John Adams – Australia: trapped by cheap credit

The Reserve Bank of Australia has all but conceded that Australia is trapped in a debt and asset price bubble which it can’t get out of without significant pain.

Last month, the RBA, through its July board meeting minutes, introduced into the economic lexicon the concept of ‘neutral real interest rates’ which it defines as the nominal cash rate (set by the RBA board) minus inflation that facilitates economic growth at its potential while simultaneously achieving stable inflation.

Despite being unobservable and subject to estimation uncertainty, the central bank has estimated that the neutral real interest rate for Australia is currently equivalent to a nominal cash rate of 3.5%.

In layman’s terms, the RBA is saying that it is unable to raise its overnight cash rate above 3.5% or the economy will grow below potential gross domestic product (GDP) which the 2017 Federal Budget stated would be 2.75% per annum over the medium term.

Given recent Australian economic history, this is a stunning statement.

It was only in 2009 in the aftermath of the GFC that the then RBA Governor Glenn Stevens told Australians that the RBA board’s decision to cut the cash rate to 3% was an ‘emergency setting’.

Eight years later, a cash rate of just 50 basis points higher than this emergency setting is now alleged to be the maximum of what the Australian economy can take before placing significant downward pressure on GDP growth.

The RBA argues that lower potential GDP growth and greater risk aversion have played a role in reducing the neutral real interest rate by 150 basis points since 2007, which in part explains their 3.5% estimation.

However, consider that from April 1990 to September 2008, the average RBA cash rate was 6.29% and even if the post-GFC period is considered with its very low rates of interest, the long-term cash rate average since the last recession is 5.24%.

What this means is that the RBA is unable to normalise monetary policy back to its long-term average without some form of economic disruption given record economy-wide debt, particularly household debt, and record asset prices such as in housing.

The rate of interest which would cause disruption to economic growth remains a point of debate among some economists, especially the potential scale of that disruption resulting from adjustments to asset valuations, household consumption, debt servicing obligations and delinquencies. Chief Economist Dr Shane Oliver from AMP Capital, for example, recently stated that the economy is likely to be able to only handle a cash rate of 2.75%.

The inability and the justification of why the RBA is not able to normalise its overnight cash rate to its long-term average is significant and requires closer scrutiny.

With respect to the RBA’s claims regarding potential GDP, consider that from 1983 to 2011, the Australian economy experienced lower average real GDP growth across four subsequent periods when unemployment was falling.

For example, average GDP growth across October 1983 – December 1989, September 1993 – July 2000, October 2001 – August 2008 and July 2009 –  June 2011 when unemployment fell was 4.6%, 4.2%, 3.5% and 2.2% respectively.

While factors such as ageing demographics, increasing taxation and regulatory costs and sluggish multifactor productivity growth may in-part explain this phenomenon, Australia’s record and growing debt, particularly in the non-government sector, is likely to be a much more significant factor in explaining declining average GDP growth and therefore potential GDP growth than what mainstream economists and policy makers currently give credit to.

In an economy whose growth has been significantly fuelled by growing consumption and debt, it makes intuitive sense that there are natural mathematical limits to how much debt individuals and corporations can assume and service relative to their income.

In Australia’s case, those natural limits have been expanded since the GFC through record low interest rates and the take-up of innovative financial products such as interest-only loans.

Importantly, the inability to normalise the overnight cash rate poses additional risks.

To date as judged by their current policy settings and official statements, the RBA has assessed the current level of systemic risk to the financial sector and to the broader macroeconomy to be manageable, especially as new aggressive macroprudential controls have been introduced by the Australia Prudential Regulation Authority.

However, despite these new controls, Australia’s macroeconomic structural imbalances continue to worsen as measured by household debt relative to disposable income, a point which the RBA board conceded in its August 2017 board meeting minutes. Lending for housing continues to grow faster than the growth in household incomes and has now reached in excess of $AUD 1.69 trillion, larger than Australia’s current GDP.

Central bank officials should heed the words of former Governor Stevens who warned in 2012 that interest rates which are left too low for too long are likely to render macroprudential controls ineffective in stemming systemic financial risk.

It remains to be seen whether the RBA has a full comprehension of the systemic risk profile facing the Australian economy.

Absent from its official statements and speeches by senior officials is any serious discussion or assessment regarding the robustness of foreign economic institutions, the quality of their regulatory frameworks and administrative oversight or the behaviour of significant market participants.

Given the high degree of interconnectedness among the world’s largest financial institutions as reported by the International Monetary Fund in 2016, monetary and financial policy deliberations by the RBA must encompass not only considerations of domestic institutional and regulatory settings, but the settings of other major economies, especially that of the United States and China.

The previous performance of the RBA has not been particularly strong in this regard as they were effectively blindsided in the lead-up to the GFC to the failures of American institutional and regulatory frameworks that contributed to the sub-prime mortgage crisis and the subsequent collapse of Bear Sterns and Lehman Brothers.

