Posts Tagged ‘Steve Keen’

Planning ahead for what’s going to happen

Sunday, June 6th, 2010

How to buy and invest in physical gold and silver bullion

In our previous article, one of our readers asked,

With either a recession on the way or increased government spending and its effects in the economy, what does everyone think are some ways/ideas for investors to plan ahead for both scenarios?

This is a very hard question to answer because every investor’s situation, outlook and opinions are different. There’s no one-size-fit-all answer. But we hope this article will set you thinking about planning ahead for yourself…

In today’s highly volatile and unpredictable economic climate, it is increasingly difficult to forecast what will happen in the future. So, in that sense, it is increasingly difficult to plan ahead. As we wrote in October 2008 at Real economy suffers while financial markets stuff around with prices,

Right now, deflationary forces are acting on the economy while at the same time, central bankers and governments are attempting to inflate. Consequently, the result is extreme volatility in prices. Volatile prices hinder business calculations, which in turn hinders long-term planning.

With long-term planning made much more difficult, how is it possible to engage in investments that allows the nation to continue to accumulate capital goods? Without the ongoing accumulation of capital goods and too much monetary capital wasted on either hoarding, bailing out bad investments and patching a dysfunctional financial system, there wouldn?t be a proper and efficient allocation of monetary capital. The economy will be engaging on capital consumption. If a nation starts to consume its capital, how can there be real economic growth. Without real economic growth, how can future generations enjoy a more plentiful and prosperous existence?

The governments’ inflationary policies are intervening heavily to fight against the free market’s deflationary forces. The results are volatile prices and unforeseen side-effects (i.e. Black Swans). Recently, Marc Faber made a very good point:

It is no longer sufficient to analyze macroeconomic and microeconomic trends and individual companies and sectors; we now increasingly need the help of a political analyst who can warn us of what governments? next regulatory ?Schnapsideen? (ideas developed while heavily intoxicated) are likely to be.

Professor Steve Keen is a very good example of someone who fell victim to the government’s ?Schnapsideen.’ His call for deflation in Australia was shredded by Rudd government’s First Home Buyers Grant (FHOG), which resulted in him having to walk a long trek for a lost bet. Unfortunately for him, his economic analysis (which is sounder than the mainstream, vested-interest-tainted neoclassical economics), is discredited because of that. This is to Australia’s great loss because by re-leveraging the Australian economy (i.e. ignoring debt dynamics), the economic margin of safety is arguably thinner today than before the GFC.

Another example is the Rudd Government’s infamous RSPT (see Why Rudd?s mining super-profit tax will encourage more commodity speculation), which threw a spanner into the works of many mining investment plans.

This kind of environment is not conducive for long-term planning of great enterprises. For investors, that means some of your investments today will be affected tomorrow by a bureaucrat’s decision. Instead, such environment favours those (in the short term) who are nimble and fast at shuffling money across asset classes and national borders. It encourages hoarding and speculations. As we wrote in Harmful effects of inflation,

With inflation, there is less incentive to be productive and more incentive to hoard, speculate and gamble. This in turn will reduce productivity and increase price inflation, which further increase the incentive to be less productive.

For investors who are more conservative, it means spreading your eggs into more baskets. For example, if you want to hedge yourself against a potential AUD currency crisis (see Serious vulnerability in the Australian banking system), it may mean diversifying your wealth from AUD into foreign currencies and physical gold (see How to buy and invest in physical gold and silver bullion). For those who are concerned that the world may perhaps end up in hell, they may want to prepare themselves by learning more self-sufficiency skills, accumulating equipment and for those who are well-off, buy a farm in the rural area.

Yet, as we wrote in If we are going to be doomed, why don?t we head for the cave and stop investing?, it does not mean we should stop investing right this minute. Even if you believe we will all be doomed, there will still be investment opportunities in the meantime. For those who are less conservative, it may mean investing in sound companies (with your eyes and ears open) or making some speculative bets.

The point of today’s article is not that we should all throw long-term planning out of the window and eat, drink, be merry and bugger all the consequences. Instead, our point is that investors today have to be alert and be prepared to act in a moment’s notice and not be locked into any particular set of investment/trading ideology. Creative thinking and flexible mental model is very important to survive in today’s economic/political climate.

Significant slowdown for Australia ahead?

