Thursday, November 27, 2008

Rory Robertson vs Steve Keen

Who's going to climb Kosciusko?

Macquarie's Rory Robertson writes:

"I was in Canberra yesterday, presenting at the Federal Treasury and the Parliamentary Library. Over the past year, I've often been the most pessimistic person in the room. My second presentation yesterday, however, followed one by Dr Steve Keen (google, if you are keen), whose high-profile forecast of a 40% drop in Australian home prices has put the wind up many homebuyers and potential home-buyers, not to mention some offshore investors.

Never say never, but a 40% drop in Australian home prices is a highly unlikely event, effectively requiring a meltdown of our financial system despite the combined efforts of the RBA and Canberra. Happily, Australia is not the United States. US home prices are down by about 20% from their mid-2006 peak, while our home prices fell by 2% in Q3, driven by the 150bp increase in mortgage rates overseen by the RBA between July 2007 and July 2008 (now more than fully reversed).

To make it interesting, I offered Dr Keen a challenge...

On the maybe 1% chance that he is right, and capital-city home prices do indeed fall by 40% within the next five years - starting from Q2 2008, and as measured by the ABS - I will walk from Canberra to the top of Mt Kosciusko (that's maybe 200km followed by a 2228-metre incline).

If Dr Keen turns out to be less than half right, as I expect, and home prices drop by (much) less than 20%, he will take that long walk. Moreover, the loser must wear a tee-shirt saying: "I was hopelessly wrong on home prices! Ask me how."

We now have a bet, and I expect to record an easy win within two years. That's because falls in Australia-wide home prices will be limited by our lack of overbuilding, our much more disciplined mortgage market, and - especially - by the RBA's ability to drive mortgage rates lower (something the Fed until this week had been unable to do; see latter part of chartset, attached).

Critically, the RBA knows that it was 15-20%-plus drops in home prices that poisoned the US and UK banking systems and economies. And so that must not happen here; accordingly, limiting the drop in average home prices is an unstated but obvious objective of increasingly easy RBA policy.

I'm still guessing that the RBA will cut by another 100bp next Tuesday, to 4.25%. A 100bp cut is more likely than a 75bp cut is more likely than a 50bp cut, I'm thinking without overwhelming confidence (given that most of us were badly wrong-footed three weeks ago).

To me, there would be a neat symmetry in reversing six years of monetary tightening - from 4.25% to 7.25% - in just four meetings over just three months, in response to the sharpest deterioration in global growth prospects in decades. Moreover, with global equity and commodity markets having rebounded nicely from last week's disturbing new lows, a 100bp RBA cut delivering a standard mortgage rate of 7% or less might allow everyone to go into the pre-Christmas season with freshly elevated hopes that everything ultimately will turn out okay.

Assuming that Dr Keen eventually will have to take that long walk, it will be because he greatly under-rated the quality of macroeconomic analysis undertaken at the RBA and in Canberra, and underestimated the power of low interest rates to support local home prices even in the face of today's alarmingly weaker global backdrop."

RORY'S UPDATE Friday November 28:

"Hi there. Sorry to interrupt. For the record, Steve Keen is keen to clarify that our bet is "peak to trough", as agreed, with no five-year limit . Obviously, I expect this distinction will not make a difference, with the ABS house price index likely to surpass its Q2 2008 level well within 5 years.

Anyway, all good fun, and thanks for all the feedback. Thanks especially to those who've offered to join me on the walk to Mt Kosciusko - one even to cook each evening! - but cool your jets. I'm not expecting ever to have to take that walk!"  

16 comments:

alan said...

House prices will drop due to private debt levels here (higher than US).

Govt has encouraged debt via negative gearing and interest only loans for investment properties and shares. Cutting the CGT in 1999 was the green light for investors to go on a spending spree; tax payers destined to pick up the interest tab.

