We received a few constructive criticisms following yesterday’s Markets and Money. So before we discuss the idea that things will get much worse for Australia in 2013, let’s have a look at where we went wrong.
We made the comment that lower interest rates wouldn’t boost spending and growth too much because any benefit to the nations’ debtors would be offset via weaker incomes for retirees and other savers.
Reader David G rightly reproached us for this simplistic comment.
‘I do not necessarily disagree with the thrust of your article today. However some of the figures you quote appear subject to more torture than a guest at Guantanamo bay. I think it decreases the credibility of your argument. For example there is significantly more benefit to mortgage holders in aggregate from a cut in rates, than impacts retiree income. If this were not the case we would not need to borrow as much from overseas to fund our mortgages. Moreover the fall in GNI merely reverses the unsustainable gains in GNI during the commodity boom. Prior to the 2008 boom the economy trundled along relatively well – the fire may burn lower but perhaps more sustainably.
‘You guys do a great job but it is unbecoming to twist data to fit a pre-conception. In the current environment it is also unnecessary.’
On the first point David is correct…to a point. Australia’s mortgage debt is around $1.270 trillion (representing a mortgage debt-to-GDP ratio of 92%) and according to the RBA, household deposits are around $700 billion. So on this basic analysis yes, there is significantly more benefit to mortgage holders in aggregate.
And that is certainly true in the short term. Longer term, there is the issue of balancing out the needs of the debtors and the creditors (both domestic and foreign). We would argue that for a small open economy like Australia, taking care of ALL your creditors (including foreigners) by offering attractive interest rates is an important longer term consideration. It’s an important point but one we’ll have to delve into on another day.
But there’s another point that David’s criticism raises. That is, just how much have lower interest rates impacted on household spending. Are they as important in stimulating growth as we think they are?
Remember, the whole point of lower interest rates is to encourage people to spend…to consume more. Because apparently that’s what leads to economic prosperity. So is that happening?
Well, we’ll present some evidence and you decide for yourself…
The best measure of household spending is what the Australian Bureau of Statistics (ABS) calls ‘final consumption expenditure’ (FCE). In the September quarter of 2010, FCE in current dollars was $184.2 billion. In 2011, it was $194.7 billion, and in 2012, $205.6 billion. That represents nominal growth of 5.7% and 5.6% respectively over the past two years.
Not bad huh? And you thought consumers weren’t spending?
The perception of tight-fisted consumers comes from complaining retailers and economists that point to a high savings rate. And on face value, it does look like we’re saving more and spending less. But that’s not what the consumption data shows.
Let’s look at the savings rate. This week’s national accounts show Australia’s household savings ratio is at 10.6%. As you can see in the chart below, it’s high relative to where it was earlier in the decade. A superficial look at that chart would have you thinking that we’re simply saving more and spending less. Not so!
The household saving ratio is a derived figure. According to the ABS it’s the difference between households’ ‘net disposable income’ and their ‘final consumption expenditure’.
What’s interesting about the chart is that our savings ratio was around zero in late 2006, and increased rapidly thereafter. Clearly the jump in the savings rate had a lot to do with China.
Let us explain what we mean by that. First, a chart of commodity prices:
The first spike in commodity prices came in 2006. This had its origins in the USD/yuan exchange rate peg. It led to an explosion of liquidity around the world (and especially in China), which manifested in a spike in commodity prices.
That in turn boosted Australia’s terms of trade and national income, which feeds into the ‘net disposable income’ figure. But instead of spending all that new income, we began to save it instead. So while consumption grew, because incomes grew faster, the savings rate increased.
Now, the savings rate began to decline again in 2007, but then it spiked in 2008. This spike reflected an increase in household ‘fear’ and attitudes towards debt and spending brought about by the GFC.
But then China opened the credit floodgates and commodity prices spiked even higher than they did pre-GFC. And again, Australia’s terms of trade and national income also jumped higher. But this time, the savings rate remained stable even though household income increased at a rapid pace.
This tells you that household spending as measured by FCE has actually been very strong these past few years. In other words, the big boost we received to national and household incomes from the China boom has supported household expenditure nicely…which turns the image of the frugal consumer on its head.
So what has all this got to do with interest rates?
Well, David’s right in saying that interest rate cuts do provide a net benefit when confining the analysis to debtors and domestic creditors. But the above analysis suggests interest rates are not as important as they once were in stimulating the economy.
That’s because the household sector is already heavily indebted and less responsive to lower interest rates. So the effect of lower rates is more in reducing household interest expense than in creating new credit growth and demand via that credit growth.
The main game for Australia then is not interest rates, but national income growth. The terms of trade driven boost to national income over the past few years is unprecedented. That growth is now in the process of unwinding. How much the terms of trade will fall is uncertain, but even minor falls could put a dent in household FCE.
As I mentioned above, in ‘current (nominal) dollars’, household spending grew 5.6% in the 12 months to September. In real terms it jumped a very healthy 3.3%. There is no consumer recession at all.
But we expect that to change in 2013. With the falling terms of trade, national incomes will take a hit. Our guess is that household spending will contribute much less to economic growth in Australia next year. Which is why the front page headline in today’s Financial Review doesn’t come as a surprise: ‘Labor prepares to ditch surplus’. The threat of recession in an election year doesn’t go down too well in a democracy.
The Australian economy will need the government to run a hefty deficit in 2013 and beyond to keep it afloat. If Labor can get to next year’s election with their credibility slightly less tattered than the opposition, watch them open the spending floodgates in late 2013/early 2014. It will be interesting to see how the Aussie dollar responds to this development.
Our point in all of this – for those of you who may have become lost in the stats and jargon – is that lower interest rates probably won’t provide enough of a boost to offset the impact of a contracting terms of trade.
The whole terms of trade/national income argument is a central focus of our ‘Fuse is Lit’ presentation. We focus on it because the effects take some time to work their way through the economy. There are monetary lags that not too many people seem to be taking into account. If you’re interested in seeing how these lags work, we encourage you to have a look here.
We were going to talk more about Australia’s current account deficit and our reliance on foreign capital to sustain our standard of living in an age of falling national income. But it’s getting late, so well leave that for another time.
Have a great weekend!
for Markets and Money
From the Archives…
William Knox D’Arcy: The Greatest Australian You’ve Never Heard Of
30-11-2012 – Callum Newman
Credit and Credibility
29-11-2012 – Greg Canavan
Nothing More than Feelings… For the Aussie Dollar
28-11-2012 – Dan Denning
The Thanksgiving Gift from the Feds
27-11-2012 – Bill Bonner
The Aussie Dollar Dilemma
16-11-2012 – Dan Denning