Analysis by Keith Rankin.
To the surprise of most pundits, substantial real estate price inflation has resumed, after a hiatus from 2017 to 2019. As to be expected, most of the usual tropes have been employed: a lack of supply, immigration (in this latest case returning New Zealanders), and low interest rates. The only missing trope this time is that of foreign buyers.
While none of these are wholly untrue, the real story is a ‘flow of money’ story, with the main issue being that money flows into certain places because it does not or cannot flow into other places. The second main issue is that financial bubbles have their own dynamic and momentum; so once started, bubbles can become quite difficult to stop.
We also should note that real estate bubbles – as monetary events – tend to coincide with sharemarket bubbles, and with exchange rate appreciations.
The central problem in 2020 is the inadequate flow of money into (and through) the government sector of the economy. In the absence of adequate lending into the government and real economy sectors, the money flows instead into the ‘bubble’ sector.
The 2003 to 2008 Bubble
From 2005 to 2007, the tradable section of the New Zealand economy was in recession; that’s the core section of the economy relating to businesses, such as primary industries and manufacturing, which compete internationally. Instead, in those years, an incipient bubble economy overtook the core economy. The Reserve Bank responded by tightening monetary policy, raising interest rates progressively towards a peak OCR (Official Cash Rate) of over eight percent early in 2008.
The underlying problem was the tradable-sector recession. It meant that money which would otherwise have been invested in the tradable-sector was diverted into the bubble sectors.
The actions of the Reserve Bank made the problem worse. By progressively raising interest rates, they kept pulling foreign money into New Zealand at a time when the core New Zealand economy was struggling, and no longer attractive to banks. This inflow of foreign money raised the New Zealand dollar exchange rate, further damaging the core tradable sector, and reinforcing the diversion of money into the bubble economy.
Many jobs were created in the growing bubble economy, and much tax was paid from the bubble economy. These were not the conditions which required the government sector to borrow money. So the New Zealand economy was awash with money, but neither the core economy nor the government were borrowing much of that money.
The money flowed into – that is, was lent into – the non-tradable economy of retail and real estate and financial (and related) services, despite high interest rates; indeed, because the high interest rates diminished the flow of money into the core economy, one can argue that, at that time, the house price and other bubbles persevered because of high interest rates. Further, if we go back to 2004 and 2005, it was probably higher interest rates that brought about the recession of the core economy that became New Zealand’s central economic problem of the years leading up to the Global Financial Crisis (GFC).
The 2012 to 2017 Bubble
This bubble came in the wake of the GFC, and was created in the global economy by the premature ending of ‘fiscal stimulus’ measures, given names such as ‘fiscal consolidation’ and ‘austerity’.
To get out of an economic depression, governments need to take the lead by running very large financial deficits. If done properly, much of this money flows indirectly into the core economy; employment and tax revenues increase, and government-sector financial deficits naturally fall to normal levels. This should be done in a way so that a country’s exchange rate does not rise prematurely; thus interest rates need to stay low for quite a long time.
A classic case of this recovery and expansion being done correctly was the 1935 to 1938 first term of the First Labour Government.
In the years 2012 to 2017, most countries’ governments did this incorrectly. While interest rates did stay low, there was a big push worldwide for governments to cut back, substantially, on their borrowing. A result was that many important government-led programmes were stifled, and an opportunity to reverse income inequality was lost. In many countries, money that should have gone into government social spending and universal benefits went instead into the bubble economy. In countries like New Zealand, this was reinforced by large inflows of foreign money relative to the size of their economies.
Bubble dynamics reasserted themselves this post-GFC time, with much lower global interest rates than in previous times. While interest rates are significant to the core economy, they are largely irrelevant to the bubble sectors. If an ‘investor’ with $200,000 can borrow $800,000 to buy a million dollar property, and then sell the property for $1,100,000 one year later, that’s a 50 percent return on their money; a substantial personal gain whether the mortgage interest rate was four percent or ten percent.
Bubbles do come to a natural hiatus after about five years. From 2017 to 2019, the capital gains from property speculation diminished, less money was flowing out of China and other saver economies, and conditions in the core economic sectors in the world became more favourable for bank lending. Economies grew, with 2019 becoming a very successful year in the global economy; though with the proviso that substantial environmental problems, inequality issues and identity issues came to the fore of our concerns. (And Brexit completely dominated United Kingdom politics.) In New Zealand in 2017, a new Labour-led government created sufficient uncertainty to quieten a bubble economy that was already running out of puff; and legislation prohibiting foreign purchases of New Zealand houses had some direct impact on dwelling purchases as well as indirect impact through perceptions that capital gains would diminish.