Sunday, May 30th, 2010

How to buy and invest in physical gold and silver bullion

Recently, we noticed a trend emerging in the Australian economy- retail discretionary spending seems to be falling off significantly. As this news article reported,

But conditions in the retail sector are savage. Consumers are buying less, despite one of the most ferocious discounting wars in history. With the two department store heavyweights, Myer and David Jones, battling it out for customers, the smaller retailers are caught in the crossfire, forced to match the prices or do better.

The latest Australian Bureau of Statistics figures show the household goods sector posted a sharp fall in prices, down 3.6 per cent, making it the second-biggest quarterly fall over the past 11 years. The first-quarter CPI showed particularly large price falls for furniture and furnishing, down 3.8 per cent, and audio visual and computing down 5.9 per cent. The next figures will be even uglier for retailers, whose margins are being cut to ribbons.

Elsewhere, Virgin Blue suffered a big fall in share price as it warned that

… earnings could plunge as much as 75 per cent due to a ”rapid deterioration” in demand from leisure travellers.

It seems that the retail industry is doing it tough. Sectors of the Australian economy related to consumer spending are in pain. Like the US economy, most of the Australian economy are related to consumer spending (say around 60%). Therefore, this trend, if continued, indicates that a major slowdown in the Australian economy is coming. A recession cannot? be ruled out.

The mainstream media will quote mainstream economists and put the blame on rising interest rates, Greek contagion and China? slowdown and so on. Blame will be laid on these “shocks” to the economy that cause consumers to “lose confidence.” That implies that to reverse this trend, consumers will have to be brainwashed to be ‘confident’ in order to spend their way to economic prosperity.

This is an example of voodoo economics for the masses. If this is the correct diagnoses for the ills of the economy, then we have a better idea for an economic ‘stimulus’ package (that will be much far more effective than the Rudd government’s $900 cash splash during the GFC)- distribute $900 worth of Myers/David Jones vouchers (that? will expire in 3 months time) to the masses. We can guarantee that within 3 months, consumers will regain their ‘confidence’ and spend, spend and spend.

Since consumer ‘confidence’ is the wrong diagnosis, then ‘stimulation’ is the wrong cure.? As we wrote in Will governments be forced to exit from ?stimulus??,

In fact, the word ?stimulus? is the most misleading word in economics lexicon because it conveys the idea of a surgeon ?stimulating? a heart into self-sustained beating. In reality, what government interventions did was to put the economy on a crutch.

What is the root of the problem?

Remember, back in Australia?s credit growth is still falling, we wrote that

… for an economy that is addicted to debt, all it needs to tip it into a recession is for credit growth to slow down- no contraction of credit is required. Also, as Professor Steve Keen explained, at this stage of the debt cycle, the aggregate spending in the economy is made up of income plus change in debt.

To understand why, consider this highly simplified hypothetical situation in the economy:

$80 (income) + $20 (change in debt) = $100 (Aggregate spending)

As you can see, of the $100 of economic activity, $20 is the result of an increase in debt. Assuming that next year, the situation looks like this:

$83 (income) + $15 (change in debt) = $98 (Aggregate spending)

Income goes up, but people decide to borrow less. Note that when there’s less borrowing, it does not mean that the total amount of credit in the economy has declined. Instead, it means that credit is still growing, but it is growing at a slower pace.

As you can see from this example, if income remains stagnant and credit growth slows down, the total amount of aggregate spending in the economy will decline, tipping the economy into recession (unless it is the government which increase the spending to fill the gap).

What if next year, everyone decides to stop borrowing (i.e. total credit remains the same)? The equation will look like this:

$83 (income) + $0 (change in debt) = $83 (Aggregate spending)

If aggregate spending falls from $100 to $83, it will be a depression for the economy. What if everyone decides to save, and thus repay their debts? The equation will then be:

$83 (income) + $ -5 (change in debt) = $78 (Aggregate spending)

The situation is worse!

Thus, you can see that for an debt-addicted economy like Australia, if wage growth is constricted, the only way for the economy to grow well (in nominal terms) is for debt to grow at faster and faster rate. Obviously, this is unsustainable because if debt grow faster and faster than wage growth, it will be only a matter of time before the entire economy becomes sub-prime. When that happens, there will be an almighty crash, which in Australia’s case, is likely to result in a currency crisis (see Serious vulnerability in the Australian banking system).

