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Like much the rest of the non-mining, non-financial economy, Australian tourism has been through tough times in recent years. The increase in the Australian dollar has a negative effect on tourism. The RBA recently published a paper on the tourism industry.

Conditions in the tourism industry mirror many of the broader economic trends observed in the rest of the economy because tourism expenditure is discretionary and, like all trade-oriented industries, the tourism industry is exposed to developments in overseas markets and movements in the exchange rate. Over recent years, the Australian tourism industry has experienced challenging conditions. However, the fundamental conditions facing the industry have become more favourable, supported by improved economic conditions in key North Atlantic markets and the depreciation of the Australian dollar, as well as continued strong growth in tourism exports to China. 

The increase in Chinese tourists, like most other aspects of Chinese demand in recent years, is remarkable.

According to this graph China still has a low level of overseas departures/capita.

Tourism now Australia's third biggest export. But look at those figures for iron ore and coal - 35 per cent of exports!

Declining energy use per capita for G7 countries

There is no debt crisis in Australia and to argue that there is/was a 'budget emergency' is imbecilic.

State and territory shares of Australian GDP

The effectiveness of vaccinations

Public Debt in Australia 1853-2013

The following graph from a recent RBA article puts the whole recent obsession with public debt in Australia into perspective.

As Peter Lindert points out in his authoritative two volume study on social spending and economic growth since the eighteenth century: Growing Public: Social Spending and Economic Growth since the Eighteenth Century :

There is no clear net cost to the welfare state, either in our first glance at the raw numbers or in deeper statistical analyses that hold many other things equal … It turns out there are many good reasons why radically different approaches to the welfare state have little or no net difference in their economic costs. Those reasons … boil down to a unified logic: Electoral democracy, for all its messiness and clumsiness, keeps the costs of either too much welfare or too little under control.[1]

Lindert also points out that ‘the history of economic growth is unkind’ to those with a suspicion that higher taxes and social spending are necessarily bad for productivity. Beyond this basic fact is another unpleasant one for those who argue that the welfare state must be cut in the interests of growth or productivity: ‘people in the countries with higher social budgets get to enjoy more free time every year and retire earlier’.[2] Well educated, healthy workers have the potential to be more productive workers. Parents with access to childcare and leave can continue careers sooner or later and maintain their productivity. Providing even more options in this area enhances the productivity of a large section of the population with parental responsibilities.

[1] Peter H Lindert (2004) Growing Public: Social Spending and Economic Growth since the Eighteenth Century, Cambridge, Cambridge University Press, p. 6.
[2] Ibid., pp.17-18.

For a primer on public debt in Australia see here and the links contained within ... 

Australia's Terms of Trade in Historical Perspective

The Reserve Bank has recently published a historical comparison of the terms of trade in Australia entitled "Macroeconomic Consequences of Terms of Trade Episodes, Past and Present" by Tim Atkin, Mark Caputo, Tim Robinson and Hao Wang.

Now while such articles may make many people's eyes glaze over, there are few concepts that are more important in understanding the Australian economy than the terms of trade and Australians could learn a lot by reading this excellent paper. The authors' conclusion (quoted below) is on the optimistic side of the debate about Australia's economic future and it doesn't canvass the possibility that the extended duration of a high terms of trade and exchange rate have caused significant damage to non-mining sectors of the tradable economy.

The terms of trade is the index-measure ratio of the average price level of exports to the average price level of imports. It effectively reflects the capacity of a given quantity of exports to pay for a given quantity of imports, and provides an important indication of the strengths and weaknesses of the economic structure. A rising or falling terms of trade indicates the possibility of improving or declining living standards, because if what we sell earns relatively more than what we buy, we will be relatively wealthier. Because the terms of trade is a ratio, increases can be a result of export prices increasing at a greater rate than import prices, or export prices increasing while import prices are declining, or export prices declining at a slower rate than import prices. Of course, a rising terms of trade doesn’t stop us from buying more things than we sell, which we have made a habit of for much of our history! Improvements in the terms of trade are not reflected in GDP figures, but improvements do contribute significantly to increases in national disposable income.

Basically Australia has been lucky enough to have a high terms of trade for an extended period of time, but the ratio is now on the way down, with the consequence of declining income for Australians. The extent and rapidity of the descent will have a very large bearing on the economy and by extension on all of us.

The mid-1980s' low point for Australia’s ‘terms of trade’ provided an indication of the extent of the structural crisis of the economy. This terms-of-trade crisis spurred Australian policy-makers to quicken the pace of liberalisation and to make a conscious effort to globalise the economy. The most famous statement about the supposed end of Australian resource prosperity was Labor Treasurer Paul Keating’s “banana republic” radio interview in May 1986. It is worth quoting at length to show how much the rise of China has changed Australia’s economic circumstances. 

We took the view in the 1970s – it’s the old cargo cult mentality of Australia that she’ll be right. This is the lucky country, we can dig up another mound of rock and someone will buy it from us, or we can sell a bit of wheat and bit of wool and we will just sort of muddle through … In the 1970s …we became a third world economy selling raw materials and food and we let the sophisticated industrial side fall apart … We must let Australians know truthfully, honestly, earnestly, just what sort of international hole Australia is in. It’s the price of our commodities – they are as bad in real terms since the Depression … If this government cannot get the adjustment, get manufacturing going again and keep moderate wage outcomes and a sensible economic policy, then Australia is basically done for … If in the final analysis Australia is so undisciplined, so disinterested in its salvation and its economic well being, that it doesn’t deal with these fundamental problems … Then you are gone. You are a banana republic.

