15/08/2009. Making Australia’s banking system more robust. Plus securitisation of debt.

• To help Australia survive the next Global Financial Crisis, we need to introduce more regulation of financial markets. Key regulatory reforms to include:
  • Applying Paul Volcker's key recommendations to Australian regulation would change the shape of financial institutions in Australia for the better. These changes would help create a “financial system which is not going to be so prone to crisis and certainly will not be prone to the severity of a crisis of this sort.” (Volcker):
    • The commercial banks. The government to provide an explicit guarantee to Australian commercial banks – the core of the system. These commercial banks would simply focus on deposit taking and providing credit. These commercial banks must be more highly regulated. These commercial banks would need to divest all highly risky entrepreneurial activities including proprietary trading and wealth management. In this vital sector, it is not acceptable that shareholders and executives gamble to win gains from risky activity, where taxpayers may wear the big losses.
    • The capital market system. Capital market players are dealing with each other. They’re trading. They’re about hedge funds and equity funds. They don’t need to be so highly regulated. They’re not at the core of the system, unless they get really big. (eg Too big to fail.) If they get really big then you have to regulate tightly them, too.
    • Since some Australian insurance companies are “too big to fail”, they would have to be regulated more tightly too. If financial institutions become “too big to fail”, shareholders and executives benefit from the gains from risk-tasking, but taxpayers potentially wear the losses as we have seen with AIG’s failure.
  • Banning securitisation of debt.
    • Volcker’s recommendations are just part of the increased financial regulation. Securitisation of debt needs to be banned. The biggest problem with securitisation is that it removed a critical tool from the tool-box of central banks. Traditionally, when new money was introduced to the banking system and when a new loan had to be retained on the bank’s balance sheet, the Money Multiplier determined the total new money that could be created by the banking system. However, securitisation allowed banks to sell on a new loan, thus the Money Multiplier potentially became infinity. By banning securitisation, we give the Reserve Bank more control of the money supply.
  • For more discussion on these issues, refer to our submission to the parliamentary inquiry.

28/05/2009. Australian attitude of entitlement will disappear over the next few years - because we can afford it.

In the May 2009 Federal Budget, it was proposed that the age pension age be gradually phased out to age 67 by 2023. This has been met with outrage from some quarters.

This outrages is an expression of an attitude of entitlement to receive the age pension. The attitude is that Australia owes me an age pension, when I reach age 65.

When I was growing up, my parents drummed into me that the world does not owe us a living. That was a great lesson. The world does not owe Australia a living. My sense is that the GDP of Australia will be lower (in real terms) in 2012 than in 2007 – possibly significantly so. We all need to come to grips with the fact that our standard of living will need to fall to meet the level of our falling income. We all need to live on less.

80% of older Australians now receive an age pension, an increasing number of Australians are over 65 and the age pension now costs the Australian taxpayer $30billion in FY10 which is one third of the total budget expenses. The cost of the age pension is projected in the budget papers to rise 20% to be $36billion in 3 years time FY13. The growth in the cost of the age pension is unsustainable. Something has to give.

Some of the sources of these numers are as follows.

• Budget gross expenses http://www.budget.gov.au/2009-10/content/overview/html/overview_34.htm Total budget expenses $338billion FY09
• Where the spending goes to http://www.budget.gov.au/2009-10/content/overview/html/overview_40.htm 33% of budget expenses is Social Security and welfare $110b
• Of which $45.5billion is spent on Social Security http://www.fahcsia.gov.au/about/publicationsarticles/corp/BudgetPAES/budget09_10/Documents/FAHCSIA_PBS.pdf Page 29.
• And $29.4 billion is spent on age pension in FY10 rising to $36billion in FY13 http://www.fahcsia.gov.au/about/publicationsarticles/corp/BudgetPAES/budget09_10/Documents/FAHCSIA_PBS.pdf Page 99.

27/05/2009. Warwick McKibbin is a Reserve Bank Board member who seems to talk a lot iof sense – and speaks plainly.

RBA Board member Professor (Economics, ANU) Warwick McKibbin, on the effectiveness of activist fiscal policy:
“Most fiscal policy doesn’t do anything except switch spending from one period to another,” the RBA director said.

“When you change fiscal policy, all you do is stimulate the economy today out of future possible growth.”

Stimulus spending had to be paid for either with higher future taxes or reduced opportunities for the private sector so that the public sector could be financed.

“The only exceptions are infrastructure and similar spending, which raises the return to private activities,” Professor McKibbin said.

“The most sustainable way of reducing a fiscal deficit is through strong productivity growth in the private sector.”

He said that in mature economies, it was hard to engineer productivity growth.

