Posted: November 08, 2006

Macroeconomic madness

Today's 0.25 per cent rise in interest rates by the Reserve Bank of Australia (RBA) is a sign of the madness that goes for macroeconomic policy these days. This is the third rate rise since May 2006 and short-term rates are now 6.25 per cent. The yield curve has been inverting for a while now - which means that short-term rates are higher than the longer term investment rates. When this happens the economy is slowing and typically sliding into recession.

The RBA defends its decision onthe basis of recent inflation figures which show that the acceleration in the price level remains above the RBA's arbitrary 3 per cent upper ceiling. When that upper ceiling was formulated, economic and social conditions in Australia (mid-1990s) were somewhat different. For a start, we were just entering the period of fiscal retrenchment. We have now suffered 10 to 11 years of Federal Government surpluses which have ripped unprecedented amounts of liquidity (purchasing power) off the private sector through taxes and denied the same sector essential public services through spending cutbacks. Second, and directly related has been the record buildup in household indebtedness. The legacy of this credit binge (driven by the Federal surpluses) has been that the household sector in parts is walking the tightrope between solvency and bankruptcy. What will tip more and more households over into bankruptcy is rising interest rates on their bloated mortgages.

Add to this the impact of the drought on national growth and the residual impacts of the recent petrol price increases and you have an economy hanging on by its fingertips. If you examine the current labour market data in New South Wales, Victoria and South Australia, the traditional manufacturing states, you will see that they are signalling that these regions are already close to recession, if not already in recession. Unemployment is rising in South-West Sydney as manufacturing employment plummets. This is also where a significant proportion of the large (over-extended) mortgages are located. It is a recipe for a disaster.

When the yield curve inverts, historical experience tells us that recession is close. Not inevitable but a high probability.

Some media commentators are now, finally, picking up on this theme that I have been banging away on for some years now. They are acknowledging the role played by the financial engineers who pushed credit onto people in the last 10 years that transcended their capacity to pay in all but the best of situations. The mortgage brokers pushed up demand for housing and so you had the twin evil: (a) houses were being bought for much more than they were worth on trend (meaning prices peaked and have started falling); and (b) the loans were higher than the households could realistically service on trend (meaning if conditions changed a little - such as a period of rising interest rates the households would be in trouble).

While the Government crows that it has established conditions whereby households could pursue the Australian dream of home ownership, the reality is that the conditions they created - fiscal squeeze, lax credit - have denied many Australian households are either over-indebted and facing negative equity or just locked out of the housing market because of the asset price inflation.

No-one, the RBA, the Treasury, the Government ever admitted that the best of situations would not last and the sensitivity of the situation that they created to small variations in interest rates, for example, was huge. Home loan defaults are now growing rapidly - up 150 or so per cent in the last 5 years.

But it is clear that the banks will not suffer when the house of cards folds. Some commentators have indicated that the banks have solid mortage insurance and APRA believes that housing prices would have to drop by 30 per cent uniformally for the banks to take any significant losses. However, data reveals that about 1 per cent of borrowers (or 40,000 households) are now falling towards loan default as they get further behind in their repayments. That is a lot of forced sales in the wind. Meanwhile the Federal Government is building a series of smokescreens to take our attention away from their economic failure (such as the attacks on multiculturalism).

It has been estimated that households are now spending more on home loan interest than they are on education and health together. What has happened to our national priorities?

Blog entry posted by bill