If the government decides to borrow to supplant the private sector’s decline in borrowing in order to maintain economic growth, then the budget deficit will continue to grow. Again, this cannot go on indefinitely because Australia will end up like the PIIGS countries.

One more point, up till now, all these growth are in nominal terms. But what about in real terms?

As we know, it wasn’t long ago that there were media reports of “skills shortage” in Australia. Also, it is clear that Australia requires more “nation building” due to lack of infrastructure. This means that Australia is at the limits of its productive capacity. That means that even if Australia somehow manages to grow in nominal terms, it will be achieved at the expense of higher price inflation. That will attract more interest rate hikes from the RBA. As we wrote two years ago in Why does the central bank (RBA) need to punish the Australian economy with rising interest rates?,

The Australian economy was already running at full steam. Accelerating price inflation is a sign that there are insufficient resources in the economy to allow for all investment projects to succeed and all consumptions to carry on. If this trend is not arrested, the economy will run out of resources, resulting in a crash. Therefore, in order to put the economy back into a sustainable growth path, consumptions and investments have to slow down in order to allow for the economy to catch a breather for the rebuilding of its capital structure. The rebuilding of capital structure is necessary for the economy to replenish its resources for the future so that growth can continue down the track. Unfortunately, this rebuilding itself requires resources now. Therefore, current wasteful consumptions have to be curtailed and mal-investments have to be dismantled to make way for the rebuilding. The curtailment of consumption involves consumers spending less and saving more, while the dismantling of mal-investments involves retrenching workers, liquidating businesses, e.t.c. These involve pain for the people of Australia.

As we all know, the RBA raised interest rates 6 times already and that is the probable reason consumers are de-leveraging (i.e. borrow less and/or repay debts).

To put it simply, a glass ceiling is blocking the Australian economy. If you can feel that the quality of your life is also hitting the glass ceiling, then you know this is the reason.

Australia’s credit growth is still falling

Tuesday, September 29th, 2009

Marc Faber once said that for an economy that is addicted to debt, all it needs to tip it into a recession is for credit growth to slow down- no contraction of credit is required. Also, as Professor Steve Keen explained, at this stage of the debt cycle, the aggregate spending in the economy is made up of income plus change in debt. In the absence of income growth, a slowdown in credit growth implies declining aggregate spending by the private sector.

Now, let’s take a look at Australia’s year-on-year credit growth (up till July 2009):

Year-on-year credit growth in Australia (July 2009)

Year-on-year credit growth in Australia (July 2009)

It’s now the government doing a bigger and bigger share of the spending.

Marc Faber vs Steve Keen in inflation/deflation debate- Part 2: Marc Faber’s view

Thursday, May 7th, 2009

In our previous article, “Marc Faber vs Steve Keen in inflation/deflation debate- Part 1: Steve Keen’s model”, we promised to explain Marc Faber’s view on why inflation (rather than deflation) will be outcome in the years to come. As he wrote in his most recent Gloom, Boom, Doom market commentary,

Now, from the numerous emails I get I have the impression that most investors are leaning toward the view that ?deflation? will be the problem in the future and not ?inflation.? An ?expert? [Editor’s note: For the sake of peace, let us all assume he was not referring to Professor Steve Keen] even opined that whereas it was possible under a pure paper money system (large quantity of banknotes in circulation) to create high inflation rates, this was not possible under an electronic banking system.

First, let’s take a look at Professor Steve Keen’s view that the destruction of credit (IOUs) will overwhelm any money printing by the government. As Steve Keen said in “The Roving Cavaliers of Credit”,

To make a serious dent in debt levels, and thus enable the increase in base money to affect the aggregate money stock and hence cause inflation, Bernanke would need to not merely double M0, but to increase it by a factor of, say, 25 from pre-intervention levels.

Our view is that while massive deflation of credit will occur, it will not happen overnight. Instead, while the deflationary pressures will continue, it can be slowed down via unconventional monetary policies (see “Bernankeism and hyper-inflation”), gigantic fiscal policies, bailouts and even government fraud. The result will be a long drawn out affair, akin to a grinding trench warfare and a war of attrition on the real economy as credit contraction (IOU destruction) collide head on with money printing, massive government spending, stimulus and bailouts. In fact, this is what is happening right now in the US as optimism for “green shoots” of economic recovery fuels a rally from the depths of the panic of 2008. To make this saga even more confusing, despite the credit destruction in the second half of 2008, prices on the street have yet to make a meaningful decline. Simply speaking, money ‘printing’ will be spread out over a number of years until deflationary pressure subsides. Thus, Bernanke is not going to increase M0 by 25 times in a flash- he is going to do so over an extended period of time until it is no longer deemed necessary.

