We took a look at the latest insight note by Shane Oliver, AMP Capital Investors’ Chief Economist here. The summary of the note says:
Household debt has risen to record levels, particularly in English speaking countries including the US and Australia. Many fret, particularly with the credit squeeze now rolling through financial markets and pushing up borrowing rates, that this means the next economic downturn will be severe as leverage is unwound and consumers are forced to cut spending. While the risks should not be ignored, the problem is not quite as bad as it looks.
Shane Oliver, while acknowledging that “increased debt has led to increased risk” (and we have to give him credit for doing that), had listed 4 points why the rise in household debt is not as bad as it seems:
Firstly, household debt has been rising since credit was invented and the surge since the 1980s partly reflects a rational adjustment to greater credit availability…
Similarly, the rise in household debt partly also reflects a rational response to reduced economic volatility…
These 2 points are not really reasons for arguing why rising debt is or is not as ‘bad’ (whatever it means) as it seems. Basically, the underlying meaning of these points is that debt had been rising for the past decades without any serious consequences and therefore we should not worry about it rising any further in the future. This is a very good example of a common mental pitfall called Lazy Induction. In this fallacy, a generalisation is being made from a biased sample. All we have to do to disprove this flawed conclusion is to provide a negative example (see Mental pitfall: Lazy Induction for more details).
Thirdly, the rise in debt has been matched by a rise in wealth.
This is the most serious error that Shane Oliver makes. As we said before in The Bubble Economy,
First, let?s see the ludicrousness of the idea that a nation?s general rise in asset value equals a rise in wealth. In a nation?s stock of real estate, only a tiny fraction of it got sold and changed hands in any given year. Those sale prices were imputed into the values of the vast majority of the other properties that never got traded in the market. Therefore, in a rising market, the vast majority of un-traded properties have rising imputed values, which is commonly described as ?rising asset values.?
If a portion of these wealth-holders decide to liquidate those ‘wealth’ simultaneously, guess how much of these ‘wealth’ will remain? As we said before in Spectre of deflation,
One thing many people fail to understand is that values of financial assets can vanish as easily as they are created in the first place. It is a fallacy to believe that just because money has to move somewhere from one asset class to another, the overall valuation in the financial system cannot contract. The very fact that all the money in the world cannot buy up all capitalisation is proof of that fact. This leads us to the next question: how do financial assets derive their value?
As we mentioned in The Bubble Economy, we have to understand the principle of imputed valuation. Suppose you have a house which you bought for $100,000. What happens if one day, your neighbour decide to sell his house (which is similar to yours) for $120,000? When that happens, your house would have to be re-valued upwards to $120,000 even though you had done absolutely nothing. The same goes for stocks. All it needs for a stock to increase in value is for a pair of buyer and seller to transact at a higher price. As long as the other shareholders do absolutely nothing, that higher price will be imputed into the values of the rest of the stocks. Thus, when asset values rise, all it takes is a handful of them to trade at higher prices in order for the rest to be re-valued upwards. If assets can ?increase? in value that way, it can ?decrease? in value that way too.
What is more worrying is that assets of such imputed values are used as collaterals for further borrowing, which becomes the borrower?s liability.
In other words, the ‘wealth’ that Shane Oliver mentioned is not real. Its value can vanish into thin air in times of deflation! On the other hand, the debt that is supposed to match the ‘wealth’ is real. No matter what happens to the value of the asset, the debt that financed the purchase of that asset will still remain.
The last point that Shane Oliver made:
Fourthly, Australians do not appear to be having major problems servicing their loans.
Does Australians have a problem servicing their loans? This is the wrong question to ask. As Professor Steve Keen of UWS as pointed out in his DebtWatch, the point is that such rise in debt is unsustainable in the long run. It will come to a point when the debt-servicing burden of the nation becomes so great that it will choke on economic growth, resulting in debt deflation. Australia has not yet reach that point, but it will be in due time given the rate of debt growth (see An update on Australia?s money supply growth). The outcome will be very nasty when it happens.
Next, Shane Oliver said,
The whole of the post-war period has been characterised by steadily rising debt levels and each time there is a financial crisis fears grow that the prior increase in leverage will result in economic collapse and that cutting interest rates and other methods of reflation won?t work. But it always has worked. There is no reason to assume that it won?t work this time around.
Wrong!
It did not work in Japan! Remember Japan’s infamous zero-interest rate monetary policy as well as massive government spending fiscal policy? Yet, deflation dogged the nation for more than 16 years. There is only one way to fight deflation and that way leads to hyperinflation (see Recipe for hyperinflation).
Finally, Shane Oliver said,
However, the risk of a major catastrophe is judged to be low as the rise in debt appears to reflect a rational response to reduced economic volatility…
Is volatility a valid definition for risk? See How the folks in the finance industry got the idea of ?risk? wrong!.
The underlying message in Shane Oliver’s note is that the risk of debt deflation is low in Australia. As he said,
While the risks should not be ignored, the problem is not quite as bad as it looks.
We are not sure what he meant by “should not be ignored.” But dear readers, we would like to stress again that the issue is not just whether the probability is low or not. The issue is the probability in conjunction with the size of its impact. As we said before in Common mistakes in failing to see economic turning points,
The importance of a particular event is the likelihood of it multiplied by its consequences. Black Swan events are events that are (1) highly unlikely and (2) colossal impact/consequences. One common mistake investors (and many professionals) make is to look at the former and forget about the latter i.e. ignore highly unlikely but impactful events.
A severe downturn to the Australian economy may or may not be statistically likely, but given the level of unprecedented leverage, you can be sure the impact will not be small. Be sure to understand the concept of Black Swans (see Failure to understand Black Swan leads to fallacious thinking).
