Australia has a new high-profile property spruiker. But it’s not a real estate agent or buyer’s advocate or even mortgage broker -- no, Australia’s latest high-profile property bull is (worryingly) the deputy governor of the Reserve Bank, Ric Battellino. Last week Battellino (who has never actually worked outside of the Reserve Bank since graduating from university in 1973) defended Australia’s ever-growing property bubble, telling the National Housing Conference in Melbourne last week that:
… Australians seem to spend less of their income on non-housing consumption then is the case for US households, with a significant part of the difference explained by lower health costs in Australia. Australian households therefore have greater capacity to service housing loans.
While the US spends a greater proportion of income on health costs, (according to the Productivity Commission, in 2005, Australians spent about 8.5% of GDP on health, compared with 15% in the US) that doesn’t actually explain the difference in housing costs. The median cost of a US property is about$US180,000 or 3.5 times median income, compared with $A405,000 in Australia or 7.6 times median income. Battellino is therefore suggesting that because Australians spend a couple of thousand less annually each on health, they are able to spend hundreds of thousands more on property. Moreover, in global terms, Australia ranks right on the OECD average for health spending, however, Australia’s housing remains expensive compared with other developed nations. For instance, Australia actually spends more on health costs than the UK, however, in Australia property prices are about 7.6 times income, compared with approximately 5.3 times income in Britain. The health-care argument appears to be a convenient furphy. Battellino continued:
It is certainly the case that the ratio of house prices to income in Australia is higher now than it was 20 years ago. However, this is explained by the fact that the fall in inflation has allowed nominal interest rates to cycle around a lower average level now … that is, lower interest rates have allowed households to take to bigger home loans, without increasing home loan payments.
Inadvertently, Battellino appeared to answer his own question: Why is Australian residential property resembling an asset bubble? The answer is simple -- massive increases in debt. While Battellino argued that the increased leverage is vindicated by lower interest rates, his premise appears based on the optimistic assumption that interest rates (and inflation) will remain indefinitely low. Given the recent tendencies of the US and UK to undertake quantitative easing (which increases the money supply), it would be foolish to declare inflation (especially in the medium to long-term) dead. Further, the use of debt has created a housing price mirage -- property appears more valuable, but that is simply because banks have been willing to lend buyers more money -- not because rental amounts have increased drastically or Australian’s are far wealthier. For example, the large banks are all willing to lend purchasers up to 90% of the value of a property. In Melbourne, RP Data reports that median prices have increased from $350,000 in 2005 to about $500,000 now. In simple terms that means in 2005, banks were willing to lend the median property buyer $315,000. However, with property prices increasing those very same banks are willing to lend to the very same hypothetical buyer an amount of $450,000 for the same property. Has the intrinsic value of Melbourne property increased in value by 43% in four years? Unlikely, given BIS Shrapnel reported yesterday that rents have increased by an average of just 3.5% annually in recent years. To put it is in perspective, since 2005, GDP has increased by about 10% (total). In theory, property appreciation should very roughly track increases in GDP (or inflation but the two have been relatively similar in recent years) -- if that had happened, Melbourne median property prices would be about $350,000.  However, currently, property prices bear little resemblance to the value of their rental yield -- instead, their value is largely determined by how much banks are willing to lend to buyers (coupled with external demand factors such as  the first home-owner’s grant). Leaving aside the issue of whether Battellino’s principles are correct (and there are certainly valid arguments to the contrary), it is arguable that a role of the central bank is to act to prevent a asset bubbles from occurring. In other words, ensuring that an asset class doesn’t deviate dramatically from its intrinsic value (which is the present value of all future cash flows). Recent turmoil in Dubai (where property prices have fallen by 50%) and in the United States (which is down by more than 30%) has indicated that asset bubbles can lead to a dramatic misallocation of wealth -- instead of capital being invested in income-producing assets, it is used for speculation. When prices eventually return to intrinsic levels, not only does that capital evaporate, but the economy’s productive capacity is substantially diminished. Had Alan Greenspan and the US Federal Reserve not maintained a low interest rate regime after the dot.com crash in the early 2000s, the US would most likely not have experienced such a violent residential property boom. The bubble and subsequent bust in 2008 led to a dramatic slump in GDP and total unemployment exceeding 16%. Australian properties offer terribly low yields, with returns coming from the "bigger idiot theory"  -- the principle that in the coming years to someone will pay an even higher price for an asset already divorced from its intrinsic value. But this isn’t a concern for our central bankers. It’s probably time someone told the Reserve Bank that the first step for any (debt) addict is to admit that they have problem.