Current account deficits and house prices

As I alluded to in recent posts, Australian banks reliance on foreign funding has lead to the alarming situation whereby we (as a nation of households) have borrowed from the rest of the world to buy existing houses from each other at inflated prices. As I said, “it makes me quite frustrated to even suggest that a fair portion of foreign debt incurred in the past decade was used to pay each other higher prices for existing houses”.

I made that claim without evidence – it was an intuitive interpretation of the data in the balance of payments and in particular, the interest payments heading abroad in the primary income account. But, in the interests of an informed debate, I have digested some of the literature on this matter and found that the intuitive principle is well supported.

In February this year, Andrea Ferrero, of the Federal Reserve Bank of New York, published this paper arguing that “a progressive relaxation of borrowing constraints can generate a strong negative correlation between house prices and the current account. Households increase their leverage borrowing from the rest of the world so that the current account turns negative”.

The following plot is from the paper (p2).

The model demonstrates the mechanism by which relaxed lending standards decreases domestic saving, increases foreign bowings and decreases the current account. The model also shows that prices vastly overshoot the new equilibrium point. The quote below is from p14 (my emphasis).

The key shock that generates a house price boom and a contemporaneous current account deficit in the model below is a reduction in the parameter that measures the loan-to-value requirement. At a broad level, lower collateral requirements capture easier access to credit for housing finance.
...
The main experiment consists of shocking the collateral constraint parameter. In particular, financial innovation corresponds to a higher loan-to-value ratio.
...
At a very basic level, the model captures the negative correlation between house prices and current account balance. In response to the shock [relaxation of collateral criteria], house prices persistently increase while the current account worsens, at least for a couple of periods, before slightly overshooting its long run average of zero. A more realistic sequence of shocks approximating a progressive relaxation of collateral constraints (the process of financial liberalization) is likely to generate a run-up of house prices and a deterioration of the external balance more in line with what observed in the data.

This appears to support the idea that simply constraining lending criteria would have been an effective measure to contain house prices, and reduce the current account deficit. Steve Keen would not be surprised.

Indeed, the evidence of this relationship appears quite strong, and it is easy enough to find other articles supporting this argument empirically.

My main criticism is the timing of the house price growth measure. China for example appears to have flat real price growth in the above graph for the period 2001-2006. That would seem consistent with the arguments surrounding the relationship between the current account and house prices. However, since that time credit standards in China were reduced, prices shot up (around 2007), then access to credit was subsequently tightened, and prices flattened (around 2008). To me, a good experiment to demonstrate this relationship, although hampered by global conditions at the time. The below graph from The Economist house price comparison tool shows China’s house price growth in this period was far below that of the US, UK and Australia. More recent data shows strong house price growth since 2009.

One stand out example of where the relationship  between house prices and the current account fails is Japan in the 1980s.  A housing bubble coupled with a current account surplus and a large growth in ownership of foreign assets is not what these models predict. 

Out of interest, here is a list of countries according to their current account balance. Eyeballing this list it is pretty easy to find the prominent housing bubble markets near the bottom.

To be clear, the access to credit is the key (and this may provide the explaination of the Japanese experience in the 1980s). Lower LVRs force domestic saving and limit the need for foreign borrowing, meaning asset prices can reflect the economic reality of that country alone. (One might argue that Japanese saving was high enough that the current account was simply lower tha it woul dhave otherwise been, but not negative.)

I will present one final conclusion from here, with my emphasis.

We find robust and strong positive association between current account deficits and the appreciation of the real estate prices/(GDP deflator).

