A new asset class growing under Hockey's nose

“By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens" — John Maynard Keynes

When Keynes wrote the above line in his 1919 book Economic Consequences of the Peace, old age was a grim business -- though the average worker didn't live long enough, or have enough in retirement savings, to worry too much about inflation 'confiscating' their wealth. 

By the latter decades of the 20th century, however, things were different. 

Wars had been fought over whether or not capitalism 'worked', and capitalism had worked to dramatically increase the wealth of nations -- Australia's more than most. 

At the same time, the post-WWII social democracies were waking up to the fact that the direct transfer of pensions from tax-payer to retiree was not the way to continue on the path to widespread affluence. 

In Australia, from 1983, then treasurer Paul Keating fell into line with big global shifts towards free trade and the deregulation of labour markets and capital flows.  Labor did more to advance capitalism, ironically, than treasurer John Howard had been able to do under Prime Minister Malcolm Fraser. 

The one reform Keating claims to have led the world on was the creation of the 'super guarantee'. To transition the nation from transfer-payment pensions to self-funded retirement, Keating forced the nation to save and invest 9 per cent of its wealth. 

Based on the actuarial models of the day, that was thought to be enough. Australians didn't live anything like as long as we now do, and we didn't expect such affluent lifestyles and expensive medical care. 

Furthermore, financial markets being what they were, there was little doubt in the burgeoning funds management industry that all that investment would produce returns well ahead of inflation -- the force that Keynes had worried would 'confiscate' the lot. 

For a long time, the funds management industry was able to do this, though each nation had its own set of tax and super laws and therefore different mixes of investment products to help retirees generate real incomes from their nest eggs. 

And then the whole thing was blown apart by the collapse of financial capitalism known as the GFC. 

Oh yes, dear reader, the newspaper headlines proclaiming "record high!" for global stock markets or property markets (ours included) are being interpreted by sophisticated readers for what they really are -- the same kind of dangerous highs that preceded the 2007 sub-prime crisis and the 2008 Lehman Bros event that brought on the full-blown GFC. 

As Alan Kohler explained yesterday, (The ghost of Basel rattles its chains and moans, again, June 30) the Bank for International Settlements has warned for a second year running that a sudden stampede of central banks exiting their super-low interest rate settings could make for a very bumpy ride ahead. Periods of obscene inflation could well be among the bumps.

And so 30 years after Keating optimistically joined the other nations in setting up new ways to manage national wealth, Treasurer Joe Hockey is trying to set the nation up to survive in a very different financial landscape. 

We are living longer, expecting more and the tax base is becoming increasingly narrow. 

Hockey's brutal first budget was one motivated by the fear of shocks to come -- and to that extent was necessary. 

That said, it was communicated to voters with such clumsy neoliberal zealotry that it scared the hell out of consumers, rallied the left, and weakened business confidence. It will be some time before all that damage is repaired. 

Meanwhile, we are observing private investors voting with their dollars rather than trusting either Labor's or the Coalition's visions of the superannuation system.

The big change in the past year has been the huge volumes of investment flowing into residential property, which has pushed house prices up to record levels and pushed first home buyers out of the market. 

The official line from the Reserve Bank and the government is that the housing market is working just fine and that our central bank need do nothing to 'lean against' a housing bubble. 

As one of the walkers who accompanied Professor Steve Keen over 280km from Parliament House Canberra to the top of Mount Kosciuszko in 2010, this columnist's views on our inflated housing market are a matter of record. The fundamentals are all wrong, and by rights prices should fall.

However, it is probably now time to answer a fundamental question about the continuing divergence between Australians' incomes and the prices of the houses we live in, and a similar, though smaller, divergence between rental yields and house prices. 

The question is this: what would make a superannuation investor plough more money into a house that that asset's yield can justify?

Obviously part of the equation is the negative gearing regime in which losses on the 'business' of running a rental property can be used to reduce the tax payable on the owner's other 'business' -- their taxable employment elsewhere. That formula means taxpayers end up subsidising renters, and owners of rental properties skim off a hefty cut on the way through. 

But for the real answer, it's worth looking at a historic change handed down by Britain's chancellor of the exchequer, George Osborne, in his March budget. 

Osborne dropped a bombshell three months ago, by declaring that Britain's retirees would no longer be forced to buy annuities with sizeable chunks of their retirement savings. 

Osborne made the most radical change in the British pensions system in 90 years because annuities based on 'normal' ranges of returns from equities and bonds have manifestly failed to do their job in a 'new normal' era.

With the stroke of a pen he wiped 50-60 per cent off the share price of some major life insurance companies which offer the products, though some of that re-rating was over-reaction due to the sudden nature of the change. 

Many Australians are unfamiliar with annuities, but for decades they have been a mainstay of British retirement. 

The product involves handing over a large chunk of capital to an annuity provider in return for, supposedly, protection against the winds of change that may affect financial markets in the future. 

Thus the retiree waves goodbye to tens of thousands of pounds/dollars, which are pooled with other investors' funds, invested, and then lower-than-average distributions made back to annuity holders. 

In this way, the investor says "I'm happy to get a low return on my investment, as long it's very safe and returns a bit more than inflation." The annuity provides longevity insurance through an income stream that is paid until the investor dies. 

So how is this relevant to Australian housing? 

It has become clearer in recent months that housing investors are seeing homes in a similar light. Buying a house for, say, $600,000 and renting it out for a yield that would only make sense if it cost $400,000 starts to look more rational. 

While the investor is still working elsewhere, their tax bill will be reduced. But when they retire, if the investment property is paid off, it will function a bit like an annuity.

That is, it will pay a low return in a way that is safe and protected against inflation by virtue of the fact that if renters' incomes fall during a downturn, yields might fall, but if price and wage inflation breaks out, yields will rise. 

Investors are, in effect, voting against the superannuation model set up by Paul Keating. Not because he 'got it wrong', but because in a global environment where 'record highs' could turn to 'record busts' very soon, an annuity built of bricks and mortar looks like a good bet, even if it's returning pretty miserable yields before any impending bust. 

The Coalition government has paused but not abandoned Labor's plan to increase the super guarantee gradually to 12 per cent. That will mean even larger pots of money, and more frightened investors choosing low-yielding houses as a kind of annuity. 

That will, if it continues, force young Australians to forget about owning a home and look for higher-yielding assets that can build them a nest egg for when they get to their own 'annuity-buying' phase of life. And as is the norm in countries such as Germany, we'll become a nation of renters.

It all sounds a bit mad, granted. But this is the phase of Australia's financial development that Treasurer Hockey is presiding over. And unlike Keating in 1983, he has to steer the ship through less optimistic times.

They are times, in fact, that Keynes may have predicted way back in 1919: "As the inflation proceeds and the real value of the currency fluctuates wildly from month to month, all permanent relations between debtors and creditors, which form the ultimate foundation of capitalism, become so utterly disordered as to be almost meaningless."