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Australia: trapped by cheap credit

The Reserve Bank of Australia has all but conceded that Australia is trapped in a debt and asset price bubble – a bubble we can’t escape from without significant pain.

Last month, the RBA, through its July board meeting minutes, introduced into the economic lexicon the concept of ‘neutral real interest rates’. It defines these as the nominal cash rate (set by the RBA board) minus inflation that facilitates economic growth at its potential while simultaneously achieving stable inflation.

Despite being unobservable and subject to estimation uncertainty, the central bank has estimated that the neutral real interest rate for Australia is currently equivalent to a nominal cash rate of 3.5 per cent.

In layman’s terms, the RBA is saying that it is unable to raise its overnight cash rate above 3.5 per cent or the economy will grow below potential gross domestic product, which the 2017 federal budget stated would be 2.75 per cent per annum over the medium term.

Given recent Australian economic history, this is a stunning statement.

It was only in 2009 in the aftermath of the global financial crisis that the then RBA governor Glenn Stevens told Australians that the RBA board’s decision to cut the cash rate to three per cent was an ‘emergency setting’.

Eight years later, a cash rate of just 50 basis points higher than this emergency setting is now alleged to be the maximum of what the Australian economy can take before placing significant downward pressure on GDP growth.

The RBA argues that lower potential GDP growth and greater risk aversion have played a role in reducing the neutral real interest rate by 150 basis points since 2007, which in part explains their 3.5 per cent estimation.

However, consider that from April 1990 to September 2008, the average RBA cash rate was 6.29 per cent and even if the post-GFC period is considered with its very low rates of interest, the long-term cash rate average since the last recession is 5.24 per cent.

What this means is that the RBA is unable to normalise monetary policy back to its long-term average without some form of economic disruption given record economy-wide debt, particularly household debt, and record asset prices such as in housing.

The rate of interest which would cause disruption to economic growth remains a point of debate among some economists, especially the potential scale of that disruption resulting from adjustments to asset valuations, household consumption, debt servicing obligations and delinquencies. AMP Capital chief economist Shane Oliver, for example, recently stated that the economy is likely to be able to only handle a cash rate of 2.75 per cent.

The inability and the justification of why the RBA is not able to normalise its overnight cash rate to its long-term average is significant and requires closer scrutiny.

With respect to the RBA’s claims regarding potential GDP, consider that from 1983 to 2011, the Australian economy experienced lower average real GDP growth across four subsequent periods when unemployment was falling.

For example, average GDP growth across October 1983 – December 1989, September 1993 – July 2000, October 2001 – August 2008 and July 2009 – June 2011 when unemployment fell was 4.6 per cent, 4.2 per cent, 3.5 per cent and 2.2 per cent respectively.

While factors such as ageing demographics, increasing taxation and regulatory costs and sluggish multifactor productivity growth may in part explain this phenomenon, Australia’s record and growing debt, particularly in the non-government sector, is likely to be a much more significant factor in explaining declining average GDP growth and therefore potential GDP growth than what mainstream economists and policy makers currently give credit to.

In an economy where growth has been significantly fuelled by growing consumption and debt, it makes intuitive sense that there are natural mathematical limits to how much debt individuals and corporations can assume and service relative to their income.

In Australia’s case, those natural limits have been expanded since the GFC through record low-interest rates and the take-up of innovative financial products such as interest-only loans.

Importantly, the inability to normalise the overnight cash rate poses additional risks.

To date, as judged by their current policy settings and official statements, the RBA has assessed the current level of systemic risk to the financial sector and to the broader macroeconomy to be manageable, especially as new aggressive macroprudential controls have been introduced by the Australia Prudential Regulation Authority.

However, despite these new controls, Australia’s macroeconomic structural imbalances continue to worsen as measured by household debt relative to disposable income, a point which the RBA board conceded in its August 2017 board meeting minutes. Lending for housing continues to grow faster than the growth in household incomes and has now reached in excess of $AUD 1.69 trillion, larger than Australia’s current GDP.

Central bank officials should heed the words of former Governor Stevens who warned in 2012 that interest rates which are left too low for too long are likely to render macroprudential controls ineffective in stemming systemic financial risk.

It remains to be seen whether the RBA has a full comprehension of the systemic risk profile facing the Australian economy.

Absent from its official statements and speeches by senior officials is any serious discussion or assessment regarding the robustness of foreign economic institutions, the quality of their regulatory frameworks and administrative oversight or the behaviour of significant market participants.

Given the high degree of interconnectedness among the world’s largest financial institutions as reported by the International Monetary Fund in 2016, monetary and financial policy deliberations by the RBA must encompass not only considerations of domestic institutional and regulatory settings, but the settings of other major economies, especially that of the United States and China.

The previous performance of the RBA has not been particularly strong in this regard as they were effectively blindsided in the lead-up to the GFC to the failures of American institutional and regulatory frameworks that contributed to the sub-prime mortgage crisis and the subsequent collapse of Bear Sterns and Lehman Brothers.

Alarmingly, many deficiencies in the American system responsible for the GFC were never addressed by the Obama administration or the US Congress and are not core tenets of the Trump agenda. Moreover, the quality of institutional, regulatory frameworks and administrative enforcement by the Chinese government remain immature and highly questionable given the geopolitical priorities of its ruling communist party.

The RBA is trapped, yet economic history tells us that the current cycle of record debt, record asset prices and ultra low-interest rates cannot go on forever.

The longer the RBA waits to normalise interest rates, the more that macroeconomic structural imbalances and systemic risk will continue to grow. This means that it will only take a relatively smaller increase in interest rates, either domestically or internationally, to deflate Australia’s largest ever debt bubble most likely in a catastrophic manner.

John Adams is a former Coalition advisor

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