Most debt in Aus is associated with property debt:

http://www.rba.gov.au/Statistics/financial_aggregates.html

$674B = Owner occupied Housing debt
$308B = Investor property debt (heavily subsidized by tax payers)

There is another $151B in personal debt (credit card, cars, white goods etc) and business debt is $770B (75% is associated with services within Aus that produces no export income, and about 25% is agricultural or mining associated debt).

$1082B in property debt produces not one dollar of export income.

On top of that there may be up to about $500B+ of business debt also not earning export income.

Little wonder Aussie dollar is marked down.

Anyone know what happened to Iceland due to its high debt levels?

Does anyone else think it is ridiculous that we have built an economy on the sands of housing debt? Housing produces no export income and therefore does nothing positive for the Balance of Trade figures.

SOLUTIONS?
To start with, phase out debt accelerants such as negative gearing and interest only loans, and create infrastructure that supports export earnings.

Michael S said...

They don't have wise macroeconomic policy makers at the Fed, Bank of England, Bank of Japan, RBNZ?

Sounds like a bit of misplaced parochialism from Rory there.

Keen's been predicting this calamity for a while, and in the meantime classical economists have been saying everything is OK. Most didn't even wake up to the problem until Lehman's collapse.

I'll stick with Keen's analysis. His concepts around the problem with debt seem more sound than the 'everything's going to be alright' brigade.

Anonymous said...

I think Dr Keen's overall standing can be summed up by his simultaneous announcement of the expected 40% price drop, and of the fact that he was putting his dwelling on the market.

Anyone silly enough to try to sell something, and at the same time publicly predict that it will be worth massively less that the asking price, in my view lacks the nous to make a useful contribution to any debate.

Anonymous said...

If the economists at the RBA are so smart, why did they lift interest rates twice earlier this year in the face of a financial tsunami?

I think Robertson is probably right, because a massive cut in interest rates could put a floor under house prices. The increase in the First Home Owners Grant will also help to lift prices.

But the danger here is that reflating house prices will be too successful. Surely, a fall in house prices is a good thing. Firstly, it would be good for young people who currently cannot afford to buy/build their first home. Secondly, cheaper housing would help to reduce rent prices. Thirdly, a lot of money has been directed towards house buying in recent years rather than at more productive investments. A fall in house prices could reverse this trend.

dyork said...

Will Steve Keen win his daring bet?

http://auschart.com/2008/11/will-steve-keen-win-his-daring-bet/

Kevin said...

What an indictment of the economic system. Both sides have arguments that are persuasive and given the gyrations in financial markets both will probably be right. No one knows because our financial system is a "chaotic" system that is uncontrollable. This should not be the case because the financial system is our invention and we know enough about systems to design them so that the system is not chaotic.

It appears that main cause of instability is the mechanism of total debt creation or the creation of extra money. Given that we have a system with $X in money in it and it is a growing system how should we increase the amount $X. Given that X is related to the total asset value of the system then we should build a system where the increase in X is matched by a corresponding increase assets. Our current system is designed so that we increase X before we know we have increased the amount of assets. That is, money as soon as it is created becomes interest bearing. This means X goes up even faster because the interest is being paid before the asset that will pay it exists. This means we have a positive feedback mechanism and it becomes difficult to control.

We create debt by guaranteeing debt against existing assets. This works when the asset exists but not when there is no asset against which to borrow - only a promise. The tendency of the system is to inflate the value of assets so more debt can be created before it is needed. This works for awhile but as we see when the bubble bursts our mechanism for giving loans falls in a heap because there are less assets against which to give loans.

The way to correct the system is ensure that we do NOT increase the money supply until we have assets to back it and the way to do that is to treat "new money" differently from existing money. New money - before it has an asset backing it - should be issued at zero interest and it only becomes interest bearing when the asset is created.

The way to do this is outlined in my various proposals with the generic name Rewards. The best one to start with, because it will also solve the greenhouse gas emissions problem, is Energy Rewards. Rewards are issued as loans at zero interest to the members of the community who use the least energy but they MUST invest the Rewards in infrastructure to reduce greenhouse gas emissions. Thus new money issued by the Reserve bank to be spent as Rewards has zero interest until it is spent on NEW productive infrastructure. Rewards are allocated efficiently because they spent in a market place.

