By Keith Woodford
House-price inflation is New Zealand’s hot-fire issue. Look back a year and very few people were predicting the fire. Now we have a fireball.
Quite simply, house-price inflation is driven by citizens’ loss of confidence in fiat currency. Having money in the bank has become a mug’s game. As long as post-tax interest rates on savings are well below inflation rates, then the fireball cannot be doused. Investors have to find somewhere for their savings.
Prior to COVID19, there was a valid argument that urban planning rules combined with high immigration were the key drivers of house-price inflation. Those urban-planning issues had been in the background for many years but were then fanned by high immigration.
However, it is COVID-19 and the reactions of the State, particularly monetary policy under the control of the Reserve Bank, that have created the current fireball.
The current Reserve Bank inflation mandate belongs to another time
The Reserve Bank Governor has made it explicit that house-price inflation is not a central issue to the Reserve Bank mandate. In a technical sense, that is correct. However, house-price inflation is central to the future of New Zealand, and any sense that we can be a property-owning team of five million.
As long as monetary policy was focused on flattening short-term business and spending cycles, then independence of the Reserve Bank using standard monetary tools made a lot of sense. Some things are indeed best left out of the hands of politicians. However, monetary policy has strayed into areas well outside historical norms.
Interest rates have been declining globally for much of the last 20 years. That aligns with global growth rates declining everywhere. China is the outlier, but even there, economic growth as a percentage of the economy has been declining, and so have interest rates.
Since COVID-19, the extraordinary measures of quantitative easing have been extraordinarily successful in artificially reducing interest rates even further, particularly across the Western World. And there lies the issue.
Back in June I wrote about the flood of capital entering the market via the Reserve Bank’s quantitative easing programme. I tried to forewarn of the risks from excessive quantitative easing. However, at that time, most people were focused on more immediate issues relating to COVID-19 and jobs. Right through to the election, the issue of house prices remained in the background.
It is now no longer possible to obtain a bank interest rate that protects against inflation, yet the Reserve Bank is trying to increase inflation further. To at least some of us, it is a crazy world.
The increasing growth of digital block-chain currencies is another sure sign of a global loss of confidence in fiat (national) currencies. These digital currencies, led by bitcoin but with others in the wings, are highly speculative and have no inherent value. However, with confidence in fiat currencies declining, the search for alternative nest eggs expands. Hence, people are drawn to these digital currencies. Once again, it is the consequence of a crazy world.
The rush to investment properties
Here in New Zealand, the rush by investors to purchase investment properties is not driven by any fundamental wish to be landlords. Rather, it is driven by a belief that there is nowhere else to go. Accordingly, under current place settings, there is still a long way for house price inflation to run. There are still many billions of dollars – indeed approximately $200 billion - sitting in current accounts and term deposits with the citizen owners of those funds now becoming very scared.
Unfortunately, the Reserve Bank has very limited expertise when it comes to behavioural sciences. Their only tools for assessing behavioural changes that lie outside historical norms are to operate through a rear vision mirror. Accordingly, they have been and continue to be badly caught out as to what they have created. Their response is that the housing crisis is a ‘first class problem’, largely outside their mandate.
If ‘first class’ problem means a huge problem, then it is hard to disagree with that assessment. But if it means something else, and the evidence is clear that Reserve Bank Governor Adrian Orr does indeed mean it in a different context, then once again it is evidence of a crazy world unsuited for a team of five million.
House inflation does not soak up excess money supply
Very few people recognise that house-price inflation does not soak up the excess money that the Reserve Bank is creating. Every time someone buys a house there also has to be a seller. Money simply flows from one bank account to another. The same principle applies with shares. It helps explain why bubbles keep growing until they pop.
This fundamental fact as set out above is why there is a fair chance that we are still in the early stages of the house-price inflation firestorm. The only qualifier on that statement is if there is a change of Reserve Bank policy in regard to quantitative easing and hence interest rates.
In the meantime, there is nothing to stop house price inflation from continuing as savers flee the banks.
