You could be mistaken for thinking we didn’t each have a part to play in the Global Financial Crisis. It wasn’t that long ago Kevin Rudd was saying “As Prime Minister I will not sit idly by and watch Australian households suffer the worst effects of a global crisis we did not create.”
But the cause is closer to home than we think.
The Great House Bubble
Despite real estate agents and industry lobbyists shamelessly spreading the concept that house prices double every 7 to 10 years, sadly this is nothing but lies. But as they say there is "truth in marketing" and you certainly can’t say they haven’t marketed Real Estate well – just too well, and now we are paying the costs.
House prices in fact, do not increase in the long term faster than inflation. Historically, you don’t buy houses for capital appreciation, but rather rental yield.
The chart above shows over 100 years of "Real" house prices, that is, prices corrected for inflation. Both the United States and Australia is featured. As you can see, over the long term house prices don’t really do anything.
What happens from the late 1990’s onwards in enough to scare anyone.
The driver of this bubble is still open for debate. After tech wreck the U.S. Federal Reserve dropped interest rates quite sharply. Rates didn’t drop nearly as much in Australia and our boom appeared to start some ten years earlier, so while some analysts suggest low interest rates were the cause, the jury is still out. What is more concerning is the implications.
Implication of Rising Housing Costs
Now what are the implications of rising housing costs? I use the term rising housing costs as this covers both mortgage repayments and rents. As the first part of this crisis developed, it was rising housing asset prices and associated mortgage repayments having an effect on household budgets.
During the later part of the crisis, landlords decided to increase rents at a pace which far exceeded wage growth, hence the same repercussions shifted into rental households and remain a real threat today.
Money doesn’t grow on trees, so as house prices continued to accelerate, homeowners needed to borrow more. It doesn’t take a highly educated economist from the treasury to work out that household debt must go up.
If you look closely at the real house prices for Australia, you will see the first part of the housing boom started in the late 1980’s and never fully corrected. This is the same time household debt started to adjust its trajectory for the moon.
In the 1980’s for every dollar earned, the average Australian household had about 40 cents of debt. By the time household debt reached orbit in 2008, the average Australian had debts totaling a fraction less than $1.60 for every dollar they earned.
Just as household debt skyrocketed, household net savings went through the floor. In the 1980’s Australia was a nation of savers, putting about 10% of household income under the pillow for a rainy day.
By 2002, the average Australian household was actually spending more than they earned and household net savings went negative. This continued for a number of years.
Unfortunately there is no free lunch in life. As house prices went up and along with it debt levels, so did mortgage repayments. Below is a graph of interest payable on dwellings as a percentage of household net income.
The figures represent the aggregate of all Australians, hence why the figures appear low. But it’s not the actual values that are of interest, but the step rise from 2001 to 2008. Payments shot up from under 4% to over 10%, a rise of 150%.
The following chart shows the Average Household Expenditure for 03/04 financial year taken from the ABS Household Expenditure Survey (6530.0). In 2003/04 the largest household expense was food and non-alcoholic beverages, followed closely by housing costs. The housing cost category includes rents, rates and interest payments on mortgages.
Below is another chart for the same year – 2003/04. What we have done is simplified the chart by grouping some of the categories into discretionary spending, that is spending that we have some choice on, like recreation, miscellaneous goods and services, household furnishings and equipment, alcoholic beverages and tobacco products, clothing and footwear and personal care.
This leaves categories such transport, medical care and health expenses and domestic light and power as necessary services. You could argue that if need be, you could leave the car at home and take public transport, cancel your private health insurance and live in the dark, but you get the picture.
Remember by 2003 we were actually spending more than we earned. Now as much as we would like it to, money doesn’t grow on trees and the average working family has probably eroded any savings by now. If house prices rise faster than household income, like has been the case for the past decade, something must budge in the household budget.
Let’s increase housing expenses. We have already decided there are some fixed expenses in our budget which will not change (not really true, both petrol (transport) and private health insurance premiums have gone up more than inflation).
So what budges in the budget? Discretionary Spending.
It simply means as housing expenses continue to outpace household income, households must cut back on discretionary spending.
Now let’s fast forward a couple more years and with rapidly rising house prices, let’s make housing costs 50% of the household budget. Now, don’t laugh. Housing stress is considered when the household spends more than 30% of income on housing expenses. Many new buyers took out 100% loans, so it’s not unreasonable for more recent purchasers to be paying this, if not more.
In a recent Melbourne Institute study, it was found in the “mining boom state”, 18% of Western Australians paid between 26% and 50% of their income in debt repayments. These figures were for March 2009, after rates have been cut by more than half, but it would be fair to say than many households have chosen to keep paying down debt at the old rate of payment.
