of course, it depends. If the inflows that cover the shortfall of saving to fund total investment create future productive capacity this will provide the wherewithal to service future debt and dividend payments. If much of the inflow goes to households through the banks to help inflate house prices and then those house prices fall, the ability to service the debt will be more difficult. The unproductive nature of those inflows will the become more obvious.  

Improvements in the CAD from June 2010 to early 2015 because of increasing export volumes and values, further lessened concern as many policy-makers argued that the boom would continue for s long time. However, it had deteriorated to 5.1% of GDP by March 2016. It is likely that an increasing CAD will once again cause concern in coming years. A worsening of the CAD will continue to be a marker of concern for foreign investors, leaving Australia vulnerable to changes in international financial sentiment. If foreign investors think a high CAD is a problem, it is a problem. 

Ultimately, the sustainability of high levels of debt is dependent on the ability of the debtor to pay off or roll over that debt. In recent years, capital flows into Australia have led to a higher Australian dollar and an easily funded current account deficit, but this could change if new investment dwindles and assessments about Australia’s economic prospects turn negative. The high level of the dollar also has also caused problems for the manufacturing sector and parts of the service sector.  

Vulnerability

Vulnerabilities in the Australian economy are building, but this does not necessarily mean that disaster is imminent. Economist, Rudiger Dornbusch once remarked: 

The crisis takes a much longer time coming than you think, and then it happens much faster than you would have thought.

It's possible that Australia could avoid a crisis, but this would require policy-makers to recognise the multilayered vulnerabilities building in the Australian financial system and to act to restrict the growth of private debt and house prices. The danger is that the very act of doing so may lead to the end of the end of the long boom. 

The flip side of the opportunities that have been available via the build up in debt have led to inflated house prices that have contributed to the success of the big four dominated banking sector. The vested interests in this structure worry about the end of the ponzi-like buildup in house prices, Australians should worry about the consequences of stretching the private debt rubber band so far that it breaks and cuts deep into the Australian economy.   

Since the early 1990s, developed countries have experienced a common trajectory in the direction of higher levels of private debt, predominantly associated with property. The outcomes for many countries with rapidly falling property prices have been catastrophic. Mix these falls with rising unemployment and stagnant incomes for those in work and the result will be a severe recession, a collapse in asset prices and a long period of painful deleveraging. The Australian economy has done remarkably well over the past quarter of a century, but part of this success has been built on a substantial increase in debt. It is likely that public debt will have to rise further as households deleverage. No doubt concerns about foreign debt and the current account will also re-emerge in coming years.