In my column last week, I argued that it was reasonable to believe that over the next decade credit and house price growth would be driven by disposable incomes, all things being equal.
My regular sparring partner Steve Keen responded with a detailed critique in which he rejected my arguments, and sought to re-cast his infamous September 2008 claim that “there’s no point in paying a mortgage on an asset that is going to fall by 40% or so in the next few years.”
Like most of Keen’s predictions, such as the “best-case scenario” during the GFC being 11% unemployment and a recession “more severe than 1990 and lasting 1.5 times as long” (unemployment peaked at 5.8% while there was no recession), his 2008 projection proved way wide of the mark.
For the record, Australian dwelling prices are today 13.3% higher than when Keen put his reputation on the chopping block, and 89% higher than the level at which Keen expected them to be.
Keen now tells us that he thinks Australian house prices will plummet by 40% over the next decade (or 13 years since his original declaration). That actually represents a forecast downgrade given a two-fifths decline in prices from today’s level is equivalent to a 32% fall in September 2008 terms.
Keen further dismisses my proposition that the growth in Australian housing costs over the last 20 to 30 years can be explained by simple reference to incomes and interest rates.
Instead, he points to a 50% “correlation” between a much more nebulous conception, which he calls the “mortgage accelerator” (the rate at which housing credit accelerates or decelerates), and changes in house prices over time.
Setting aside the fact that Keen offers no evidence of any causality between these two variables, and rises in house prices could just as easily cause an acceleration in credit (rather than the other way around), Keen’s “correlation” still fails to explain half of the times-series change in Australian dwelling values.
Indeed, when I look at the relationship between Keen’s “mortgage accelerator” variable, which he supplied to me, and a more precisely-measured estimate of changes in dwelling values – RP Data-Rismark’s Hedonic Index – I get a much lower 12% correlation.
More importantly for the Keen critique, I will show that by indexing up median Australian dwelling prices by per capita disposable incomes and changes in borrowing capacity (as determined by mortgage rates) one can account for about 90% of the rise in Australian housing costs over the last two and a half decades.
If we accept that the big structural changes that took place over the last 20 to 30 years are behind us, we can then project with confidence that future dwelling prices will be determined by household purchasing power, ceteris paribus.
The structural changes I am talking about here include the circa 40% plus reduction in variable mortgage rates from the 12.6% average that prevailed between 1980 and 1995 to the 7.3% level that has held since (see the grey line in the first chart below).
This was brought about by the RBA’s adoption of a so-called “inflation-targeting” approach to monetary policy in the early 1990s, which has helped keep inflation, on average, within the central bank’s target 2% to 3% band and allowed nominal interest rates to remain lower than had previously been the case. (There was a cap on lending rates in Australia until the early 1980s, which makes like-for-like comparisons prior to this period difficult.)
Consigning double-digit inflation and commensurately high mortgage rates to history has in turn empowered households and businesses to undertake a once-off upward adjustment to their borrowing capacity (or leverage) in recognition of the 40% reduction in the cost of debt.
In the chart below, this can be seen by the rise in the RBA’s household debt-to-disposable income ratio from the early 1990s onwards, which coincided with the time that the RBA started using its 2% to 3% inflation target (refer to the red and blue lines).
You can see that in 2005-06 (i.e., several years prior to the GFC) Australia’s household debt-to-disposable income ratio started to flat-line.
The RBA’s (and my) central case is that this will continue: that is, the “new normal” will be one where credit growth is bounded by incomes. This brings me to one of Keen’s factual errors.
In his article, Keen asserts, “My data comes from the RBA; Chris’s comparable figure clearly uses different data to conclude that ‘Australia’s household debt-to-disposable income ratio has, in fact, flat-lined since a number of years prior to the GFC’, since RBA data shows it rising from 115% to 135% from 2005 until now.”
In private discussions with Keen I have confirmed that his statement is, in fact, wrong. That is, I was using the correct RBA ratios, and he has arrived at very different (and presumably specious) numbers through his own independent calculations.
According to the RBA’s official measure, Australia’s household debt-to-disposable income ratio hit 155% in 2006, which is where it remains today. It has not, as Keen maintains, expanded from 115% to 135% over this period. The striking deceleration in Australian housing credit growth since its peak in late 2004 can be vividly seen in the next chart (refer to the downward-sloping black line).