08/04/2009. Richard Russell's view on the right government strategy on the crisis."I would not do a thing".

Richard Russell famously called the bottom for stocks in December 1974. He told readers of his newsletter, Dow Theory Letters, to buy... after stocks had fallen roughly in half in the preceding two years. During those two terrible years, Richard recommended his readers hold 100% of their money outside of the stock market. On Saturday night, there was a tribute dinner for Richard, who's been writing his newsletter since 1958. At his tribute dinner, Richard was asked “If you were in charge of the country, what are the top three things you'd do to turn this country around?” Richard replied, “I wouldn't do a thing. I'd let the bear market take its course. The fixes won't work. They prolong and compound the problem. And they're costing us (USA) trillions.”

07/04/2009. What needs to change before we are out of this crisis? (Work in progress over the next few weeks)

Here are some of the issues that needs to be fixed:
• First and foremost, Australian debt (currently about 1.6xGDP i.e. about $434billion) must be gone. However, I note that the government is adding to this debt at a significant pace.
• Wean the Australia off debt addiction. Personal debt, Corporate debt. Government debt. Live within our means.
• Banks must focus on being banks, and be required to divest themselves of other functions like life insurance and funds management.
• We must consider and develop a strategy for the TOO-BIG-TO-FAIL risk that we have seen in the USA. We have this problem too. We need to be working on this problem now, before it bites us.
• Re-adjustment and realignment of currencies around the world, where over the cycle, at least the major economies are not continuing to run deficits on the current account.
• Credit need to be available to credit worthy entities at a reasonable price.
• Banks need to be able to trust banks so that the financial system can function. So there must be very high level of regulatory scrutiny on bank balance sheets including:
  • What is the quality of bank assets?
  • Is average loan to valuation ratio to high?
  • Has there been reckless lending? What is the quality of the loan book?
  • Is bank funding sustainable? eg a high reliance on off-shore lending has been seen to be a problem for mid-tier banks.
  • What level of exposure is there to derivatives including credit default swaps?
• Regulations:
  • Capital adequacy of banks.
  • Capital adequacy of insurance companies, in particular with reserves.
  • Regulation of hedge funds.
  • Regulation of investment banks.
  • Review of ASIC.
  • Banning of the securitisation market, which took control of the money supply away from the RBA.
  • Ratings agencies.
  • Adjust the mind set to allowing or even encouraging a recession at least every 10 years.
    

20/03/2009. Why Australia is likely to have a 50% crash in house prices?

In a nut-shell, the reason why Australia is likely to have a 50% house price in real terms is this chart.




Why does this chart suggest that we have a 50% house price crash ahead of us?

To answer this question we need to start off with Professor Robert Shiller's analysis of US house prices. This is important, because the logic of Robert Shiller's analysis applies equally to Australia.

Before US house prices started to crash in mid 2006, Shiller declared that US house prices were experiencing a speculative bubble. How did Robert Shiller come to that conclusion?

• Robert Shiller cleaned up the very long-term US house price data in a manner which enables us to see that over the 119 years from 1890, US real house prices have a very clear trend line of maintaining their value in real terms.
• Robert Shiller's data also demonstrated how US house prices doubled in real terms since the mid 1990s. It just so happened that this co-incided with a very rapid rise in the US debt bubble over the same period. This is no accidental co-incidence, but in fact the cause .... but this observation about the debt bubble is not central to the point being made.
• Now one of the most reliable guides in investment markets is reversion-to-the-mean. Apply this to Robert Shiller's data, it is an EASY conclusion to come to that after rising 50% in real terms, US house prices needed to fall by 50% in real terms.
• Please note that we do not need to consider anything about supply and demand to come to this conclusion. The data clearly speaks for itself.
• Robert Shiller's data is shown in the following chart, together with the most natural projection. Yes, I have also used this chart in my 25/2/09 blog.
  