Keating used the sense of crisis to further the case for economic reform. The subsequent financial, trade, competition and labour reforms of the 1980s and 1990s helped Australia deal with the current boom, providing a flexibility to adjust to externally derived price shocks. 

Keating was wrong, however, that the era of resource wealth was over. He was not alone. Many commentators believed that the era of resource wealth was over. Arguments about the rise of the information economy seemed to preclude the possibility that resources - apart from oil - could once again substantially increase in price.  

Form the 1960s, the rise of Japan, followed by South Korea and Taiwan, Singapore, Malaysia, Thailand and other non-communist countries of Southeast Asia had provided significant expansion of export markets for Australian commodities, but had not led to a sustained structural increase in their prices.

Then along came China, changing everything. Not only did rapid Chinese demand increase the prices Australia received for its exports, but also Chinese manufacturing production helped to decrease the price of Australian imports. Manufactured goods made (or assembled) in China became significantly cheaper. Chinese competitive pressures also helped to keep in check the prices manufacturers throughout the world could charge for their goods. Interestingly, the prices of food and raw materials have not reached their 1970s peaks.

In 2000, Australia was pilloried as an ‘old economy’ too reliant on resources and unable to take advantage of the coming technology boom. The tech boom, however, soon turned into a tech wreck and Australia benefitted from two other booms – a resources boom fuelled by China and a credit boom that went largely into increasing the price of Australian houses.

Before we make the mistake of going too far back in the other direction away from the possibilities of information technology, the internet is now sparking another structural change that will profoundly affect the retail sector as consumers increase online purchases. While the technology boom got ahead of itself at the turn of the millennium, the impact of technological change will accelerate over coming years. Thus far, however, the level of online sales remains relatively small, even if it is growing rapidly from a low base
Betting on China

The major story of recent years, however, has been the rise of China. It is possible that China, India and most of the rest of Asia will continue to grow rapidly as the authors suggest for the next decade or so, but it is unlikely that this growth path will be smooth. China is actively seeking to diversify its sources of supply of the key resources it imports from Australia. Price increases eventually produce supply increases, which often then lead to oversupply and falling prices. And so on. This is the nature of the commodity cycle. China currently appears to be slowing and restructuring its economy away from commodity-intensive development. The debate over the extent of these changes is controversial but the outcome will be very important for us. 

The paper provides many excellent graphs that show the significance of change in the Australian economy. 

The historical snapshot of the terms of trade reveals important periods of boom and gloom in the economy. Especially important is the period from the early 1970s to the mid-to-late 1980s, which caused Keating's despair.

The graph on Australia's goods exports shows just how significant the transformation of exports has been from rural to resource exports. It also highlights the short period of adjustment in the 1990s towards more manufactured exports, which was overtaken in the 2000s by the continuous increase in the value of resources particularly iron ore and coal. Iron ore prices, for example, increased from $12.68 in 2001 to a high of $179.26 in 2011. 

This graph captures not only the extent of the shift to Japan, the rest of East Asia and China since the 1950s, but also the massive dependence on the UK before this. 

The next graph shows the correlation between the real exchange rate and the terms of trade. The manufacturing and tourism sectors will be hoping that the terms of trade declines and that the real exchange rate declines with it. 

Consumer price inflation has been subdued during the latest sustained rise in the terms of trade. 

A long-term look at public debt shows that the current situation is relatively benign when compared with the past, despite continual scare-mongering by policy-makers and commentators. According to the authors: "The primary reason for the large size of public debt in the past was the legacy of major conflict and the ‘settler nature’ of the Australian economy, the latter requiring high rates of social and economic infrastructure. In contrast, public debt in the current episode is at low levels. It could be argued that there is significant room to move to build the physical and mental (health and education) infrastructure to make Australia an economic powerhouse in the 21st century. But this certainly can't happen when public debt is seen as bad regardless of how it is used.

Another major difference of the recent boom was that earnings did not increase in tandem with the increase in commodity prices, as they had done in previous episodes. Undoubtedly, this helped macroeconomic management. Given the hefty wage increases in mining related industries it begs the question as to who was keeping the average down. Obviously some workers were not doing quite so well! According to the authors

The institutional structure of the labour market during the current episode has been the most flexible over any expansion since Federation; a considerable increase in relative wages in the resources sector and a more decentralised industrial system facilitated a relatively low unemployment rate during the upswing in the terms of trade without creating substantial inflationary pressures. 

The authors conclude:

Australia’s current terms of trade cycle has parallels with earlier episodes. Historically, large movements in the terms of trade were mainly driven by changes in export prices, particularly wool, which reflected strong demand from industrialising economies, coupled with adverse supply developments, such as drought. Upswings in the terms of trade have generally boosted domestic demand, usually with a sizeable contribution from investment, probably reflecting both a direct response to higher commodity prices and the associated improvement in wealth and confidence. In some episodes, growth in immigration and pent-up demand following war also supported growth in investment. Typically, net exports have contributed little to economic growth during the upswing in the terms of trade; sluggish supply responses are exacerbated by the real exchange rate appreciation, which dampens growth in other exports and supports imports. Many of these features have been present in the current episode.
The current episode, however, has some distinct features. One is that it has been mostly related to bulk commodities, instead of rural commodities. Consequently, the sluggish response of supply partly reflects the characteristics of resources investment – namely long periods to plan and gain approval for projects and the need to develop infrastructure. However, just as Australia was the world’s major source for internationally traded wool throughout previous episodes, today it is the world’s largest exporter of steel-making materials and it is likely that Australia will also become a major source of liquefied natural gas exports in the coming years. A decline in the terms of trade is therefore, to some extent, the result of new supply from Australian producers coming on-line.