Next, credit contraction will not go on forever. As Professor Steve Keen commented before, he expects deflation to end eventually and inflation to return after say, a few (or several or dozen or whatever) years.

Now, we will talk about Marc Faber’s argument. Consider what’s happening as the Global Financial Crisis (GFC) unfolds:

  1. Economy contracts
  2. Interest rates are cut
  3. Fiscal policy is stepped up to assist failed monetary policy (see “What makes monetary policy ?loose? or ?tight??”). Then as Marc Faber said,

    But for the fiscal stimulus to even have a small chance of succeeding at reviving economic activity it has to be larger than the private sector credit contraction.

    With that, he had a chart to show that “US Private Sector Credit Contraction Is Offset by Public Sector Credit Expansion!”

  4. Government spending going up when tax receipts declines.
  5. Upward pressure on interest rates (see “How are governments driving up fixed mortgage rates?”)
  6. Governments forced to monetise debt (i.e. print money, which is already happening in the US, UK and Japan) in an attempt to force long-term interest rates down. See “Why are nothing-yielding US Treasuries so popular?”.

That’s where the crux of Marc Faber’s argument,

And here lies the crux of the problem most deflationists do not understand. By keeping short term rates artificially low and by monetizing the growing fiscal deficits a central bank digs its own grave in terms of its ability to pursue tight monetary policies when such policies become necessary.

If the US Fed failed to tighten monetary policies after the US economy began to recover in November 2001, what are the chances of tight monetary policies in the future (which would significantly increase in the short run the cost of servicing the government?s debt) when both the US government and the Fed will be loaded with toxic assets and burdened by all kinds of other liabilities? The chances of the US government implementing tight monetary policies in the next few years are exactly zero.

But my point is simply this: Once a government embarks on highly expansionary fiscal policies which entail government expenditures vastly exceeding revenues (leading to enormous budget deficits and soaring government debt) and simultaneous monetization (?printing money?), the reversal of these inflationary policies becomes for all practical purposes impossible. Inflation and higher interest rates follow. At this point the reader should clearly understand that any upward pressure on interest rates brought about by the market participants will actually force a central bank that embarked on monetization to monetize even more [Editor’s note: This is the time when money supply will increase exponentially!]. The other point to remember is that the longer an economy does not respond to such ?inflationary? fiscal and monetary policies, the larger the ?doses? will become.

So, by implication, any global recovery from the Global Financial Crisis (deflation) will bring forth another crisis (inflation)!

Marc Faber vs Steve Keen in inflation/deflation debate- Part 1: Steve Keen’s model

Tuesday, May 5th, 2009

One of the strongest leanings among investors is the view that deflation (instead of inflation) will be the problem of the future. The best argument for deflation we have seen so far is Professor Steve Keen’s “The Roving Cavaliers of Credit” article. We highly recommend that you take a read at that article if you have the time. If not, we have a summary as well as our additional commentary of that article below. Keen’s view is that in today’s GFC context, inflation, while it is possible under a pure paper money system, is impossible under the credit system of today.

To understand why, you have to understand the conventional textbook model of how money is created through the banking system through the fractional reserve money multiplier model. Our article, “The difference between money and credit” is the best illustration of how it works. In this conventional textbook model, banks can only lend out of their existing deposits. The inference of this model is that quantity of money will always be more than the quantity of credit in the system.

