Greece was recently granted its third bailout since 2010. But the political and civil unrest that has ensued is bringing more questions about whether the European Union’s (EU) economic problems have really been solved or not.
Greece owes Europe more than €300 billion that it will never be able to repay. Even if the Greek people relax and parliament accepts the EU’s offer, little more has been done than kicking the proverbial can a little farther down the road. At best, this latest deal may buy Greece an additional three years, but then what?
The Greek people themselves know that Greece is ultimately screwed. Their rejection of the EU’s original deal reveals that what they really want is to hit the reset button, default, take their economic beating now, and then begin their recovery. But of course, that is not in the interest of their European creditors.
So, what is ultimately at the root of Greece’s dramas? Why did they declare “bank holidays,” and limit people to an ATM withdrawal allowance of €60 per day?
The problem in Greece is not simply that there’s not enough money. The ultimate problem is that the money the Greek people thought they had never actually existed in the first place. And ultimately, this is the very same reason why real estate is so expensive in Australia.
The Fractional-Reserve Banking System
For at least a hundred years, governments around the world have been attempting to grow their economies by encouraging debt. Not only are governments borrowing big, our current world banking system has also enabled average people to seek prosperity – or at least the appearance thereof – through debt. As you can see in the chart below, personal debt in Australia has risen dramatically over the past 30 years.
HOUSEHOLD DEBT PER PERSON IN AUSTRALIA
Source: Australian Bureau of Statistics
This growth in our culture’s love for debt has meant huge profits for banks. Banks primarily make money by receiving deposits, then loaning that money out to individuals and companies for a fee, called interest. What’s interesting, however, no pun intended, is that governments allow banks to loan out more than they take in through deposits; a whole lot more.
This system originally began in Europe hundreds of year ago. It’s called fractional-reserve banking, because the cash the bank keeps on hand is only a fraction of what it loans out. Banks are only required to maintain whatever amount they need to manage daily transactions by depositors.
It’s then up to the government regulators to act as the moral compass of the banking industry and enforce the reserve requirement, a limit on what fraction of a bank’s assets must be kept in cash. APRA regulates this requirement in Australia and uses it as a tool to either increase or decrease the money supply.
Large banks may be expected to maintain 10 percent reserves. Smaller banks may be given greater latitude at three percent or less. At present, required reserve ratios in most countries are no more than five percent.
In Australia, the liquid reserves to bank assets ratio was last measured in 2013 by the World Bank at 1.22 percent. That means the typical bank in Australia only holds about 1 percent of your deposits in cash. The other 99 percent has been loaned out to homeowners, investors, and businesses. Just in case you’re unsure how to feel about that, let me help. It should scare you.
The fractional reserve system works most of the time because rarely do all depositors demand their cash at the same time. But if depositors lose faith in the system, and all at once come to get their cash out of the bank, the house of cards would collapse.
Then, if the bank’s debtors are ultimately unable to repay their loans, depositors may lose some or all of their savings. The challenge is that until depositors know that the loans won’t be repaid, they don’t know that it’s time to withdraw their savings. By that time, it’s too late. We saw this happen in Cyprus several years ago, and it has happened many times over throughout the world. In fact, it happened here in Australia in 1893 and 1931.
Our banking system today is becoming increasingly more electronic. When a bank lends to a consumer, rather than handing over bags of cash, it simply processes a credit into the borrower’s account. This digitalisation of the system has enabled banks to ramp up their lending all the more.
If a bank holds $100 million in deposits, it could conceivably offer $1 billion or even $10 billion in loans. This new money does not actually exist, except as 1’s and 0’s on a hard drive.
Herein lies the root of the problem in Greece. The money that the Greek people think is sitting in their bank accounts never actually existed in the first place, except as numbers on a computer screen. The same is true for you and your savings deposits.
How Does Fractional-Reserve Banking Impact Real Estate Values?
The ultimate reason why real estate is so expensive is because of our fractional-reserve banking system. Without it, there would be much less money available for lending. With less money to lend, fewer people would be able to afford homes. Less demand would mean lower prices. History illustrates this fact.
