At Last, the 1975 Show?
My main topic this month is a comparison of the economic events of today to those of 1973–75, but the most recent Case-Shiller data on US house prices simply has to be “the Chart of the Month”. Last *month* the index dropped by 2.3 percent–implying an annual rate of decline in the realm of 25%! US house prices are down 13% from the peak in mid-2006, and in free-fall now.
Meanwhile, back in the 1970s…
In late 1972, Whitlam’s Labor defeated the McMahon’s Liberals, and embarked on an ambitious program of social reform. Two years later, the economy had gone to hell in a handbasket. Inflation tripled from under 5 to over 15 percent, unemployment doubled from under 2 to over 4 percent, and Labor’s reputation as an economic manager was ruined. Labor was slaughtered at the 1975 election, and “stagflation” was the paramount reason for its defeat.
In late 2007, Rudd’s Labor defeated Howard’s Liberals, and embarked on an ambitious program of social reform. Two years later…
Will 1975 make a comeback? Some commentators see ominous signs, with a booming economy and rising inflation: will “stagflation” once again kill a Labor government? Clearly the Rudd Labor Government is determined to avoid this fate. A symbolic freezing of MPs’ salaries was its second policy initiative after the opening of Parliament, while virtually every statement by Treasurer Swan emphasises fighting inflation.
However, identifying stagflation as the villian in 1975 may be a mistake. The real culprit was something entirely different, but strangely familiar: the collapse of a debt-driven boom.
In 1972, the rate of growth of debt accelerated as a speculative boom (mainly in shares) took hold, and just two years later, the debt to GDP ratio had increased by almost a third. Unemployment, which had dropped from 2.5 to 1.7 percent as the boom accelerated, suddenly turned around, hitting 4.75 by the time Whitlam was turfed out of office.
The boom itself was short-lived, and in the context of an overall bear market since the Poseidon bubble of 1970. But it was followed by one hell of a slump, with share prices tumbling almost 60% in two years.
The engine behind the boom and its subsequent bust was the acceleration, and then sudden deceleration, in the rate of growth of debt. Aggregate spending in the economy is the sum of GDP plus the change in debt. With the boom of 1972–73, the change in debt went from providing under 3 percent to over 10 percent of demand.
Then the boom ended, debt went into reverse, and demand fell well below its previous peak.
The collapse in debt gave us the “stag” in stagflation. The “flation” component came from a wages push in a truly fully employed economy (that 1.75 percent unemployment rate should put the recent celebration of “a 33 year low in unemployment” in perspective), and OPEC’s oil embargo and price rises from October ’73 to March ’74. If the surge in inflation hadn’t happened, then the downturn caused by the collapse in debt may well have been worse.
The same story played itself out again in 1990 when “the recession we had to have” hit our shores. This time, there was no pre-existing inflationary surge, and inflation fell drastically as the economy went into recession. So the inflation-unemployment story was very different to 1975.
The debt-unemployment dynamics, on the other hand, played to the same tune. The 1980s share and commercial property bubbles were debt-financed, and as debt levels accelerated from 54 to 85 percent of GDP (a rise of almost 60%) unemployment plunged from 9.5 to 5.6 percent.
Then the rate of growth of debt decelerated–as the bubble in commercial property became obviously ridiculous, and the RBA’s dramatic increase in rates finally bit–and the economy went into its deepest recession since WWII.
The 1990s downturn was more severe than the 1970s and mainly because debt was so much more important. Debt’s contribution to demand in the 1980s bubble peaked at 14 percent–compared to 10 percent during the 1970s. Its minimum was actually negative (-1.5%) as corporate Australia drastically cut its debt levels–in part, deliberately and in part under duress.
So what about today? We haven’t had a bust–yet. And by conventional measures, we have had “the longest economic expansion in Australia’s post-War history”. Unemployment has fallen from 11 to 4 percent, while inflation has been quiescent, at normally under 3 percent.
And behind this apparent success, once more, has lurked a debt bubble–the biggest in our history (and I’m talking since Captain Cook). The debt to GDP ratio bottomed out at 79 percent in mid-1993, and began a climb that is truly “the longest expansion in private debt in Australia’s recorded history”. When the “recovery” from the 1990s recession began, the debt to GDP ratio had fallen to 79 percent; it has since more than doubled to 164 percent. This, more so than China, has given us the apparent but illusory economic success of the last fifteen years.
Today, the annual increase in debt is responsible for almost 20 percent of aggregate spending in our economy. We have truly become addicted to debt.
The danger is that, if–when–the rise in debt comes to an end, so too will our apparent economic prosperity. As the 1990s collapse showed, debt can quickly go from making a positive contribution to demand to a decidedly negative one. Given that we have become so much more dependent on rising debt to fuel demand, the scale of the turnaround, when it comes, could dwarf 1990.
The secret to avoiding such problems, of course, is to develop “ a ‘good financial society’ in which the tendency by businesses and bankers to engage in speculative finance is constrained” –to quote Hyman Minsky from over 30 years ago. But we didn’t do that, and at some stage, we must cope with the consequences.
When that day of reckoning arrives, one thing that won’t make things better is keeping the rate of inflation low. The high inflation of the 1970s is one factor that made that downturn less extreme than it could otherwise have been; and the lower inflation (and almost deflation) of the 1990s extended that recession.
Journalists with long memories may remember Warwick Fairfax lamenting that the low inflation of that time made his woes worse. If inflation had been higher, he could have put up the cover price of the Sydney Morning Herald and perhaps avoided bankrupting the family firm.
With inflation now even lower than it was when the ’90s bubble burst, the real future danger is not rising prices, but the possibility of deflation.
END OF COMMENTARY
But as Steve Jobs sometimes says, “there’s just one more thing”. The next two charts (which appear at the end of the PDF for this month’s Debtwatch) show the nominal and real debt burden on the economy–i.e. nominal (before inflation) interest payments as a percentage of GDP, and real (after deducting the rate of inflation) interest payments.
The nominal burden is edging ever closer to the maximum in recent times: in 1990, when average interest rates were just under 20%, debt was about 80% of GDP, and interest payments represented 16.7% of GDP. The increase in rates and the ever-present trend to rising debt levels will, it seems, lead us to crossing that nominal threshold sometime this year.
However, when we adjust for the impact of inflation, the 1990 debt repayment peak gives way to 1891 and 1931, when falling prices–deflation–drove the real burden of debt up to 19% and 12.5% of GDP respectively.
We’ve already passed the 1990s level of the real (inflation-adjusted) debt burden on the economy; but notice how the recent rise in inflation has actually reduced the real burden of debt recently–even though nominal rates have increased substantially.
Nonetheless, the real burden of debt on the economy is now in the realms of the 1890s and the 1930s, when both debt levels and nominal rates of interest were much lower than today, but the burden was amplified by falling prices–deflation. We are in that same ballpark, even with inflation. The reason I am concerned about the RBA and the Government’s obsession with keeping inflation low is that we could possibly be tripped into deflation when the economy tanks. Then the real burden on the economy would skyrocket–and we would enter a true debt-deflation.