Our results are consistent with the notion that for all countries, current account deficits are associated with sizeable appreciation of the real estate. This effect holds controlling for the real interest rate, GDP growth, inflation, and other conditioning variables. We also find evidence consistent with the growing globalization of national real estate markets. These findings are consistent with various scenarios explaining patterns of capital flows across countries, including differential productivity trends and varying saving patterns. In the absence of pre-existing distortions, financial inflows are unambiguously welfare improving. Yet, in a second-best environment, public finance considerations imply that inflows of capital may magnify distorted activities, increasing thereby the ultimate costs of these distortions. Arguable, the experience of emerging markets in the aftermath of financial liberalization during the 1990s illustrated these concerns. Needless to say, this second-best assertion is not as argument against financial integration, but a cautionary tale – greater financial globalization implies the need to be more asserting in dealing with moral hazard and other pre-existing domestic conditions. (p20)

What sovereign wealth? Continued...

To the cynic, the RBA’s role is to assure citizens that they have everything under control. In this light, we can see the recent speech delivered by Guy Debelle, the Assistant Governor, where he defends a persistent current account deficit. While he shows that much of the deficit has historically been the results of Australian banks seeking funding abroad (an inflow in the capital account), only to send interest payments back annually (an outflow in the current account), he artfully avoids the distasteful conclusion that we have gone into debt with the rest of the world to sell houses to each other at inflated prices.

Indeed his speech is a critique of the reasonable conclusion that “the Australian banking sector is ‘funding the current account’." The balance of payments accounting identity, where the sum of the capital account and the current account should equal zero, appears to demonstrate this is true. If banks did not seek offshore funding, they wouldn't pay interest on these funds, and the current account would more closely reflect the balance of trade (which is much less negative).

The graph below shows that capital account flows since 1990. To translate, this account reflects the sum of our sale of assets to foreign ownership and our international debts incurred (inflows of funds), which is balance by outlfows of funds in the current account.

With the RBA’s view of the economic landscape in the back of our mind, I thought it worthwhile to repost the Wildebeest blog explaining why a sovereign wealth fund in this environment is simply funded by debts in the rest of the economy.
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Should Australia have a sovereign wealth fund (SWF)? Whenever I hear this discussed my first thought is what do you mean by sovereign wealth? The Australian government can set aside a pool of funds at any time and call it whatever it wants. For example the “Future Fund” is listed in wikipedia as being an Australian sovereign wealth fund. The discussion in recent times seems to be linked to the once in a generation mining boom. Mining by definition extracts a non-renewable resource, so at a time when windfall profits are being made in mining, due to the demand from China, people understandably feel that some portion of that money should be set aside for the future. But does Australia actually have “sovereign wealth” from which a SWF can be funded?

There is a national accounting identity:

CA = (T – G) + (S – I)

This says that taxes, T, minus government spending, G, plus private savings, S, minus private investment, I, must equal the current account CA. If (T - G) is positive then the government is running a surplus, if it is negative a deficit. (S - I) can be thought of as the net private sector savings. If it is positive then wealth is being accumulated. This accounting identity is what it is independent of ideology or political beliefs: the identity is the same whether you are progressive or conservative, or regardless what brand of economic belief system you subscribe to.

If the government sets up a SWF it could be funded from existing money:

CA = SWF + (T – SWF – G) + (S – I)

or it could be funded by raising taxes

CA = SWF + (T – G) + (S – SWF – I)

Australia has been running current account deficits for ever and a day.

So the left hand side of the equation is negative, has been negative for a long time, and is likely to be negative for a long time. By definition the right hand side must equal the left hand side so must be negative. Now imagine that the government was to “quarantine” money in an investment fund which, we'll call a SWF. Prior to the formation of a SWF we know that (T – G) + (S – I) is a negative number. In order to create the SWF the net government and private sector balances have decreased by an amount equal to SWF:

(T – G) + (S – I) – SWF

If follows that while Australia runs a current account deficit, if money were to be placed in an investment fund by the government the rest of the government and private sector would be further indebted by an amount equal to the SWF. In such circumstances a sovereign wealth fund would be an inappropriate name since the fund would in fact be funded by driving the rest of the economy further into debt.