Alarmingly, many deficiencies in the American system responsible for the GFC were never addressed by the Obama administration or the US Congress and are not core tenets of the Trump agenda. Moreover, the quality of institutional, regulatory frameworks and administrative enforcement by the Chinese Government remain immature and highly questionable given the geopolitical priorities of its ruling communist party.

The RBA is trapped, yet economic history tells us that the current cycle of record debt, record asset prices and ultra low interest rates cannot go on forever.

The longer the RBA waits to normalise interest rates, the more that macroeconomic structural imbalances and systemic risk will continue to grow. This means that it will only take a relatively smaller increase in interest rates, emanating either domestically or internationally, to deflate Australia’s largest ever debt bubble most likely in a catastrophic manner.

John Adams is a former Coalition Advisor. This op-ed first appeared in The Spectator.

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21 Responses to John Adams – Australia: trapped by cheap credit

  1. JC

    The Reserve Bank of Australia has all but conceded that Australia is trapped in a debt and asset price bubble which it can’t get out of without significant pain.

    That’s not the case, John.

    Last month, the RBA, through its July board meeting minutes, introduced into the economic lexicon the concept of ‘neutral real interest rates’ which it defines as the nominal cash rate (set by the RBA board) minus inflation that facilitates economic growth at its potential while simultaneously achieving stable inflation.

    Despite being unobservable and subject to estimation uncertainty, the central bank has estimated that the neutral real interest rate for Australia is currently equivalent to a nominal cash rate of 3.5%.

    I don’t believe that’s what the RBA said described.

    The RBA’s policy is to aim for 2% inflation rate over the cycle. Setting the o/n rate at 3.5% and guiding to tight policy would most likely crush the economy.

  2. anonandon

    In summary, we’re fucked.

  3. Chris

    I have been hearing some from people trying to get capital for the new economy – Uber car, contrqactor ute, or a 4WD loan for a remote site shuttle contract, that sort of thing. According to the operator I use the banks do not consider it employment or a business even if they are running a business with several paid-off cars and buses with drivers and a documented history of operations and income over several years.
    My bank is happy to lend for consumption, because I am a drone with a payslip.
    I see a LOT of people looking for a self-employment solution after losing jobs or because they are refugees or whatever. Some success stories, most not. Uber drivers in Perth (ironically) are feeling the pain because the entry barrier is so low and the company is just screwing them harder and taking on more drivers as they show up.
    A huge barrier to basic contracting appears to be that small business finance is just about impossible for startups to get.

  4. Motelier

    The more I observe this economic farce in Australia the more I am convinced that everyone should get into the cash/black economy and starve the bastards.

    Except the bastards are on to this with the “Black Economy Taskforce”.

  5. BoyfromTottenham

    Being rather old-fashioned in economic terms, my understanding is that an increase in official interest rates will result in a lower price of government (and related) bonds, aka a loss to those wanting to sell those bonds, and an increase in their yield. A large increase in official interest rates will result in a much lower price, aka very large bond losses, but much higher yields. IMO any discussion of the possibility of resetting interest rates to ‘normal’ must look at how much these bonds are currently worth, who holds them, and how great their losses will be for a given rate increase. On the other hand, as a self-funded retiree with a Defined Contribution pension, any increase in bond yields would be applauded, because they are about the only investment class that offers the low volatility that allows me to sleep peacefully. Unfortunately, for the past several years the returns on bonds have been dismal. Personally I look forward to plenty of interest rate rises!

  6. JC, just a quick word – I think the Avian is repeatedly try to dox you on the open fred.

  7. Squirrel

    RBA inflation targeting is somewhat of a sick joke, based as it is on the rather artificial construct which answers to the name of CPI and which is increasingly detached from the cost pressures experienced by so many Australians – but job-for-life officials, with salaries way into six figures, and with a nicely indexed pension upon retirement, would be oblivious to all of that.

    For many years now, the debt-fuelled phony growth model for the Australian economy has been like a boa constrictor, slowly but surely reducing the scope for monetary and other economic policy makers to take the necessary decisions for the national interest – and here we are now, with the lowest interest rates ever known, catastrophically high debt and dependence on foreign lenders, insane, anti-productive asset prices and those in positions of power and influence pretending it’s all OK, and obviously desperately hoping that they can keep the circus rolling on until it’s someone else’s problem.

  8. JohnA

    The RBA mandarins need to start turning the ship around now. A small rise in the cash rate would signal that interest rates are on the increase, and they could “jaw-jaw” their way towards shifting expectations and thus at least stopping the stupid asset inflation.

    The longer they wait the harder it will become.

    Maybe someone needs to remind them that their super funds could still go broke taking their nest eggs with them.

  9. jock

    Look to be fair the rba has done better than most other central banks. But essentially you are correct. The big problem is how do you keep your wealth safe with so much bad policy?

  10. JohnA:
    Just as a thought experiment, what would happen if people got nervous and, say five percent of them took out their super?
    The 5% is just a WAG (Wild Arse Guess) as I doubt it would put much strain on the system but it only takes a tiny crack to shatter a windscreen.

