Instead I will throw a curve ball. Please bear with me. Animal Spirits was written by two US economists – George A. Akerlof and Robert J. Shiller. They are part of an emerging field of behavioural economics — a branch of economics which has arisen to compensate for the perceived shortcomings of neo-classical thought. Duke University put together a great video primer on the topic.

In Chapter 15 the authors take a hard look at the causes of house price booms. Taking the time to demolish the majority of arguments that are touted by property boom mongers. In their cross hairs, is the argument that house prices will always go up in response to land shortages and population growth.

They argue conclusively that rapid price escalation in the housing market, is driven as much by human psychology, as it is by any of the economic factors cited in the press.  In particular our intuitions and foibles as they relate to fairness, confidence, story telling and money illusion.

I thought of an interesting experiment during my reading of the book.

I wondered what would happen if for the next three months the press only published articles on how house prices would drop precipitously due to debt overhang, economic issues overseas, rising interest rates or a change in government policy. Would prices stage a dramatic reversal even though the economic fundamentals kept humming along?  I am betting that they would. I believe that such a change in story would do much more that a few pithy changes in interest rates, mostly soaked up by the tax payer through negative gearing tax deductions.

This is a blindingly unrealistic experiment. But it seems to me that so much of the price increase is driven by the ever more prevalent belief that real house prices will rise for ever. A belief that is perpetuated even by media commentators lamenting the negative impact on first home owners and the economy more broadly.

We are still stuck on the story that we are growing every richer digging stuff out of the ground for China and India. It is true to a certain extent. But it is also easy to argue that we have just enjoyed a nice little debt binge that will give us a splitting headache when we wake up to the reality of our actual national situation.

Okay, time to get back on track. In Animal Spirits, the authors make clear that the boom mongers claims are like a broken record. The same arguments keep appearing during a run-up in prices and then hightail themselves back to obscurity during the more prevalent times that prices are falling or stagnant. Here are some of my favourite quotes from the book:

“It appears that the fixed land, population growth, economic growth story has perennial appeal…”

“The story spreads by word of mouth and is enhanced by the intuition behind it… Outside of booms it is hard to find statements that real-estate prices will always go up… ”

“It is relatively easy to find places and times where land prices have fallen significantly despite population pressure and land restrictions”

It all brings a smile to my face. Perhaps we Australians are not smarter than people in other countries after all. Perhaps we are  just dismally slow at recognising a good fictional tale.

Summary of articles

• Housing Market favours the Grey rehashes the conflict between the older and young generation in respect of house prices
• Ever Rising House Prices echoes the sentiment of Animal Spirits and laments peoples conventional wisdom on the Australian House Price Miracle
• Housing Drove Rate Rise makes the rather startling point that Housing Price Increases might be just as important as GDP numbers
• Australia Faces Housing Affordability TimeBomb paraphrases the CEO of Stockland starting a panic about house prices
• The Great Divide provides an interesting insight into the consolidation of family groups in the affordable outer suburbs
• Bubble and Squeak as the First Home Owners Market Feels the Squeeze is another round of confusing speculative predictions on the housing market
• Batten Down the Hatches, The Water is Still Treacherous does its best to warn of the disparity between our renewed optimism and the world around us
• Banks Put a Squeeze on Housing provides the startling statistic that 88% of mortgage lending was for buying or renovating existing homes
• Dazzled by Housing’s Magic Rise is by Tim Colebatch and is a better written version of my previous commentary in Misplaced Price in Australia’s Housing Market

I still remember coming back in 2002 from London with cash in hand and rather naively calling the top of the market. A friends renovated spacious 1 bedroom in Glen Iris sold for $160k and we thought he had made out like a bandit. An agent offering a 2 bedroom in Carlton for $260k was taking you for a ride.  In today’s market both of those places will have doubled in price.

Real-estate agents use phrases such as “it looks like the market will be good this year” in response to glowing predictions of future house price growth. I’ve met agents I like personally. Unfortunately, as an industry they are like carrion — feeding off the dying hope of a generation priced out of the housing market.

If I could I would retrain them all as builders and labourers and get them out there helping to increase the supply of great places to live – not gleefully rubbing their hands together at the shortages that drive up prices.

But it is not really agents who can be solely or even mostly blamed. It is an ugly gordian knot of intertwined interests that conspire to keep us moving forward on our present course.

Our ability to borrow without a downpayment, negative gearing and foreign investors are the source of the hot air blowing up the bubble. Our intolerance for bearing the consequences of past risks taken and the resulting years of hardship are blocking the safety valve of reason, historical lessons and just plain old common sense.

Trish Bolton shed some light on the dilemma in her article,  Always Thinking Positive Can Be a Negative .  You can read the detail, but her point is that we seem to be captured by the belief that no matter what happens – everything will turn out alright in the end.  It is an argument for suppression dissension and against reasoning forward and discovering an ugly cliff at the end of the road we are on.

