21 Oct 2008

Is There a Recession Brewing in Our Housing Bubble?

By Ben Eltham
The next phase of the economic crisis could be a crash in Australian property prices, writes Ben Eltham
"Auctions fall despite grant boost" read the banner headline of The Sunday Age.

"Melbourne's property market yesterday suffered its worst day in at least four years, despite yesterday being the first auction day when prospective buyers had access to the increased first-home buyers grant," wrote Chris Vedelago and Peter Weekes. The Australian reported much the same thing, although there was an increase in Sydney.

Could this be the beginning of the end of Australia's house price bubble? If it is, we should all be pretty concerned.

Paul Sheehan certainly is. In a breathless article for Fairfax, he quoted BNP Paribas strategist Hans Redeker saying that the Australian current account deficit could "spiral out of control".

It couldn't happen here, could it? Well, yes actually. After all, it's happened before: in 19th Century Melbourne.

1880s Melbourne was a wonder of the world. Driven by a booming mining sector and a white-hot property bubble (sound familiar?), the southern city grew into one of the largest metropolises in the British Empire — and for a time, one of the richest. For a few years, "Marvellous Melbourne" had the world's tallest office building and some of the most expensive real estate on the planet. This was the famous Land Boom of the 1880s, which culminated in a speculative frenzy amazingly similar to the US subprime mortgage bubble of 2002-2006.

As Michael Cannon wrote in his history of the boom, The Land Boomers, "under the loose banking and company laws of the time, [so-called Land Banks] were able to take savings deposits, issue shares, float loans, discount promissory notes and other commercial paper, and in general perform all the functions of an established bank."

Cheap money flooded in from Britain, land prices soared, while rental yields dropped to 2.5 per cent — in other words, it would take 40 years of rental earnings to pay for a property.

Economic historians today consider the colonial Australian banking system as a model of free market deregulation. In the words of two historians from Belfast University, "it had few legal barriers to entry, no branching restrictions and ... no credible restrictions on assets, liabilities or bank capital, nor legally established price controls."

Surprise, surprise: it turns out that this was not a good thing. The Australian colonies' unregulated banking system produced a property bust and banking crisis that looks eerily familiar in our own time. As land prices plummeted, borrowers defaulted, taking banks and building societies down with them.

Between 1891 and 1892, 20 major financial institutions failed and investors lost more than ₤20 billion. Confidence in colonial banks collapsed. After a brief respite, a full-scale banking crisis ensued in 1893 when the Federal Bank collapsed, followed a few months later by the Commercial Bank of Australia and 10 other institutions. Of 65 building societies operating in Victoria in 1885, only three survived by 1893.

With no central bank or national government, Australia had few available policy options. The result was a devastating economic depression: Australian GDP fell 17 per cent and it took nine years for the economy to recover to 1891 levels. Some economists think the 1890s depression may have been worse than that of the 1930s.

Could it happen again? Let's hope not. But drawing on the recent experience of other nations' property sectors, a property bust and ensuing recession is all too likely.

As I have remarked here many times before, Australian house prices are highly over-valued. In 2007, house prices in cities like Sydney and Perth briefly reached an astonishing nine times median incomes — among the most over-valued in the entire world.

You can do the figures yourself: if you're a young couple on a combined income of say $90,000, even a relatively "cheap" house in a capital city — say $500,000 — is still going to set you back five and a half years of your total income. Factor in tax and other living expenses and you can see why so many home buyers are experiencing what the Australian Housing and Urban Research Institute calls "housing stress".

The result of this asset price bubble has been unsustainable levels of household debt. The Reserve Bank of Australia's household finance statistics tell us that Australian households now hold debts equal to 160 per cent of disposable income — higher even than in the US. Unsurprisingly, RBA Governor Glenn Stevens thinks that consumers may be reaching their borrowing limits.

This huge debt burden is one reason why house prices must fall, and soon. Like their US counterparts, Australian households simply can't keep borrowing and spending indefinitely. Inevitably, balance sheets must be repaired as consumers begin to save again. In the long-term, this is a good thing. But in the short-term, this means much lower consumer spending — something that Gerry Harvey says we're already seeing.

As consumer spending drops, so does growth. The economy slows, and unemployment rises. Higher unemployment eventually means more mortgage defaults.

Another looming problem is directly related to the credit crisis. Houses, remember, are nearly always paid for with mortgages. And some types of mortgages will be harder to get as the international funding sources for non-bank lenders dry up.