Several years ago, a Deakin University Masters student wrote a research paper on the history of Australian property values. His study goes back 150 years by comparing house prices and land values to a number of fundamental metrics. The following are just a few of his many findings.
This first chart shows us that between 1880 and 1960, home prices remained relatively constant. Since that time, the cost of a home has increased by a multiple of five. This data only goes up to 2012, and we know prices have increased significantly since then.
This next chart shows the increase in the median house price to median income ratio dating back to 1960.
What we can see here is that until the 1960’s, median home prices in Australia were less than double the median annual income. In other words, the typical family could live on 75 percent of its income and use the remaining 25 percent to pay off a home in full within eight years or so.
Today, the national median house price to income ratio is about five to one. Melbourne is about 10 to one and Sydney is pushing 12 to one. The same family today in Sydney allocating 25 percent of their income to mortgage reduction would take not eight years, but 48 years to pay off their home.
Never mind Sydney and Melbourne investors, nothing to see here. Just keep on borrowing and spending.
So, what happened in the 1960’s that caused home prices to start moving up? If we can answer that question, we’ll know the ultimate reason why real estate has become so expensive today.
Until the mid-1960’s, the Australian financial system was much more highly regulated. Banks were required to hold more cash in relation to lending and there were tight requirements on who could qualify to borrow. In short, it was much harder to get a loan back then.
As a result of these tight regulations, banks only loaned money to build houses, not buy land. The land had to be paid for either in cash or purchased from the developer through vendor finance. Click on the image to the right to see the terms this Melbourne developer was offering in 1906.
This inability to borrow required a much different mindset than today, one that promoted savings rather than debt. The number of people who were able to buy houses was therefore limited.
Then the Commonwealth Government changed its regulations, opening the door for banks to more readily lend for housing. Once banks started lending money to also buy land, then savings wasn’t as crucial to home ownership. This meant that many new buyers could enter the market, and property values began to rise.
But even then, it was not like today. Throughout the 1970’s and the early 1980’s, before a borrower could qualify for a mortgage, they would need to show 12 months of savings history and have enough cash to cover a 25 percent deposit. A 75 percent LVR was the maximum risk banks could accept. This was due to the government’s tighter reserve requirements back then.
Then in the mid-1980’s, the government, under Treasurer Paul Keating, loosened up even more, further deregulating the financial industry. This opened the door for foreign banks to enter the housing finance market, bringing increased competition and further relaxing lending policies. Banks were able to further reduce the security they required and to lower mortgage interest rates.
You’ll notice that the timing of the gradual loosening of the banks’ required reserve ratios perfectly matches the historical increases in the prices of real estate. Lower reserve ratios make more money available for lending, thereby increasing the supply of money into the economy in the form of debt. This new money creation has flowed primarily into our housing industry, bringing significant inflation.
The ultimate reason real estate is so expensive in Australia, and throughout the world, is the fractional-reserve banking system that creates money out of nothing.
At the end of the day, our property values have little to do with proximity to a CBD, an influx of skilled migrants or billions of dollars of foreign investment.
If local buyers could not freely borrow, the property market would collapse. If and when lending tightens up, either through government regulation or market forces, asset values must decline. This is just as true in Australia as it is in Greece.
What do you think?
- How is Australia different than Greece? Do you think we could ever experience a banking crisis here?
- How does it make you feel to know that virtually all of your deposits are invested in housing and businesses?
- What would it take for Australians to lose faith in the banking system and show up all at once to withdraw their savings?
- Should our banks be forced to maintain a higher capital reserve than 1 or 2 percent?
- APRA this week tightened the capital requirements of the big banks by about 80 basis points (.8 percent). Do you think this will have an impact on property values?
I’d love to hear your thoughts on this.
EDIT: I originally stated that APRA is tightening the capital requirements of the big banks by about 20 basis points or .2 percent. The accurate figure is about 80 basis points or .8 percent.