Unfortunately, the conventional textbook model is wrong. In the real world financial system, the quantity of credit is greater than the quantity of money. In today’s modern financial system, banks do the lending first before coming up with the ‘deposits.’ This sound very counter-intuitive, but let us explain how it works. Suppose you borrow $100 from the banks. All the bank has to do to ‘lend’ you money is to create an accounting entry of the $100 loan on their books. Suppose you transfer $50 out of the loan to your friend’s bank account:

  1. If your friend’s account reside in the same bank as yours, then it’s just a matter of the bank adjust the accounting entries between your loan account and your friend’s cash account. Simultaneously, you have to pay interest for the $50. A neat way of making money isn’t it?
  2. If your friend’s account reside in a different bank and let’s suppose the bank is short of say, $50 at the end of the day after all the bank transfers are netted out in the system. All the bank has to do is to borrow $50 from either another bank, the central bank, investors or depositors (or perhaps even run down its existing cash reserve). In the end, you will owe an IOU to the bank and the bank will owe an IOU to another entity. The interest rate that you pay for your IOU will be greater than the interest rate that the bank pays for its IOU. The difference is the bank’s profit.

So, you can see that ‘money’ in the financial system is just a long chain of IOUs. The quantity of ‘cash’ (or technically, monetary base) to back up the IOU is unimportant as long as trust reigns among participants of the financial system. A growing quantity of IOU relative to ‘cash’ implies greater leverage in the financial system, which further implies greater level of trust. But then, as we explained in “What is the role of real assets in preserving your wealth?” trust breaks down during the Global Financial Crisis (GFC):

Interestingly, the word ?credit? comes from the Latin word ?cr?dere,? which has the meaning of trust (?to believe?). Therefore, the credit crisis implies a crisis in trust in the global financial system. Without trust in the financial system, the value of financial assets becomes suspect.

With the breakdown of trust, institutional participants in the financial system began a mad scramble to reduce their vulnerability caused by their trust of others. This is what we call de-leveraging. De-leveraging implies that you reduce your obligations to others so that you don’t have to trust on others who have obligations to you to remain solvent. Also, you reduce your trust on others to protect yourself. As the quantity of IOUs in the system far exceeds the quantity of ‘cash’ in the system, many participants will be caught short in the scramble for cash to settle their IOUs. That’s why central bankers (e.g. The Federal Reserve, Bank of England, Bank of Japan) are busy printing money (technically called “quantitative easing”) to flood the system with ‘cash’ so that market participants can use them to settle their IOUs.

Now, Steve Keen reckons that this printing of money will not cause inflation. Because the quantity of IOUs far exceeds the quantity of newly printed ‘cash,’ which means market participants will still hoard the ‘cash’ to protect themselves. Unless the central banks print enough money to match the scale of IOUs destruction, then inflation will not happen. This has the same effect as what we described in “Demand for money, inflation/deflation & its implication”

Let?s say the quantity of money increases in the system. But if people want to increase their holdings of cash due to fear and uncertainty of the future, they will withdraw these cash from circulation in the economy. Consequently, prices fall.

The destruction of IOUs causes the quantity of credit to contract in the economy, which in turn causes asset price collapses and if not arrested, ultimately result in the fall in prices in the real economy. This is deflation. The second half of 2008 witnessed the destructive effects of deflation as the prices of assets and commodities collapsed, and the real economy deteriorated at an unprecedentedly rapid rate.


Last month, we took the liberty to forward Steve Keen’s “The Roving Cavaliers of Credit” to Marc Faber and asked for his opinion on Steve Keen’s deflation view. His reply was very short: “In my opinion, he is wrong.” Please note that this does not automatically imply that Steve Keen’s model is wrong. We think Steve’s model is highly valuable in understanding what is going on in the real world. It just mean that Marc Faber disagrees that the result will be deflation.

We did not get any further explanation from Marc Faber from his short reply. But in his latest Gloom, Boom, Doom market commentary, he finally explained his view further. We will present Marc Faber’s view in the next article. Keep in tune!

Can price inflation occur in the midst of debt deflation?

Thursday, February 26th, 2009

Right now, major economies like the US and UK are undergoing debt deflation. Large swathes of Europe is also going through this malaise. According to Professor Steve Keen, Australia, with its debt levels in the 3rd position behind US and UK, will suffer the same fate soon. Indeed, in the month of December 2008, Australia’s credit growth turned negative. Year-on-year credit growth in the second half of 2008 was decelerating. This is a worrying sign for Australia because as we explained before in Will Australia?s own pump-priming work?,

According to Professor Steve Keen, Australians? increased debt last year added $250 billion in spending into the economy. Currently, Australia?s credit growth is decelerating very rapidly. Should credit growth stagnate (or worse still, contract), this $250 billion (or more) in spending will go up in smoke.

