Will the Australian Dream Lead Us Into a Debt Crisis?

Australia has one of the highest household debt levels in the world. Our primary motivation for borrowing has been to fulfill the Aussie home ownership dream. As house prices have surged, so has the need to borrow big.

While credit card and personal loan debt has remained relatively stable, mortgage debt has skyrocketed. According to recent data from APRA, Australian owner-occupier home loan liability is now at an all-time high – more than doubling in the last 11 years. In December 2004, the outstanding mortgage debt per Australian adult was $20,802. By December 2015, that figure had ballooned up to $49,165.

In light of our proclivity to borrow, famous Australian economist Steve Keen ranked Australia in a recent Forbes article as number two on the list of seven nations that are most likely to face a debt crisis and recession in the next three years. The only country more likely is China, which also doesn’t bode well for our economic future.

Steve Keen has been strongly influenced by the writings of Hyman Minsky, who I’ve written about in this post. They both believe the primary cause of a financial crisis is the accumulation of private debt.

The following is a three-point summary of how Keen sees the next few years playing out.

1. We can’t borrow like this forever.

The foundation of Keen’s prediction is his assumption that our current borrowing trajectory is unsustainable.

While lending to investors has fallen sharply, the drop has been almost entirely offset by an increase in owner-occupier lending. According to the RBA’s latest data, mortgage debt rose by 0.5 percent in January, making the annual increase 7.3 percent. This level of growth is below last year’s spring peak of 7.5 percent, but well above the 5.5 percent average from 2010 to 2014.

What kind of debt growth in sustainable? Keen believes that only a growth rate at or below the growth rate of the overall economy – measured in terms of GDP – is sustainable. A growth rate above that of the overall economy is not sustainable.

Our economy is currently growing at about three percent per year, so Keen sees anything above that as unsustainable. Our debt is now growing at over twice the rate of our economy, and has been outpacing GDP for decades.

So why does he believe this is unsustainable? Think about your household finances. If your personal debt is growing faster than your income, then eventually you’ll be unable to service your loans. We can only borrow so much, until our income increases.

This is exactly what Keen expects to happen on a broader level. As a nation, we’ll soon reach the point where there’s not enough margin left in our collective budgets to afford loan payments. People will stop borrowing, and credit growth will decline, and possibly even go negative.

Here’s a graph showing the growth in our economy in relation to the growth of private debt:

Keen expects to soon see the blue line fall near or below the red line. We nearly got there in 2010, but government stimulus bailed us out.

2. When we’re no longer willing or able to borrow, the economy will shrink.

The growth of any debt-based economy will always be dependent upon credit growth. We need people to borrow and spend in order to keep the economy growing at the current pace. In other words, the only reason the red line is trending up is because the blue line is pulling it along.

This is exactly why the RBA and virtually every other world central bank has been lowering interest rates. The aim has been to spur people to keep borrowing more and more in the hope of stimulating economic growth.

Central banks must keep credit growing faster than the overall economy in order to reach their stated goals for inflation, GDP-growth and maximum employment. The problem, according to Keen, is that perpetual credit growth is impossible to sustain.

If Keen is right, and credit growth soon falls or even worse, goes negative, there will be less demand for goods and services in the economy because people will have less money available to spend. After all, thanks to our fractional-reserve banking system, it’s the banks that create new money through lending, but when banks take in more money through repayments than they lend out, the money supply shrinks.

A shrinking money supply means that demand is draining out of the economy. Wages and capital gains must therefore decline. When demand falls, the economy begins contracting, and this is what economists call a recession.

3. When the economy shrinks, asset prices will fall.

The unintended side effect of an economic system that encourages debt through low interest rates is higher asset prices. When you make money cheap and easy to borrow, you encourage people to take on greater risk to achieve higher returns. People start investing more, sometimes unwisely, in assets like shares and real estate, because the risk-free return is so low.

As real estate becomes more attractive, it also becomes more expensive. This means people must borrow more money to pay for houses. Eventually, when the borrowing must stop, so does the buying. Demand falls, and then the value of the underlying assets falls, too.

This can be especially painful for those who buy during times of euphoria, when no one believes that asset prices will ever fall. As legendary investor John Templeton said, “Bull markets are born on pessimism, grow on skepticism, peak on optimism and die on euphoria.”

Typically, it’s the last ones who buy just before asset prices fall who are the ones who borrow the most, which means they are also the ones who have the most to lose.

According to Keen, and Mensky, you’ll know the party’s almost over when people who buy assets can only do so on interest-only loans. They must borrow so much to aquire the asset that they can’t afford to reduce their debt through principal repayments. They justify interest-only repayments on the assumption that asset prices will always increase, or that incomes will be higher in the future. They’re speculating on either asset or wage inflation, or both.

According to ASIC, one in four owner-occupier loans in Australia are interest-only. In a recent industry crackdown, the corporate regulator found that demand for interest-only loans has grown by 80 percent in the past three years alone. It seems like the number of people who can afford to pay down their principal is shrinking fast.

Most interest-only loans offer a period, typically up to five years, before they require additional principal repayments. What happens if these loans roll over and borrowers can’t afford the higher monthly payments?

Some banks don’t seem to care. ASIC found the following astonishing results after a lending industry review:

• In more than 30 percent of cases, there was no evidence the lender considered whether the applicant could afford their repayments over the long term.
• In 20 percent of cases, the lenders did not consider the actual living expenses of the applicants.
• In 40 percent of cases, the lenders had incorrectly calculated the affordability of the loan.

While Steve Keen believes the end of days for credit growth is soon approaching, he admits the timing of the inevitable is impossible to predict. No one knows exactly when people will stop borrowing or banks will stop lending.

We may even see our government kick the can further down the road, just as they did in 2008, through hard-core stimulus measures. If recent patterns of central bank intervention are any indication, property may have a few solid years of growth remaining.

Or perhaps not. As Keen says, the timing of “the inevitable” is impossible to predict.

What Do You Think?

Is Steve Keen right? Is our current level of credit growth unsustainable? Is deflation and an asset price correction on the horizon? What do you think this will mean for real estate values?

Or do you side with central bankers? Is the level of private debt irrelevant to the health of our overall economy? Can regulators save the day by devaluing our currency? If so, how high will property prices go?

By Jason Staggers

Jason was a personal mentor working with Steve McKnight's Property Apprentices. He helped hundreds of investors apply Steve's teachings in the real world and achieve greater results on their journey to financial freedom. Jason now lives in Perth, WA where he leads Neuma Church.