The RBA's 1 per cent cut in interest rates and Kevin Rudd's top-up of the first homeowner's grant will loosen the constraints somewhat, but there is already evidence that the credit crunch is constraining housing starts. The Master Builders Association's Wilhelm Harnisch recently told The Australian that "even some of our biggest building members, despite having been major clients of the big banks for many years, are now being told there is just not enough money to go around."

In the long-term, this might help prop up house prices by constraining supply. But in the short term, tight credit will depress house prices because customers who can't get a mortgage will be unable to buy homes. Perhaps this is one reason why Kevin Rudd's economic stimulus package included a special bonus for home-buyers purchasing new constructions.

As we've seen in the US, UK, Spain and Ireland, when property bubbles deflate, they can do so rapidly and damagingly. But here in Australia, the majority of property analysts still believe we will escape the fate of Florida and Nevada. Are they right?

One argument popular among real estate analysts is that there is a still a significant lack of housing supply, which means prices shouldn't fall too much. There is some validity in this point — Australia built far fewer houses during its property boom than the US did. But even a shortage of properties won't stop house prices declining rapidly if demand drops off a cliff. And if home owners default, foreclosure sales will depress house prices. A vicious cycle can ensue, as the US experience demonstrates.

If Australian house prices do crash, we will certainly have been warned. University of Western Sydney economist Steve Keen is perhaps the most prominent property bear out there — but not the only one.

Famous doom merchant Marc Faber said in July that an Australian house price bust "could be larger" than America's. Morgan Stanley economist Gerard Minack has been consistently pessimistic about Australian property all year. As he told Tony Jones on Lateline in March:

"You've got a lot of borrowers out there that have never seen a recession — they always assume they can service their debt, and they've never seen house prices fall and so they think 'I can make a lot of money by buying a second house or a third house'. Once we see some job loss, once we shatter that illusion that house prices don't fall, then I think you can see substantial losses as indeed you've seen in part of Sydney already."

No wonder the housing industry is "pessimistic". Perhaps we should all be.

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Jonah Bones
Posted Tuesday, October 21, 2008 - 15:50

Couple of points :
Why do people keep quoting the financial analysis of major banks , surely their opinions are thoroughly discredited.

We may see housing become more realistic , with the average house size up to 270m2 from 170m2 in the mid eighties, more medium to high density housing at the affordable end of the market around $250k mark may ease the pain for a lot of people.

We still need to examine the government policies that fed the boom.

Posted Tuesday, October 21, 2008 - 15:59

Sure, you can argue that many major banks have got a lot of things wrong. But Gerard Minack has a solid forecasting record and I happen to agree with his analysis.

Posted Tuesday, October 21, 2008 - 21:50

I believe there is some data to support the view that residential property is not overpriced relative to income - it's the opposite, and salaries are too low.

Posted Wednesday, October 22, 2008 - 02:25

Hi Ben.

I think it's as much a mistake to believe the housing shortage story in Aus as it was overseas.

"Australia built far fewer houses during its property boom than the US did." is a great story for the spruikers. The trouble is it's not true. It's not too hard to find the changes in population, dwelling numbers and empty dwelling numbers by area via the ABS. Here are some of them tabulated: http://bubblepedia.net.au/tiki-index.php?page=OverbuildingByLocation

Between the last two censuses the results are pretty consistent across areas of Aus, and are very similar to the US. For the country as a whole the number of people rose by 5.8%, the number of dwellings rose by 8.2% and the number of empty dwellings rose by 15.7%.

Between 2000 and 2005 the US population grew by 5% and the number of dwellings increased by 7.1% according to the US census bureau here: http://www.census.gov/

The numbers are less likely to lie than the real esate institutes and housing industry associations don't you think?

The housing shortage story seems to have been a part of the bubble everywhere. eg: "
High housing prices, low vacancy rates, and low levels of new construction have convinced many observers that California is experiencing a critical housing shortage, especially in the state’s largest metropolitan areas." from here: http://www.ppic.org/content/pubs/rb/RB_304HJRB.pdf

It's time we questioned it here too.

all the best


Dr Dog
Posted Wednesday, October 22, 2008 - 10:32

Since it seems generally accepted that there is a housing bubble I wonder how the necessary adjustment can be anything but painful and rapid.

Since the growth that inflated the bubble was unprecedented isn't it certain that the subsequent bust will be equally massive?

Is there any suggestion, Ben, as to how we might carefully deflate the bubble without bursting it?

