By Greg Peel

UWS associate professor and outspoken economist Steve Keen recently walked from Canberra to the top of Mt Kosciusko because he lost a bet with Macquarie Bank economist Rory Robertson. Keen said Australian house prices would fall 40%. Robertson said “bet they don't”.

Keen's view was, and is, based on the dramatic upsurge in Australian household debt over the past decade which has funnelled into surging house prices and higher proportions of income required to service mortgages. His view on this debt, both locally and globally, led him to correctly predict a global recession. He correctly saw housing in the US as the big risk, but he also assumed Australia would suffer the same fate.

Keen has not changed his view, but acknowledges that the GFC did not lead Australia to either suffer a recession on paper or a house price collapse. Assuming the housing bubble continues, Keen still foresees a house price collapse down the track.

The typical argument against any notion of an Australian house price collapse, apart from the fact Australia did not participate in the US-style subprime mortgage binge, is the combination of record population growth and lack of housing supply. Put these together and house prices can only go up, or at least not go down. And of course, the government provided significant stimulus to house prices through its GFC fiscal measures, and the RBA provided further stimulus through low emergency interest rates – both measures which Keen saw as throwing petrol on a fire.

The Global Markets Research team at Commonwealth Bank nevertheless suggest a further reason why Australian house prices won't go down, and it's all to do with the way we traditionally measure indicators such as house price to income ratios. Traditionally, we assume that if this ratio rises too far it puts so much strain on household budgets (a higher proportion of income must go toward mortgage payments) that any little downturn in the economy could trigger mass delinquencies and, inevitably, a house price collapse.

CBA challenges the traditional thinking.

If we go back to the high inflation era of the 1970s and 80s, we recall that double-digit mortgage rates were standard. High inflation was largely a result of the oil shocks of the time, but back then global central banks, including the RBA, did not consider inflation was something that needed to be controlled. It was a hard lesson learned, given the 1970s was virtually one long period of recession and the return to economic strength in the 80s ended with the deep recession of 1992-3. Since then, central banks have decided high inflation is destructive and thus monetary policy is now structured to keep inflation at manageable levels.

In January 1990, the RBA cash rate was set in a range of 17.00-17.50%. Hello? Can you imagine what life would be like for the average aspiring Australian now if mortgage rates were 20%? It is simply unthinkable.

But it was certainly the case, and it was a time when this writer bought his first property. Back then, the rule of thumb on mortgage lending was that the borrower should not be committed to anything more than a third of monthly income as mortgage payments. So if interest rates were high, clearly incomes needed to be proportionately high as well. That's why back then children shared bedrooms and families fought over the one shower.

Nowadays families expect nothing less than five bedrooms and three showers, a double garage and home cinema. At least that's the case in the suburban sprawl – others choose to squeeze into trendy inner-city terraces which back in 1990 were slums, and were about ten times cheaper. But inner-city aside, CBA notes the floor space of the average Australian home is now 46% greater than that in 1986. Consequently, the average house price is now much higher.

But average house prices have grown far more rapidly than average incomes. Surely today's need to live in a McMansion only fuels the bubble argument?

Not if you consider the “structural shift” of monetary policy, suggests CBA. In short, the shift from a high interest rate environment to a low interest rate environment makes all the difference.

In 1990 the RBA cash rate was 17%. Eight years later it was 4.75%. In October 2001 it was 4.50% - where it is now. It has not exceeded 7.25% since, and has been as low as 3%. What do you do with all the extra money you save from your monthly income when you're paying a mortgage rate of 7% instead of 20%? Do you buy a Porsche? Do you book passage on the QE2? Or do you, perhaps, buy a bigger house?

If the answer is C, then you're not alone. CBA argues that the lower interest rate environment has simply translated into higher house prices. Today's houses also tend to be made of more expensive materials than in the days of yore (fibro is none too popular these days) which further adds to house costs and thus prices.

It is thus erroneous, CBA argues, to compare house price to income ratios in 2000-2010 compared to previous decades in declaring a “housing bubble”.

CBA nevertheless concedes that HP/Is did get a little overblown there for a while, and will probably spend the next four years drifting back to more sustainable levels. But with the lack of supply versus growing population issue continuing over that period, the end result will be flat house prices. Now that fiscal stimulus is done with and RBA rates are back to “normal” there will be no raging upside, but neither will there be a collapse.

Steve Keen would jump in here and note that despite the lower interest rate environment, the old rule of thumb of a third of income being committed to a mortgage has now risen to 40% and even 50% in the rush to jump on the Australian housing bandwagon. And with equity loans being all the rage in the pre-GFC boom, many households have little home equity to fall back on.

He would also note that some 70% of home sales in Australia are to buyers who already have a home – either they're investing in a second property or rolling up to a bigger place. These are not new buyers supporting house prices, these are buyers simply jumping over the top of each other at each sale to fuel the housing bubble. That, he would suggest, must all end in tears one day.

Oh, and the structural change in the interest rate environment also occurred in the US, and the UK, and Spain...

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