Contrast this with Norway which runs current account surpluses from which it follows that (T – G) + (S – I) is a positive number. As long as their SWF does not exceed the current account surplus, then money can be set aside while still leaving the net government and private sectors in surplus. Norway is accumulating sovereign wealth and is able to set aside this wealth in a SWF without making its economy indebted. Australia on the other hand, by running current account deficits is not accumulating sovereign wealth. While one sector of the economy, mining, may be doing very well, as a nation you have to ask “what sovereign wealth?” If an investment fund was created it would be from money which drives the remainder of the economy further into debt. Perhaps “sovereign debt fund”, SDF, would be a better description of such a fund. Creation of a SDF would have a negative effect on GDP growth.

This analysis of the national accounts also ties in to discussions about balanced budgets. We can see that if T – G = 0, i.e. the government balances its budget, then the private sector must carry the debt burden arising from the current account deficits. This presumably hasn't occurred to politicians from either persuasion who thump the table about the need for the budget to be balanced, or even worse for the budget to go into surplus. A balanced budget in these circumstances of endless current account deficits is likely to hamper GDP growth.

However should it be decided, for whatever reason, political or ideological, that Australia needs to run a sovereign investment fund, or needs to balance its budget, then the national discussion would be better off focussing on the structural reasons for continued current account deficits, since mandating a balanced government budget merely shifts the debt burden to the private sector rather than addressing the source or cause of the debt.

On the other hand the purpose of this article is not to make a case for or against current account deficits, but to note that if they exist it follows that an equivalent deficit must exist among the private and government sectors.

In summary while Australia is experiencing a mining boom it doesn't have sovereign wealth in the same sense as other countries that run successful sovereign wealth funds. So to the question of whether or not Australia should have a sovereign wealth fund I say “what sovereign wealth?”

What sovereign wealth?

Glenn Stevens recently noted that Australian households grew their consumption faster than their incomes from the mid 1990s till 2006 and that this wasn’t particularly sustainable. He produced the below chart.

As a nation we have consumed more than we have produced in 52 out of the last 53 years, and as the chart below shows, the growth in imports has far outweighed the growth in exports over the past decade. Is that sustainable? (note the chart is a chain volume measure and the $ values are not representative of the current price value of exports and imports)

*As a side note, the country is made up of its households and businesses so we would expect the country aggregate situation to be similar to households in aggregate.

As a backdrop to this situation, the Australian economy is in debt to the rest of the world, with a debt balance that continues to grow due to our persistent current account deficits (graphs below).

This background is an important consideration for policy makers listening to calls for Australia to establish a sovereign wealth fund (SWF) with revenue generated from a resource rent tax (let’s put aside the political debate for a moment).

Blogger Wildebeest has explained that in these macroeconomic conditions, a sovereign wealth fund is necessarily comprised of public and private debt. To use an analogy of the household, Australia would be investing in foreign markets by mortgaging the house – borrowing from foreigners to invest in foreign economies. We don’t actually have any sovereign wealth to speak of, unlike other countries where such funds operate (such as Norway and Saudi Arabia – see chart below comparing the current accounts of a selection of countries).

Even if as a nation we produced more than we consumed to actually generate sovereign wealth, there is a strong argument that we should use the income to continue to invest in our own economy, not in the economies of others. There is also an argument that a fund that simply chases short term returns abroad is not being used in the best long term interests of the country.

When some people talk about a sovereign wealth fund, as I have in the past, it usually goes hand-in-hand with some kind of tax regime to equalise the two speed economy – resources vs services and manufacturing. But these issues should be separated. By all means, if the people decide that fiscal policy should be used to ‘balance out’ the economy, then I see no reason not to. But whether the revenues from some kind of ‘equalising taxation’ should be invested abroad to protect the exchange rate is another question entirely.

I will expand these arguments surrounding optimal investment of surpluses in another post. Today, I want to explore in more detail why Australia, blessed with a massive capacity for agricultural production and plentiful mineral and energy resources, has consumed more that it has produced since WWII.

No doubt we are all aware that the terms of trade measure, the ratio of prices of exported goods to imported goods, is at an all time high. But terms of trade calculations tell us nothing about the volume of the countries' exports, and the net financial position.

