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.