So, there is plenty of scope for de-leveraging in the Australian economy, which will lead to debt deflation. Under such a scenario, asset prices will fall. As the theory goes, consumer prices should follow as well.

But is it possible for price inflation to rise in the midst of debt deflation? We were thinking of that possibility in What will happen if RBA cuts to zero?. The most likely culprit to blame for such a disturbing scenario will be the trashing of the Australian dollar. Debt deflation theory says that such a scenario is impossible. But there is a real-life example that shows that this can happen- Iceland. Today, Iceland is suffering sky-rocketing unemployment as well as price inflation. From the Icelandic central bank’s web site, you can see their price inflation rate has gone to the moon at 18.6% in January 2009.

How can both debt deflation and price inflation be possible? As someone in Professor Steve Keen’s blog site asked,

I?m wondering about what?s happening to Iceland now and going forward. When no one has a job, no one has savings and no one can sell a single thing. Everyone has no money. If no one has money, no one can buy things. If no one can buy things the shops must drop price further and further. This is monetary deflation and price deflation. More businesses fail and unemployment continues to rise. Where does the future inflation come from?

So, how can we explain Iceland?

Well, under the conventional demand-supply equilibrium model, prices should come down. But in this case, the system is out of equilibrium and cannot return to equilibrium. If there?s no money to buy imported things, it does not mean that the prices must come down. What will happen is (1) demand destruction and/or (2) the seller goes out of business (and contributes to higher unemployment). The remaining few sellers that survive will most likely sell to the richer Icelanders who can cough out the higher prices.

Furthermore, as we explained with an example in What will happen if RBA cuts to zero?, even locally produced goods can rise in price too.

Can this happen to Australia? Fingers crossed. The inflation part depends on the Aussie dollar.

Soft landing hope built on faulty framework assumptions

Sunday, January 4th, 2009

Looking forward, what will happen to Australia’s economy in 2009? Currently, the mainstream economic forecast is for a soft landing. As Shane Oliver was quoted in this article,

But with the economy on track for a mild recession…

Shane Oliver’s opinion is fairly representative of the mainstream economists, which include those bureaucrats in the Reserve Bank of Australia (RBA). Why are the mainstream economists’ forecasts so tame and mild? As Professor Steve Keen criticised their neo-classical economic thinking here,

This is not a prediction by the model as such, but a product of its structure, which assumes that the economy will always return to a supply-side driven equilibrium in a relatively short time frame.

Built into the blinkers of the mainstream neo-classical economic framework, the assumption is that the economy is like an elastic band that will spring back to its previous un-stretched state of ‘equilibrium’ after being stretched by external ‘shocks’ (e.g. global financial crisis). For those who studied economics at university, you will realise that the phrase “external shock” is often used in the text-books to describe phenomena that are beyond the scope of economic model. Furthermore, you will find that your text-book are full of simultaneous equations, which implies some sort of ‘equilibrium’ has to unquestionably happen.

But this is a very erroneous assumption built into the framework of mainstream neo-classical economic thinking. Does the economy always have to return to equilibrium the way an elastic band spring back into its previous relaxed state? Can there be other forces that can pull the economy further and further out of equilibrium until a breakdown occurs? Can there be snowball effects? Mainstream economics do not entertain those questions seriously. They consign the answers to those questions (that they do not understand) as an excuse called “external shocks.” As a result, their forecasts are next to useless, especially during turning points (see our guide, Why are the majority so wrong at the same time and in the same ways?).

Thus, we are very sceptical of the mainstream economic opinion that Australia is on track towards a soft landing. Such thinking is more of a reassuring, good-feeling hope and less of serious analysis.

Will RBA’s cutting of interest rates help?

Sunday, October 26th, 2008

Recently, Associate Professor Steve Keen made the prediction that interest rates in Australia will be cut to zero by 2010. As this news article reported,

University of Western Sydney associate professor of economics and finance Steve Keen is radically bullish on interest rates, predicting a 2% cash rate by the end of 2009, dropping to 0% in 2010.

Dr Keen said the RBA would become more concerned about high household debt levels than inflation, as deep rate cuts in 2009 failed to stimulate the economy.

”The debt bubble is bursting and when it bursts, people stop spending and borrowing,” he said.