Debt? We didn’t do it. They did.

Three newspaper pieces stood out this week. All of them proving that I can still be shocked by some politician’s innate ability to confuse a relatively straight forward subject matters.

For those who are too busy to read the broad sheets, here is a upshot of three topics that appeared in The Age newspaper between the 9th and 11th of February. Senator Joyce got strung up for questioning Australia’s debt levels by a hardball Labour party.  Australia’s largest bank, CBA, opined that Australia cannot afford to adopt conservative international liquidity standards. Vic Urban’s got taken to task for daring to sell affordable housing in Melbourne at a bargain base price of around $800k .

I thought I would take the time to clarify exactly what debt is, why it matters and how it relates to our housing obsession. If anyone finds a better explanation – send me the link.

What is debt?

This explanation is the non-economist types under the impression that derivatives are scraps left over after cutting up a cow and equilibrium is what you need whilst walking drunk down a narrow painted line being observed by a gun toting cop in Texas.

Everyone else can your eyes and skip down the page.

There are two dimensions of debt. If you understand both these dimensions you are ahead of most published financial commentators in the media.

First dimension. One word -  “who”. In most countries, ours is no exception, we divide our debt into two categories based on who is doing the borrowing. For simplicity we will divide debt between the public and private sectors.

So called ‘public’ debt is primary made up of what our Federal and State Governments owe, both here and abroad. Government’s in persistent deficit can sell all it’s assets and pray for the next generation.

Private debt is a big beast. What we owe each other matters for social justice types, but what makes our national economy vulnerable overall is Foreign Debt. That is what Australian individuals and companies owe overseas to foreign individuals, companies or sovereign wealth funds.   If we run constant trade and current account deficits it is likely that our foreign debt is heading up.

Second dimension. Two words – “what for”.  This dimension causes headaches for politicians and their minders.  It complicates a simple story. They spin themselves frantically to create a narrative that includes it.

Debt, like cholesterol, comes in two flavours – good debt and bad debt.  Confuse one with the other and the economy get’s a heart attack. Not enough of the right one and the economy get’s lacks the ability to operate at full capacity.

Good debt is cold hard cash used to invest in capital that will increase our future earning capacity and comparative advantage versus our international competitors. When all is said and done, we should be left with ample cash to pay the interest and and get a better lifestyle over the long term.

Bad debt, on the other hand, is squandered on purchasing consumables and speculation of assets that does not itself increase the overall earning capacity of the nation. When all is said and done, a big interest bill greets us and we either double down on the credit card or take a big cut in our lifestyle.

Please feel free to copy and send to your local parliamentary friends.

Wait. We are not wealthier? Crap.

Over the last fifteen years it has become trendy; in Australia at least, for politicians to compete for the public’s favour by quoting statistics on changes in public debt.

A canny opposition can cause the incumbent government considerable grief by threatening to take a gaudy ‘debt truck’ out for a spin in vulnerable electorates. The media particularly love’s a good debt scare story.

As our brave politicians compete to undertake a fearless battle against  the evil’s of public debt, they have eagerly encouraging an explosion in the private debt that individuals and corporations are willing to take on. It is the easiest way to wear a smug smile whilst quoting economic growth and employment figures. No  hard work required.

The Commonwealth Bank opinion on new global liquidity rules gives us some indication that we may be at the end stages of this game. Our banks have been the principles dealers satisfying (and some say encouraging) our dependency on private debt.  To satisfy us they have borrowed overseas in amounts that dwarf any historical record that exists in Australia.  Like derivatives trading for Lehman Brothers it has been a profitable business whilst it lasts.

The game has an end because the majority of this debt has been ‘invested’ in ever more expensive properties and much more importantly, the land on which it sits.  It may shock you to learn that housing wealth. So wrote the author of The Wealth of Nations.

Adam Smith, the inspiration for many a budding capitalist, was quite clear on the true investment value of a house. Crap. Waste of Time. In his opinion a nation that started speculating on houses was threatening its long term wealth. He thought this because he believed that a house does not increase the earning potential of an economy. In fact he thought it reduces the investment available for much better options – even investment properties that are rented out.

If the money flowing into housing is not an increasing our national earning capacity, then as the debt used to fund the investment is principally “bad debt”.

From this angle, rapidly escalating house prices and scarcity of supply are not success. They are a collective failure. A march of lemming creatures cheering and celebrating as they build a house of cards that will eventually collapse under its own weight. It is a failure that will come back to haunt us in the future. I don’t know when and neither does anyone else. Which is why the easiest thing to do is kick the can down the road.

Talking of kicking the can down the road,  the loosening of foreign investment rules on real-estate should surprise no-one. It is one of the few options remaining to turn our virtual housing wealth into income for locals – at least those who already own property.

The only way to keep the music playing is to deliberately allow foreign investors to crowd out local home owners. It isn’t fair. It is rational if you are going to be fighting an election in the near future.