Rising housing costs strangle discretionary spending and the broader economy
So it should now be easy to visualise the repercussions of house prices outpacing household income growth year in, year out for a decade, and why historically house prices only increase in line with inflation or wage growth in the long term. Australia is not alone. Most OECD countries were caught up in this bubble.
But why hasn’t the effects of this been felt earlier?
As house prices increased in the early part of the cycle, we saw household savings deteriorate. Temporary relief was sought by channeling money that would otherwise be spent i.e. the 10% of the household income, into housing.
After 2002, the net savings ratio went negative. So rather than cut back on discretionary spending to make the household budget balance, we started using debt as a means to continue our spending excesses.
Then there is a phenomenon called the wealth effect. As house prices rose, those owners felt wealthy and had a tendency to spend more. In reality, the capital gain is not realised until you sell the asset at a price agreed between you and the buyer. Before then, the price of the asset may deflate. Yet many households have already spent any gains they have made from their housing assets as they are continually told house prices only go up and hence there must be little risk.
Hence a good part of all the unrealised or artificial housing capital gains have flowed into the economy and helped drive (or overdrive) consumption. The excess consumption of households spending beyond their means helped to bolster the domestic and global economies.
Closer to home, the extra retail spending required extra shop assistants. The cuppa chino and newspaper before work supported the café, just like the eating out at restaurants supported the chiefs and waiters. The kitchen and bathroom renovations required extra tradespeople and well you get the picture.
Further abroad, the spending on the latest consumer gadget or flat screen telly did wonders for the Chinese economy, and as that boomed, they brought our resources to build factories and homes.
We now have a considerable problem on our hands. Not only do we have to cut back on spending and live with in our means, we also have to start paying down some of this mountain of debt we have in our names. For every dollar a household spends in paying down debt, is one more dollar not spent in the economy supporting jobs. It’s a double whammy.
The journey ahead – 2009 onwards
The journey ahead still remains cloudy thanks partly to interference from governments.
The housing market remains the key to the problem. The longer house prices remain artificially high in comparison to household incomes, the more households will need to spend on this expense, and hence the less money that can be spent on other goods and services underpinning domestic jobs.
The quicker we can get house asset prices versus household income back to historic trend, the quicker this crisis will pass, freeing up important money to be spent as discretionary spending.
Many OECD countries have the same problem than us. As you can see from the real house price graphs featured earlier, the U.S. housing bubble has popped and U.S. house asset prices are 27% down from the peak of the bubble. The sooner prices get back to a healthy trend, the quicker they can move into recovery and get back on their feet.
Time to pick and choose: Housing or Jobs
In Australia, our Government is playing a game of tug of war.
One aspect of the economic security package has seen the introduction of the First Home Owners Boost (FHOB), an incentive to encourage first home buyers into the market by giving them extra grants on top of the existing first home buyers grants. If you build a new house, first home buyers get an extra $14,000. If purchasing an existing home, it is $7,000.
If you want to measure the success of this package by the number of First Home Owners signing up, then it’s one thing that Real Estate Agents don’t need to lie about – there is a subprime frenzy out there as buyers, some of which are bidding up prices more than the grant is worth, just so they don’t miss out.
But economically, how is propping up the housing market helping our recovery? Are we just delaying the inevitable, while at the same time encouraging a new generation of home buyers into so much debt, they won’t be ready to stimulate the economy for another 25 years until they pay down the mountain and have some free money left over? This off course assumes they make it through the 25 years, and don’t default once the cash rate starts to head north, requiring yet another bail out from the Government.
To me, this seems to be encouraging our old ways. Have we not learned anything since this crisis has started?
Then we have the $900 handouts. Of the money that is not going to overseas visitors, deceased estates or the dog and cat benefactors of deceased estates, it appear to be going straight into paying down debt. If this helps just one or two households avoid foreclosure, then I certainly wouldn’t mark the package unsuccessful. In fact, just to see the net savings ratio spike up, I think is a huge success.
But at the end of the day, we appear to have two policies – on one side of the rope we have the stripping large sums of money from retail and service sectors by encouraging young first home buyers into a life of excessive debt in a bid to keep the housing bubble afloat, while on the other side of the rope is trying to put money back into the economy with the aim to save jobs.
With news out today suggesting retail jobs which employ 15% of the workforce is under threat from the next stage of this crisis, It is time the government needs to decide what is important: High house asset prices or jobs?
The economy can’t sustain both.