There’s been a lot in the media recently about ballooning housing prices and debt – and not just in Australia.

The IMF has recently warned that Australia, New Zealand, Canada, the UK and others, face the possibility of major economic disruption because of high house prices, and the debt incurred by households to pay those prices. High house prices flow into the whole cost structure of an economy and make it less competitive with economies with much lower house prices (like the USA).

Debt works when accumulated savings pass through the banking system to borrowers who have a continuing prospect of sufficient future income flow to pay the back the interest and principal on the loan. Debt fails when the future income falls short and repayments can’t be met. The risks are: future income falls short of expectations (like losing a job); interest rates rise; or the principal borrowed in the first place is just too damned high. This last risk is the issue with high Australian house prices.

When debt fails, some one must lose: there’s no avoiding it. Could be a bank, savers, the borrower, or maybe all of them. These losses hurt people badly. If there are lots of them, the economy and even the whole fabric of society can be threatened. (There are plenty of examples of huge debt failures related to housing and debt through history – Japan 1989 for example. Many in 2008 – Spain, Ireland, USA – where it might take a whole generation to recover.)

Managing the money supply and interest rates are the key elements of monetary policy. The theory is that if policy makers (in Australia the Reserve Bank) adjust these, they can stimulate or dampen market activity and borrowing to smooth the bumps in economic activity. Good in theory.

One result is that a key mechanism for boosting or dampening house prices is an adjustment to interest rates (by making it more or less expensive to borrow and hence afford a house). Hence, in Australia, because of our obsession with house ownership, there is an almost manic focus on the next RBA move up or down on interest rates.

But this traditional monetary policy tool is broken.

Before we look at why, let’s look at just how big the debt is.

Australian households owe about $1.8 trillion. 75% of that is housing debt. This is about 1.8 times household disposable income (the flow required to repay the debt). In the USA this ratio is 1.1 and in the UK 1.5. So we are huge borrowers relative to our disposable income. (And the magnitude is about twice all business debt, and huge compared to the much talked about Australian Government debt of only $350 billion.)

So here’s why current monetary policy is broken …

In Australia the RBA sets a cash rate that then becomes a major determinant of market interest rates for all lending – for housing and personal loans and for business.

In an effort to help stimulate business and the economy, the RBA has driven the cash rate to all time lows. At 2.5% there is still scant evidence for this being the sought after stimulus to business. So business argues (selfishly but in some ways with justification) for even lower rates to stimulate the real economy. Retailers and manufacturers are on this theme all the time. But does a percent here or there really change a business decision to invest? It never has for me.

Furthermore, because rates are even lower overseas (near zero), some of the huge volume of hot money that floats around the world, has floated into Australia in search of higher interest earnings on cash. This drives up the $A exchange rate. That, in turn, makes Australian exports less competitive, and causes businesses that compete with imports (like car manufacturing) to struggle. To stem that money flow to drop the exchange rate, interest rates would have to go down.

But … because 2.5% is seen to be very low, and mortgages more “affordable”, households have been piling on new debt and bidding up house prices. So, to cool the housing market interest rates should go up.

Down? Up? The RBA can’t have it both ways, and is caught with a huge policy dilemma.

The solution is to drop interest rates further to stimulate business, and use other tools (lending rules, bank regulations, taxes) to cool the overheated housing market.

Already Singapore, Hong Kong and New Zealand, and probably others have done just this, when faced with similar economic policy issues. This week the Bank of England has joined that club.

The BoE is set to impose a tight limit on banks lending more than 4.5 times the household income available to support a mortgage. That’s pretty tough. Think how that would work here: $560,000 house (typical in my town); 80% mortgage of $450,000; would require reliable household disposable income of $100,000 (not typical in my town).

Hmmm …

In Australia we now have a Parliamentary Committee looking at foreign investment in housing which is only a small part of the problem. Nevertheless they seem to be talking about stamp duties, taxes, and specific restrictions to try to cut off some demand.

Watch for the RBA to move this way too!