So how does Robert Shiller's analysis enable us to come to the conclusion that Australia is also due for a 50% fall in house prices? The line of logic goes like this:-
• First, I am not aware of anyone producing such a high quality very long-term data series for Australian house prices as Robert Shiller has for USA.
• Yes, there are some Australian house price data series around, but typically they do not compare like with like. A long-term data series of median house prices or average house prices is systematically flawed because as Australia has got wealthier, we have lived in bigger houses. Shiller solved this problem by only using data pairs of where the same house has been bought and sold.
• Now to my first proposition. I think it is reasonable to assume that even though we do not have the data, if US house prices simply maintained their value in real terms over the very long-term (1890-1995), then it is most likely that Australian house prices will have simply maintained their value in real terms during the same period. That is, it is highly likely that the long-term trend line for US and Australian real house prices is similar.
• This is where the ABS Australian house price data show in the chart above, comes in. The chart of ABS house price data demonstrates that since the mid 1990s, average Australian house prices have tripled in nominal terms. ABS data also indicates that we have had about 42% inflation since June 1995. Therefore, Australian house prices have more than doubled in real terms since the mid 1990s.
• Interestingly enough, this rapid rise in house prices in Australia since the mid 1990s has co-incided with a rapid expansion in Australia's historically large debt bubble. Again, no accident.
• Therefore, forecasting a 50% fall in real terms, is a natural and simply outcome of a line of logic based on data. And if you have quality reliable data, the data rarely lies. Yes, data is often mis-interpretted or mis-used, but properly used, data rarely lies.
• Please note that a 50% crash in house prices would probably be a record Australian average house price crash. I form this view based on reviewing a report of house price crashes in Australia in the 1890s economic depression and in the 1930s economic depression.
• Am I sticking my neck out to make such a big forecast? No, not really because it is actually the data which is making this forecast. Besides, we are experincing the biggest debt bubble in Australia's history, so it would seem unsurprising that a record house price crash occurred.
• Timing? The data does not privide any good indicator on timing, however, given the shape of the chart (and what is happening around the rest of the world), this Australian house price crash looks like it may have already commenced.
• How long does a house price crash like this take to occur? You should expect a house price crash like this to take a number of years once it commences. For example, look at the US house price chart. US house prices have been crashing for 2.5 years and it only seems to be half completed. However, the house price crash might take much longer. The Japanese house price crash after 1989, took about 15 years.
• Does the data tell us the mechanisms that will be operational that bring about the house price crash? No. The data just tells us that it is highly likely to happen.
• Can the government prevent this crash from occurring? Clearly Kevin Rudd's measures stimulus before Christmas (a big short-term increase in first home buyers grant) seems intended to prevent a house price crash. But no, I do not believe the government can prevent this 50% crash in average Australian house prices in REAL terms. Yes, government action can postpone the crash, or it can make the house price bubble worse before resolution, or it can drag the crash out. At an extreme with extreme measures, potentially the government can prevent an Australian house price crash in nominal terms. This would require the government to cause high inflation which normally would be very destructive to the economy. But in real terms, I cannot see any significant probability of the government (or anything else) stopping this crash. This is why it is potentially very wasteful for the government to even try to prevent this house price crash.

Of course, there are always plenty of people who would scorn a forecast of a 50% share price crash. So where are the weaknesses in their arguments:

• Many who argue against a house price crash, do so based on a supply and demand argument. That is, they argue that unlike the USA, Australia has a house price shortage. So the line of argument would be that if you ASSUME you have a fixed demand, and you have a shortage of supply, how can house prices fall?
  The problem is that demand for house prices can weaken.
  • Demand might fall because less people being able to afford to live alone, reversing a trend over the last few decades.
  • Demand might fall because less people not being able to afford a second home (eg beach house or holiday home) and that they have to sell their existing second home.
  • Or the kids might live at home for longer ... into their 30s, because they cannot afford to move out.
  • Falling immigration will also reduce demand. The Australian government has already cut back the immigration program in response to the financial crisis.
  • Professor Steve Keen thinks the prime driver will be rising unemployment, causing many people to default on their loans. If we get unemployment up to 20%, which is a real possibility in the next few years, a lot of people might default on their loans ... and the banks take the houses.

  More broadly, if we go back to supply and demand curves from economics 101, we can see a range of ways mechanisms that could cause house prices to fall:

  • If demand falls quicker than supply is falling, prices will fall.
  • If demand rises slower than supply is rising, prices will fall.
  • If demand falls and supply remains constant, prices will fall.
  • And from watching volume house price advertisements, supply of houses to sell seem to have risen, while the supply of buyers seems to have shrunk.
  • But it does not matter. We do not need to be able to forecast the mechanism, to forecast that house prices will fall.
  
  So in summary, this supply-demand argument is a furphy, a bit like the way that supply and demand arguments were used to justify why dot-com share prices were as high as they were during the 2000 dot-com speculative bubble. One of the common weaknesses in supply and demand arguments, is that they focus on just one side of the equation. In the dot-com bubble, the argument was that there is only a limited supply, so you had better get in quick or you would miss out. I think many house-buyers have been feeling that about houses over recent years.
• Needless to say, there are always many many people who have a vested interest in forecasting that house prices will not fall.