Band-aids focus on the wounds rather than the cause
Some may think that the firestorm can be controlled by other means such as rent freezes and extending the bright-line taxation test for investor housing. But they are mistaken. Such measures focus on outcomes rather than cause.
Rent freezes are extremely bureaucratic and can lead to multiple unintended consequence. It takes one back to the Muldoon days of wage and price freezes. These measures can douse a few flames but the flames soon return. This is because the fundamental issues lie elsewhere.
Increasing the bright-line period for capital gain taxation may also slow things down a little, but as long as savers have nowhere else to put their money, then the effects will be limited.
If bright-line is to be extended then it needs to exclude newbuilds. Quite clearly, there is a need for newbuilds to continue.
Increasing loan to value requirements will surely have some effect. However, the likelihood is that it will affect first home buyers more than investors. The Reserve Bank could limit new restrictions to investors, but that would imply that the Reserve Bank was acting in a social context rather than a financial stability context. And that is on not how the Reserve Bank Governor thinks.
The Reserve Bank Governor has now asked for debt-to-income tools to be made available to him. That tool, if granted, is likely to constrain first-home owners much more than investors.
There are no painless solutions to self-created problems
If the Reserve Bank really wants to control the so-called ‘first class problem’, then it has to rein back severely on its quantitative easing (QE) programmes. Reining back on QE means less digital money creation and thereby leaving more Treasury bonds out in the market place. At that point interest rates will stabilise and in high likelihood start to drift upwards again. Some savers may then begin to think that their bank deposits have some safety.
Of course, higher interest rates will be very unpopular for those who now have big mortgages. That illustrates that there are no painless solutions. Accordingly, our politicians have good reason to be cautious of declining house prices. However, the immediate aim is not to drop house prices. It is simply to put out the current inflationary fire.
Quite simply, the longer the fireball continues, the greater the long-term pain must be. And the more that any notion of a team of five million can only be an irony.
Interest rates cannot be changed in isolation
If the Reserve Bank steps back from QE but does nothing else then there may well be some damaging effects. In particular, there will be an inward flow of speculative funds from overseas and the exchange rate will rise. That will have to be addressed.
This illustrates how over the last thirty years New Zealand has become closely integrated within the American and European international financial system. Arguably, that has worked well, and has helped create financial responsibility here in New Zealand. But these are now very different times. It is a strange world where our physical economy aligns primarily with the East but our financial systems align with the West.
One ready tool the Reserve Bank does have to sit alongside the reining in of the QE system is to require New Zealand banks to place increasing reliance on NZ-resident funds. That is simple; it is just the stroke of a regulatory pen.
Nothing will change without a change in the Reserve Bank inflation mandate
The current actions of the Reserve Bank all stem from the specific mandate that requires them to keep consumer price inflation between one percent and three percent, and with a long-term aim of two percent. This target is a consequence of a deep-seated belief within mainstream economics that inflation of this level is necessary to somehow stimulate productive investment.
An alternative perspective is that these mainstream economists have got confused between cause and effect. Even then, the relationship belongs to another time.
I have previously argued that reducing the inflation target by one percent, so as to lie within a range of zero to two percent would have a transformational effect. That is where the target used to sit twenty years ago.
It would immediately mean that the New Zealand consumer inflation rate was within target and therefore QE could be reined in. To the extent that economic stimulus is still required, it would also place the emphasis firmly back on fiscal policy. But most importantly, it would be the first step to prevent saving behaviours being a mug’s game. And that would take a lot of heat out of the housing market.
A New Year’s wish directed at Grant Robertson
I hope that Grant Robertson will spend the summer break reflecting deeply on the long-term impact of the current Reserve Bank mandate.
The consequence of that mandate is that pathways for young people without parental financial support to become part of a property-owning team of five million have largely disappeared. Accordingly, major social inequalities are being further institutionalised. For a Labour Government, this must be a real irony. Grant Robertson is the only person who can change that.
*Keith Woodford was Professor of Farm Management and Agribusiness at Lincoln University for 15 years through to 2015. He is now Principal Consultant at AgriFood Systems Ltd. He can be contacted at firstname.lastname@example.org