In New Zealand, neither immigration nor housing supply were the main causes of real estate inflation. In an economy with a growing population and a housing shortage, the first symptom should be an increase in market rents. Rising house prices should then follow, as landlords’ yields increase. That’s not what happened. Rather house prices increased first; rents eventually followed, though many property ‘investors’ did not care so much about their rental income because increasingly their ‘wealth’ came from capital gains rather than from collecting rents.
The actual housing crisis in New Zealand had little to do with house prices; and much to do with inequality, a lack of social housing, and a broken private rental market. In the 2017 to 2020 period, social housing and the private rental markets have improved in many cities; in Auckland there are many newly constructed apartments, recently completed or still under construction, sited close to public transport nodes.
The 2020 Bubble
At a time of Covid-19 pandemic emergency, there were few expectations that a property bubble could happen. But the conditions for such a bubble soon emerged.
The first thing to note is that the Reserve Bank is not the problem. Not only is it following its mandate by expanding its balance sheet, it is seeing that the bigger picture requires such an expanded balance sheet in order to play its part in preventing a pandemic from becoming a great economic depression. Under current conditions, monetary policy will not be able to induce the inflation that it is mandated to achieve – indeed that mandate is a case of bad social science (a story to be addressed elsewhere). If substantial inflation does recur in the world – and it might sooner than most of us expect – it will be due to covid-induced supply-chain breakdowns in the coming few years; nothing to do with monetary policy.
We need to picture a (monetary) basin with three plugholes; yes we can use water flows as a good analogue for monetary flows (its called liquidity). When more money is required for the economy, the Reserve Bank supplies the basin with money by expanding its balance sheet. The first plughole leads to the ‘real economy’, which is households buying goods and services and businesses making and selling them. The second plughole leads to governments – the government sector including local governments – the ‘fiscal’ economy. The third plughole leads to financial markets; to an inherently speculative ‘bubble economy’ that includes the market for urban land. The draining of the (monetary) basin represents the injection of necessary money into the economy.
The three plugholes are:
- real economy plughole (private sector)
- fiscal plughole (public sector)
- bubble economy plughole (speculative sector)
The Reserve Bank’s effective mandate is to ensure a sufficient flow of money into the real economy. But the commercial banks are the gatekeepers (plughole keepers!) which facilitate or inhibit the draining process.
The economy we inhabit can be likened to a human ecosystem below the plugholes, and the economy needs to be lubricated by sufficient quantities of money. Economic contraction (eg recession) occurs when the real economy is under-lubricated; inflation, on the other hand, may occur when the economy is over-lubricated. The bubble-economy is the part of the human ecosystem that is most susceptible to inflation; the real economy is usually able to slow down the circulation of money when it is over-lubricated, thus averting inflation.
The commercial banks manage these three plugholes, though unevenly. The extent of their gatekeeping relates to the different grades of ‘security’ that accompany different types of bank lending. Bank gatekeeping constrains the ‘real economy’ plughole, because ordinary business finance is the least secure form of lending. The fiscal plughole is subject to minimal bank gatekeeping, because governments’ legal powers to tax constitute a very high level of financial security. Bank gatekeeping is reflected in interest rates; ordinary businesses and consumers (eg via credit cards) pay the highest interest rates. Governments generally pay the lowest interest rates.
Typically, economic recessions follow financial crises. During financial crises, the ‘bubble economy’ plughole closes, precipitating the recession. This induces a loss of spending confidence, as people and businesses exposed to the bubble economy sharply retrench their spending. So the real economy plughole also closes; not fully, but substantially. This diminished monetary flow into the real economy is partly a result of less business and household desire to borrow, and partly a result of more stringent gatekeeping by the lending banks.
In such a recession, the ongoing success of the economy depends on the fiscal plughole. In 2009 we saw all governments open the fiscal plughole to save their economies – it was called ‘fiscal stimulus’. The New Zealand government response was comparatively muted; the New Zealand economy largely recovered as a result of new spending enabled by other countries’ governments’ stimuluses.