But you will argue how many Rewards should you issue? The answer is how many do you need to reduce greenhouse gas emissions to what is needed. If we issue them at too fast a rate then Energy Rewards will inflate - not the general currency - but that does not matter as long as we get the desired reduction. Also given the drop in asset values elsewhere we need sensible ways of creating some new asset backed money.

Of course it will make Emissions Permits Trading redundant because Renewable Energy Plants are immediately economic because they have no cost of capital. In most scenarios 90% of each energy sales dollar goes in finance costs of interest, capital return, profit and taxes account. We now eliminate the first two because the investors get their return from profit.

Anonymous said...

I just hope whoever loses the bet doesn't get lost looking for the Mt Kosciuszko spelt without a 'z'.

Anonymous said...

I still don't understand why Steven Keen thinks we should listen to him, he admitted he had a large mortgage on his $510 000 property so obviously he hasn't done too well so far in his economic life especially as he's due to retire in a few years. Given he's an economist he would have most if not all of his equity in his own home therefore his personal wealth would put him in the bottom 20% of Australian society. I think i'll pay more attention to those in the top 20% who aren't wishing the world would end to cover up there own countless mistakes made over a very drab and non eventful life.

fabian said...

House price bears like Steve Keenn look pretty silly. See the Residex data released today. Apparently they are up 3 per cent in year to November.

House prices maintain positive growth

Tuesday, 16 December 2008

Australian house values managed to grow by just under three per cent in
the year to November, according to figures released by Residex this
week.

The median value of the Australian home grew 2.97 per cent, Residex
said, to $398,500. This compared to growth of 9.88 per cent in the year
prior but was a strong result compared to share markets which lost
around 40 per cent in value over 2008.

The median unit value grew by 3.94 per cent; this compared to 6.41 per
cent in the 12 months to November 2007.

Residex said it expected capital growth to remain subdued for the next
five years, given the current economic climate.

It forecasts Australian houses and units to grow at an average rate of
2.96 and 1.49 per cent respectively per annum over the next five years.

Anonymous said...

This is one of the best articles I've read debunking Steve Keen's headline grabbing opinions.

A common theme in Steve Keen's material is the assumption that the RBA and policy maker's are a bunch of neo-classical economists who keep on making incorrect policy decisions because neo-classical economic theory is flawed (which it is, but that's not the point).

Firstly, this crisis began in the US and by causing major losses to investors globally as well as effectively shutting down the wholesale funding and credit markets caused a major crisis in liquidity, and subsequently is causing a major economic crisis world wide. It did not begin in Australia and certainly did not begin because the RBA is full of neo-classical economists.

Secondly, as many supporters point out, Steve Keen has been saying this will happen for years. Have you ever heard of the economic cycle? Preaching doom for almost the length of the economic cycle does not give you the licence to say I told you so when it finally happens.

And finally, in this economic crisis, which is potentially the worst we have ever seen, I could not think of a better place to ride out the storm then in Australia. We are in much better shape than a lot of other countries partly because we have a very well regulated financial system and a responsible central bank.

We have/had some of the highest interest rates in the world in recent years. So if our RBA economists weren't neo-classical fools would interest rates have been even higher?

I hereby predict a boom, some time (any time) in the next twenty years, when it happens I'll be knocking on the door of a current affair quoting my prediction.

Michael S said...

Anon, you've completely misunderstood Keen's argument. The argument is that high levels of debt make the economic system more unstable and extremely sensitive to minor fluctuations in the economy.

This is pretty obvious when early last year, with interest rates around their long-term average (not at double digits) and employment at generational lows, Australia witnessed default rates higher than the early 90s recession, which had high unemployment and double digit interest rates. Absent the picture of debt, 7.25% OCR and 4% unemployment would have looked like a runaway boom compared to the 90s. But it wasn't, the economy was slowing, and families were defaulting.

