On April 15th 2010, I will commence a walk from Australia’s Parliament House to Mount Kosciousko. Below I explain how this event came about. Though it has been triggered by me losing one part of a two-part bet on house prices, its genesis goes back much further–to when I, along with a handful of other non-orthodox economists, predicted that a serious financial crisis was just around the corner.

The cause, as always, would be the bursting of a debt bubble. The reason why I saw it coming, while the vast majority of economists did not, is because my approach to economics emphasises the importance of credit and debt. In contrast, conventional “neoclassical” economics ignores both credit and debt.

The bubbles in Australia and the USA were clearly the biggest in post-WWII history. The ratio of debt to GDP had risen fivefold since the 1960s in Australia, and since 1945 in the USA.

Bubbles that were that big, and growing that rapidly, had to burst–as had previous bubbles in the mid-1970s and the 1990s. When they did, an economic crisis would ensue. Because debt levels were so much higher than in the 70s and 90s, the crisis this time would be much larger.

The world escaped those previous crises by piling on yet more debt in yet another speculative bubble. But this time the debt was so much larger that the “borrow our way out of trouble” remedy was unlikely to work again. We faced a serious economic crisis for which there was no easy cure, and yet conventional economists and the politicians they advised had no idea it was approaching.

I decided to raise the alarm, and took the highly unusual step (for an academic) of engaging in public debate on economic policy. From December 2005 on, I spoke frequently to the media about the dangers of excessive private debt and the likelihood of a serious economic crisis (see for example AM August 2006 and Lateline November 2006); in November 2006 I established a monthly newsletter (“DebtWatch”), which was mailed to about 400 people (mainly journalists) just before the RBA’s monthly meetings to set interest rates; and in March 2007 I started the blog Steve Keen’s Debtwatch.

The crisis that I warned about finally arrived in 2007, and became acute in 2008. The exponential increase in debt that had fuelled the false boom since the end of the 1990s recession reversed, and the Global Financial Crisis began.

A collapse in house prices in the USA was an integral part of the crisis there, and inevitably I was asked what would happen to Australian house prices if my prediction of debt-induced economic crisis here came true.

I commented, on a number of occasions, that house prices in Japan had fallen 40% over since their Bubble Economy burst in 1990, and I saw no reason why we should be any different over much the same time frame of ten to fifteen years.

I didn’t think particularly much about that question at the time, since to me the main game has always been the debt bubble, and property prices are a side effect to that–an important issue, but ancillary to the main problem of allowing economic performance to be dominated by rising debt.

There I have to confess to being somewhat naïve: I was not prepared for the onslaught from vested interests which that comment would evoke. Predict a financial crisis unlike any other, warn that economic policy was headed in the wrong direction, challenge the merit of conventional economic theory, and (before the GFC) you’ re still largely ignored. But claim that house prices might fall, and you stir up a hornet’s nest.

Shortly after I made that statement, the Government introduced the so-called “First Home Owners Boost”.

I had advised against such policies before the crisis hit:

“Debt has reached unsustainable levels, and whether its reduction is done smoothly or abruptly, economic growth has to slow in the meantime… In this situation, doing anything–like … increasing subsidies to home buyers (as happened in 1991 with the doubling of the First Home Buyers’ grant)–will be worse than doing nothing at all.” (Debtwatch November 2006, p. 18)

And I railed against the Boost when it was announced (see Rescuing the Economy or the Bubble?), arguing that it would simply cause a house price bubble and a larger bust in the future:

Many elements of the recently announced package are justified… But yet another increase to the First Home Buyers Grant??? Is this because, um, house prices are, like, maybe too low? A collapsing housing bubble may be a scary prospect, but the more it is inflated, the scarier the final bust…

Then in October 2008, I gave a talk at the Parliament House Library to an audience of about 80 people–mainly researchers and Ministerial support staff. On the same bill was Macquarie Bank’s “Interest Rate Strategist” Rory Robertson, whom I had never met. Rory put the bet to me during his speech (PDF slides here). I hadn’t referred at all to property prices in my talk (Powerpoint slides here), since I saw them as a sideshow to the overall debt crisis, but Rory argued that this was the point of interest to the many in the audience. Paraphrasing and editing him slightly, Rory introduced the bet this way (at the 37 minute point in this recording):

“I think some people came along today to hear about why house prices are going to fall 40%… [I interject "over a 10-15 year time frame mate" at this point]. In the spirit of competition, … if Australian house prices fall from peak to trough by 40% I will walk from Canberra to the peak of Mt Kosciousko, and if in fact they fall by less than 20%, you do.”

