We can’t take on any more debt – so what will drive the economy? | Greg Jericho

Whenever the governor of the Reserve Bank speaks, all ears are pricked for any signs that might indicate where interest rates are headed. On Friday, when Philip Lowe appeared before the House economics committee, he was very careful with his words. The markets barely moved, and yet amid his unsurprising talk on interest rates he made some interesting points about the level of household debt that suggest he desires some quite significant changes in our economy.

Right now households hold a record level of debt – equal to 188.4% of annual household income. A vast majority of that is housing debt. In September the level of housing debt had reached 137.5% of disposable income – a new record:

To be honest, saying it is a new record is not news. In 22 of the past 23 quarters, a new record level of housing debt has been set. And this growth of debt is having an impact on other areas of the economy.

Lowe noted in his testimony to the committee that lower expectations of income growth due to low wages growth is affecting households’ spending – “especially in an environment of high levels of household debt”.

Basically, households are getting worried about the amount of debt they have and so are limiting how much they spend elsewhere.

And while the total level of debt is of concern, the big issue has been the pace of its growth over the past few years, which has been at levels not seen since the heady mining boom days of 2006:

When we look at the value of housing assets to income we see a similar record level:

And a similar spike in the growth of the asset to income ratio over the past three years:

This is a worry because when the price of assets keeps outstripping income growth you start getting into bubble territory.

Lowe isn’t too concerned about that because, as he told the committee, “in the property market, prices are no longer rising in Sydney and they have fallen for some higher priced houses. The Melbourne market has also cooled a little”. There are a few reasons that the heat has come out of the market – among them reduced ability for investors to access financing and a drop in foreign investment.

Lowe then said something that seemed quite innocuous but that has a quite significant impact on how our economy will run. He suggested that “it would be a good outcome if we now experienced a run of years in which the rate of growth of housing costs and debt did not outstrip growth in income, as they have in recent years”.

It is not too odd that he would like debt levels to stabilise – arguing for more record levels of debt would be a strange thing to wish for. But what he leaves unsaid is that, essentially, he would like to see our economy grow in a way it hasn’t really ever done.

Our economic growth since the 1990s recession has been largely built on household debt. When the level of debt in relation to income has not grown, this has generally meant the economy is in a slump – such as occurred in the early 1990s, during the GFC, and 2010-2013.

A stable debt to income ratio has not necessarily meant we’re in a recession, but it generally has not been an arbiter of good things.

Mostly this is because we have structured our economy to engender higher house prices.

Lowe was explicit on this point, telling the committee that “if you asked anyone how a country would deliver high housing prices, you’d find we’ve made all those choices: live in fantastic coastal cities, under-invest in transport, have a liberal financial system, and not want high density”.

He argued that while this has led to high levels of debt, it has also led to high levels of asset prices, and he said the current situation was “perfectly sustainable”. He argued that “absent some major shock, I don’t have a particular worry about it”. And yet history shows that absent some major shock, debt levels have kept rising.

In the past few years, while house prices – and debt – have risen, the level of interest payments being made on that debt has fallen as interest rates have gone down:

The current level of interest payments is the same as it was in 2004 – but whereas total housing debt back then was 100% of annual disposable income, now it is more than a third higher at 137.5%.

That means increases in interest rates are going to have a bigger impact than they did in the past – so it is very unlikely interest rates will be able to go up like they did prior to the GFC; whereas a 7.25% cash rate in 2008 slowed the economy, now it would destroy it. And it means the RBA has to be more careful about raising interest rates than in the past.

The governor of the Reserve Bank is not worried at the moment about our economy being destroyed, but he sees a path that would make a major change from what has occurred in the past 30 years of a solidly growing economy accompanied with rising levels of debt.

The question is – can we achieve strong economic growth without also increasing debt? And if so, can we achieve that with our current housing policy?