Some of the more interesting comments I have read in recent times were made by the RBNZ Governor, Adrian Orr a few days ago.
"The fact we're talking here and complaining about house prices or these types of activities, that's a problem but it's a first-class problem. The alternative is being in a recession or depression and having high unemployment." (The AM Show).
Without getting lost in semantics as to whether NZ housing is in a bubble, there can be little doubt it is extremely extended. NZ median house prices are now 7.7x average gross household income, versus 3x to 5x for much of the last 20 years. For Auckland, the ratio is 10.1x.
Worse, household credit growth has rocketed as Kiwis swap houses between each other at ever higher prices. Household debt to GDP has reached 95%, having been 60% in 2000 and in the 40% region in the 1990’s. RBNZ data shows total new bank lending in the month of September was $7.323bn, up 33% on a year ago. A mere $61m of that was new business lending.
The RBNZ’s dual mandate is CPI inflation and unemployment. A house price bubble accompanied by a credit surge that doesn’t immediately cause wider inflation pressure doesn’t fit neatly into this mandate. Hence the RBNZ’s new funding for lending scheme has gone ahead.
It is hard to fathom why this has been designed so that much of the money will end up funding mortgages. The RBNZ and Government should be finding creative ways to skirt their mandate and fund cash-strapped councils. Their parlous financial condition is a key impediment to providing the infrastructure required for more housing supply.
Does the surging credit boom matter or has NZ reached some new permanent plateau of rational exuberance? Is the housing bubble really a “first-class problem” as the RBNZ Governor contends?
In the absence of any recent RBNZ research papers on the subject, we have trawled through the economic literature that looks at whether asset price bubbles are a big risk to the real economy or whether they are indeed a “first-class problem”.
The answer is that it depends. Some bubbles have dire economic consequences and some don’t. However, 150 years of economic experience shows that a housing bubble financed by debt has frequently preceded a deep recession. It is not a choice between having a housing bubble or a recession – high risk monetary policies are quite likely to be the cause a deep recession when the bubble eventually bursts.
The most frequently cited research in the area is a paper titled “Leveraged Bubbles” by Jorda et al published in 2015 by the Federal Reserve Bank of San Francisco. This looks at a massive data-set from 17 countries over the last 150 years and finds bubbles can be divided into four categories.
Equity market bubbles that aren’t financed by credit typically aren’t a big deal. Losses are mainly borne by investors who are wealthier than average and don’t need to cut consumption to fund their losses. Companies can still raise new equity. The average recession thereafter tends to be a -2% economic contraction rather than -1% for a “normal” business cycle recession. By five years later, the economy is typically 4% bigger rather than 7% bigger after a “normal” recession.
An equity market bubble that is credit-financed is more of a problem. The typical recession is slightly larger and the recovery isn’t as strong. Typically, losses may be borne by investors less able to handle them, who then need to curb consumption to rebuild their savings. A weaker market makes it difficult for firms to raise new equity.
A housing bubble without a credit boom seems unlikely to the modern eye but there have been historical instances. The initial recession is about the same as “normal” at -1% but the recovery is far slower, with the economy only being 2% bigger five years later.
The worst outcome by far is when there is both a housing bubble and a credit boom. The typical recession here is longer and deeper, with the economy bottoming at -4% smaller after a couple of years. The recovery path is then far slower, with the economy still being 2% smaller than its pre-recession level five years later. Think of say Spain or Ireland after the GFC as examples.
As Alan Greenspan put it on CNBC in 2013: “All of us knew there was a bubble. But a bubble in and of itself doesn’t give you a crisis.... It’s turning out to be bubbles with leverage.” That indeed was the difference in US economic outcomes post the Nasdaq bubble in 2000 and post the GFC in 2008.
NZ housing right now looks and feels as though it could be in the fourth category. Maybe outstanding political and economic management can see housing supply expand, tax advantages be removed and funding costs stay low. The air might gradually be let out of our bubble without adverse outcomes. Maybe not. 150 years of economic experience from around the world suggests we are playing with fire rather than experiencing a “first class problem”.
So what should the RBNZ be doing? To be fair, they were clearly correct in aggressively easing monetary policy when Covid-19 first hit and economic soothsayers across the spectrum were predicting far more dire economic consequences than have turned out to be the case.
However, just because they were correct in opening the spigots in April does not mean they are correct in opening the spigots even further now. The facts have changed.
One key constraint on the RBNZ is that as a small open economy, NZ is affected by what other central banks do. If we dare march out of step and run slightly tighter policy, then the NZ$ could appreciate sharply and crimp the all-important export sector. Indeed, this has happened a little in recent weeks.
However, we would suggest that an appreciating NZ$ is a “first-class problem” for a small open economy that is running large twin deficits (fiscal and current account). Global investors do not have to fund us, and one day, they may just decide not to. NZ has been in that situation in the past but 30 years of hard-won policy credibility have seen memories dim.
One option that the RBNZ has mentioned in passing is foreign asset purchases. It might be worth exploring a mix of tighter domestic policies that lean against the demand-side of housing, together with aggressively purchasing foreign assets to keep the NZ$ under control. The Swiss central bank has been a notably aggressive exponent of this policy. What better example could the “Switzerland of the South Pacific” have? We have a rare moment in time where US bond yields are above NZ yields and large foreign reserves may come in very handy one day when the next external shock hits.
Matthew Goodson CFA
MD, Salt Funds Management
(Published in the NBR).