Are we painted into a corner where if we don't maintain growth a bust is inevitable? Rowena's idea sounds like old fashioned inflation to me, and similar to the idea of printing more money to overcome a depression.

But then what I know about economics could be written in crayon on the back of a bus ticket.

Bryan Kavanagh
Posted Wednesday, October 22, 2008 - 11:26

We almost certainly will experience a house price bust next year, Ben, because Oz has been in an even bigger bubble than the US. I defined a bubble and quantified the extent of the current bubble in "Unlocking the Riches of Oz: a case study of the social and economic costs of real estate bubbles 1972 to 2006" early last year and every federal politician received two copies in 2007.

Jonah Bones makes the suggestion that "We still need to examine the government policies that fed the boom." I agree, and, IMO, it was not capturing enough of our publicly generated annual land values (thereby encouraging real estate rent-seekers), and fining those excessively who were involved in the productive side of the economy.

My data supporting this thesis can be found in my brief submission to the AFTA review of the tax system- http://www.lvrg.org.au/Text/1224289039015-3691/uploadedFiles/12242942401...

BTW, I also have a "solid forecasting record".

Jonah Bones
Posted Wednesday, October 22, 2008 - 15:20

Thanks for the analysis Bryan , nice to see a logical economic argument put forward , rather than the 'populist tripe ' economics we normally see posing as market analysis. :)

This user is a New Matilda supporter. Venise Alstergren
Posted Wednesday, October 22, 2008 - 17:37

I'm not totally surprised about the housing boom/bust crisis. However, since I am in the company of financial experts, could someone please explain why, when a year ago the Share Market was in full throttle and everything was positive, did our financial experts accept that everything was rosy? The market reached dizzying heights, forecasts were positive, company reports were positive, especially mining, and superficially everything seemed rosy. Except it wasn't, was it?
My major question is: How was it that it took the USA to touch off the crash? If things were heading for the great retreat, (or falling indices-is this the right word?) what prevented Australian financiers from realizing all was not well; leading to us regulating our own markets BEFORE America turned turtle? Why were we allowed to ignore unpalatable and v unpleasant facts? I realize that when America hiccups the rest of the world collapses. But surely financial geniuses like Malcolm Turnbull-for the right wing voter-must have been aware what was going on and started to ride herd on our financial markets?

Posted Wednesday, October 22, 2008 - 18:51

"Why were we allowed to ignore unpalatable and v unpleasant facts?"

No-one wants to believe that the party actually has to end. So it just keeps going until the cops show up and physically confiscate the sound system.

This user is a New Matilda supporter. Venise Alstergren
Posted Wednesday, October 22, 2008 - 19:33

Um. Yeah, but doesn't anyone at the party try warn the revelers that the cops will be called if they continue to ramp up the sound system: doesn't anyone try? Or does he/she sit back ,say nothing, watch the action, then lecture the rest of the party on their foolishness before going on to criticize the over- zealousness of the wallopers.



Posted Wednesday, October 22, 2008 - 19:52

There are always people who try to warn. Steve Keen is the outstanding example in this country; in the US, probably Nouriel Roubini. But such voices get lost in the crowd of optimists; also, they usually make a few early calls that get the timing wrong, and this gives everyone another reason to dismiss them.

This image is a good cynical first approximation to how things work.


The majority mood at any time will simply be an epiphenomenon of the cycle, though buttressed by ingenious rationalizations. The hard (impossible) part lies in predicting when things will turn around, either at the top or the bottom.

Bryan Kavanagh
Posted Wednesday, October 22, 2008 - 20:45

Thanks Jonah.
In 1983 UK writer/economist Fred Harrison demonstrated that ever since the Industrial Revolution recessions come along approximately every 18 years. The only exceptions have been during WWs I and II. Harrison noted that a bubble in land prices precede every economic downturn, even in the case of the Great Depression. (We remember the 1929 Wall Street collapse but forget the worldwide real estate bust of 1925/1926 that directed investment funds out of property and into the share market!) Inspired by Harrison, and because Australia has excellent records on land values, I've investigated this and consider my data corroborates him.

Venise might be interested to know that you can't warn the authorities during the revelry. THey won't have it. 'These are the good times.' I've tried at each bubble since 1987, to no avail. The powers that be aint interested because they believe that Treasury bureaucrats should have all the facts. But Treasury and the RBA don't understand the catastrophic influence of real estate bubbles on the economy - because the real estate market is not a part of the study of economics.