A better measure of the international performance of a country is the current account, which considers volume, price and ‘non-traded’ financial transactions include ownership of foreign assets. A deficit in the current account occurs when a country's total imports of goods, services and transfers is greater than the country's total export of goods, services and transfers. This situation makes a country a net debtor to the rest of the world.

Australia has run a current account deficit every year since ABS records start in 1959, except the 1972/73 financial year. Indeed, Australia economic growth in light of the persistent deficits has lead to the Pitchford Thesis, which contends that after the floating of the exchange rate the current account deficit was the residual outcome of rational optimizing decisions of private agents ...[therefore] the policy of targeting the reduction of the current account deficit... was misconceived.

Whether this is a logical position is a debate for another time.

So let us take a look at the data to see exactly why Australia’s current account is persistently in the red.

First, the chart below shows the monthly balance of trade in goods and services in current dollars. Notice that it is rare for us to even export a higher value of goods and services than we import, happening just 4 out of the last 32 years. As the second chart above showed, with the recent trends of import volumes growing faster than export volumes it will get even more difficult to maintain a trade surplus if the terms of trade return to historical norms.

Next, we explore the capital and financial accounts, which measure changes in ownership of financial and non-financial assets, capital transfers, and transactions between residents and non residents. In particular, the account known as primary income, and the part of this account called investment income, is the key to understanding the current account. The ABS gives the following definitions -

The primary income account shows primary income flows between resident and non-resident institutional units. The international accounts distinguish the following types of primary income: compensation of employees; dividends; reinvested earnings; interest; investment income attributable to policy holders in insurance, standardized guarantees, and pension funds; rent; and taxes and subsidies on products and production 

Investment income is income generated by financial assets. This includes dividends paid on direct and portfolio equity investments and interest paid on debt securities and other debt instruments.

The investment income category shows that $21billion of investment revenue is heading out of the country each quarter (ABS Cat 5302.021 column D). Important observations include the $4billion of income from shares and $7.6billion in interest generated (down from a peak of $8.4billion in 2007) leaving our shores last quarter. On the other side of the ledger, $3.5billion in income from shares and just $277million of interest entered Australia from abroad.

The graph below shows the balance of these two items alone (which comprise about 50% investment income). By my reasoning this means that foreigners are buying up more assets - property (the media has taken note of this in agriculture) and shares - and lending more to local households and businesses over time.

On primary income alone, Australia was $50billion in the red this past year. It takes a lot of trade in agricultural and mining products to offset this transfer of financial assets, and our best effort was a peak of $23.3billion of net exports of goods and services over the past 12 months with an all time high terms of trade (noting that even the balance of trade is usually negative).

So not only do we usually import more than we export, we sell more domestic assets than we buy foreign assets, and the incomes from the transfer of assets to foreign ownership far outweigh the value of the actual trade of goods and services.

A quick example.  The government owned business Telstra was privatised, and 25% of the company is now foreign owned.  That purchase by foreigners was a transfer of assets to foreign ownership as part of the capital accounts, and the dividends earned on the foreign owned portion now leave the country as part of the deficit in the primary income balance of the current account.  The same applies to foreign purchases of agricultural properties, mining shares, and lending to Australian businesses.

For the past 50 years is seems that Australia has been selling off its bountiful natural assets, and going into debt to the rest of the world. It makes me quite frustrated to even suggest that a fair portion of foreign debt incurred in the past decade was used to pay each other higher prices for existing houses, doing nothing to improve our productivity as a nation.

In a later post I will consider the Pitchford Thesis and policy remedies in more detail, including the role of the Foreign Investment Review Board.

RBA pragmatism and global stagflation

Since the higher than expected CPI print last Wednesday, the economic blogosphere has flooded our screens with opinions on the likely RBA decision at its board meeting tomorrow. Some have argued that the CPI was filled with ‘once-off’ movements in price (eg, the deposit and loan facilities and some fruits) and should therefore be taken with a grain of salt. Others have argued that the CPI is clear evidence that the RBA should move on interest rates to get ahead of the inflation curve.