In 2020, the economic contraction had an unpredictable ‘exogenous’ cause rather than a predictable financial cause; namely, the Covid19 pandemic. In this case the bubble plughole never closed; that is the key point of difference this time. The private economy plughole, however, in 2020 closed to a similar extent to which it closed in late 2008 during the GFC. In response, the fiscal plughole briefly opened wide in New Zealand early in 2020, but then it closed again.
The result, by mid-2020, was a national economy with a basinful of new money, and only one substantially open plughole – the bubble plughole. So, guess what? The money drained through that plughole into the bubble economy. There was nowhere else for that money to go.
Who is to blame? Well, maybe the banks could gatekeep less re the real (private) economy plughole. But much of the private economy is in a balance sheet recession, so is not presently confident to borrow much, even if subject to reduced gatekeeping. Unsecured distress lending imposes high financial risks to the commercial banks.
The problem is the Government; in particular, the Minister of Finance. The fiscal plughole needs to be wide open, at least until the private economy plughole opens sufficiently as a result of increased governments’ contributions to the real economy. To discourage money from draining through the bubble plughole, and while awaiting the real economy plughole to reopen, the solution is one of fiscal policy. Opening the fiscal plughole is the solution.
The irony is that – by setting historically record low interest rates – the Reserve Bank is imploring both businesses and governments to borrow. The trouble is that businesses cannot borrow more (due to gatekeeping, and to their own balance sheets) and the government will not borrow more. The New Zealand government chooses to resist the strong price signals from a Reserve Bank which is implicitly begging the government sector to take the lead to defuse the now out-of-control bubble economy.
What the Government could do, this year
The newly-elected government is committed to passing legislation this year to reintroduce a 39 percent tax rate on high marginal incomes. While this tax increase may be an unnecessary expedient that complicates matters, we have to accept that this will happen.
So, as part of the same fiscal package, the government could and should also do the following, to be implemented on the same date as the new income tax bracket:
- Replace the lower income tax brackets with a Basic Universal Income of $9,080 ($175 per week) per year to all economic citizens (resident citizens, resident permanent residents, and other people presently resident in New Zealand with working or student visas. For present beneficiaries, the first $175 per week of their benefit would become unconditional. (This provision would have no immediate financial impact on either beneficiaries or on persons earning more than $70,000 per week. By ‘lower tax brackets’, I mean the 10.5%, 17.5% and 30.0% brackets.)
- Increase jobseeker and assisted living benefits by $25 per week, and accommodation supplements across the board by 10%. (This provision would mean that all such beneficiaries would be at least $25 per week better off.
- Place a substantial ‘stamp duty’ tax on all second homes, all rented homes, and all homes owned by trusts.
- Introduce a ‘good landlord’ voluntary warrant of fitness for rented houses, and exempt complying landlords and trusts from the new stamp duty.
The Basic Universal Income (BUI) and benefit increases, in an economy such at that in New Zealand at present, would soak up much of the money otherwise flowing into the bubble economy. The BUI would also free up labour supply – especially for young people presently constrained by the requirements of conditional benefits. And it will free up government agencies to help those people and families with more complex needs. The BUI will ensure that all adults in a household – including recently unemployed women with employed partners – will have unconditional access to a basic income.
The stamp duty will create a disincentive for speculative ‘investor’ money to flow into the real estate market. This money is pushing up prices in such a way that only people who already own houses – or whose parents already own houses – are themselves able to buy houses; and this money is treating houses as a form of financial wealth rather than as a place to call home.
The landlord warrant of fitness exemption becomes a ‘good landlord subsidy’, a way of using a monetary incentive to address the emerging problem of slum housing in New Zealand’s cities.
The present real estate price bubble is easily explained as the result of a lack of ‘rational’ fiscal policy. In economics, it is rational to respond to price signals; in this case the governments of New Zealand are not responding rationally to the lower interest rates made available to them, and are instead watching as much of the money they could and should be borrowing flows into the secondary housing market.
While there are many things the government could be spending money on – including higher wages in female intensive industries such as health and education – the Basic Universal Income and benefit increase cited above represent the best immediate uses of increased government borrowing.
The improved fiscal policy suggested is a case of win-win, immediately easing the stresses of daily life in today’s uncertain times, while also defusing the out-of-control real estate market.
I am not confident that the government will choose this or any other win-win option. Rather I believe they will choose a lose-lose option; continuance of unnecessary economic insecurity and escalating house prices.