The most recent upswing was the largest sustained increase of the terms of trade on record, and the Australian economy is likely to continue to be a beneficiary of strong growth in Asia. Indications suggest China’s industrialisation and urbanisation process, which has underpinned the increase in demand for steel-making commodities, is likely to continue for a number of years, although it may well grow more slowly than in the past. Chinese infrastructure needs remain large; an example is that steel demand for residential construction is not estimated to peak until around 2024 (Berkelmans and Wang 2012). While the path of economic development is not always smooth, it is important to remember that this is not the first episode during which one country and a narrow range of commodities have been of particular importance to the Australian economy; rather, that is the norm.

Another stark difference is that despite the unprecedented movement in the terms of trade, the macroeconomic adjustments in Australia have been relatively smooth. Inflation, for example, has remained contained, in contrast to many previous experiences, such as the Korean War wool boom. Furthermore, inflation expectations have remained relatively low and stable. Factors facilitating this include the greater flexibility present in the labour market, the inflation-targeting regime adopted by the RBA, and the flexible nominal exchange rate, which has enabled the necessary appreciation of the real exchange rate to occur in a less disruptive manner.

Historically, for several years following a peak in the terms of trade, growth in investment and output per capita tends to be below average. As we have emphasised, the real exchange rate and the terms of trade generally move together.

Consequently, the expected easing in the terms of trade, reflecting growth in the global supply of the bulk commodities, may be accompanied by falls in the real exchange rate. More generally, an increase in Australia’s competitiveness would help facilitate the macroeconomic adjustments necessary during the transition from the investment to production phase by providing support to sectors outside of the resources sector, thereby helping to rebalance growth in the economy. Reflecting the unparalleled magnitude of the expansion, the transition necessary is considerable and is likely to pose challenges to both firms and policymakers. The current policy frameworks and institutional structures, which were important in facilitating better macroeconomic outcomes during the upswing than occurred historically, may also assist this transition.

Debt Denouement?

Debt is the major problem facing the world economy at the moment. But it's not as clear cut as many commentators make out. The recent focus has rightly been on Europe and on the sovereign (public) debt crisis.  (See here and here and here and here for earlier posts on debt).

For Australia there are two types of debt to worry about directly and another type indirectly.  Indirectly Australians need to worry about the reactions of European and American policy-makers to their public debt problems.

As many commentators have recently pointed out, contractionary fiscal policy in a time of economic stagnation, fear and credit anxiety is likely to lead to - surprise, surprise - contraction. To think otherwise is slightly ridiculous. The real question is whether the decline in the price of sovereign debt is worth more to getting the economy back on track than attempting to support growth with limited fiscal resources. 

Directly, Australians need to worry about their own foreign and household debt. Both are private forms of debt and are of course related. Households have borrowed from the banks, who have sourced some of their funding from overseas lenders. The balance of offshore borrowing by the banks has improved since 2007, but it is still very important as the banks keep telling us when they decide not to pass on the full weight of RBA interest rate cuts.

A post from Leith van Onselen covers the possible negative impact of rising household debt for younger Australians.

Last week, the Reserve Bank of Australia’s (RBA) Bulletin noted how high housing costs are disproportionately affecting younger Australians:

Median housing debt-to-income ratio for Australians under 39 years of age has risen 29 per cent in the six-year period to June 2010, compared to the 20 per cent rise for the oldest Australians in the same time.

The increases leave younger Australians with a median housing debt of 333 per cent of household income or more than double the 159 per cent for the over-60 crowd…

“The increase in the cost of housing has affected younger households, whether renters or purchasers, more than other age groups”, said the report…

Now the Galaxy Australian Debt Study has found that younger Australians are more stressed about repaying debt than any other generation:

People aged between 24 and 35 topped the debt anxiety list, with nine in 10 concerned about making debt repayments.

Big purchases such as a first home were largely to blame for the stress, with 55 per cent of people in this age group nominating rising rents and mortgage repayments as their biggest financial concern, according to the Galaxy Australian Debt Study…

“While most Australians are trying to be financially responsible, it is worrying that people aged 25 to 34 appear to be feeling the greatest strain,” Matthew Strassberg, senior adviser at Veda, the debt investigation company which conducted the survey.

The survey also found 15 per cent of people in this age group were likely to apply for more credit over the next six months, compared with 9 per cent in the remainder of the population.

This is where it can all go wrong, Mr Strassberg said.
“It is concerning that there are people struggling with their current debt levels but are turning to more credit as the answer, potentially edging closer to a debt spiral,” he said.
“While people can have large credit commitments, the debt spiral begins when a person starts slipping behind on payments and seeks yet more credit as the solution.”

The bi-annual Galaxy survey reveals Australians are facing unprecedented levels of debt stress as 82 per cent of the population worry about meeting debt repayments, up from 75 per cent in September 2010…

The research also suggested one in five Australians were struggling to pay off their credit commitments.

As a means of coping with the stress of debt, 87 per cent of consumers have chosen to cut back on everyday spending and lifestyle, 49 per cent have cut back on groceries and 35 per cent received assistance from family or friends…
“Borrowing from family and friends is common, so is wanting to access superannuation early.

