CBA: Time is running out to find Australia's next growth engine

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Unless you’ve been living off the grid for the past three years, you’d know house prices, particularly in Sydney and Melbourne, have taken off, boosted by a series of interest rate cuts from the Reserve Bank.

It’s been nothing but one-way traffic for prices in most major capitals. And this fantastic chart below, supplied the Commonwealth Bank, provides some background as to just how large the price increases have been.

With the exception of Perth, which saw prices slide mirroring the fortunes of the mining sector it is highly exposed to, prices in all other mainland capitals soared, as indicated by the blue and red lines. As a consequence, millions of households saw there perceived wealth increase as well.

For those who own their house outright, or are still paying it off (particularly those who bought before the recent price cycle took off), it has provided an enormous financial boon, making households feel wealthier as a result.

It’s known as the “wealth effect”, a term stemming from the idea that changes in household demand are influenced by changes in the value of asset prices, in this case, housing.

As they have increased, it’s made homeowners feel wealthier, encouraging them to spend rather than save.

To Gareth Aird, senior economist at the Commonwealth Bank, there is considerable evidence that suggests the wealth effect has played a large part in helping to bolster Australian economic growth over the past few years, not only encouraging spending but also helping to lift employment as a consequence.

“The household savings rate has been trending down since early 2013, which is about the time dwelling prices took off nationally,” says Aird.

“As low interest rates pushed up activity in the housing market, including lending growth and dwelling prices, the savings rate drifted lower.

“When the household savings ratio is declining, consumption growth will outpace income growth. Households are effectively consuming a greater proportion of their income in each period compared to the previous one,” he adds.

How housing drives jobs

Along with encouraging spending, and likely as a consequence, Aird notes that the wealth effect generated by increased house prices has also helped to boost employment growth, particularly in New South Wales.

“The evidence in NSW of the wealth effect on employment growth over the past few years is telling,” says Aird.

“As interest rates came down, investor activity in the housing market lifted substantially which led to a massive rise in dwelling prices. Spending and employment growth followed.”

The chart below, supplied by the Commonwealth Bank, certainly adds to this view. While New South Wales has the natural advantage of being the most populous state in Australia, it comes as little surprise that it has seen the largest increase in employment in recent years given it has also recorded the largest increase in house prices over the same period.

Excellent, just what the doctor ordered at a time when Australia’s economy is undergoing one of the trickiest rebalancing acts in modern times following the mining infrastructure boom.

The growth baton for the economy passed from the mining sector to housing and households, helping to buttress economic growth over recent years.

But before we crack open the Bollinger to toast to our continued economic success, there is one small problem that needs to be considered: who will housing and households pass the growth baton to once the current upswing in prices peters out?

Where to next

As Aird points out, a lot of monetary firepower, and a lot of household debt, has been used to fire up house prices, continuing the cyclical pattern seen over the past two decades.

“The ability of dwelling prices to inflate above and beyond earnings growth over an extended period of time has been made possible by interest rate cuts and the accumulation of debt,” he say.

“In fact, you could argue that this has essentially been the recession-free business cycle in Australia over the past two decades, notwithstanding the mining investment boom.”

However, with housing affordability already a concern in many capitals and with interest rates already plumbing record-low levels, Aird suggests that the wealth effect generated by housing cannot last forever.

“As the interest rate structure in Australia approaches a lower bound, the wealth effect will wane; it must wane,” he says, adding that the RBA is unlikely to cut interest rates below 0.75% to 1% given Australia’s large current account deficit.

We currently borrow from the rest of the world, and therefore must be able to offer reasonable returns to offshore investors.

With the RBA’s monetary policy firepower fast running out, and a large supply of housing stock about to hit the market, this seemingly increases the risk that the wealth effect generated from house prices may be nearing its end.

So what is there, if any, to take the growth baton when the housing cycle eventually turns?

Aird believes that there are a few options available to policymakers.

Policies should be developed that encourage and channel capital into projects that improve the productive capacity of the economy over the long run. Establishing an efficient taxation system that incentivises innovation and productive investment is one area that could help lift business investment. The importance of fiscal policy, and in particular tax policy, in creating an environment that supports business investment cannot be underestimated.

Public infrastructure investment is also important. For example, greater investment in transport infrastructure will improve the productive capacity of the economy. And in the current climate it would support private investment rather than crowding it out. At a time when the yield curve is at historic lows, there must be no shortage of viable projects where the costs of finance is less than the social rate of return.

Fiscal expenditure and reforms, in a nutshell. Given the current political malaise in Canberra, that appears anything but certain. Quite the contrary, in fact.

Given non-mining investment has yet to find any traction after the mining boom, quelled by weak demand, high hurdle rates for investment and pressure on companies to return profits to shareholders rather than reinvest, it’s more than a little concerning.

Some may suggest that increasing immigration levels could be a solution, but that too appears to be fraught with danger, particularly from a political standpoint – independent MP Bob Katter, who announced he’d back a .

Whatever the answer is, Aird suggests time is running out.

“Additional monetary policy stimulus can support the economy over the near term. But as the wealth effect wanes, there must be successful handover to additional drivers of growth for the economy to continue to prosper,” he concludes.

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