I have a different opinion.

Raising the cash rate while Australia could be in a technical recession is a situation the RBA needs to avoid more than anything else. Think about the criticisms – “How could our central bank be so out of touch?” “Give Glenn the boot!” The very institution itself would be at risk. Forget demonstrating independence. Self preservation is the name of the game (note also that the inflation target is not a mandate of the RBA, but its own interpretation of how to fulfil is statutory role).

Therefore, the only logical decision for the RBA board tomorrow is to leave the cash rate unchanged, even if it has strong concerns about inflation. It is the same action central banks are taking in the UK and other developed countries in similar situations.

But there is more to this story. The present bout of high inflation and low growth is global, and there is little our domestic policy can do to intervene. Further, I suspect that this has much to do with physical constraints to global oil supply (at least in the short term).

As I said two years ago during the financial crisis –

...some interesting trends should occur in the next year or two. First, we should see the price of oil rise again from its current price of around $60 a barrel. Second, we should see an increase in the inflation rate on a relatively global scale. (Note that in the UK, inflation is currently at 4.4%. With the base interest rate at 4.5%, the real interest rate is now effectively zero). Third, we will see a sustained decline in global output. Taken together, a recipe for stagflation. (I also predict continued volatility on financial markets as demand and supply expectations feed back on each other).

The following three graphs show the oil production, oil price and the correlation between oil price and inflation in Australian, Asia, and other developed markets (DM). (Thanks Ricardian Ambivalence for the third graph).

The simple explanation for oil price led inflation is that a century of capital equipment, particularly in transport, is reliant on oil, has very little ability to substitute to other energy sources.  Therefore, the cost of goods is at the mercy of the oil price due to our invested capital.

Typically, there is an expectation oil production will respond to higher prices. But if there are short term physical and technological limitations, this cannot occur. In 2007 the oil price was double the price in 2005, yet total global oil production was identical. If there was not a physical limit to oil production, oil producers should have responded to this price by greatly increasing supply.

Ricardian Ambivalence has weighed in with an opinion that global inflation is not about oil. Oil price leading inflation globally in the above graph is explained away because “Oil leads CPI, in part, because variations in demand lead variations in CPI”. There may be some element of demand and oil price as co-contributors to price volatility, but my suspicion is that physical production limits to oil are the key.

Indeed, the reason these limits are having such a dramatic effect is because they were not foreseen, and investment decisions were made on the expectation of higher volumes of oil available at similar prices.

As a final statement, I want to address the ‘lunacy’ of peak oil. Many economic thinkers rule out the possibility of such an occurrence, as high prices lead to more inaccessible reserves becoming viable, as well as substitute energy sources becoming economical. Yet the recent evidence is that global oil production is back where it was in the late 1990s even though the oil price is more than 5x higher. This doesn’t seem consistent with the economic rationalism, which ignores the major prolonged adjustments necessary for these investments and subsitutions to occur.

Some may still be arguing in their mind that the reason for lower oil production currently is because of a global demand slump. But again, this fails to explain why we are willing to pay 5x the price for oil, and producers are not willing to sell any more oil at that price.

In the end, Australia is at the mercy of global forces as much as anyone, and it would be foolish for the RBA to believe that our domestic interest rate will have any significant effect on inflation without crushing our economy.

The housing market's 'once-off adjustment' meme

There is a meme floating around which has its origins in Chris Joye's numerous articles on the Australian housing market. While I often challenge Joye's economic arguments on this blog, I hope that readers realise this is simply part of a rigorous intellectual debate, and not a personal attack. Indeed, I admire his quest to provide better housing data, and agree with quite a few of his economic and political beliefs.

The meme is that the surge in debt levels and the price of Australian homes since the late 1990s was a once off adjustment to a period of low interest rates and inflation. Therefore, if these conditions hold, current prices are sustainable.