That more people are worried about repaying debt now than in September 2010 is interesting given that the official ratio of household debt to disposable income has fallen over the past year, from 154% in September 2010 to 151% in September 2011. Perhaps the reasons for the rising anxiety levels have to do with:

1. Housing prices falling. 90% of household debt relates to mortgages. And with home prices now falling, households are losing the ability to simply sell-up, repay outstanding debt, and walk away.
2. The economic (employment) outlook is far less certain, owing to the slowing domestic economy (outside of mining) and overseas concerns (including Europe and China).

With the baby boomers starting to retire, and needing to liquidate their housing assets to fund retirement (remember: they own roughly half of Australia’s housing assets, including 57% of all investment properties), the question beckons: will younger Australians be in the position to buy these homes from the boomers at current prices?
From the above studies, the answer is doubtful.

The phenomenon of high debt and the consequent need to

In an article I wrote a couple of months ago I considered three structural changes that were affecting the Australian political economy.

The first structural change is the long-running shift away from manufacturing towards services and the more recent revitalisation of the mining sector. This has come, to some extent, at the expense of manufacturing and important service industries such as tourism and international education. 

The second structural change - and the one I'm focused on in this post - is the shift away from debt-financed consumption and rising housing prices to a higher rate of saving – generally considered under the description deleveraging or more simply the paying off or consolidation of debt.    

Perhaps we should call this the end of an earlier structural change that began with financial liberalisation and gathered pace as credit markets expanded over the 1990s and kept going until 2007 when the music stopped and not everyone found a chair. The growth of household debt as a percentage of disposable income grew rapidly over the 1990s and 2000s rising from: 

48% in September 1990 to 156.7% in June 2007 to 150.8% in September 2011.

Debt for housing is 89.7 % of total household debt.

Investor housing debt is 29% of total household debt.

Interest payments as a percentage of disposable income reached a high of 13.4% in June 2008 to a low of 9.3% in June 2009 to 11.4% in September 2011.(see Structural Shenanigans for graphics)

So ... household debt remains at high levels and the inability to continue to grow debt even further undermines an important source of growth over the past 20 years. 

Think about it.

The growth that occurred after the recovery of the 1990s recession was augmented, buttressed and sometimes driven by the expansion of household debt by around 100% of disposable income. 

If we were to have the same favourable conditions over coming years this would mean that household debt as a percentage of disposable income would have to go to 250% of income. 

The question I often ask myself at times like Christmas is how much debt could I get into. Now not owning a house means that this would probably be unproductive debt spent on expensive dinners and wine and presents. 

But regardless of what I spent it on, at some point the debt burden becomes too much to service and I either have to pay it off, reschedule it or declare bankruptcy. Extrapolate this task across households across the economy and you can see why a major source of growth has at best stabilised and at worst gone into reverse.

This is the change that may matter most of all for Australia in 2012 as households save more and the "paradox of thrift" exacerbate the impacts from overseas. 

People start to feel pessimistic about their spending capacities and if growth slows further then we could end up in a negative spiral. 

Another reason why people are feeling pessimistic is that the value of assets has fallen significantly since 2007-08.

The fall in the share market may matter more in Australia than elsewhere because more Australians have their super invested in shares than anywhere else. 

As a matter of interest, the third structural change causing anxiety in the community is a tentative shift towards a less pollution-intensive economy through the establishment of a carbon price and support for renewable energy through a variety of schemes and policies.

The first two structural changes are long-running and largely unavoidable without significant and perhaps costly policy interventions, which could cause more problems than they fix.

The third involves a greater level of immediate political choice. But government has the ability to encourage a shift towards a more diversified, future oriented economic structure.

And though policy change associated with this is likely to have only a minor impact in the short-term, the way that debate has polarised the community has added to negative perceptions of the Gillard government.  

Next year should be an interesting year. But just as problems could occur it's also possible that Europe will sort out its mess, China will gradually begin to shift from high investment to higher consumption. If the Communists can manage the Chinese economy through another period of global crisis then maybe everything will be hunky dory in 2012. 

Let's hope that those focused on vulnerabilities and negative spirals (like me) are wrong and the boomers are right for at least one more year.

Why Japanese Debt is better than Greek Debt ... and Australia Compared

A lot of guff is written about debt. Part of the problem stems from a failure to distinguish between types of debt - between public and private debt, between foreign and domestic debt and between gross and net debt. I've written about these issues before here and here.

The graph from The Economist shows clearly why the public debt situation in Japan is less worrying than Greece's, despite Greece having a considerably lower level of gross debt.

Gross debt is the preferred focus of news media because it sounds more extreme.

What matters is net debt and how much debt is owed to foreigners.

The problem for Greece (and Italy, Ireland, Portugal and Spain ... perhaps even France) is that they are stuck with the Euro, which means they can't devalue or inflate their debt levels down. This makes bondholders worried that the eventual outcome will be the departure of some countries from the Euro or default. The two options may of course be related.

Imagine the scenario of Greece going back to the drachma or Spain to the peseta. Both currencies would suffer a large devaluation against the Euro and the dollar - the currencies in which a large part of their debt is denominated in. So while they would get a competitive boost from the devaluation, their debt would expand in local currency terms.

There are no easy options for Europe at the moment.

Interesting to note that a majority of US debt is held domestically. Despite the US debt to China being such a big issue and an indicator of US weakness in relation to China, US debt is more of a problem for China than the US.

