In the run-up to the May budget each year, the talk is often about tax cuts and welfare cuts, or general hubbub about the budget balance. This year a topic which is only of secondary importance to the budget balance is front and centre – housing affordability, and more crucially, whether or not Australia’s property market is in a bubble.

The problem with talk of housing bubbles is that it very much brings to the fore the issue of Australia’s divergent economy. Sydney is not representative of the nation, but neither is Adelaide or Perth.

Since the Reserve Bank of Australia began cutting rates in November 2011, the housing price boom has overwhelmingly been Sydney-centric.

Reserve Bank head warns house price speculation is a risk to Australian economy Read more

In December 2011, the median house price in Sydney was $533,000, only just ahead of Canberra’s $500,000, Melbourne’s $495,000, and not absurdly above the median price for houses in Perth of $480,000.

But now the median house price in Sydney is just shy of $1m at $970,000, while the rest of the nation has been left in the dust.

While the median house price in Melbourne and Canberra in that time has increased by what you would think is a pretty steep – 36% and 30% respectively – that is nothing compared with the 82% increase in Sydney:

Now housing prices going up – or even booming – does not mean we are necessarily experiencing a bubble. A bubble occurs when the increase in price is at a rate that is unsustainable and is also out of whack with the reality of the situation.

Now that is not easy to pick; if it was easy, we wouldn’t have them. But there are things we can look at with concern, and we know we should because the Reserve Bank is very much looking at them.

The big one is debt.

Housing prices and debt are joined at the hip. There aren’t many people out there paying cash for a house. So if housing prices are going up, a good space to watch is whether the level of debt in the economy appears to be at levels that are unsustainable and/or out of step with other aspects of the economy.

And here we look to the the governor of the RBA, Philip Lowe, who, in a speech on Tuesday night, made it pretty clear there are warning signs. He told the audience that “the level of household debt in Australia is high and it is rising”.

It sure is. The current level of household debt to disposable income is at a record 188.7%:

Lowe noted that “over the past year the value of housing-related debt outstanding increased by 6.5%” and that because incomes have not risen by as much, there “has been a further rise in the ratio of household debt to income, from an already high level”.

The final part is important.

The rise in the level of household debt and housing debt over the past few years has been large, but not unprecedented:

In the 1990s and early 2000s (before the global financial crisis), Australians gorged themselves on debt.

When Australia exited the 1990s recession, our debt level was at 80% of disposable income. From there Australians would set off on a 15-year-run of increasing debt. By the time the GFC hit, the ratio was up to 171.1%.

During the GFC and years that followed, we took a breather from our climb up the debt mountain. But once the RBA’s cuts to interest rates began to fully take hold, we set off again at a furious pace.

But while the growth of debt over the past three years is not too out of step with what we saw in the 1990s, and much less than during the super housing boom in the very early 2000s, the key, as Lowe noted, is that debt is at “an already high level”.

Increasing the level of debt in the economy is much different when it is just 80% of disposable income, than when it is 180%. The other major problem is that this increase is out of step with what is happening in the rest of the economy.

Lowe noted that while Australians are generally coping well with their debt levels, “at the same time, though, slow growth in wages is making it harder for some households to pay down their debt”.

In a line that rather goes to the heart of the problem, Lowe noted that “for many people, the high debt levels and low wage growth are a sobering combination”.

And if we compare the increase in the ratio of debt with the Australian Bureau of Statistics’ measure of “national economic wellbeing” – real net national disposable income – the recent increase in debt certainly looks out of whack:

So we have strong rises in housing debt due to house prices going up – especially in Sydney and to a lesser extent in Melbourne – at a time that wages and income growth is weak.

That is not a combination that is sustainable, and it is a combination that is worrying given we have record levels of debt.

If we were to try to calm everyone about debt, we could say that, yes, debt-to-income is rising, but so too are asset values. The ratio of debt-to-asset values is well down on the record highs of three years ago:

Partly this is because the price of houses (assets) has been rising faster than the level of debt, and because, with low interest rates, people are able to pay off the debt quicker.

And while it is good that asset prices are rising faster than we are accumulating debt, that ratio only works so long as the asset prices keep rising and interest rates stay low. It can get ugly quickly if house prices fall, or interest rates start going up.

Sydney property prices rise almost 20% in past 12 months Read more

Amid all this discussion has come focus on the supply of housing. Lowe mentioned this aspect, and the prime minister has been quick to echo his statement that “it is hard to escape the conclusion that we need to address the supply side if we are to avoid ever-rising housing costs relative to our incomes”.

Within this debate has also been talk of population growth – especially that of migration. And yet migration figures are down from levels hit at the end of the mining boom, and even the recent peak of December 2012:

And interestingly, there has also been in that time a supply boom – especially in apartments and flats:

The boom in apartment construction came at a time when our migrant intake began to fall. So big has been the surge in apartment construction – especially in Melbourne and Brisbane – that the RBA is worried about an oversupply of such housing.

And then there is the problem of bank-lending practices. Lowe told his audience he is worried that “too many loans are still made where the borrower has the skinniest of income buffers after interest payments”. He noted that “in some cases, lenders are assuming that people can live more frugally than in practice they can, leaving little buffer if things go wrong”.

Right now, with record debt levels rising at a time when income growth is flat, apartment construction exploding while population growth is slowing, and all the while house prices in Sydney and Melbourne rising by nearly 20% in the past year, while banks are already starting to raise interest rates, it feels as though the market is at a point where it wouldn’t take much for things to go very wrong indeed.