Wednesday, November 07, 2007

Predicting debt crises

A prominent economic forecaster based in Melbourne makes his livelihood predicting the next major economic crisis. He has been doing it for 20 years so eventually he will get one right and be able to say ‘I told you so’. The fact is that capitalism for all its faults is a resilient sort of economic system. Energy crises, global warming for example can be good business.

A couple of features of the current international debt situation however do concern me:

1. Credit card debt. Fortune points out this week that US consumers have a massive $915 billion in credit card debt and this debt is starting to come under strain. Banks last quarter announced their worst results since 2001 with credit card delinquencies impacting on earnings. Citigroup announced a 57% decline in earnings citing higher credit card costs. It has set aside $US2.2 billion to cover defaults.

For the first time cardholders were increasing their balances outstanding and taking cash advances on these cards. American Express is also seeing signs of distress. Credit card debt is a real problem since it is unsecured. Difficulties arise when customers start using credit cards to repay home mortgage debt. In the UK, which is further ahead of the US in a phase of declining house prices, has 6% of its homeowners using credit cards to repay their mortgages – since 2005 delinquencies have risen 50%.

Australia has not yet entered a phase of major decline in house prices – in Melbourne they are rocketing ahead to rival Sydney prices – but when the crunch comes the same difficulties will develop here.

2. The sub-prime mortgage crisis last summer involving about $US 900 billion was not just a flash in the pan. The massive extent of the underlying problems is just starting to unfold. Citigroup has sacked its CEO and announced up to $US11 billion in write-offs to reflect the declining value of its sub-prime mortgage related securities. Merrill Lynch ousted its CEO a few days ago amid huge announced losses on sub-prime securities of $US 7.9 billion amid claims from Deutsche Bank that it might need to write-off another $US 11 billion.

I worry that Australia might be hit hardest precisely because the real estate market - outside of Sydney - has been slow to adjust downward – if you believe the OECD we have the most overvalued real estate on the planet. 1.7 million people in Australia are currently living under housing stress paying more than 30% of their income for housing and the bet is interest rates will rise again today.

Despite the attempts of my macroeconomic colleagues to convince me all is fine I still find it hard to understand how Australians can be in a sound credit position when 16 years into an economic expansion our credit aggregates are growing at 15.9% annually and our money stocks are growing at 15.4%. This is during a phase where inflation looks like peaking at around 3%.

It worries me with an inexperienced Labor Government looking as if it will take the helm.


Spiros said...

Harry, all oppositions are inexperienced, by definition. On your argument, governments should always be re-elected, because they have the experience.

Anyway, I agree that household debt is a problem. Who, politically, has said this is a problem? Labor. Who has said, "no worries". The Liberals. On whose watch has it all happened? The Liberals. And yet you reckon they should be chargef with fixing the problem - a problem they deny exists.

But what would you do about it? The orthodox wisdom is that the Reserve Bank sets interest rates to keep inflation low, which they have, and neither they nor anyone else should be concerned about anything else.

Got any bright ideas about whay policy levers could be pulled to stop people from borrowing?

derrida derider said...

Yes, there's the old joke that economists have forecast seven of the last three recessions. But history shows that capitalism, for all it's tremendous wealth-making capacity, is by nature an unstable beast. There is *always* a risk of a recession - so as spiros notes you are effectively arguing for permanent govermnents.

I reckon the Australian economy would not be harmed greatly by a mild-to-moderate US recession. The decline of US power (accelerated by Bush's economic and foreign policy stupidities) means that it's no longer true that the world automatically catches a cold if the US sneezes. The danger is more indirect - that the flight from the US dollar will make China unstable (now if China sneezes ...).

hc said...

It is difficult to just keep increasing interest rates as this contributes to the problem. I generally favour much less liberal credit markets where debt is issued on the clear basis of ability to pay with a safety margin. For inexperienced young borrowers I think a minimum deposit is essential - if nothing else to confirm their ability to save.

My guess is that 'moral suasion' and warning about taking out too much debt is one way.

People need to understand that the trade cycle has not been abolished and that house prices will definitely fall much further.

Also getting the banks to act responsibly in relation to issuing debt and putting their shareholders at risk.

I have a fair bit of debt as a consequence of a house rennovation but am always being offered more by the banks. I don't take it up but others might. One recent offer I got was a credit card for $35,000 at 18%. This is crazy.

Responsible colleagues who work out what they can afford to repay on a mortgage are typically offered much more than this.

Bad debts will punish the shareholders of the banks. These shareholders should insist on careful lending.

Spiros said...

Harry, the good old days when the bank manager was some on old fart who would give you a lecture on your saving habits when, Oliver Twist like, you dared to ask for a loan, are long gone.

These days, you can ring up a call centre and they will lend you as much as you like, and then some. Why? Because they know that if they don't, the next bank will.

Are the banks stupid? Possibly. But they have data that shows that the chances of you defaulting on your loan are very slight. It's a risk they are prepared to take. And by the time the shit hits the fan, the current crop of bank managers will be long gone, and it will be someone else's problem to clean up the mess.

And let's face it, neither you nor I not anyone else knows when it will hit the fan.

hc said...

I am a bit in favour of this older approach. Its not being paternalistic from the bank's viewpoint - it is a matter of optimising returns after accounting for default risk.

In the last stock market crash the banks - apart from NAB - lost a lot through foolish lending. It is not a marginal issue.

Spiros said...

But Harry, they banks say they do account for default risk. They have very complex credit scoring indicators that tells them that a middle aged economics professor who has a income of $X and has $Y equity in his house etc etc has a probability of z% of defaulting on his loan.

The problem of course is that all this data has been gathered during the Good Times when hardly anyone has been defaulting on anything. But the bank loan officers have lending targets that they have to meet and if someone asks for a loan and they tick all the boxes on the credit scoring, then they will get the money.

Bring Back CL's blog said...

only an inexperienced Labor government could introduce spending cuts to protect the budget after advice from Ken Henry.

Just remember if a debt crisis eventuated then commodity prices would fall.
Imagine the impact on the budget when company tax revenue as a % ot total tax revenue suddenly falls from its current 26% to 14-20%.

suddenly red inks occurs and the previous experienced team are seen as the cargo cultists they were

Anonymous said...


I keep saying that we cannot afford any... any policy mistakes with an economy holding this much leverage.

Labor makes a few mistakes, we're done for.

Anonymous said...

Thanks for sharing this post on your blog harry. It's informative and useful. I'll share with you an article, "Get the Most Out of Your Business Credit Card Now", that is somewhat related to your post. Not too similar but connects with the topic since you've mentioned Credit Card Debts.

David said...

As an economist can you explain why we need central control of (some) interest rates?

I would have thought these are better set in an open and free market.