Eventually Japan too will have to face up to the issue of just how much debt can you get yourself into before it's unsustainable.

Australia's public debt situation is remarkable by comparison as the following graphs from The Final Budget Outcome for 2010-11 released recently.  Neverthless, as I recently argued in "Structural Shenanigans in the Australian Economy" for Australian Policy Online, Australia's private foreign debt and household debt is still a major issue for the economy.

United States Debt: Who Buys It?

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US debt purchases have become an important story in the world political economy and a symbol of supposed US powerlessness in the face of a relentless Chinese ascendancy. I think this equation is overdone and instead think that the fact that the Chinese feel obliged to buy US debt as a sign of continued Chinese weakness in their economic structure rather than strength. But it undoubtedly is a complicated debate.

But let us at least get a few facts on the table.

The first is to look at figures for the purchases of US Treasury Securities from an article by Floyd Norris of the NY Times: "For a Change, U.S. Debt Is Staying in the U.S."

The most interesting fact is that Americans themselves are now buying most of this debt. This is not unusual. Most of Japan's debt for example is bought by the Japanese themselves. This amounts to what Hugh Stretton calls "borrowing from ourselves" and therefore removes foreign risk. It also helps to keep interest rates lower.

According to Norris:

Before the financial crisis struck in 2008, neither Americans nor private foreign investors showed much eagerness to finance Washington’s deficits.

In calendar year 2007, the Treasury borrowed a net $237 billion. Of that, 81 percent came from foreign governments, mostly from central banks. Private foreign investors took up the rest, as American companies, banks and individuals reduced their combined Treasury holdings by $13 billion.

In the first six months of this year, the Treasury numbers indicate that foreign governments reduced their holdings of Treasury securities by $10 billion. Not since 2000 — when the United States government was running a surplus and did not need additional funds — have foreign governments been net sellers for a full calendar year.

But then again in a globalising financial world, Norris notes also that often it is not exactly clear who the buyers may be:

The figures are estimates by the Treasury and are subject to substantial revision. And they need to be interpreted with caution, because they do not necessarily reflect the ultimate ownership of securities. Holdings of a London-based money manager are attributed to Britain, even though that manager’s clients could live in New York, Hong Kong or Paris.

The trend, however, is clear:

Over all, domestic investors purchased more Treasuries than did overseas ones — including foreign governments — in 2009 and again in the first half of this year. Those purchases came as government borrowing rose to pay for bailouts and recession-related spending.

By contrast, during the six years from 2002 — the first year that the United States ran a significant deficit after the years of surpluses — through 2007, three-quarters of the $1.7 trillion in new borrowing came from abroad, with $1 trillion of that coming from foreign governments.

In the two and a half years since the end of 2007, the Treasury has raised twice that amount in new money, $3.5 trillion. More than half of that came from American companies and individuals, double the proportion they contributed in the earlier period.

Still more than 46 per cent of debt is held by foreigners, down from 46 per cent in 2008:

Even with those increased domestic purchases, 46 percent of the publicly issued Treasury debt is held overseas. That is down from 49 percent in early 2008, just before the financial crisis began, but it is way above the 31 percent proportion at the end of 2001.

The figures also don't include debt bought by the Federal Reserve itself, which involves a notion called quantitative easing, colloquially known as "printing money"

The figures exclude Treasury securities owned by the Federal Reserve or other United States government agencies. As a result, Fed purchases and sales are not counted.

Three Graphs and a Silly Question: Debt and Housing

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

Source: http://www.rba.gov.au/speeches/2010/sp-gov-200710.html#f3

Stevens argues that there are three main lasting international legacies. The first is the "fiscal burden" of the crisis involving both financial sector bailouts and discretionary fiscal stimulus. In relation to the bailouts he argues:

Note that this is not necessarily a permanent burden since, if carried out successfully, the ownership stake can be sold again in due course. In fact about 70 per cent of the funds invested by the United States in banks have been repaid, and the US Government expects to make an overall profit from these capital injections.2 Nonetheless for a period of time governments are carrying a little more debt than otherwise as a result of the provision of support to the banking system.

In relation to fiscal stimulus:

while there was a lot of national variation, for some countries this spending was quite significant relative to the normal pace of annual growth in GDP. To the extent that the packages had measures that increased spending for a finite period but not permanently, the result is a rise in debt of a finite magnitude, but not an ever-escalating path of debt.

Debt ratios, he suggests are being exacerbated by the magnitude of the crisis and the anaemic recovery in Europe and the United States.

According to the IMF, for the group of advanced economies in the G-20, the ratio of public debt to GDP will rise by almost 40 percentage points from its 2008 level by 2015. Fiscal stimulus and financial support packages will account for about 12 percentage points of this. Close to 20 percentage points are accounted for by the effects of the recessions and sluggish recoveries. Another 7 percentage points comes from the unfavourable dynamics of economic growth rates being so much lower than interest rates for a couple of years

... the major countries generally are going to have significantly higher public debt relative to GDP after the crisis than before, and the debt ratios will continue to rise for several more years.

This was largely unavoidable. ... Generally speaking, the public balance sheet has played the role of a temporary shock absorber as private balance sheets contracted.

... At present that additional cost is, in some countries, reduced compared with what it might have been due to the low level of interest rates on government debt that we see. Moreover had the debt not been taken on it could well be that the economic outcomes would have been much worse, so increasing fiscal and other costs. Nonetheless this lasting debt servicing burden is a real cost.

