Treasury Secretary says financial crisis teaches NZ to be wary of asset bubbles; says NZ household debt is too high

By Bernard Hickey

Treasury Secretary Gabriel Makhlouf has warned in a wide-ranging speech about the lessons from the Global Financial Crisis (GFC) that asset bubbles can be damaging for the wider economy and policymakers shouldn't ignore them.

Makhlouf was speaking as the Reserve Bank is putting the final touches on its new 'speed limit' for high Loan to Value Ratio (LVR) mortgages and as Prime Minister John Key has ramped up comments about the risk of a asset bubble bursting in the Auckland housing market and the need to avoid faster rate hikes that hurt the rest of the economy.

"What the GFC did bring home to us was the damage that large booms and busts in asset prices such as housing can inflict on the financial system and the wider economy," Makhlouf told a Trans Tasman Business Circle luncheon in Auckland. "It raised questions about the ability of monetary policy alone to respond to the collapse of an asset bubble," he said.

Models used by central banks, Treasuries and other policy makers before the GFC had failed to take into account the dangers of such debt-fuelled bubbles blowing up and then bursting through the financial system and into the rest of the economy, he said.

Policymakers had thought financial markets were not crucial for economic cycles and that bubbles were hard to spot in advance or deflate easily, he said.

"We know now that this thinking was flawed. Asset prices can grow much faster than can be justified by fundamentals, especially when the supply of credit and the appetite for taking on debt are rising sharply and investors are keen to maximise their returns by taking on more risk," he said.

"When prices correct, the fallout on the financial system and the impact on the rest of the economy can be substantial, and can take many years to resolve."

Prime Minister John Key commented yesterday that Auckland house prices were unsustainable and the Reserve Bank was justified in acting with macro prudential tools to avoid having to use the blunt and nationwide tool of faster and more hikes in the Official Cash Rate. Key also referred to the impact on the financial system of the bursting of a housing bubble in America and the need to avoid such fallout in New Zealand.

Makhlouf said the Reserve Bank's new Policy Targets Agreement, which included a clause about monitoring asset prices, was the start of an attempt to address these pre-GFC failings.

"The Agreement more explicitly allows for the Governor to monitor a wider range of prices, including asset prices and set monetary policy accordingly, even if CPI inflation is low," he said.

Treasury had been reviewing its economic models to take into account the linkages between the financial system and the economy, and how to identify emerging risks.

In later comments after the speech, Makhlouf said New Zealand's private sector and household debt was too high, which meant combined total debt after the inclusion of government debt was very high.

"By international comparisons, total debt -- Government plus household -- we're in a grouping with the 'bad' Europeans," he said.

Makhlouf said in the speech the GFC should have taught economists to be humble about previous claims of the end of depressions and banking crises.

"History does repeat itself and excessive growth in debt – whether by governments or households – is one sure sign of trouble ahead."

'Policy too loose pre-GFC'

Elsewhere, Makhlouf said that with hindsight the Government's fiscal policy before the GFC had been too loose.

"The Treasury can put its hand up and say we misjudged the extent to which surpluses were structural – in other words, more or less permanent. This may have contributed to the fiscal policy decisions the then Government took. Structural surplus, and indeed the surplus itself, disappeared with the GFC," he said."

The GFC had taught policymakers it was important for fiscal and monetary policy to work in tandem.

Also, he said Treasury analysis showed a 1% fall in Chinese GDP growth was likely to reduce New Zealand's GDP growth rate by around 0.2-0.3%.