House prices are a bubble waiting to burst

Author: Kenneth Davidson 
Date: July 31, 2008

A recession is the biggest threat to Australia's real estate market.

ARE house prices going to crash in Australia as has occurred in the US? Based on West Sydney University economics professor Steve Keen's regular Debtwatch newsletter, the answer is probably yes.

The doubling in real terms in house prices in the past decade is a bubble waiting to burst. According to Keen, the bubble is based on speculation financed by debt. Keen claims it is effectively a "Ponzi scheme" where dividends are paid out of new rounds of capital injected into the scheme instead of the non-existent profits. The scheme collapses when there are no new investors to pay the dividends.

In the case of real estate speculation, according to Keen, "the only way the individual speculator profits from real estate speculation (and sharemarket speculation) is either by selling to somebody with a higher income or by selling to another individual with a similar income, who takes on sufficient debt to buy the property at a price that exceeds the speculator's price plus accumulated net losses from debt serving".

The banks and the Government are the witting, or unwitting, financiers for this massive Ponzi scheme. The banks are directly or indirectly responsible for most of the lending for housing. The Government offers an inflation multiplier through the tax system through negative gearing, which allows investors to write off the interest expense against all income instead of just rental income, and pay only half the capital gains tax when the house is sold for a profit. These concessions cost tax revenue some $2 billion a year. It is a notorious form of middle-class welfare that is never on block in discussions about the need to curb Government spending. And yet, by directly adding to the inflation in house prices, the tax concessions reduce the supply of affordable housing and shuts an increasing proportion of the middle-class out of home ownership.

The banks have contributed to the Ponzi by lowering lending standards. It is an iron law of financing: apart from meaningless advertising, the only way banks can compete for customers is by lowering lending standards. It was the reason why, after financial deregulation in 1983, the banks quickly ran up some $20 billion in "non-performing" loans — they were able to borrow unlimited amounts from overseas to onlend to customers. This led to the closure of two state banks, rising debt, massive asset price inflation and then treasurer Paul Keating's "recession Australia had to have".

Within two decades, the lesson was forgotten. Driven by the "carriage trade", where Australian banks could borrow cheap on the capital markets of Asia and the US to lend dear to their customers in Australia, foreign debt nows exceeds $600 billion, or more than half annual GDP, and domestic debt is about $1.7 trillion or 65% of GDP.

As Keen has noted, while an individual can escape from an excessive debt by selling property for a profit, the nation as a whole can't.

It is possible to imagine the Australian housing market going into meltdown, but probably not in the magnitude of the US, more because of the different culture within which the two financial systems operate rather than superior risk management within the Australian system.

The "subprime" meltdown in the US was a consequence, rather than a cause, of the collapse in house prices.

The US is a far more stratified society than Australia and this is reflected in a lack of standards and planning in outer suburban developments, apart from stratified and gated communities for the middle-class and the rich.

About 11 to 12 million houses throughout the US are empty and about 20% of people live in streets where houses are simply boarded up.

The loans that financed these homes were allocated by agents who didn't care that their clients were NINJAs (no income, no job, no assets), or the housing was in jobless ghettos without public transport, because the loans were bundled and on-sold.

Fortunately, we have no single-industry cities like Detroit, no urban ghettos on the scale of many US cities and a more egalitarian distribution of income and social infrastructure. But we are following the US down. House prices are falling in the outer suburbs of Sydney and Melbourne because of substandard public transport.

Thankfully, we have resisted the recommendations of right-wing think tanks such as the IPA to deregulate urban planning and cut development taxes to boost the supply of affordable housing.

The biggest immediate threat to Australian house prices is recession leading to rising unemployment and a slump in immigration.

Kenneth Davidson is a senior columnist. Email: kdavidson@theage.com.au