The great money and credit boom

Growth of debt has surged in developed nations in the past 30 years. Now similar growth is occurring throughout the developing world, especially the leading new developers including China, India, Russia and Brazil.

As previously reported, in recent years growth of global money (and credit) in the developing nations has greatly exceeded that in the developed nations. This growth has fed the massive asset boom we are enjoying so much now.

For a group of 16 developed nations, including Australia, the “debt ratio” - the ratio of debt to GDP - has risen since the mid 1970s from approximately 60 % to 130. Over the same period, Australian debt has risen from less than 50 % of GDP to approximately 160.

We are grateful to Reserve Bank Deputy-Governor Ric Battellino and The Economist for presenting these facts. Battellino has gone further and shown for Australia some long-run data, from the middle of the nineteenth century. During this long period the debt ratio rose from 30 % to almost 75 % in the boom of the 18880s, then fell back to a bit over 25 % after which it rose again to almost 50 % in the boom of the 1920s. Now after super-exponential growth in the past 30 years, the debt ratio is close to 160 % and still rising.

The explosion of debt in the past 30 years is mainly due to an orgy of lending to households. Battellino says: "... deregulation, innovation and lower inflation have simultaneously increased the supply, and reduced the cost, of finance to households", who have responded by using it on a far greater scale.

This is the overt message of Ric Battellino's talk. The explosive growth of debt ratios is all about consenting adults optimizing their portfolios. Most of the increased borrowing is by wealthier households who have used it to purchase assets and thus become even wealthier. The US sub-prime fiasco is about overlending by financial institutions and overborrowing by people who mostly cannot afford the debt they have acquired. Australians, it seems, are more careful, or perhaps this is an example of the US leading edge (of financial innovation) turning into the bleeding edge.

The ripples from the US sub-prime crisis have spread widely. Parcels of dud loans have been passed from investor to investor, and end holders have not always been at all sure of what is in their parcels. This uncertainty has spooked markets and in the UK there was an ugly run on a mortgage bank, Northern Rock, which greatly embarrassed the Bank of England and was quelled only by a hasty government guarantee of its deposits.

The big fear is that the crisis is far from over. Many sub-prime loans have yet to have their interest rates “reset” from below market (in many cases zero) to well above market (to compensate for the initial concession and the theoretical risk of default.. The “reset” effect is expected to peak in early 2008 and ripples might then be at their largest.

Central banks have leant freely although not at penal rates, as the central bankers were too nervous to risk this classic response. The US central bank has cut cash rates by 50 basis points, stimulating a large bounce in share prices.

Australia has been relatively immune from the effects of the sub-prime ripples. One or two banks have been the subject of rumours but the Reserve Bank has reportedly begun to mop up the excess liquidity created in the early days of the sub-prime crisis.

The graph shows the official cash rate while the slightly higher line shows an average market-based bill rate. The gap is a measure of stress in cash markets. The normal gap is ten to 15 points, but this blew out to more than 50 basis points during the crisis. Note the subsequent fall back, not all the way but signaling a clear relaxation of market stress.

Two very recent bits of economic data suggest the overall effect on the economy has been effectively unnoticeable. With the "sub-prime ripples" crisis and the August rate hike, credit growth was expected to moderate. Instead it accelerated. Total credit grew by 1.5 % for the month and 15.6 % for the year to August. Housing credit grew by a "robust" 0.9 % for the month, while business credit grew by a "staggering" 2.7 % for the month and 22.4 % for the year.

And job vacancies are still growing strongly, by 2.9 % in the 3 months to August and a dramatic 11.9 % over 12 months. Unemployment is set to fall below 4 % for the first time for a generation, and may fall further yet.

Clearly the boom goes on, and may even be accelerating. Monthly data on inflation suggests outcomes close to the top of the target range of 2 to 3 %.

Ric Battellino concludes by saying there are two issues that arise from the developments in household finances over the past decade or two.

"The first is that the rise in household debt has made the household sector more sensitive to changes in interest rates. This has meant that central banks have been able to achieve their monetary policy objectives with smaller interest rate adjustments”.

This general point has made the Reserve Bank cautious – too cautious it will be judged if indeed the boom is accelerating. "Second, the household sector is running a highly mismatched balance sheet, with assets consisting mainly of property and equities, and liabilities comprised by debt. This balance sheet structure is very effective in generating wealth during good economic times, but households need to recognise that it leaves them exposed to economic or financial shocks that cause asset values to fall and/or interest rates to rise".

A third point was not made. That is that the great credit bubble of the past 30 years has been caused in part by monetary policy that has been too easy. If this great boom is followed by a great bust – as happened following the great booms of the 1880s and the 1920s – this point will be the main point.

It was entirely appropriate that Ric Battellino’s talk was delivered in Marvellous Melbourne, the focal point of Australia's great asset and credit bubble of the 18880s. Could the Deputy-governor in fact be more subtle than he seems?

This article was published today in The Australian

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