RBA Governor Glenn Stevens mentioned this 'once-off' adjustment in his recent speech 

The period from the early 1990s to the mid 2000s was characterised by a drawn-out, but one-time, adjustment to a set of powerful forces. Households started the period with relatively little leverage, in large part a legacy of the effect of very high nominal interest rates in the long period of high inflation. But then, inflation and interest rates came down to generational lows. Financial liberalisation and innovation increased the availability of credit. And reasonably stable economic conditions – part of the so-called ‘great moderation’ internationally – made a certain higher degree of leverage seem safe. The result was a lengthy period of rising household leverage, rising housing prices, high levels of confidence, a strong sense of generally rising prosperity, declining saving from current income and strong growth in consumption. (here) 

Chris Joye recently reiterated the argument here

This was a once-off "level-effect" (ie, sustainable adjustment reflecting the huge reduction in the cost of debt), not a permanent growth effect, and now these ratios are flat-lining. This is why the household debt-to-disposable income ratio, as shown below, has gone sideways since 2005, years before the GFC first materialised. That is, credit has been tracking incomes, as you would expect.

The household debt to disposable income graph is below, as is a graph demonstrating the structural adjustment of interest rates.

What makes this meme powerful is its truth. Australian interest rates did see a structural adjustment in the mid 1990s. There is also no denying that lower interest rates should lead to asset values rising relative to other prices in the economy. It also makes sense that the level of debt able to be sustainably managed, as a portion of incomes, is greater.

In the housing context, the 'once-off adjustment' argument can be demonstrated as follows.

Prior to the structural adjustment in interest rates, a buyer looking to buy a home that rents for $15,000pa, who is willing to pay a 20% over the cost of renting to buy the home, would capitalise $18,000 at the going rate of 12.8%. That's a price of $140,625. After a structural adjustment, the cost would be capitalised at 7.3%, giving a price of $246,575. A 75% real price increase should be as sustainable as the previous price (almost).

The same calculation can be made against household income, where for a fixed percentage of incomes, a 75% greater price, and level of debt, can be sustained.

Unfortunately, this logical argument only accounts for a part of the debt build up and house price growth since the mid 1990s. The RBA graphs of household finances and real house prices (below) show clearly why this is the case.

The graph of interest paid as a proportion of disposable income shows that the actual cost of debt relative to incomes has doubled (4% to 8%) since the mid 1990s. This is clear evidence that much of the debt binge, and the subsequent house price inflation, is not attributable to the 'once-off adjustment'. This adjustment would only account for the amount of debt, and home prices, that could be supported with interest costs of 4-5% of household incomes - not 8%.

The RBA also shows that real home prices have more than doubled (100% growth) since the mid 1990s to 2007, rather than seeing 75% real gains. Indeed the 2009 boom saw real home prices inch up again (with some subsequent falls in real terms).

The ABS home price figures (though not ideal for this purpose) suggest that real home prices gained approximately 150% since 1996. That's twice what is expected from interest rate conditions alone.

To get back to that 'sustainable' point, either home prices need to fall by around 30%, or interest rates need to fall by 30% (mortgage rates to 4-5%), or some combination of the two (noting also the geographical disparity any correction is likely to have). With today's CPI print surprising many on the high side, the market prediction (and mine) of rate cuts by year's end seems far less likely.  The negatively geared housing investor should take note.  

In all, the meme is powerful because it is true, but dangerous because alone it is an incomplete explanation of debt and home price trends of the past two decades. What appears clear from the data is that we have overshot the expected price and debt adjustment due to the changing interest rate environment. With this in mind, the downside risks for property values appear to far outweigh any upside potential.

Is Australia a net food importer?

Measuring food is difficult. Do we use kilograms, or calories?

I’ve covered the value of food security before.  But the obvious truth that Australia is a massive exporter of food, in terms of both kilograms and calories, does not stand in the way of the grocery lobby group, the Australian Food and Grocery Council (and yes, I am very late to this story).

