Why the Reserve Bank of Australia is Getting Worried

australian home with banknotes

More good news, everybody. It involves vodka. If you’re one of the 800 passengers who’s booked a ticket on Richard Branson’s Virgin Galactic service, you’ll be able to get properly liquored up before taking off. A takeoff before liftoff!

Branson announced a partnership with Grey Goose Vodka at a press conference yesterday. The parties said it was a good match because they share the philosophy that ‘extraordinary achievement comes from acting on your beliefs.’ Extraordinary self-belief is also directly related to vodka consumption, at least for some people.

Good on both of them. Virgin Galactic leads the race to begin commercial spaceflight. Mind you, it’s prototype form; Virgin’s service is really an expensive roller coaster ride. It’s not as if you’ll be able to commute from London to Sydney in a few hours. But all great commercial ventures begin with an innovation.

The sooner we can get off this rock cheaply, the sooner we can begin mining other rocks in space. Speaking of which, there was yet more good news on the asteroid mining front this week! Under a law proposed by a sub-committee of the US House of Representatives, private space mining companies would have ownership over any resources they extracted from an asteroid.

Now hold up. I know what you’re thinking: ‘What right does the US Congress have to decide what property rights apply in space?’ And it’s true. The US Congress can’t make laws for everyone else, though I’m sure it would dearly love to try.

But the United Nations Outer Space Treaty of 1967 — signed by 102 countries — actually bans countries from appropriating astronomical bodies. This would prevent the US, Russia, China or India from saying, ‘The moon is mine!’ The Treaty was designed to prevent a Space Race dominated by the acquisition of territory by national governments.

If you want to encourage the progress of mankind in the solar system, though, you need to extend the right to private property to the stars. Clear legal title to the fruits of your labour is a good incentive for anyone, in any galaxy, at any point in space-time. Let’s hope the US Congress can show some vision and get it done.

In more terrestrial matters, let’s talk about real asset prices right here on planet Earth. The Reserve Bank of Australia certainly had property on its mind when it published its semi-annual Financial Stability Review. I’m not going to quote chapter and verse from it. It would bore you nearly as much as it bores me. But the warning on property was clear.

The Bank is worried that both borrowers and lenders are taking on more risk than is prudent. It reckons the risk isn’t serious yet. It’s manageable. But it’s discussing the use of ‘macro-prudential’ tools to cool speculative lending and borrowing. That lending and borrowing could be bad for banks, households, and the economy.

Before I get into all that, let me ask the obvious question. If the RBA were concerned about the destabilising effects of rising house prices, why wouldn’t it just raise interest rates? Why on Earth would it resort to ‘macro prudential’ regulation instead of using the most powerful tool in its own box — higher interest rates?

Oh! That’s right.

The RBA is completely boxed in. It knows that leaving the cash rate at 2.5% for over a year has led to a bubble. But the rest of the economy has stagnated. It can’t raise rates to pop the Australian housing bubble without throwing the economy into recession. Instead, it will handball the problem to the Australian Prudential Regulatory Authority (APRA).

APRA is charged with regulating the banks. And for its part, it reckons there may be a bit of a problem with the status quo. Investors with interest only loans are a bigger part of the market than ever before, according to APRA data from its report on the June quarter.

Klaxons! Alarm bells! Someone tell the risk managers at the Big Four.

Over $1.22 trillion in residential property is held on the books of Authorised Deposit-taking Institutions (ADIs) in Australia, according to APRA. By comparison, ADIs hold about $230 billion worth of commercial property. I’ll come back to commercial property tomorrow, as it’s directly linked to the value of the Aussie dollar and could put property developers and AREITs at risk to a big correction.

But on the residential side, the risks are real too. Of that $1.2 trillion in housing, 66.2% ($811.7 billion worth) is owner-occupied housing. The other 33.8% ($413.5 billion) is investors’. More importantly, 35.7% of all housing loans, for investors and owner occupiers, are interest only.

This explains the almost neurotic fixation Australia has on interest rates. And it explains why interest only loans are so dangerous if and when interest rates rise again. A negatively geared, interest only loan, is nothing more than a bet on higher house prices. If those prices fall, or rates rise, the borrower will be in negative equity quick smart.

Funnily enough, the RBA said it wasn’t that worried about the risk to bank balance sheets from falling house prices or rising interest rates. Apparently, it’s confident the banks have plenty of capital to withstand losses in the value of their assets. What’s more, it’s pretty confident the assets themselves won’t fall in value that much.

The RBA seems far more concerned with the ‘macroeconomic risks’ of rising rates and falling house prices. A borrower in negative equity is not going to be a good consumer. And the last thing the Bank wants — in an economy where the mining investment boom is dead and house prices are elevated — is a consumption bust. It wants the ‘wealth effect’ to keep people happy, borrowing, and spending.

A ‘macro-prudential’ regulation might, just might, give the Bank what it wants. Specifically, APRA might look at limiting the loan-to-value ratios for investment properties. But if it’s going to do so, it better hurry. Lending to investors was up 14.4% year-over-year, according to the June data. Nearly 38% of all new loans were to investors. And a record 43.2% of those loans were interest only.

Really, if you were scripting this as a car crash, this is how you’d write it. The explosions and sirens wouldn’t be far away. The ambulance would be called.

Even the factors for preventing a crash in Australia may not be working in its macroeconomic favour right now. Take recourse mortgages as an example. Because borrowers cannot mail in the keys of the house to the bank (‘jingle mail’) here in Australia, it’s been said that you can’t have a US style house price crash.

But Ireland had a predominantly recourse mortgage market. Borrowers were stuck with the loan no matter what. The bank could chase their other assets up if it wanted. The housing market crashed anyway. Whether or not the mortgage was recourse or non-recourse had nothing to do with the soundness of the lender’s judgement or the borrower’s ability to pay.