A fairly balanced position from out Governor.

The second long-term implication is the increased role of government in the financial sector.

the intervention was broader than just a temporary period of public ownership – as massive an event as that has been. Take guarantees. Once the Irish Government guaranteed its banks, governments all over the world felt bound to follow suit in some form or other – expanding or (as in our case) introducing deposit insurance, and guaranteeing wholesale obligations (for a fee). The feeling was probably most acute in countries whose citizens could shift funds to a bank guaranteed by a neighbouring country without much effort.

Stevens acknowledges the fact that governments simply must shore up the financial sector in a crisis. The consequences of not doing so are too catastrophic to contemplate. The question for the future is how do governments shape the system so they do not have to make such forceful interventions in the future.

So some central banks, like their governments, have found themselves in very unusual terrain. It is terrain: in which the relationship between the central bank and the government is subtly changed; where the distinction between fiscal and monetary policy is less clear; from which it may be hard to exit in the near term; and a side effect of which may be wastage, over time, in some elements of market capability.

The third implication is the changing regulatory agenda:

In a nutshell, what regulators are pushing toward is a global banking system characterised by more capital and lower leverage, bigger holdings of liquid assets and undertaking less maturity transformation. It is hoped that this system will display greater resilience to adverse developments than the one that grew up during the 1990s and 2000s.

The implication is that the costs of intermediation - the role played by banks in bring borrowers and lenders together - will rise, which in turn will have broader economic effects. The first, Stevens contends, is lower growth and possibly less lending. Stevens observations on the potential impact of regulatory changes are worth quoting at length.

First, I think we ought to be wary of the assumption of a mechanical relationship between credit and GDP. ... did the steady rise in leverage over many years actually help growth by all that much? Some would argue that its biggest effects were to help asset values rise, and to increase risk in the banking system, without doing all that much for growth and certainly not much for the sustainability of growth in major countries. Some gradual decline in the ratio of credit to GDP over a number of years, relative to some (unobservable) baseline, without large scale losses in output may be difficult to achieve but I don’t think we should assume it is impossible.

Secondly ... we have to remember that there is a potential benefit on offer too: a global financial system that is more stable and therefore less likely to be a source of adverse shocks to the global economy in the future. ...

Thirdly, however, the reforms do need to be carefully calibrated with an eye to potential unintended consequences. One such consequence, obviously, would be unnecessarily to crimp growth if the reforms are not well designed and/or implementation not well handled.

Another could be that very restrictive regulation on one part of the financial sector could easily result in some activities migrating to the unregulated or less regulated parts of the system. Financiers will be very inventive in working out how to do this. If the general market conditions are conducive to risk taking and rising leverage ... people will ultimately find a way to do it. Of course while ever the unregulated or less-regulated entities could be allowed to fail without endangering the financial system or the economy, caveat emptor could apply and we could view this tendency simply as lessening any undue cost to the economy of stronger regulation of banks. But if such behaviour went on long enough, and the exposures in the unregulated sector grew large enough, policymakers could, at some point, once again face difficult choices.

In the discussion afterwards, Stevens gave short shrift to one question.

Source: http://boardroom-pc.streamguys.us/files/RBA/RBA20100720_GS_final_1/

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

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

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

Source: http://petermartin.blogspot.com/2010/07/wednesday-column-debt-free-got-any.html

 

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

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

For those wanting a more 'balanced' view of the prospects for Australian housing see Rory Robertson, "Extreme predictions on house prices will continue to be wrong". Robertson argues:

Average prices could rise a bit further or fall a bit over the coming year, but they will not collapse, as happened in the US and Japan.

Claims that there is a "bubble" in Australian housing markets don't stand up to serious scrutiny.

Investment legend Jeremy Grantham sees a bubble based on his calculation that housing trades near 7.5 times family income today versus about 3.5 times in earlier times.

Prices supposedly are around twice what they "should be". And "sooner or later" they will return to the "normal" multiple of family income.

Don't bet on it. For starters, the Reserve Bank estimates Australia's price-to-income ratio is near five times income, not seven times, removing any need for home prices to fall that first 30 per cent.

The step up in Australian house prices and housing debt relative to incomes over the past decade and a half was largely a function of the sharp drops in average inflation and interest rates delivered by the early-1990s recession.

These downshifts in inflation and interest rates are structural rather than cyclical. So don't expect the price-to-income ratio ever to return to three times, a level typical in Australia's long gone, bad old days of high inflation.

The recent 30 per cent drop in US house prices is a very poor guide to what might happen here.

Why? Well, because Australian and US housing and mortgage markets are like chalk and cheese. The relative strength of our economy -- 5 per cent unemployment here versus near 10 per cent there -- is part of the story.

More importantly, we have carefully supervised banks and mortgage markets that offer only "full recourse" loans. Australians know they cannot "walk away" from their mortgages without serious financial penalty. There is no "jingle mail" here.

And our home lenders generally hold their loans for the full term, so take very seriously the need to assess whether any would-be borrower is a "good risk" or not.

For those who worry that the level of Australia's mortgage debt is simply "too high", the Reserve Bank has estimated that three-quarters of all mortgage debt is held by the top 40 per cent of income earners.

Home ownership has been steady near 70 per cent for decades, yet the home ownership rate for households with heads aged under 35 years is just 40 per cent, down from 50 per cent in the late 1980s.

The bad news is that young people are finding it harder to buy where they want to live.

