By Ewen McCann*
This is my second article on the housing market in New Zealand. It considers the substantive question, not yet a part of the debate, what is the appropriate policy if NZ house prices fall?
The first article argued that the rises in house prices have been the result of inevitable long run forces that were analysed there.
The price increases themselves are not an economic problem where they are the outcome of underlying economic processes. No economic policy response would be required. Where those price increases are driven by policy intervention the policies should be corrected. The discriminatory tax drivers of house price increases requiring correction were highlighted in the first article.
However, a reduction in house prices is a different story.
A general decline in house prices is not symmetric with a general increase; a policy response is necessary. That decline would have economic effects as other countries have shown us. We should not respond to a general fall in house prices in the ways that they did.
We need a plan
It may not happen, but if it does, New Zealand needs a policy plan ready to pull out of the top drawer to deal with it.
An important driver of the entire NZ economy since the dairy price slump has been the income from the capital gains accruing in the housing market. Capital gains are income. If the income from this source falls or turns negative the effects will be like any other fall in income. It will cause economic distress across the country with its centre on Auckland, the economic region from Hamilton to Warkworth.
Suppose that foreign lenders to NZ banks partly close off the money tap. This may be because they become uncomfortable with the risks that NZ banks take by their high lending percentage of the value of a house. Maybe banks sanguine notions of viable debt to income ratio will be a trigger. It could be because of a recession in foreign markets. Or, it could be the result of banks becoming less profitable and foreclosing on dairy farmers, which cannot be far off. In any event NZ bank lending to the housing markets shrinks and the demand for housing with it. So the capital gains to housing decline or turn negative, this last meaning that house prices fall.
Small capital gains, or worse, capital losses result in a recession because they reduce incomes below what was expected by households. Some households are unable to meet mortgage interest payments, banks foreclose and the recession worsens.
Banks find themselves with un-performing assets on their books so they hold mortgagee sales and the downward spiral intensifies. Don’t forget that banks foreclose, they deliver the stern message of capitalism and households lose wealth. The job market contracts as the household sector spends less and poverty increases. The policy intent of the prescription to follow is to constrain the decline in private sector wealth thereby constraining the recession. There is no policy that would eliminate such a recession.
What should the RBNZ do?
What should the Reserve Bank do? The Reserve Bank’s main functions are to act as a lender of last resort and to control inflation. It is a lender of last resort because, during a recession, other commercial lenders to banks vanish. Mortgage foreclosures occur in recessions and weaken banks’ balance sheets. Lenders to banks become miserly, bank customers become nervous and move their funds out of the bank. These circumstances yield bank runs.
Trading banks hold less than 10% of customers’ deposits in reserve so only 10% of deposits are returned customers during a bank run. A run on a bank is one of the worst things that could happen. An extreme recession would result were there a run on the banks.
This is why the Reserve Bank has to lend to the trading banks in this situation. It is the lender of last resource because the usual commercial lenders to banks evaporate like the mist. But the Reserve Bank should remember the hard lessons of capitalism too and charge the banks a salty interest rate on its loans, say 20% or 25% per annum. These rates are not too much higher than the rates charged on credit cards.
The high Reserve Bank lending rate is warranted because the banks are a poor risk, being possibly subject to a bank run. Alternatively, the high interest rate is an incentive for shareholders stump up more capital to protect their investment. Australian parent banks could well be obliged to sustain a New Zealand investment that has profited them so handsomely in the past. Banks who will not pay the high rate go to the wall just like the people they foreclosed on. Such a trading bank should be liquidated because it could not properly run a banking business.
The Reserve Bank seizes all of the trading bank’s assets. The only liabilities that the Reserve Bank would assume would be the various deposits of NZ located customers. It should loudly proclaim that liability in order to support public confidence in time of need.
This is less of a problem than it may seem. If a trading bank demures on the high interest loan, its license would be withdrawn. Its staff would be instructed to work as per normal as the Reserve Bank is now running the defunct bank.
It is most important at this time that the Reserve Bank feeds a run. Any customer wanting their cash should be given it by the Reserve Bank through its newly acquired trading bank. The Reserve Bank can easily manufacture any amount of cash that the public tries to withdraw. People would learn that their money is still there so they will stop the run. The important point is that the run on the banks has been averted.
There would be no inflation from the newly printed money because a recession would be going on and people would hold the new cash, as a precaution, and not spend it. The new money would be recaptured as times improve.
What of the un-performing mortgages that the Reserve Bank has acquired from the defunct trading bank? In the argot, the households involved are said to be “underwater.” A recession will be under way by the time that the Reserve Bank has taken hold of the failing bank. The Reserve Bank acts to contain the recession. What else would it do?
The Reserve Bank should respond with a lottery. It conducts a lottery among the failing mortgagors of the defunct bank. The winning percentage in the lottery among the failed mortgagors have their mortgages forgiven. It has to be a lottery, otherwise everyone would default on their mortgage. The allowed percentage of lucky borrowers really depends on how much relief the Reserve Bank wishes to grant the household sector.
The objective of the policy is to sustain the wealth of the household sector instead of allowing a free fall in it. This support of household wealth would help maintain private expenditure and would mitigate the recession.
The defunct bank’s shareholders and debenture holders bear the loss since the Reserve Bank simply confiscated the mortgage instruments or assets owned by the failed bank. In the case of an overseas owned bank the loss is not a cost to New Zealand because the shares and some of the debenture capital are held overseas.
