Australia - the Galapagos Islands of housing debt?
With England and Australia’s cricket teams locked in a scintillating struggle for the Ashes, and with England 2-1 down in the series so far, some comfort can be drawn by England fans that winning away from home is difficult. The last time Australia won a series in England was in 2001.
It is sometimes hard to believe that the last time that Australia was in recession was a full decade before then. In 1990-1, the economy shrank by 1.7% and unemployment rose to 10.8%. The cause was high interest rates in response to high inflation. Ever since then, it’s been a story of continuous economic growth.
That Australia has had its own trente glorieuses is in no small part due to the way its economy has developed. Given its wealth of natural resources, particularly iron and coal, the country has benefited enormously from China’s lightning-fast economic and industrial development. It even missed the worst of the 2007-9 financial crisis, in no small part due to raw material demand from China’s enormous economic stimulus that began in 2009.
Yet all is not well down under. 30 years of growth have led to a massive bubble in the housing market. The most expensive housing in the world is in Hong Kong, but in second place is Sydney, where house prices are around 11x average earnings1. Other cities such as Melbourne are not far behind. With real wages lagging and inflation biting even as the Reserve Bank of Australia (RBA) hikes rates, a cost of living crisis is brewing.
The prospect of recession is on the horizon. With China’s economy enveloped in its own property debt crisis, the possibility exists that demand for Australia’s basic resources dwindles, and given the lopsided nature in which its economy has grown, this could mean rising unemployment becomes a problem. While house prices in Oz have been suffocatingly high for a number of years, it’s really only when employment falls and households struggle with mortgage payments that property prices tend to tank.
Australia’s housing crisis is often blamed on the government’s aggressive immigration policy creating excessive demand on the country’s housing stock. Clearly there is a supply and demand dynamic at work, especially given how far behind immigration the stock of housing is growing. Yet common sense suggested that poor arrivals from Asia or South America are unlikely to be coughing up A$1,000,000 or more for a flat as soon as they arrive.
At the turn of the twentieth century, Western philosophy underwent a transformation called ‘the linguistic turn’. Philosophers such as Bertrand Russell (above) began to realise that language was not just a neutral medium through which propositions could be expressed, and therefore they increasingly felt that the structure of language itself was the critical factor in understanding the sense and meaning of what we say and write.
In the same way pre-twentieth century philosophy largely thought language was just language, neo-classical economics in the nineteenth century didn’t really have a lot to say about money or credit. If one looks at Alfred Marshall’s classic ‘Principles of Economics’ (1890), in nearly 700 pages of analysis of supply and demand functions and how this affects prices there isn’t a single chapter on banking or credit.
Money for Marshall was neutral, and he was right to think so. The nature of the gold standard with respect to how movements of bullion automatically stabilised credit flows and ‘corrected’ nation’s surpluses and deficits of imports and exports meant that credit creation as a separate process in the economy, and banks’ role in facilitating it through lending, could largely be ignored.
Fast forward to 2023 and the current fully-flexible credit money system which replaced the gold standard, then understanding high house prices in Australia not only involves issues of demand and supply with respect to the actual stock of housing and related issues such as immigration, but also equivalent demand and supply functions with respect to credit and money. While immigration grabs the headlines, it’s credit that’s the real issue at hand.
The thing about debt is that it carries interest, and this compounds and grows over time. Fiat money systems have no means of naturally limiting the growth of credit as the gold standard did. For Australia, abetted by government policy and a willingness (or need) for the banks to keep on lending as debt grows, this meant that asset bubbles started to appear, principally in housing.
Public policy has clearly helped the process. In March 2020, as the Covid-19 pandemic began, the RBA cut interest rates and began a policy of yield-curve control, pinning 3-year government bond yields at 0.25%. The focus on the 3-year tenor is no coincidence; Australian mortgages, despite being 25 or 30 years in duration, refix every 3 years. RBA policy, aided by other government incentives, was clearly aimed at propping up the housing market during the crisis.
When you get debt doing its thing by compounding and government and central bank policy aimed at providing incentives for house prices to rise, you end up with a bubble. In Australia, getting on the property ladder is now a pipe-dream for many. A recession after a thirty-odd year bender of rising asset prices may create quite a hangover.
What might an Australian housing crisis look like? Ireland’s fate after the global financial crisis offers some interesting precedents. When Ireland joined the euro in 1999, like many countries, it experienced a sharp fall in interest rates and with it, a credit and property boom. No one seemed to tell the Irish that in a Ponzi scheme, the aim is to sell the risk on to someone else. Instead, they spent nearly a decade buying and selling houses amongst themselves, and with a liberal dose of banking fraud, they ended up with a housing bubble that popped spectacularly in 2008.
To halt the collapse, in September 2008, the Irish government took the extraordinary measure of guaranteeing all the bank debt in the country. With the National Asset Management Agency (NAMA) instituted in April the following year, the state took on all the debt from the bubble. Irish debt-to-GDP went from a modest 15% pre-crisis to a peak of 124% in 2014. Things recovered, and Ireland is once again a thriving, open economy.
So Australia will be OK? According to the IMF, Australian government debt is currently around 52% of GDP, a healthy level when compared to other developed economies. Clearly there is room to support the banking sector should it get into trouble from bad mortgage debt. Yet the Irish recovery has to be considered within the context of the euro currency area and the enormous external support that the Irish government debt market got both from the EU and the European Central Bank. The Aussies, in contrast, don’t have that support. The Australian economy is on its own - hence being a sort of Galapagos Islands of debt.
So what about the the Australian banking sector? Unlike the Irish banks in 2008, which had paper-thin levels of equity of around 3%, the Aussie banks are, on paper, well capitalised. The largest bank, CBA (photo above), has a core Tier-1 equity level of 11.5%. It is profitable, and its cost base is well-managed, with a cost-to-income ratio of 46.7%. The other three big banks are similarly capitalised. So far so good.
Yet the concentration of residential mortgage debt on the balance sheets of the big four banks is substantial. CBA for example has a loan book of A$885 billion, of which A$570 billion is Australian residential mortgages with another A$115 billion of foreign residential mortgages, many of them in New Zealand, a country which has its own housing-bubble problems2. IMF data suggests Australian household debt was a whopping 118.5% of GDP at the end of 2022, and the concentration of second-home and rental property ownership in the country is first in class globally (not that this is a class one necessarily one wants to be leading).
In The Financial Instability Hypothesis (1992), economist Hyman Minsky detailed how during prolonged periods of prosperity, financial economies move from what he called hedge financing (banks limiting their interest rate and capital exposure) to speculative and Ponzi financing, which by their very names suggest a much higher degree of riskiness.
Minsky’s theory suggested that stability leads to instability over time. With 32-odd years and counting since Australia’s last recession, and with residential house prices amongst the dearest in the world, there are strong reasons to believe that the country is well and truly in the speculative and Ponzi stages of the process. The Australian government and central bank must really be hoping that the global soft landing narrative turns out to be true.
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Stephen Johnson, Why houses in Australia REALLY became unaffordable, Daily Mail, 18/12/2022.
Commonwealth Bank of Australia (CBA), Annual Report, 2022.