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).
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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:
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"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.
One might hope that the RBA would take this historical precedent to heart - and in at least one sense, it has. The problems of the 1890s were compounded by laissez faire regulatory practices that allowed many over-extended banks and pseudo-banks to fail, taking their depositor accounts with them. That didn't happen during the Great Depression, and the Reserve's swift actions when the subprime crisis began two months ago shows that it will act to prevent financial collapses today.
But in other respects, Battellino's speech had a "crisis? what crisis?" ring to it. Though he had the long term parallels at hand, he chose not to look at them, but instead concentrated on the demographics of debt today. He took heart from the fact that most debt is held by wealthier, older households, who presumably have the capacity to service the debt out of income.
However, the same would have been true in the 1880s - after all, only the wealthy (and especially the older wealthy) have the idle money and apparent assets needed to kick start speculation. The poor are, by definition, poor, and are normally too busy ensuring survival.
Nonetheless, Battellino argued that, even though the current debt ratio is 50 per cent above any previous peak, it is still below some hypothetical long-term equilibrium level:
"I don’t think anybody knows what the sustainable level of gearing is for the household sector in aggregate, but given that there are still large sections of the household sector with no debt, it is likely to be higher than current levels...
Eventually, household debt will reach a point where it is in some form of equilibrium relative to GDP or income, but the evidence suggests that this point is higher than current levels."
I hope these comments were an attempt to "not scare the horses", rather than a serious consideration of the current data and its historical precedents. What I see in the above graph is not a climb towards equilibrium, but a speculative bubble that has well overshot any equilibrium, and will inevitably have a downside. Debt will fall, but at the expense of a serious contraction in aggregate demand.
I just hope that, public utterances like Battellino's paper aside, the RBA is ready to cushion the blow when the debt bubble finally bursts.
See also Steve Keen's article: Deeper in Debt