People don't like Keen because he is a housing Cassandra, but his analysis of the situation of debt is spot on. Meanwhile, the RBA have looked at the debt picture and said "nothing's wrong".

Kevin said...

Exactly right Michael S. The way we have structured our financial systems where money = debt gives rise to positive feedback loops in the creation of money which inevitably leads to instabilities or to what others call chaotic behaviour. To see a good description of chaotic behaviour in climate systems take a look at http://www.onlineopinion.com.au/view.asp?article=8341&page=0 - our current financial systems fit this model much better than the general equilibrium models.

Anonymous said...

Thank you guys for your replies, this is a great topic for debate.

Firstly, you don't really need any model to know that an overleveraged economy or business is extra sensitive to fluctuation. That is obvious and it is true that debt levels in Australia are at record high levels by many measures, but this side of the story is quite complex.

I'll get back to that, but first let's be clear about at least two things.

1. The crisis DID NOT start in Australia
2. Australia is not in a recession and there is a good chance that it won't go into a recession

I work at what many phrase as the epicenter of this crisis, that is the global financial markets and specifically money and credit markets. You can consider this a first hand witness account of what actually happened. Let's start at the point where first CDOs started defaulting. The immediate effect was that anyone holding these things lost a whole lot of money. It caused uncertainty about the credit ratings and as an immediate result credit spreads began widening and liquidity started to contract, or in other words capital began to become scarce. A combination of that and losses from subprime CDOs resulted in the defaulting of financial institutions, most significantly Lehmans.

Now, think about what is the role of the financial institution? Essentially they are a money shop, they get money wholesale and either sell it retail or find more efficient uses for it, such as lending it to corporations which use it to make profit for example. You have to realise that after Lehmans the pools of liquidity for financial institutions dried up COMPLETELY - no one was going to give any bank a damn cent unless the banks paid up ridiculous credit spreads.

So how does that effect the economy, to really understand that you have to understand that the economy as we know it is essentially a flow of money. I like to think of money as the economies life blood and the banks are the heart or the distribution muscle. What happens when no blood goes to the heart? The economy has a heart attack and this is what happened.

Yes - we have too much debt, yes credit card debt is huge, yes housing debt is huge BUT this has NOTHING to do directly or even indirectly with the current crisis.

What happened here is that the money flow in the GLOBAL economy was completely shut off at the very center of it. Any recessions are a direct result of this, and again it WILL hurt more because of high debt levels but this is a consequence not a cause.

Debt is one factor in as you said very complex system. Australias high debt is a consequence, again not the cause of an unprecented boom, caused by commodity prices and demand never seen before. Even wtih massive falls in commodity prices look at the current account balance as capacity to export increases.

You quote 2 or 3 figures related to debt - do you think the RBA does not know this? They do know that and a thousand times more.

Let me tell you - there a many people who work very hard at understanding the economy, they don't need to go to tabloid media to be heard because the people that matter listen to them and not mass media. These people consider hundreds of factors, apply many different types of analysis to those factors, and guess what! Do you think anyone believes in equilibrium?? Do you really think that?? Why, because Steve Keen said so, how would he know what real economists believe?
It is very arrogant as well as ignorant to qoute a few figures, use one little model and think that you know better than hundreds of talented people who work very hard and can call on years of experience.

Watch our economy compared to the rest of the world, assess our financial institutions compared to the rest of the world.

To me the beautiful thing about the markets is that rubbish things don't survive long. If the market economists were giving advice which made the banks lose money, they would not survive. Do you think subprime will happen again? I'm sure something else similar will, but the market is slowly learning and that is the power of the market.

Kevin said...

Anonymous gives a good description of what has happened. The "real economy" will continue. There will be a recovery. Australia may or may not go into a recession. The money market will continue - but we have the opportunity of making a small change to the system that will turn the system from a chaotic system to one we can predict. As stated by anonymous the problem is that the flow of money has stopped. How can that be? We have a system where debt = money. We create new money by making new loans of money we do not have. We also keep the flow going by making loans of old money. If there is more debt than we need and if our mechanism for keeping the flow going is debt then of course the system will slow down because it makes little sense to keep creating new debt or to risk the money we have through loaning it out. This is why there appears to be widespread agreement that governments have to increase the flow of money by spending in some way.