Investors should realise is this: if interest rates is ever cut to zero (i.e. Zero-Interest-Rate-Policy or ZIRP), it will not be good news for the economy. It will reflect the complete failure and impotence of monetary policy in regulating the ‘temperature’ of the economy. In other words, to arrive at ZIRP, it means that the economy is in a very serious trouble.

Japan fell into ZIRP in the 1990s. As we all know, the malaise in the Japanese economy lasted 16 to 17 years before a glimmer of hope was seen at around 2003. Today, due to the global credit crisis, they are falling back into the recessionary hole. With interest rates at 0.5%, they have no more room to cut further.

One thing that is different about the Japanese economy from the Australian/UK/US economies is that Japan had a relatively high savings rate. During their lost decade of the 1990s, the Japanese drew on their savings and retreated to their economic bunkers as their economy and asset prices contracted year after year.

In contrast, Australia/US/UK today have no savings and are heavily indebted.

If the RBA cut interest rates further, it will be in reaction and anticipation to Australians closing their wallets, cutting up their credit cards and shunning debt. As we explained before in Will Australia?s own pump-priming work?, all we need is for Australians to stop borrowing in order to induce a deflationary force of $250 billion. This deflationary force alone will wreck havoc to many Australian businesses, which in turn will wreck havoc to the employment market. Once mass unemployment appears, a lot of prime debt will become sub-prime debt. When debt becomes sub-prime, cutting interest rates to zero will not help.

Dangling pornography in front of a dead man will not induce him to open his dead eyes. Likewise, the RBA dangling free credit to banks (i.e. ZIRP) will no longer induce banks to lend because of the pervasive fear of bad debts. To understand this, we highly recommend that you read What makes monetary policy ?loose? or ?tight??.

Currently, Australians are voluntarily shunning debt (as shown by the rapidly decelerating rate of credit growth) as banks are still willing to lend money (although lending standards are tightening). When this voluntary action crosses over to involuntary, it will be the day when the deterioration will accelerate.

If property prices follow long-term inflation, will prices not fall in the long-term?

Monday, October 20th, 2008

Back in Do property price always go up?, we have looked into a Dutch study, which found out that in a period of more than 300 years, property prices ultimately follow the general price levels. In other words, in the long-run, property prices are flat in real terms.

For today’s discussion, let us suppose that this is true.

Does this mean that it does not matter when one purchase the property (assuming that one is only concerned about real capital preservation) because in the long-run, it will always preserve your wealth by tracking the price inflation rate? If one thinks that the answer is yes, then one has fallen into a mental pitfall called Lazy Induction. Back in Mental pitfall: Lazy Induction, we explained that

The trouble starts when the sample that we used for our observations is drawn from our own personal bias. Then, from the observations of the biased sample, we make generalisations based on our flawed observations. Lazy Induction allows us to prove anything that we want to be true. All we have to do is to pick a sample of observations that conforms to our bias and then generalise from there.

The error in the logic of that answer lies in the crucial fact that one implicitly assumes the long-term price appreciation starts on the day that one bought the property. To explain this point more clearly, we will use Professor Steve Keen’s graph of property prices relative to CPI:

ABS Established Home Price Index vs CPI

Source: Rescuing the Economy or the Bubble?

This graph shows that property prices have been tracking CPI till around 1998, after which it took off.

Now, let’s imagine that you have a time machine and travel forward 300 years. Let’s say that our assumption that property prices follow long-term inflation rate still holds true in 300 years. What will we see? Assuming that long-term price levels follow a nice gentle rise (i.e. no hyper-inflation), we will see that the prices from 1998 to, say 2008, is part of a small blip before returning to the long-term price levels.

So, what is the implication of this? If surge in prices over the past 10 years (1998 to 2008) is a huge aberration away from the long-term up-trend, then it will have to fall in due time in order to follow the long-term price levels. That is, property price can still fall a lot in real terms if it has a prior huge run-up in real prices. If price inflation is relatively benign, then this will mean a fall in nominal terms too.

“Property 2009: Crash, Boom or Stagnate?!” debate begins today!

Wednesday, October 15th, 2008

Just a reminder to all our readers: the Property 2009: Crash, Boom or Stagnate?! forum debate is starting now.

Two of our special guest experts will be taking part in this debate. See Interviewing Steve Keen for the upcoming property forum debate and Interviewing Michael Yardney for the upcoming property forum debate.