Talk about a balance of power that clearly favours the banks over consumers! It’s practically medieval. Let’s call it serfdom. And I’m only partly joking.

There is a clear social and macroeconomic negative to having people locked into mortgages with negative equity. Not only are borrowers in thrall to the lender, they’re immobile too. They can’t move to find better, higher-paying work. Or they can’t move to find a cheaper place to rent.

In this sense, Australia’s fixation on homeownership, coupled with recourse mortgages, is bad for the punter on two counts. It doesn’t make sense, economically, to be overly invested in houses. But in the elusive chase for fictional financial security, the housing obsession distorts the structure of the labour market. That’s a lot of wealth destruction in the name of property prices.

But getting back to yesterday’s topic of the relationship between political power and banking, you can see why the status quo is favoured by the banks, property developers, and the government. They all make out like bandits from it. When the bubble pops, it will be the taxpayers who pay the tab.

Historically speaking, it all began to go pear shaped when the merchant bankers shifted their focus from enterprise to financing the debts of monarchs and governments. It was at that point that their profit was derived not from the creation of wealth through productive trade and enterprise, but from bankrolling the sociopaths’ intent on accumulating power and lording it over the less well-armed.

You simply couldn’t have the modern nation state without a sound, reliable, and pliable lender of last resort (the central bank). That’s why you see the merchant banks of the 14th, 15th, and 16th centuries giving way to the central banks of the 17th Century. And that’s about the time we see the formation of the modern nation state.

The Bank of England, capitalised by the debt of the crown, was created in 1694. England began her glory years as an empire. The British Navy enabled/enforced global trade. Britain accumulated great wealth and military power. John Law’s Banque Royale came a few years later. And Napoleon’s empire a few years after that.

It’s been more wars and less liberty ever since. The early relationship between the merchant banker financiers and the State evolved, to be sure. As banking aided the growth of centralised political power, it wasn’t enough to be on favourable terms with your bankers. You had to own the bankers. Or they had to own you. It’s not clear which is which. These days, it’s a revolving door between those who work for treasury departments and those who work for banks. They are one in the same.

What is clear is that that the rise of the nation state — something geographically bigger and bureaucratically larger than a city state — is dependent on access to debt and control over money. Since we are now engaged in a great financial war over the control of money, it’s worth considering an idea: If money does not survive in its current form, the nation state may not survive in its current form either. And that might not be such a bad thing.

City states like Hong Kong and Singapore — and even smaller nation states like Switzerland and the Nordic countries — seem to be pretty effective arrangements for producing wealth, order, and a fair degree of political liberty. Nothing’s perfect. But perhaps size matters after all. And when it comes to civil society and political liberty, and trade over force, smaller is better.

If you were building a Jenga tower from scratch, it would probably end up being the size of a city state. You could build lots of different towers, in fact, on the same blueprint. They would all have the same basic foundation: low taxes, free trade, the rule of law, sound money, and a constitutional basis for individual liberty and private property. More on that tomorrow.

For today, let me close with another idea from mathematician and science fiction writer Vernor Vinge. It’s why I’m so optimistic about the colonisation of space by entrepreneurs. Not only is the prospect a much more optimistic future for our species that one world government. It’s a morally superior vision for how we might evolve as a species.

In his novel A Deepness in the Sky, Vinge wrote about the only lasting empire in human history: the empire of trade. ‘No government can maintain itself across light-years,’ he wrote. ‘Hell, most governments don’t last more than few centuries. Politics may come and go, but trade goes on forever.

But trade, he points out, never sets out to be an empire. It’s just an idea about how to get along in life and create value for others at the same time. Traders don’t seek conquest or power. They seek profit through exchange. You find trade anywhere you find the rise of a great power. The wealth comes first. The pursuit of power and conquest comes second.

Government power relies on force. But force comes at a price. It can be paid for with taxes. Or it can be paid for with borrowed money. That is why the centralisation of power in the nation state is tied directly to control over money.

That control comes at your expense, both financially and politically. It makes the world poorer and less free. There has to be a better way. There is. Tomorrow, I’ll return to the subject and apply it Australia itself.


Dan Denning+
For The Daily Reckoning Australia

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Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.

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2 Comments on "Why the Reserve Bank of Australia is Getting Worried"

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slewie the pi-rat
slewie the pi-rat
2 years 27 days ago
Galactic Virgin + Vodka…? this space mining is not something i had seriously considered before… “More importantly, 35.7% of all housing loans, for investors and owner occupiers, are interest only. This explains the almost neurotic fixation Australia has on interest rates.” private property in space will be very important to all the banksters and government-monopoly-cabal combines. i’m sure that’s why they have their legal-beagle Congress Critters working on the boilerplate with their money-lobbies, legal staffs, revolving-door engineers, and [of course] the obligatory spooks, military officers, and ethicists. meet the new boss… some questions arise: ~doesn’t private property also rely on… Read more »
2 years 26 days ago
The liquidity problem… is a risk pricing & collateral scrutiny problem underlined by limited liability regimes & fake insurance The private citizen investor’s 19th century cry of “I’m rooned!” once sat alongside the then prevailing raw leverage alarm bell orthodoxy. Lately, the latter at least is back in vogue among corporatists, and an indicator of things to come in changes to limited liability incorporation laws (private bail-ins called capital calls). http://www.bankingday.com/nl06_news_selected.php?act=2&stream=1&selkey=17423&hlc=2&hlw= Increasingly, from those days to now, corporatist public servants, and the politicians they groomed, came to view themselves as the most accomplished risk-takers on this planet. And they had… Read more »
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