One final point. As an additional support from history for a house price crash, we could consider the very long-term study by the US Fed, which found that the big crashes in property and shares happen together. In recent history, we saw this in Japan from 1989 (property down about 65% from the peak), Hong Kong in Asian crisis in 1998 (property down about 60%), and in Australia where crash pair was made up of the 1987 share market crash and the office property crash in 1990. We are also seeing a share/property crash pair unfolding in the USA, where the share market crash event has been occurring since 2000 and the house price crash event commencing in 2006.

We live in interesting times.

Here are some links to some others who feel that Australian house prices will crash:
Economist Gerard Minack warns Australian house prices could fall by 50 per cent

October 2008 7.30 Report interview of Professor Steve Keen - "we're talking about a house price level in Australia which is twice the level that America got to"

October 2008 7.30 Report interview of Professor Steve Keen - transcript

Professor Steve Keen's blog - search the page for the text "house price"
Here is a chart from Steve Keen's web site.




AFR 5/5/09 Falls in the top and middle segments of housing market have outweighed the resurgent activity of first-home buyers, to cause an overall drop in house prices."

AFR 26/3/09 The similarities between UK and Australian housing markets, particularly in affordability, came as a surprise to Bank of England economist Kate Barker."


Marc Faber 20/3/09 - "The global economy is really stuffed for a long time."

11/03/2009. Will western government stimulatory measures work?

If you are faced with a choice between:-
• Economic depression and a huge debt that might take decades to pay off OR
• Economic depression without a huge debt

which would you choose?

It is quite possible that our choice is as simple and stark as this.

I am all in favour of deficit spending on well-focused infrastructure projects because this is typically a good long-term investment for the community which the community will get a return on.

I am all in favour of short-term aggressive monetary policy (slashing interest rates) to stimulate a weakening economy because this can quickly be reversed.

But taking Australian into fiscal deficits through government handouts and tax-cuts are unlikely to be good investments for our community. These spending measures simply cause:

• a massive drag on future generations having to pay off this debt,
• higher fixed-term borrowing rates over the medium-term as thsi debt is being paid off, and
• the likelihood of serious inflation down the track as governments seek to pay off the debt with cheaper future dollars.

08/03/2009. How big and long will this financial crisis be?

• remember that the sub-prime debt problem is about US$3trillion is size ....
• and against this, a few trillion dollars being thrown at this problem by Obama et al is starting to measure up to the same league in terms of size
• but we have the bigger problem still ahead for us .... credit default swaps ..... the size of this problem is thought to be of the order of 60 or 70 trillion dollars ... I don't think the US could throw enough dollars at that problem to buy all the bad debt that might result or fix the damage simply.
• and the US debt bubble is about 3.5 x US GDP and that has to deflate (it probably has shrunk somewhat over the last 12 months). US GDP is about US$13.8trillion dollars ... so getting rid of that debt will need:-
  • paying down that debt (this necessarily comes by way of reduced spending i.e. reduced GDP) OR
  • having default losses OF about US$47trillion dollars

If we just ponder these numbers for a moment, it is easy to see why current western government stimulus measures (even if well-focussed) are likely to be far to small to head off this crisis. But then there is the secondary issue – How can a crisis caused by debt and excess liquidity, be solved by more debt and excess liquidity? Or are these measures just pouring petrol onto the fire? I think the main impact is that the latter is potentially taking the West into a “debtor’s purgatory” (or potentially even hyperinflationary depression) according to George Karahalios. Clearly these ugly outcomes are possible. But this is a topic for another day.

So we have a long way to go before we are out of the trees .... probably at least 5 years of UGLY in the west .... possibly more. (Robert Shiller recently reminded us that the last economic depression was about 8 years long.) Yes, I think we will go through periods where we look like we are out of the trees ....and then the next round will hit us. There is a possibility that the US will destroy their economy in the process of fighting this ... in a similar way to the way that the UK bankrupted themselves fighting World War II. (That was the end of the British Empire as we knew it).

A big player in credit default swaps was AIG ... their losses last quarter of about A$96billion ... may have been the beginning of writing off losses from credit default swaps. ???

Anyhow, we are mixed up in a challenging game that will test us all for a few years yet.

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25/02/2009. The house price crash virtually guarantees a deep and long recession.

23/02/2009. George Soros says 'the world financial system has effectively disintegrated'

21/02/2009. Exchange traded funds (ETFs) will revolutionise investment planning for fee-based advisors.

06/02/2009. Market timing is crucial for geared investors.

25/01/2009. History tells us that governments often ‘get it wrong’, in major financial crises.

24/01/2008. Will Australian government stimulatory measures work?

16/01/2009. We need to grapple with the market timing issues more than we ever.

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22/Nov/2008. Next 5 and 10 years a traders market, not an investors market!