Keith Rankin on Low Interest Rates, House Prices and Public Finance

Popular wisdom has it that low interest rates create or exacerbate house-price bubbles.

Economic analysis by Keith Rankin. This analysis was also published on

Popular wisdom has it that low interest rates create or exacerbate house-price bubbles. Yet recent reductions in interest rates in New Zealand appear to have, if anything, slowed the housing market, at least in Auckland.

Further, countries with negative interest rates – Switzerland, Denmark, Sweden and now Japan – are not countries renown this decade for housing bubbles. The 2004-08 housing bubble in New Zealand took place in an environment with rising and high interest rates.

People on the political left should be challenging these popular wisdoms. And should have empathy (but not sympathy!) for financial speculators. We deal with these behaviours best by putting ourselves in the heads of the perpetrators.

Let’s consider a situation reflective of Auckland in recent years. An ‘investor’ buys a house for $800,000 with the expectation of selling two years later for $1 million. If ‘he’ (statistically more probable than ‘she’) pays cash, and allows house-sitters to stay there rent-free, his expected financial return will be $200,000 (25% of the outlay).

If he borrows 80% on his real estate purchases ($3.2m loan) he could buy 5 houses with his $800,000 cash. (He would now be a ‘leveraged’ investor, borrowing $3,200,000.) If his loan is interest-only, his interest costs will be $256,000 (4% mortgage interest rate), $320,000 (5% interest rate), or $384,000 (6% interest rate). His two-year investment return on outlay is 93%, 85%, or 77% (depending on the interest rate). These are very high returns (even without letting the properties), and higher returns with lower interest rates. This is the conventional story.

But what if higher interest rates lead to higher capital gains? This is not the conventional view, but it does make sense. When interest rates are high, banks lend less to businesses and more to speculators with securable assets. So, if higher interest rates increase the proportion of lending that goes into real estate (as well as attracting bank deposits and the like from foreigners), then expected capital gain will rise as interest rates rise. Increased capital gains with increased interest rates is what we saw in New Zealand in 2004-08.

I redo the above figures, but allowing for 20% expected capital gain if the mortgage interest rate is 4% and 30% capital gain if the interest rate is 6%. The two-year rates of return on outlay would now be 68% (with 4% mortgage interest rate), 85% (5% mortgage interest rate), and 102% (6% mortgage interest rate). The higher the interest rate, the higher the return.

While a capital gains tax would only make a small dent in such speculative profits, lower interest rates in 2015 may be making bigger dents. Already New Zealand banks are lending more to a diverse range of businesses which employ people, and relatively less to speculators. Interest rates could fall more, despite the lack of appetite for lower rates from the Reserve Bank Governor.

Negative interest rates – as in Europe and Japan – stabilise the debt accumulation process that gave us, for example, the 2008 global financial crisis. And, where they exist, negative rates do not appear to have created the rampant expectations of capital gain (as discussed above) which destabilise world systems much more quickly than greenhouse gases do.

With very low interest rates, governments can borrow with minimal debt-service cost, improving public services as well as modernising physical infrastructure. Even The Economist thinks (Building Works, 29 August 2015) governments should be taking more advantage of “rock-bottom interest rates”.