The proposed forgiveness of households debt is then costless to NZ as the foreign shareholders and debenture holders learn the hard lesson of capitalism too. This transfer of the losses to the foreigners, who are ultimately responsible for the failure of the bank that they owned, is a useful effect of the programme. This is the sort of behavior that shareholders expect of banks when their bank is the creditor. Shareholders have no come-back when it happens to them.
The Reserve Bank will have to foreclose on the unlucky participants in the lottery, whether the failed bank is foreign or New Zealand owned. The families who are unlucky in the lottery lose their homes but the affected houses do not disappear. Other families use them and it is in this sense aggregate welfare is unchanged. The national loss is in the probable decline in the price of houses.
What about term deposits?
Many New Zealand households hold debentures of quite flimsy security in banks that operate in NZ. These are sometimes called term deposits. They are thought to be sound investments but they would not be so in the climate that we are examining. Actual debentures, of low preference ranking, are also on issue. Holders of such paper would lose this part of their wealth which would deepen the recession, unless the Reserve Bank acts.
It should run a lottery scheme among NZ holders of this paper similar to the one suggested for bank deposits. The prizes in the debenture lottery would be the continuance of the contracted interest payments. Foreign bond holders don’t matter to NZ and would not be bailed out. They suck on this lesson of capitalism that they profit from in better times.
Just how far up the ladder of near monies the Reserve Bank should climb with the rescue package is a judgement call but is should extend to term deposits and NZ held debentures because they are so easily converted into cheque account balances as to be considered money by households.
The reason for these actions on bank debentures and term deposits is purely to soften the negative wealth effects of bank failures upon the domestic economy. The suggested policy is rather different from the policies of “quantitative easing” that were designed in other countries to protect bank shareholders from the lessons of capitalism that their banks administered to others as a matter of course. Those policies did not help maintain household wealth the way that the present proposal would. That is why there was a Great Financial Crisis.
Abandon the OBR policy
A further characteristic of the New Zealand banking system needs to be severely scrutinised. The Reserve Bank has significantly destabilized the banking system by an inexplicable policy that it introduced few years ago. The policy makes the banking system more susceptible to runs, especially when there is financial uncertainty. This policy should be immediately abandoned.
A legalistic view has been taken of the banking system by this recent policy that allows the liquidator of a bank to take 10% of customers’ chequeable deposits and apply them to satisfying the rest of the banks’ creditors. This is a legalistic position that treats depositors as simple creditors of bank. Bank deposits have an economic function which is much richer than being a mere unsecured creditor of a firm. Cheque accounts should not be treated like low priority business creditors in a liquidation, even if just 10% of them are to be so treated.
The policy should be abandoned immediately. At root it contradicts the principle of lender of last resort, one of the main principles of banking theory, as old as central banks themselves. The purpose of this principle is to maintain confidence in the banking system. The confiscation policy undermines the public’s confidence in it.
This policy of partial confiscation fails to recognize that it increases the likelihood of a bank run. Under the confiscation policy, customers withdraw early to avoid the loss of 10% of their cheque deposits. They precipitate a run. Such an event would be an economic calamity. Liquidators should not be in charge of winding up banks. A liquidator would be lost in the ramifications of the ideas of this article. It would anathema to a liquidator to let mortgagees off the hook. But this is essential, and sometimes costless to New Zealand.
This is the sense in which banks are too big to fail. It is not the losses that a bank’s shareholders would encounter that makes it too big to fail. The reason that banks are too big to fail is that bank runs would occur as they approach insolvency.
The suggested policy applies the necessary hard lessons of capitalism to incompetent banks and avoids bank runs.
Here are some features, largely distinct from each other, of the housing market that do not lie comfortably in the structure of the article.
- There is one consequence of the increase in house prices that is not attracting comment at the moment. This the mal-distribution of wealth that it induces. New Zealand already has a skewed distribution of wealth compared with OECD countries. Once wealth and incomes are too heavily skewed the skewness becomes self perpetuating. Social mobility in future generations is reduced by skewed inheritance where the mobility otherwise would be merit based. This consequence of the present characteristics of the buoyant housing market is being neglected.
- Higher house prices increase the aggregate capital stock without directly raising private and aggregate welfare. The increase in the price of a house does not expand its capacity or add to the flow of accommodation services from it. The community’s well-being is unaffected directly by higher house prices. If more junk food and sugar drinks are consumed out of the greater wealth then welfare is indirectly increased by the wealth effect on consumption.
- One the other hand if, instead of the price of a house doubling, a second house were to be built at the original value of the first there would be one more family accommodated and the aggregate value of the housing stock has increased by the same amount in each case. Social well-being expands in this case through the extra accommodation. This is the grain of truth in the supply side approach.
- A decline in house prices is a reduction in personal and national wealth. An earthquake that demolishes houses is also a decline in personal and national wealth. The reductions in wealth are not the same because even though the price of a house may decline there is still a place for people to live whereas this is not the case if a house is demolished. In an underlying sense, aggregate welfare does not directly fall as result of a house price decline but it does fall a house were demolished. This distinction is quite useful when thinking about the housing market. Nevertheless, in both cases the nation is poorer and there are knock on, or indirect, effects of the impoverishment in both of them.
- Economic forces are glacial in their speed and force. If the social issues surrounding house prices are a concern then we should decide where they rank against other social issues. There are undernourished and impoverished children of poor health in NZ whose plight should rank above the bleating of the DINKs and their parents.
Ewen McCann was formerly Head of the Department of Economics, University of Canterbury and latterly Principal Economist at the Inland Revenue Department.