Here are some examples

This alarming result shows food and grocery manufacturing – which employs 288,000 people – is now a net-importer of food and grocery products which impacts industry’s growth and competitiveness (here)

But Ross Gittins' b%&*$it detector was straight on to it

According to figures compiled by the Department of Foreign Affairs and Trade, last year we had total exports of food of $25.4 billion and total food imports of $11 billion, leaving us with a surplus of $14.4 billion. Even if we ignore unprocessed and look only at processed food, we still had a trade surplus of $5.8 billion. (here)

He continues to pick apart the claims.

So how did the food and grocery council get exports of $21.5 billion and imports of $23.3 billion for 2009-10, giving that deficit of $1.8 billion? By using its own definition of ''food and groceries''. We're not talking about farmers here, but the people who take their produce and process it for supermarkets.

So the council's figures exclude all our unprocessed food exports, including wheat (worth $4.8 billion in 2009), other grains and live animals. On the other hand, they include ''grocery manufacturing products'' such as medicines and pharmaceuticals, plastic bags and film, paper products and detergents.

That's food? It turns out that our exports of ''groceries'' totalled $4.9 billion in 2009-10, whereas our imports totalled $12.9 billion, leaving us a ''grocery'' trade deficit of $8 billion. This is hardly surprising. Since when was Australia big in the manufacture of medicines? If you leave out groceries, the report's figures show we had exports of processed food and beverages worth $15.9 billion, compared with imports of $9.9 billion, plus exports of fresh produce worth $700 million against imports of less than $500 million.

That leaves us with a trade surplus of $6.2 billion for fresh and processed food and beverages. We've been conned.

This all leads me back to the arguments I made about the value of food security. If food security is important, why isn’t computer security, or medicine security, or car-making security, or plane-making security, or any other "fundamental economic ingredient" security given the same attention? Indeed, we could not produce the amount of food we currently do without imported picking, packing and transport equipment, so unless we secure those, we won’t even have food security.

The graph below is a final reminder about our food net export position relative to other nations, and our relatively low direct agricultural subsidies.

The Believing Brain

Michael Shermer talks about his theory of the brain as a ‘pattern believing machine’.  Put simply, we first believe in patterns subconsciously, then add logical explanations post hoc. This partly explains why debating passionate people on their topic of choice often leads each person more entrenched in their beliefs than afterwards, since logic doesn’t govern our already held subconscious beliefs.

He has a book exploring the idea in more detail, and if you want another brief take on his theories you can read one of his articles here.

And the conclusion from one reviewer -

Having presented the case that we form beliefs on the basis of unconscious, often irrational processes, and that all our argumentation in support of these beliefs is then added post hoc and subject to a wide range of cognitive biases which he lists and explains, Dr. Shermer leaves us in a near-hopeless state. The human condition, according to this perspective, is one of deep-rooted, biased subjectivity and perpetual, unresolvable conflict between believers with different sets of beliefs.

Real per capita wealth trend

As part of my recent habit of examining trends from the perspective of the individual, or household, I have compiled a measure of real net wealth per capita.

The reason for this is to add another perspective to the more general question of how the Australian economy has fared post-GFC.

As you can see, the average Australian's real net wealth is exactly where it was at the end of 2006.  Have we really spent four and a half years just treading water?

The interesting relationship is between the trend in real wealth and the trend in retail turnover.  The 2007 peak of per capita wealth also happened to be the end of the growth trend in retail spending.  It is also important to note that in the last decade, home values have comprised around 60% of total household assets, which leads on to conclude that the fate of retail rests heavily on the fate of home prices.

The Sydney housing boom ripple effect

Sydney is different. Since 2003 rents have risen faster than prices. I imagine the rest of the country would find that hard to believe, given their experience. But this is just one piece of evidence to show that the property cycles in Australian cities are nonsynchronous.

The past twenty-five years of data show that the Sydney residential property market is the least volatile, and is always first to boom. In fact, you can chase the price growth ripples from Sydney and Melbourne across the country – to Adelaide, Brisbane, Perth then Darwin. This might be one reason that such divergent opinions exist in the media, academic and professional circles.