The good news is that -- contrary to some claims -- not everyone is overgeared. Some 60 per cent of younger households -- many with steady jobs and good incomes -- do not have a mortgage at all.

According to Robertson we should not worry about simplistic debt to income ratios and should not forget high immigration and chronic under supply of new housing.

Having won his bet with Steve Keen (an easy target) Robertson is feeling reasonably sure of himself:

Australian home prices are relatively high in part because, rather than "spreading out" across our continent, most of us choose to compete to live on the same best-located bits of ground near the beach.

With housing, you get what you pay for.

I'm not so sure.

No Bubbles in Sight?

For those wishing for an antidote to negative news on the housing market, the person to read is Christopher Joye. (The institution to follow for optimism on debt is the Reserve Bank of Australia). I must admit that despite a lot of study, I simply have no idea whether there is a bubble or not in the Australian and Chinese housing markets. (After being a long time pessimist I fear being too optimistic and being wrong again in reverse).

Luckily I'm not paid to be either an optimist or a pessimist. What I think is obvious is that increased debt does lead to increased vulnerability as the RBA Governor recently warned about.

But that doesn’t mean it would be wise for that build-up in household leverage to continue unabated over the years ahead. One would have to think that, however well households have coped with the events of recent years, further big increases in indebtedness could increase their vulnerability to shocks – such as a fall in income – to a greater extent than would be prudent.

It may be that many households have sensed this. We see at present a certain caution in their behaviour: even though unemployment is low, and measures of confidence have been quite high, consumer spending has seen only modest growth. This may be partly attributable to the fact that the stimulus measures of late 2008 and early 2009 resulted in a bringing forward of spending on durables into that period from the current period (though purchases of motor vehicles by households – a different kind of durable – have increased strongly over recent months). But the long downward trend in the saving rate seems to have turned around and I think we are witnessing, at least just now, more caution in borrowing behaviour. Of course this will have been affected by the recent increase in interest rates but the level of rates is not actually high by the standards of the past decade or two. We can’t rule out something more fundamental at work.

We can’t know whether this apparent change will turn out to be durable. But if it did persist, and if that meant that we avoided a further significant increase in household leverage in this business cycle, it might be no bad thing. Moreover if a period of modest growth in consumer spending helped to make room for the build-up in investment activity that seems likely, perhaps that would be no bad thing either.

Fortunately, however, for those who don't like to sit on the fence like I (and the Governor it seems) do, there are definite proponents of boom or doom that you can read. For doom read Steve Keen; for boom (but not bubble) read Christopher Joye.

Joye's arguments are very persuasive and he always brings interesting data to the table. But I'm still concerned about the level of private debt in Australia. Most commentators are much more focused on public debt (partly because economists as a bunch are generally anti-govt and pro-market as a first principles assumption).

The problem with private debt is that there is no political constituency to develop policies to keep it down, as there is with public debt. Despite democratic pressures that encourage higher spending and lower taxation - what the Marxist James O'Connor in the 1970s called the "fiscal crisis of the state" and what others on the right called the "crisis of democracy" - eventually governments have to face the judgement of those from whom they borrow or tax.

While the 1980s did not signal the demise of the state as many predicted it did stop the growth of the state - at least while growth remained subdued. As Lindert (2004: 22) points out: "For all the often-reported “crisis” or “demise” of the welfare state, all one really sees after 1980 is a slowdown, not a decline, in the shares of GDP that welfare-state taxpayers put into such programs."

Recent events have shown just how important states remain in the global economy and I'm imagining that the last few years will show a considerable growth in the size of the state throughout the world. But as in the 1980s, this growth cannot continue and the constituencies in favour of fiscal retrenchment are reasserting themselves despite the uncertain nature of the recovery. Last week's G20 meeting was divisive compared to previous meetings and the major divide was over appropriate fiscal stances. (Just quietly those pesky global imbalances are unlikely to go away with the Germans tightening policy and the Americans keeping things pretty loose.

Retrenchment is well under way in Europe as countries as diverse as Greece and Ireland deal with fiscal crises. The Irish have decided to take harsh medicine and as a consequence the Irish population is going through hard times. Greece is another story and the major problem is actually building up a decent tax base. In other words, Greek authorities need to get people to pay tax. The Germans are major advocates of fiscal retrenchment, much to the annoyance of the United States.

One of the excellent points made by David Lindert (2004: 6) in his seminal study of social spending Growing Public is that governments are constrained by democracy:

There is no clear net cost to the welfare state, either in our first glance at the raw numbers or in deeper statistical analyses that hold many other things equal … It turns out there are many good reasons why radically different approaches to the welfare state have little or no net difference in their economic costs. Those reasons are many, in terms of an institutional list, but they boil down to a unified logic: Electoral democracy, for all its messiness and clumsiness, keeps the costs of either too much welfare or too little under control.

But what are the restrictions on the expansion of private debt? Governments have encouraged the growth of debt through taxation policies for housing and company debt.  And financial liberalisation has massively increased access to credit. Don't get me wrong. I'm not anti-financial liberalisation. I would much rather live in an era where access to credit is not rationed and the financial sector is innovative and consumer oriented. But like all good things there is need for balance.

Rather than deal with the consequences of private debt in Australia, governments have attempted to underpin debt through subsidies, guarantees and . There is a good reason for this - any major pay down of debt in Australia will lead to lower spending. Now I hope that the optimists are right, but in the back of my mind is the continuing worry about what level of debt is too much.

