RBA committing logical errors regarding Australian household finance

March 31st, 2009

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Ric Battellino, the deputy governor of the Reserve Bank of Australia (RBA) gave a speech today. Regarding Australia’s household finance, he said,

We continue to believe that the market here will hold up better than overseas. There are a number of reasons why this is likely to be so, but perhaps the most important is that we did not have the same deterioration in lending standards that occurred elsewhere. By and large, the great bulk of Australians who took out housing loans have been able to afford the repayments. Notwithstanding some rise over the past year, the 90?day arrears rate on housing loans is only 0.5 per cent, which is broadly in line with its long?run average and well below that in countries such as the US and UK.

As he said that, we imagine he was thinking somewhere along the line like this:

  1. US sub-prime loans resulted in bad debts
  2. Bad debts busted the US economy
  3. A busted US economy led to higher unemployment
  4. Higher unemployment led to more bad debts
  5. And so on…
  6. Because Australia has very little sub-prime debt
  7. Therefore Australia’s economy is not likely to be as busted as the US

If this is what he’s thinking, we think Ric Battellino has made a very grave error in logic. He’s mixing up cause and effect.

No doubt, in the US, it’s sub-prime (which by the way is yesterday’s story) that triggered the bust in the US economy in 2007. But for Australia, it’s the deterioration of  the global economy that will trigger the bust of the Australian economy. The effects of a bust will be rising unemployment, followed by bad debts, then debt deflation and then finally falling asset prices. In other words, the triggers are different, but the effects will be the same because Australia has the same debt disease as the US and UK.

Given Australia’s high household debt (see Aussie household debt not as bad as it seems?), prime debt can easily turn sub-prime when unemployment rises. As unemployment rises (which all mainstream economists in the government and private sector are forecasting), it will eventually reach a critical mass of prime debts turning sub-prime. Once this critical mass is reached, the deterioration in the Australian economy will accelerate (see what’s happening in the US and UK today). This is the point we made in March 2007 at Can Australia?s deflating property bubble deflate even further?,

In Australia?s case, with her towering levels of debt, any external shock can easily tip her over to a recession, which can lead to further asset (e.g. real estates and stocks) deflation.

By now, it should be clear that whatever the external shock is not the issue?the point is that Australia is highly vulnerable.

To make matters worse, the First Home Owners’ Grant (FHOG), while giving housing sector a temporary boost, are increasing the proportion of potential sub-prime loans in the financial system.

The fact that those at the helm of the RBA are committing such logical errors does not engender our confidence.

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