Always look on the bright side of debt

For the last year, I have been playing the role of Australia's "Paul Revere of Debt": warning that private debt had reached a critical level, and that it, more so than anything else, would shape Australia's immediate economic future.

Until recently, the Reserve Bank of Australia (RBA) appeared to ignore my warnings, since to it, the true bogeyman is not debt, but inflation. But the press gave my views substantial coverage, and this perhaps inspired Deputy Governor Ric Battellino to present a contrary analysis of debt last week ("Some Observations on Financial Trends").

The empirical centrepiece of his paper was a long term - really long-term! - graph showing the ratio of debt to GDP from 1860 till today. Battellino's graph only included bank debt prior to 1953; in the graph below, I've enhanced his data by estimating all credit (using data on non-bank credit from the excellent RBA research paper RDP1999-06: Two Depressions, One Banking Collapse).

One look at this graph makes it obvious that we're in totally uncharted waters: the debt to GDP ratio has never been as high as it is now. If the debt ratio has any economic significance at all, then we have to take it seriously today.

The only historical precedents for today are the two obvious peaks in the data, in the 1890s and 1930s. The latter alone implies bad news: the 1930s were the decade of the Great Depression, which was easily the greatest economic crisis that market economies have ever experienced.

It is less well-known that the 1890s were also a decade of Depression for Australia, and Fisher & Kent argued in Two Depressions that the 1890s experience was more severe for Australia than the Great Depression.

It was also "home grown": the cause of the 1890s Depression was the bursting of a speculative housing bubble, which centred on Melbourne real estate after the preceding Victorian Gold Rush. Fisher & Kent's description of what happened at that time sounds ominously like a description of the last decade in Australia:

"the financial system during the 1880s was becoming increasingly vulnerable to adverse shocks. During that period there was a sustained increase in private investment associated with extraordinary levels of building activity and intense speculation in the property market. This was accompanied by rapid credit growth, fuelled in part by substantial capital inflows (much of which appears to have been channeled through financial intermediaries). At the same time, banks allowed their level of risk to increase in an attempt to maintain market share in the face of greater competition from a proliferation of new non-bank financial institutions". (p. 2)

The only difference between the boom that preceded the 1890s bust and today, was that there really was a building boom in the 1880s: building investment was equivalent to up to 14 percent of GDP in the 1880s, versus an anaemic figure of below 2.5 percent in the 1990s. The 1990s was more a pure speculative bubble, with almost 95 per cent of lending financing speculation on the prices of existing houses, rather than the construction of new dwellings.

When the bubble burst in the 1890s, housing prices dropped by over a third, and the country fell into a sustained Depression. GDP took a decade to return to its pre-bubble levels, and per capita GDP was still more than fifteen percent below pre-bubble levels a decade later.