The need for boundless growth is a problem: Catherine Cashmore

There seems to be a perceptible sigh of relief across Australia now that spending has started once again. As RBA deputy governor Philip Lowe pointed out in a speech last week:

“Nationwide measures of house prices have increased by around 4% since mid last year, after having declined for around 18 months. Home lending approvals and auction clearance rates have both risen. Equity prices are up over 20% since the middle of last year. And the level of consumer confidence is now well above its long-run average level. Despite what one often hears, households do appear to be feeling better about both their finances as well as Australia’s medium-term prospects.”

Mr Lowe is correct in his assessment of the housing market: conditions have improved and people are once again out and about leveraging against existing assets, and pooling their savings into bricks and mortar.

In Melbourne, according to the REIV, the overall value of residential sales at auction has increased substantially compared to this time last year. Transactions sold at auction over the first few months of 2013 currently total $1.8 billion, compared to $1.5 billion in March 2012 - and the value of private sales has also risen from $3.9 billion to $4.5 billion. It’s a remarkable improvement considering overall turnover last year was back at levels not seen since 1996 as we limped through 12 months of no perceptible growth, aside from a slight ‘uplift’ in the numbers attending both auctions and ‘open for inspections’ in December.

So is it back to business as usual? Well, for the time being maybe – except of course for first home buyers who are struggling to join the party in any significant proportion – a segment that seems to be discounted amongst those calling ‘recovery.’  Albeit, it’s clear from the Governors speech that the post GFC period, during which we’ve been encouraged to save and pay down debt, is drawing nigh.

I suspect, outside of the daily grind most endure to keep their mortgage repayments under control whilst squirreling away funds for retirement, scant thought is given to the broad concept of ‘money’ – or indeed where money essentially comes from.

Whenever we hear a speech on the housing market from the RBA, it’s accompanied by a short history lesson on the major influences that have lead to our fortuitous years of ‘boom’ appreciation, during which we’ve seen median house prices balloon some 200% – outpacing both wage growth and inflation over the same period.

For example, in one of their most recent publications cautioning on a lower growth atmosphere, we were educated thus:

“Over the past 20 years or so, upturns in the housing market have been accompanied by an increase in the growth rate of credit. But those years were also a period of structural change as the economy moved to a higher level of household indebtedness. Generations of households yet to buy their first home, or still wanting to trade up, were taking advantage of easier access to credit, which among other things had been facilitated by the shift to lower inflation and lower interest rates in the early 1990s.”

It’s a seemingly fitting non-emotional explanation to explain away the dramatic increase in prices – albeit it doesn’t quite paint the full picture of where this supply of money actually originated from.

The economist JK Galbraith coined what is perhaps the best explanation of our monetary system when he said "the process by which banks create money is so simple that the mind is repelled. When something so important is involved, a deeper mystery seems only decent."

I’m sure some reading this that will be well educated in the dynamics of debt creation – it’s no hidden secret, just rarely discussed.

However, there will be a good proportion who have yet to be initiated into the remarkable system of monetary supply that has allowed the majority of our currency – some 95% of it – to be created out of thin air through the process of bank lending.

In fact the story behind this great supply of money would make a fitting accompaniment to the unfolding plot in the film Oz The Great and Powerful. As long as we ‘believe’ it doesn’t really matter what’s occurring behind the scenes – processes which in arguably ‘less responsible’ hands ultimately lead the world to the brink of economic collapse.

And as countries around us wake up to the devastating repercussions of what can happen when ‘things go awry’ – organisations campaigning for a better way are slowly gaining traction.

If you have an innocent understanding of economics, you may still be under the illusion that banks make their profits by leveraging against depositors funds and thus, charging interest on the loans they advance through a process called ‘reserve ratio’ or ‘the money multiplier’ – keeping a proportion of the balance safely aside whilst extending the rest to a borrower as credit.

However, whilst no one would disagree that economics is a complex subject in its own right – this myth was debunked a long time ago – although perhaps more publicly so since the on-set of the GFC.

Importantly, the central bank doesn’t control the amount of money circulation – commercial banks do – based on their own models of risk assessment, which are arguably developed and manipulated behind closed doors.

You see, when a bank extends a loan, the figures typed into your loan account are just that – simply numbers put there on the premise that the bank has assessed you a credit-worthy individual who will honour the terms of their contract.