Now I am not defending Barnaby Joyce. His misleading rant about debt is based on the historical Peter Costello obsession with lowering public debt – whether good or bad. Whether it private debt increased to compensate or not.

But if Barnaby Joyce should get a rap on the knuckles, Rudd and Swan should hang their heads in shame. They know the different between “good” debt and “bad” debt. Instead they caved to their political instincts. Keep short term economic growth high. Keep unemployment low. Let the future take care of itself.  The same weakness that led them to squander the Government’s money on buying flat screen televisions and overseas holidays. They know that a lot of that debt is “bad” and that in cloaked in the insolence of the guilty they strike out to suppress a genuine conversation that needs to be undertaken with Australia.

Superannuation is one of the more lauded policy innovations in Australia. It has spawned a multi-billion dollar industry and a slew of high paying jobs. It absolves Government of considering how it will support a minimum living standard for future generations of retirees. It provides a way for individuals to minimise their tax on retirement savings.  Our media limits itself to a relatively safe territory of reporting on the relative performance of funds and the ever present threat of policy changes by the Government. What are we missing?

Suffer the little People

Paul Keating introduced Australia to the Superannuation Guarantee in 1992. Policy experts foresaw the risk of the baby boomer generation draining the tax purse as they shifted into retirement.  Eighteen years later and you would need to undertake a long quest to find an economist advocating against the system as a whole. 

Unfortunately this particular sacred cow poses some thorny issues for how we forge policies that benefit both the young and old. In fact, a older generation has never had so much incentive to play a scrooge to those that follow them.

The weight of impending retirement

Our hunter and gather forebears put their kids to work early and depended on them as they aged. Our recent crop of retirees likewise had a vested interest in ensuring the taxable earnings of their offspring covered their generous benefits that they expected to draw down in retirement.

The closer one gets to retirement the more legitimate pressure you will place on your superannuation to ratchet up capital gains prior to locking it a more risk adverse annuity. The publishing of league tables of relative fund performance adds another incentive for investment managers to take a short term perspective .

Double whammy

The younger generations get a double whammy. The first is that they lose out on tax revenue from financial flows that are going in Superannuation. Much of this tax revenue could be funding essential services such as Education, Health and Transport infrastructure. The second is that these investment flows are chasing a fixed pool of assets that are perceived to be low risk and immediately profitable. This is driving asset inflation in the residential housing and financial sector.

Little of this investment seeps through into income (especially export income) producing infrastructure that gives exciting new opportunities to the next generation. That would take too long and be too risky. Even worse, the appreciation of asset prices (since saving’s are rarely building anything new) forces the young generation to take on high debt, minimises the opportunities for genuine entrepreneurial activity and confines a generation to the stresses of two incomes all so they can fund the growth in retirements assets for those greyer than them.

Finding ways to align our interests

The implications of the divergence in our interests have shown up in a stunning lack of long term infrastructure spending and declining investment in future growth engines such as education. Finding ways to align our interests will be the challenge for the next twenty years as Baby Boomers start to withdrawal their funds and the flow of investments needed to fund infrastructure declines further.

For the great majority of the population who purchased their first property before the year 2000, the ever escalating prices appear like money growing on trees. Our banks even let you get hold the cash without having to sell the property. What can possibly be bad about that? It turns out it may not be quite the win-win most individuals expect.

Forgetting the economic wisdom of Adam Smith

Before we turn our hand the jagged shoreline rising before us, its time to debunk some very dubious theories thrown out there to support what has happened.

1. It is supply outstripping demand and we don’t have enough houses for all the new immigrants arriving in the country;
2. The prices are only high because stupid people are willing to pay too much. They have no common sense and refuse to live within their means; and
3. All the money made in the commodity boom means we can spend more on our houses.

All these theories have one thing in common – falsehood wrapped in a grain of truth, coated with a dollop of self-serving spin.

Let’s take supply and demand. Competition can explain why two or more individuals will pay up to the maximum they were willing to pay. It does nothing to explain what that maximum value is. That is a personal decision, made separately to the supply/demand situation and based on a host of information and factors – both past and present.

Calling people ’stupid’ for paying too much money is also misleading. After all, all those ’smart’ individuals who didn’t buy ten (or even three years ago) are now, no doubt, feeling pretty stupid themselves. It is cold comfort that they saved prudently and only bought within their means. Even purchasing in the outer suburbs has just meant that their reported wealth has grown far far slower than those who went into maximum debt in the inner 10km suburban circle. An area aggressively promoted by property investment advisors. The longer the prices have been going up, the more ’smart’ people capitulate and enter the game. Usually with all they can borrow. That’s why it is called a bubble. The price isn’t set by allocation of scarce resources to the most productive investment. It’s linked to the desperation of individuals not wanting to be left out of an ever louder game of musical chairs.