If we looked only at the above graph, we would note that the two biggest markets, and arguably most attractive cities, have had the least growth since 2000. That seems particularly counterintuitive.

But if we look long-term the explanation is clear – Sydney and Melbourne had their major boom years before the other cities in the late 1990s.

Each of the charts that follow this post compare the timing of booms in capital cities against Sydney’s booms. The blue background shading matches the Sydney boom periods, with the red shading the boom periods of comparison cities. This exercise reveals a number of things.

• Sydney and Melbourne booms in the 80s and 90s started and finished within a year of each other. In fact, their cycles are the most in synch of all markets. 
• Brisbane lagged Sydney’s late 1990s boom by 4 years – making it an early 2000’s boom. This appears connected to the fact that Brisbane’s 1980’s boom lasted about 4 years longer than Sydney’s. 
• Adelaide followed Sydney’s lead more closely than Brisbane in the 1990s, and lagged Syndey more closely in the late 1980s. 
• Perth’s 2000s cycle was similar to Brisbane, although in the 1980s it had sharper and shorter price rises. 
• Darwin is a world of its own - booming when other capitals had prices tracking below trend. 
• Brisbane, Melbourne and Perth prices have been ‘catching up’ to Sydney over this 25 year period. This could be because the quality of homes is catching up to those in Sydney, and also due to a convergence of income levels between the cities. 
• For some reason, Adelaide is falling behind other major cities (lowest long term growth trend) 
• Sydney never falls as far below its trend as any other city. My eyeballing suggests that price volatility is lowest in Sydney. 

This might have lessons for property investors outside of Sydney. If you are in Brisbane, Perth or Adelaide and follow the Sydney trend a couple of years behind, you will do well. If prices are flat in the major capitals, take your money to Darwin.

What about from 2011 on? Sydney appears below its long term trend, and it rarely drops far below this trend. The other capitals are above their trend and do fall quite far below trend during economic downturns. My personal view is that Sydney stability will continue.

The other question to ponder is the trends in this period could validly be applied from now on. Deleveraging is the most important new consideration, and we have seen the dramatic affects this can have on asset values if we simply look to the US and some European property markets.

My expectation is that prices will fall until such time as yields are high enough to be attractive to investors who aren’t expecting capital gains in the near future. To me, this might mean yields might get higher, relative to interest rates, than we have seen for 30 years. And for that to happen, prices will fall. Of course, if the RBA drops rates significantly, this will dampen falls, but I doubt lead to the market grinding out modest growth (ie. matching inflation) for a couple more years yet.

Economic images

Sometimes I stumble across humourous images and quotes in which I instantly find a deeper meaning. Here are a few recent ones, and my accompanying thoughts.

The first I stumbled across at Bryan Kavanagh's blog (which is worth a read).

What makes it funny is that it is so close to the truth. To me, the deeper meaning is that we have lost an understanding with what real productivity actually is.

The next image can be found all over the web now, but to me provides insights into exactly how new technology integrates into society. 

While we can laugh that the publicly run enterprise is stuck with 1960s technology, to me it says much more. It shows that aggregating many new technologies (computing, flight control, materials etc) into one much larger and more ambitious technology (the space shuttle) takes a long time. Also, it shows me that there are lock-in effects. The car has not changed much at all. This is partly because roads and associated infrastructure are still much the same, and drivers are trained to use the same controls in the car itself. This limits scope for macro improvements in car transport. The same applies to the space shuttle.

I also stumbled across this quote -

As Douglas Adams wrote in 1999, "Anything that gets invented after you're thirty is against the natural order of things and the beginning of the end of civilisation as we know it until it's been around for about ten years when it gradually turns out to be alright really." Yes, the world is different now. Do try to keep up 

This is an important one to keep in the back of our minds when we imagine seeing society deteriorate before our eyes.  I recall that the ancient Greeks worried about the proliferation of written texts, because it meant people no longer needed to remember and recite long passages. Only if you could remember a passage word for word did it show you truly understood its meaning.