Undoubtedly Australia has survived a very big stress test, but it did so by increasing public debt to maintain private debt. As Keynes supposedly once said: "the unsustainable cannot be sustained".


Reference:
Peter H. Lindert (2004) Growing Public: Social Spending and Economic Growth since the Eighteenth Century, Cambridge, Cambridge University Press.

Australia's Debt

With all of the kerfuffle about debt this week, it's important to realise what debt we're talking about when using the word.

Broadly there is private debt and public (govt) debt. Both of these types of debt can be domestic or foreign.

To be clear, Australia has a low level of public debt when compared to most other developed countries, but private debt is extremely high. Indeed, Australia is more (privately) indebted than it has ever been in its history.

The two other occasions when debt has been high have been before the 1890s and 1930s depressions. The 1890s revealed how external developments could exacerbate domestic economic problems. During the 1880s, servicing Australia’s debt increased from 15 to 40 per cent of export earnings. And when the British bank Barings nearly went bankrupt through bad deals in Argentina, British investors did the sort of wholesale reassessment of developing country investments that has been common in recent years at times of crisis. The substantial decline in the demand and price of commodities, and the decline in foreign sources of capital, intensified the problems caused by over-expansion in the wool industry, property speculation (especially in Melbourne), banking collapse and over-investment by colonial governments in infrastructure.

Public debt during the Great Depression of the 1930s was high – about 128 per cent of GDP – because of government efforts to develop the economy through the provision of infrastructure and support. Rolling over debt was no longer possible after the crash of 1929 and debt servicing as a percentage of export grew steadily during the 1920s, reaching a peak of 50 per cent in 1931 and remaining over 30 per cent for most of the 1930s.

Foreign debt was a major policy concern of the late 1980s and early 1990s. It seems, however, that concern about debt has lessened as the debt has risen and it has risen almost continuously from the mid-1970s (see graph).

Foreign Debt

Percentage of GDP

1976-2008

Australian General Government Sector Net Debt

Australia’s major problem is with private debt, although public debt is also increasing due to government efforts to stimulate the economy. After reaching a high of 18.5 per cent of GDP in 1995–96, Australia’s general government net debt fell markedly to a net surplus in 2005–06. Continuous growth and a sustained resources boom can do wonders for a government’s fiscal position, but given the revenue that the boom created, greater efforts could have been committed to build up of a true counter-cyclical budget surplus ready for use during a downturn. The political difficulty of such a task should not, however, be under-estimated. The problem is that a growing surplus tends to be accompanied by assertions that the government should limit future revenue by returning surpluses through tax cuts. Governments also fear that if they build up a surplus, oppositions will be able to make electorally popular spending promises. Nevertheless, Norway managed to legislate with cross-party agreement in 1990 for the creation of a sovereign wealth fund to invest surpluses from its resource wealth so that when the oil revenue runs out Norwegians will continue to reap the benefits of resource abundance. Astute public management of national wealth during the good times will enable Norway to deal more effectively with future vulnerabilities. Throughout the world, public debt is increasing, but some countries are clearly in better positions than others.

Australia’s public debt position is reasonably sound, but this is not the case for many other countries, including the world’s two largest economies – the United States and Japan. And it's certainly not the case for the PIIGS. The Greek situation is very very serious. While much of Japan’s public debt is taken up within Japan, this may not be possible if debt continues to expand. The huge government debt of the United States will soak up a considerable of amount of global capital, but the United States has the advantage that its debt is denominated in its own currency, which means that any fall in the value of the greenback diminishes the size of its debt.

While the Howard government pared back net government debt to positive territory, private debt increased significantly. Both political parties now appear to accept the ‘consenting adults’ view of foreign debt – the idea that as long as debt is between private businesses with the aim of creating economic activity it should not be a concern of government policy. Those who are concerned about the increase of debt worry that it has not gone into creating the productive capacity that will earn the foreign exchange to eventually lower the level of debt. The persistent warning of analysts that high foreign debt left Australia ‘vulnerable to a change in global financial market sentiment’ will be tested over the coming years. The main variable here is the danger of self-reinforcing movements of sentiment. If Australia’s foreign debt is seen as a problem by those who fund the debt then it will be a problem.

A major factor in the growth of foreign debt in Australia and the corresponding deterioration in the CAD has come through the huge expansion of household debt, much of which has gone into housing. This has helped to make Australia one of the dearest places in the world to buy a house. Debt has been expanding almost continuously since the early 1960s to levels never-before-seen in Australian history. Particularly noteworthy, as the graph below shows all too clearly, is the almost continuous expansion of debt as a percentage of disposable income since the early 1990s recession. At its peak in December 2007, debt reached 160 per cent of income. How this debt unwinds over the coming years will matter a lot to Australian households. After falling slightly in late 2008, debt rose again in mid-2009. Like so many good things in life, increased access to credit is a double-edged sword. Credit and debt are, of course, two sides of the same coin. Once again the question is how high debt can go as a percentage of income.

Household Debt to Disposable Income

1979-2009

 
 

Interest Payments to Disposable Income

1979-2009

The second graph shows the percentage of disposable income spent on interest payments. Despite interest rates reaching unprecedented levels in the late 1980s, interest payments as a percentage of disposable were much higher in the 2000s. The Reserve Bank’s 4.25 per cent reduction in interest rates over late 2008 and early 2009 acted to substantially reduce interest payments. Now that interest rates are once again on the rise, interest payments as a percentage of income will also increase.