Fred Harrison even warned Gordon Brown of this particular
bubble as early as the late 1990s, and again in 2005 in "Boom Bust: House Prices, Banking and the Depression of 2010". Brown yawned. http://www.youtube.com/user/RenegadeEconomist

Posted Wednesday, October 22, 2008 - 23:19

Bryan - thanks for your post, I am aware of your work and I think it's very interesting. I'm not an expert in macro-economics, but I find your analysis of the imbalances in land value taxation persuasive. A senate enquiry has estimated the annual aggregate of property tax concessions at $50b.

Jonah Bones
Posted Thursday, October 23, 2008 - 14:05

Anybody read Isaac Asimov anymore ?
The Foundation Series and Hari Seldon's psychohistory ?
Ultimately it is all about the mob psychology , if we do an historical , empirical study of this we call it macro-economics.
Trouble is government uses it backwards thinking they can control the immediate (next 3 years) affairs of state using 'economics'.
It is a bit more brutal than that . It will instead indicate what type of actions they will probably take with certain factors at certain levels. The problem being one of time scale , Keating's reforms where intended to cover us to this point , the real crisis being that no plan for the next ten years was instigated in that ten year period , so a period of turmoil is inevitable.
The grace of the situation is that a strong leader has the option to reset the course of events with reformative industry and social policy.
Take Bryan's argument as cause for reform , you instigate policy that raises taxation on the real estate market , stamp duty rates , rates , land tax et al while lowering the taxation on productivity (in the main income taxes). Aiming for all contributors to GDP to share an equal taxation burden.
Another reflection on the current situation is that selling your family home has become the great retirement bonus. It could be argued that this has fuelled the desire for large elaborate homes , to provide this nest egg , essentially untaxed compared to super funds.
Read history , we have done it all before.
Bring back the window tax ?

Bryan Kavanagh
Posted Thursday, October 23, 2008 - 16:11

No thanks, Jonah. Tax windows and you'll have fewer windows. Tax hearths and you'll have no hearths. Didn't South Africans start to use skids when they introduced a wheels tax to pick up wealth differentials?

Asimov? Yes an annual charge on the value of land held would have dealt with some of his concerns.

Posted Thursday, October 23, 2008 - 16:24

Dr Dog: Steve Keen suggests the least-worst way to get through this is a bout of inflation - to close the gap between incomes and debt. Six months ago the RBA wasn't listening, but lately they seem to have eased their obsession with inflation. Of course it may be too late.

Venise: Mitchell's cycle of emotions (earlier comment) is reminiscent of Minsky's Financial Instability Hypothesis that Steve Keen is a fan of, and I agree makes a lot of sense. Didn't someone write a book called Dow 30,000 a few years ago?

And no, the mainstream economics profession has no understanding of what they're dealing with, largely because their fundamental theory is one of equilibrium, which has no relationship with the real world.

Steve's stuff is at www.debtdeflation.com/blogs/

Jonah Bones
Posted Thursday, October 23, 2008 - 16:25

Asimov ?
Good sci-fi always dealt with the human condition.
Must be showing my age , wasn't brought up in the era of authors contractual story cycles , that could also be analogous to boom times also - more is good , much more is much betterer (sic) :)
Remember the days when treasury was allowed to calculated the correct level for taxes ? Now that may have resulted in better outcomes , GST well 10% is a figure people can do quickly in their heads !
What about a television tax based on screen size to try and recoup some of those baby bonus bribes ?

This user is a New Matilda supporter. Venise Alstergren
Posted Thursday, October 23, 2008 - 16:27

Mitchell: Thank you v much for your opinion. I'm about to follow up the link provided.



This user is a New Matilda supporter. Venise Alstergren
Posted Thursday, October 23, 2008 - 16:34

Geoff Davies: Your third para is terrifying. I'm about to follow up the link you provided.



PS: I've read about the Dow Jones index, I've even tried to come to grips with it. There has to be an easier way. Please don't say Standard and Poors or Nikkei. Way over my head.

This user is a New Matilda supporter. Venise Alstergren
Posted Thursday, October 23, 2008 - 16:40

Mitchell: "Shrieks of laughter". Followed by awed silence.



This user is a New Matilda supporter. Venise Alstergren
Posted Thursday, October 23, 2008 - 16:51

Geoff Davies: Thank you v much. Tonight I will forgo the dubious attractions of the Tube and get stuck into my homework. Deeply grateful.