In the simplest sense, this loan (the figures typed into your bank account created from ‘nothing’) are counted as a ‘deposit’ – money you owe to the bank, and therefore instant ‘wealth’ upon which the bank can extend further credit into the economy.

Banks don’t have to limit themselves to lending out this somewhat fictional money based on any ratio set by the RBA – or the funds they receive from depositors. In other words, it’s commercial banks that control the level of ‘money’ (debt) which circulates in the system.

Consequently, almost all the currency out there is money which has been created and expanded through an increasing variety of financial models. Money ‘loaned’ into existence with interest attached – for which additional funds are required to service the extra repayments. As the money supply increases, so does inflation, but principally on the goods that it ‘funds’: real estate.

Let me briefly recap. In almost all modern countries operating under the same system, only 3-5% of ‘real’ money originates from the government-owned mints, the rest is conjured up with the words ‘I believe’ when a bank makes a loan.

As Adair Turner, Chairman of the FSA, eloquently put it in a speech ‘Credit Creation and Social Optimality’ following the GFC in Sept 2011:

“The banking system can thus create credit and create spending power – a reality not well captured by many apparently common sense descriptions of the functions which banks perform.  Banks it is often said take deposits from savers (for instance households) and lend it to borrowers (for instance businesses) with the quality of this credit allocation process a key driver of allocative efficiency within the economy.  But in fact they don’t just allocate pre-existing savings, collectively they create both credit and the deposit money which appears to finance that credit.”

Considering banks favour lending against existing collateral over and above the support of say small business and enterprise, it should come as no surprise that the vast majority of bank lending has been towards the purchase of ‘bricks and mortar’ – and whilst the only constraint on the amount of money ‘created’ is people’s ability to service the debt – we should not be under any illusion that the RBA wouldn’t welcome a return to ‘business as usual’ in our revolving system of finance.

According to RP Data, Australia’s property market is worth an estimated $4.86 trillion, which is three-and-a-half times the value of Australia’s stock market and combined superannuation funds. Therefore, it’s no surprise that the health of our property market dominates the conversations of both those in and out of the real estate industry – an asset class towards which banks are highly exposed.

Without going into further detail, the one problem with our economic model is the requirement for boundless growth – more debt requiring more activity just to maintain the amount of money we have in circulation. Without it, we lose our jobs and our ability to service this growing supply of credit.

Collectively, we’re all in debt – and for those who aren’t, the remainder pick up the slack.  And although its broadly recognised that the initial boom in borrowing which occurred in the decades leading up to the GFC is unlikely to continue at such a rapid pace, you would be foolish not to recognise the risks associated with an economy which has its foundations pinned on a future which has to forever ‘be bigger’ in order to stay afloat.

I came across a cartoon the other day with the wording:

“Oh, The World is $40 Trillion in Debt?”

“Please, tell me who the world is in debt to?”

The answer of course, is the banks. Albeit, whilst we’re rocking along under the protection of the mother of all mining booms, underpinned with increasing demand from China, and in the throes of relatively rapid population growth, the party can seemingly continue ad infinitum.

Albeit, make no mistake - the rocky foundations are there - a younger generation slowly ‘priced out’ – for which the government can only assist through the extension of a further allowance of ‘cheap’ credit, which thus far has not produced any lasting effect.

Not to mention an ageing population who will eventually outnumber the workers, leading the ‘big Australia’ advocates yelling ‘populate or perish!’

The game of checkmate won’t change until the system changes, and the system won’t change until its hand is forced.

With these thoughts in mind, perhaps it’s time to remind ourselves what Citi's Global Head of Credit Strategy, Matt King, cited late last year as “'The Most Depressing slide” he had ever created.

“In almost every country you look at, the peak in real estate prices has coincided – give or take literally a couple of years – with the peak in the inverse dependency ratio (the proportion of population of working age relative to old and young).

In the past, we all levered up, bought a big house, enjoyed capital gains tax-free, lived in the thing, and then, when the kids grew up and left home, we sold it to someone in our children's generation. Unfortunately, that doesn't work so well when there start to be more pensioners than workers.”

Food for thought is it not?

Catherine Cashmore is a market analyst with extensive experience in all aspects relating to property acquisition.