  11. Michel Lasouris

    Of course there is no way back. Once those criminally liable allowed and encouraged the obscene increase in property prices, Australia was trapped. The only way I can see out of this, is rapid inflation with commensurate wage compensation while holding property prices at present levels. Even this will make mortgage repayments painful for most as they will paying more for everything except housing. I’m so pleased ( yes, and self satisfied) that I saw this coming and have made every endeavour to insulate myself from the collapse when it comes. Our so-called government ( both of them) are utterly incompetent

  12. BoyfromTottenham

    ML – +10!. IMO there is only one sensible corrective policy – sharply higher interest rates (remember Keating’s ‘the recession we had to have’?). Sure it would hurt many recent property buyers, and probably many other parts of the economy. But there would also be many winners, i.e. young homeseekers and retirees (esp those on DB pensions). Like you, I have been sensible, reducing my debt to the minimum, etc. and as a retiree would much prefer higher returns on my super. But I’m not holding my breath for a sensible outcome from the pollies – they clearly live on the same remote planet as the RBA. Unless of course someone publishes figures that show that those on DB pensions (think many older federal public servants!) would not get their full pensions if the pollies don’t increase interest rates!

  13. Tel

    Last month, the RBA, through its July board meeting minutes, introduced into the economic lexicon the concept of ‘neutral real interest rates’ which it defines as the nominal cash rate (set by the RBA board) minus inflation that facilitates economic growth at its potential while simultaneously achieving stable inflation.

    Not so very new, it’s fairly close to Irving Fisher’s distinction between real and nominal interest rates:

    r ≃ i – π

    The belief that you can trade off inflation for unemployment is basically the “Phillips Curve” that comes out of 70’s data in the US, but although it might apply in the short term (at least you get an apparent stimulus from printing new money and splashing it around) it certainly doesn’t create any meaningful result in the long term (printing the way to prosperity always always fails). Keynesians love to think short term, politicians are happy with the idea that somehow their spending saves the nation from depression, so we get persistent hammering on the “Phillips Curve” despite almost everyone knowing it doesn’t work.

    Be happy that inflation is reasonably steady, that’s the best you are going to get out of these guys.

  14. Habib

    Sooner the better, I’m cashed up and waiting. Onlyreason I’m hanging around this dump is to go buzzard on the carcass.

  15. H B Bear

    The RBA will be an onlooker when international capital markets finally pull the plug on the banks cheap wholesale funding having decided that Australia is over-geared, over-paid and uncompetitive. All economic crisis in Australia are international when the world decides Australia has pushed its luck too far again.

  16. Driftforge

    At some point we are going to have another Keating moment.

    We really should just get on with it.

  17. flyingduk

    I’m so pleased ( yes, and self satisfied) that I saw this coming and have made every endeavour to insulate myself from the collapse when it comes

    Me too, but of course the Feds will be equally industrious in stripping the assets of those of us who were prudent enough to prepare.

  18. But the RBA know that the country will soon be ‘run’ by Michael O’Conner, Paddy Crumlin, Sally McManus with economic advice from The Goose. Power prices will quadruple, $1 trillion public debt, the states nationalising any industry that falls over.

    The productive 10% of the population who pay tax whooping it up in their holiday homes south of France and everyone left paying cash.

    It will be spectacular in its awfulness.

  19. John Constantine

    Australia, Trapped by bailing out the too-big-to-fail Stalin’s own banking system.

    The banking system that has learned that the more threatened australia’s politicians feel by the outcomes of banks doing it tough, the more free stuff the banks get.

    anti-trust the banking system now.

    Let Mcdonalds run banking robots in booths in hamburger shops open 24/7 [with clean dunnies] and give them the same banking guarantees as the Stalinist social engineers running the crony corruptocracy that is australias current ponzi banking scheme. [import more client herds to open bank accounts and rent houses, the banks instruct their political puppets.]

    Blockchain/A.I. software/ banking robots/ end of endless house price growth. How will the current Australian banking system crush the competition ?.

  20. Peter Greagg

    Of course the RBA stuffed up interest rate policy because that’s what always happens when so called experts use their judgment without that judgment being anchored to a sound conceptual framework.
    What we need is something like the John Taylor Rule.
    I have hopes the the Donald will appoint him to replace Yellon.

  21. Ralph

    Well said. The RBA is trapped by a problem of its own making. The enormous private debt is Australia’s Achilles heel but the house prices and consumption driven by it is the basis of the economy. The RBA can’t raise rates because even the slightest increase would pop the bubble and send the economy into a tailspin. But it doesn’t want to lower them either because that would further inflate the housing bubble. In a word, the RBA is f**ked.

    No government of any persuasion has the courage to do anything substantial about it. Nor can it, because at this precarious point, almost any corrective action will bring down the house of cards and crash the economy. Hence we have had do-nothing governments since Rudd and we will probably continue having do-nothing governments well into the future because nothing is all they can do without being blamed for bringing the whole circus undone.

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