With no warning of the bet, and in front of such an audience, I agreed to the bet. But a bet that was going to be live until roughly 2025–since that was my time frame for the fall–was hardly interesting, so in subsequent discussions we also agreed to a “closure” term: if house prices were higher than their September 2008 level a year later, I would walk.

It’s hard to remember, but at the time I think I expected that the First Home Owners Boost–which was supposed to expire in June 2009–wouldn’t have enough impact to push prices above their September 2008 peak. So I agreed to the bet, without any caveat about waiting until the government’s attempt to stop house prices from falling was over.

Then in May 2009, the Government announced that they were going to extend the scheme for another six months–and I knew that I was sunk. The house bubble bubble that The Boost caused not only stopped the fall in prices, but spiked them well above the previous peak.

This repeated the experience of the Howard Government in 2000 and 2001. Its introduction of the Grant–as a temporary(!) measure to alleviate the introduction of the GST on the building industry–and then its doubling as a stimulatory measure when a recession was feared in 2001, clearly spiked house prices. At the time prices had only just returned to the same level, relative to household disposable income, as they were in 1986. Within 3 years, they were 40% above this level. Though there are many factors behind this bubble–primarily the role of the finance sector as a promoter of speculative behaviour–Government policy was also complicit.

Rudd’s policy has clearly achieved the same result this time round. House prices, which had falling relative to household disposable incomes, rapidly shot up again (even though disposable incomes were also rising dramatically at the same time, courtesy of the stimulus measures and the 4% cut to the official interest rate). The economy also received a substantial boost, as the clear trend for mortgage debt to fall (relative to GDP) that had set in during 2008 went into reverse. This is both the reason for the success of the policy to date, and its Achilles Heel.

Without The Boost, the reduction in mortgage debt levels that was in train in late 2008 would have reduced expenditure in the economy by roughly 3% of GDP. Instead, the Boost enticed households into a dramatic 6% increase in mortgage debt during 2009. This effective 9% turnaround in debt levels is a major reason why Australia has avoided the worst consequences of the GFC to date.

The increase in debt was not limited to First Home Buyers. Certainly they levered the additional A$7,000 into A$30-50,000 of additional buying power, and bid up sub-$500K house prices by 5-10% as a result. But the vendors then took the additional $20-30,000 in cash that this higher sale price gave them, and levered that up to an additional $150-$200,000 for their next house purchase.

The Boost has also given Australia a dubious distinction when compared to the rest of the OECD. Yes, we are the only country that avoided a technical recession; but we are also the only country where debt levels are rising once more compared to GDP, rather than falling.

We have also experienced a faster turnaround in debt levels in this crisis than in previous recessions. It took us almost two and a half years to go from falling to rising debt levels during the 1990s recession, and about 15 months during the 1973 downturn. This time the switch from a falling to a rising debt ratio has taken just a year.

This is the classic “hair of the dog” cure for a hangover–avoid the consequences of drinking too much one night by getting drunk again the next morning. It worked in the 1970s and 1990s because debt levels were substantially lower than today (45% in the 1970s; 90% in the 1990s; over 150% today) and because there was another group to whom lending could occur. However, now both households and businesses are carrying record levels of debt, and businesses are still rapidly deleveraging while mortgages are the only source of rising debt. I don’t believe that the “hair of the dog” will work this third time: instead debt growth will falter once the impact of The Boost wears off, and Australia will feel the painful effects of debt-deleveraging. I expect this will renew the fall in Australian house prices that The Boost interrupted.

But that’s in the future. For the present, I will be walking to Kosciousko between April 15th and 23rd of this year.

I intend using this event as a way to highlight the absurdity of the economic situation Australia has locked itself into, where continued prosperity is dependent upon house prices forever rising faster than incomes–an outcome that is only possible if debt rises faster than both incomes and prices.

If you agree with me that this situation is absurd, then join me on the walk for an afternoon (or more).

Also consider donating to Swags for Homeless, to help make life slightly less difficult for the homeless. RP Data, who offered to give $1,000 to the charity chosen by whichever of us (myself or Rory) lost the bet, is the first corporate sponsor, and their donation will enable 16 homeless people to sleep more easily in future.