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Bursting bubbles

By Donal Curtin

Friday 17th February 2006

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The housing market has been demonised in recent months: if the alarmists are to be believed, New Zealanders are borrowing bucketloads of cheap money, plunging into an overvalued and speculative housing market, and tapping into home equity to support a spending habit we can't afford. The Reserve Bank's at its wit's end: the spending splurge based on the increase in families' housing wealth has caused inflationary pressures, and the bank's attempts to rein in the housing market haven't worked.

Indeed, higher interest rates not only haven't brought the housing beast under control but have contributed to other problems (notably, the high Kiwi dollar). As a result, Treasury is now devising some new bludgeon that might beat some belated sense into house prices.

But two parts of this story seem, to me, to be seriously wrong: that New Zealanders are feckless with debt, and that the housing market has gone into a speculative mania.

It's true that some of the statistics on debt and savings look bad - particularly the estimate that in the year to March 2006 New Zealand households spent $1.14 for every $1 of after-tax income. On the other hand, the data show the average household is no more leveraged than before. Over the past year, house prices and housing lending have risen by roughly the same percentage, so the proportion of the value of the house that is the family's home equity hasn't changed (in the year to October house lending was up 16% and in the year to November national house prices were up 15.4%).

So if you had a $400,000 house with a $200,000 mortgage, and it becomes a $500,000 house with a $250,000 mortgage, the house, the loan, and the home equity have all gone up 25%, plus you've had a lump sum of $50,000 to spend (which is where the $1.14 comes from).

So from a balance-sheet point of view, households are in no riskier a position than before. From a cashflow or loan servicing perspective, while it's true that borrowers have had a bit of luck (such as a mortgage war between the banks), it's not obvious they're going to run into serious problems even as rates rise. Banks generally don't lend unless you pass a serviceability test, and in any event household incomes have been rising strongly with wage, salary and employment growth.

The second part of the story that is questionable is that the housing market has lost touch with economic fundamentals.

The housing market is actually behaving as it always has - and its normal behaviour can include pronounced cycles, up and down. And that cyclical behaviour lies in the way house buyers think about the cost of borrowing.

Arthur Grimes and two colleagues from Motu Economic and Public Policy Research recently did a sophisticated analysis of the housing market (see Perhaps the most important thing they found was that the housing market is a predictable mechanism. That, in itself, would lead you to be careful about assuming there's something irrationally exuberant going on.

Over the long haul, real house prices respond to three things - real economic activity, the cost of finance, and housing stock - in the ways you'd expect (growth is good for prices; expensive borrowing and increased housing supply are bad). But the really interesting thing is that 'cost of finance' bit. What matters for house prices is not the banks' mortgage rates, but the 'user cost of capital', which is the real mortgage rate, less house buyers' expectations of real house price gains. And that makes sense: you might not borrow at all, even at a low interest rate, if you thought house prices were going to fall, but you might well borrow, even at a significantly higher interest rate, if you thought house prices were going to rise strongly.

What the data clearly show is that people's expectations are formed by looking backwards, usually at house price movements in their region over the past three years. Hence cycles in the housing market: if prices rise strongly over three years, the 'user cost of capital' goes down, demand increases even more, prices increase some more, and on it goes.

But this is not a cycle that ends in a big bang. As Grimes and his colleagues show with some nifty maths, it's a stable process. Prices don't indefinitely stray further away from where they 'ought' to be relative to incomes, cost, and housing supply. Sooner or later, one or more of the moving parts kicks in and starts moving prices back towards the 'ought to be' level.

It's true the hot housing market has had effects across the economy, and has put the Reserve Bank in a hard place. It's equally true that when it cools, a lot of the current spending previously fuelled by housing wealth will slow or stop. But it's probably not true that households have behaved unusually recklessly, and it's almost certainly not true that the housing market is in a 'bubble'. House prices wind up in good times, just as they as they are right now in the US: the median price in October is up 16.6% on a year ago. And they unwind in due course: house prices in Sydney are down 4.7% on last year. We're on the same, well-beaten track.

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