Governments can continue to do what they are doing which is to spend money over which they have some control but they also need to create some new money and get it into the system. The current method of allowing some banks to loan more money than they have on deposit is not working because banks are reluctant to lend the money they already have and are soaking up money by getting it onto their balance sheets. Creating money through issuing loans is a sensible way of creating money. Loaning existing money works well because loans have to be paid back and so it is likely that new money created through a loan will be used to create an asset that will enable the money to be repaid with a bit left over for the borrower. However leaving it up to the banks to create loans with money that does not exist is not the only sensible way to create money.

Another way is for the government to create zero interest loans that will be repaid from taxes on the profits earned on the zero interest loans. The question is how to do it? We know governments are not good at allocating resources (spending money) for productive purposes. We know that markets are the best way to allocate resources.

We have another problem called greenhouse gas emissions. We want to reduce the amount of emissions. We are putting in place a system called emissions permits trading which will increase the price of emissions producing energy which will then encourage investment in ways to reduce emissions or to generate emissions free energy. There is another way of encouraging investment in emissions reducing infrastructure and that is to build the infrastructure with zero interest loans. If you make the cost of money zero then all renewable energy projects are immediately economically viable. The reason is simple. The running of costs of most renewable energy systems is low because the cost of the source energy is zero and maintenance costs are normally low or no greater than the maintenance costs of energy plants from fuel burning heat sources.

Put these two problems together and distribute the zero interest loans through a market and we will solve both.

How do we do it? Who gets the loans? How can we be assured they will invest it in infrastructure to reduce greenhouse emissions?

We can do it by

1. Giving zero interest loans to those people in society who consume little mains electricity.

2. Setting up a market place for infrastructure to reduce emissions.

3. Require the loans to be invested through the market place in emissions reducing infrastructure.

4. If either buyers or sellers do not use the money to create infrastructure that reduces emissions then they are banned from the market place and do not get any more zero interest loans.

How many loans do we issue? We issue enough to solve the emissions problem within some time frame - say zero within 10 years. We can make an estimate of the amount of money and if it is too high we can reduce it. If it is too low we can increase the amount. It will not be inflationary because the money has to be spent on producing an income producing asset and because there will be a lot of choice on how to invest the loans.

A system to do what is suggested can be started immediately with the issue of zero interest loans to existing renewable energy projects and energy saving initiatives. This will start the process and give time for the broader emissions reduction infrastructure market place to be set up and loans distributed to the general population who are frugal in their use of energy.

Tim Auld said...

Kevin said: "The "real economy" will continue. There will be a recovery."

Our current economy is based on non-renewable resources, the most critical one being oil which has almost certainly hit global peak production. There's absolutely no guarantee that this economy will continue and that "normal" growth will resume. Almost everyone is assuming this "recession" is just like every other, but it is not. We're past the peak of this civilisation and Steve Keen's 40% drop is optimistic (assuming you like high property values). Automatic Earth is predicting 80-90% reductions. In the long term it may be meaningless as there could be an abundance of derelict homes that people claim or squat in, like in Detroit.

AIEC said...

Australian Property Prices Robertson vs Keen
Recent article in The Australian:

UNIVERSITY of Western Sydney academic Steve Keen made a name for himself with forecasts of economic doom, predicting a 40 per cent decline in Australian house prices. Keen put his money where his mouth is, selling his unit in Surry Hills in Sydney in October last year for $526,000.

However, as always, no comments allowed? Scared that people may agree with Keen and not believe the myth and bull***t surrounding Oz property prices?

I still back Steven Keen, why?

See http://aiecquest.blogspot.com/2009/11/australian-property-prices-robertson-vs.html

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