Wellington branch, NZ Shareholders Association, 10 June 2014

Keywords: Business & Finance; Macroeconomics & Money;

My topic tonight is New Zealand as a bubble economy. But I need to start with a listener warning. I am an economist, not a financial adviser – registered or unregistered. Economic theory tells us something about the context of investment decisions, but it is not designed to give specific investment advice. Tonight I am going to talk about that context in terms of the contemporary challenges the New Zealand economy faces. Just to make sure that you dont think I am giving you any advice, I am going to illustrate the issue with the housing market.


What do we mean by a financial bubble? The physical analogue is a fragile physical entity which inflates, pops and deflates – usually with a smattering all around. Financial bubbles are much the same. Fragile, inflating, inclined to go pop and leave a mess behind.


The use of the term ‘bubble’ to characterise such events is about three hundred years old – London’s South Sea Bubble burst in 1720, but there were comparable crashes about this time in Paris and Amsterdam. Asset price inflation followed by collapse has repeated itself many times since, so economists have thought a lot about the phenomenon.


I shant have time to go through the entire history of economists’ analysis – nobody has that time – but I must mention the great Austrian economist Joseph Schumpeter, who argued that booms and busts were an integral part of capitalism and the process of economic growth. If he is right, we face future bubbles until capitalism itself fades away.


From this point of view public policy does not want to stop bubbles as a matter of principle, although it may want to reduce the impact of the pop. Hence the measures taken throughout the world to make banks more robust so that the payments system continues to function following a financial crisis


An important consequence is that in a capitalist economy investors will always to be at risk of losing all or some of their funds. The higher the return the investor aims for, the greater that risk, that is the greater the likelihood the investor will lose the invested funds. However investors should have a reasonable expectation that those they are investing with exhibit ethical behaviour in accordance with the law. Without those preconditions the transaction costs of running a market economy would become too onerous for it to work effectively.


Recently, a Forbes commentator, Jesse Colombo, said New Zealand had a housing and credit bubble. the Minister of Economic Development, Steven Joyce, responded with Colombo’s ‘view on life is that the whole world is pretty much in a bubble and there’s no place he doesnt pick on’. Both were right. You’d expect there to be bubbles in most prospering economies. The issue is the size of the bubble, the significance of the sectors in which the bubble occurs, how soon it pops and the magnitude of the disaster it brings down on itself.


There was a view that we had finally conquered financially caused business cycles. Yes, there were business cycles but they were caused by external shocks. The notion of the end of the business cycle became very fashionable a couple of decades ago; some of you will have been taught real cycle theory at university as though it was the truth, the whole truth and nothing but the truth. In which case your teachers would not have pointed out that at the time there were financial crashes occurring all over the world. Apparently the economy did not take as much notice of real business cycle theory as some economists did.


I dont know if they still teach only real cycle theory – some of our university economists have terrible trouble catching up with reality – but some economists continued to work outside the fashion. The most notable was Hyman Minsky. Dying in 1996, he did not live to see his theories being used to understand the Global Financial Crisis. Nor did he see his name enshrined in the ‘Minsky moment’, the point in the cycle when sufficient investors realise collapse is inevitable and the downward plunge begins.


At the heart of Minsky’s analysis is that there are speculative bubbles which the financial system exaggerates because investors can purchase assets with debt. Leveraging is necessary there at the boom. It is a terrific way to make a profit during the speculative phase, but during the bust the debt is a terrible burden, which can be personally very destructive.


If the investor thinks that the asset is under-priced – that the return will be higher than the market thinks – they can borrow and get an even higher return. There will always be some investors more optimistic than the market average Some optimists will prove right; others will lose their shirts; they are perfectly normal investment outcomes.


However if there are enough optimists, the price of the assets they purchase rises. The capital gain may be justified – perhaps the optimists had picked up a trend in productivity which would boost the future income from the asset. Whatever, others see the capital gain and buy into the asset too. The asset price goes up again. More capital appreciation, more people bet on the asset, using borrowed money. Without the borrowing the spiral would soon come to an end.


Now of course it must come to an end one day. Herbert Stein, an advisor to Richard Nixon, coined what today is known as ‘Stein’s law’: If something cant go on forever, it will stop.


Why dont those involved in speculative bubble realise this? Some do and sell out, but some investors stay in long after the asset prices become unrealistic relative to the true return.


Isaac Newton, who was involved in the South Sea Bubble, famously said ‘I can calculate the movement of the stars, but not the madness of men’. Three hundred years later we have made only a little progress.


The most helpful insight comes from a research program we associate with Daniel Kahneman, who despite being a psychologist was awarded the so-called Nobel prize in economics in 2002. One of its empirical insights is that we seem to have two modes of decision-making which Kahneman labelled ‘thinking fast; thinking slow’.


Thinking fast uses short cuts and heuristics with a short time horizon, a consequence of which time-inconsistent decision-making. Thinking slow involves more careful reflection, a longer perspective and consistent decisions through time. However, greater reflection requires more energy, so we tend to rely on the think fast mode – it is a sort of ‘think lazy’.


So we go into many investment decisions without a careful evaluation using prices as proxies for the underlying economics – forgetting that they may be poor indicators. Frequently we forget Stein’s law until the Minsky moment.


Many of you will be broadly familiar with this analysis, and will know particular stories which illustrate the theory ranging from tulip to share market bubbles. I’ve gone over some of the theory in order to talk about the particularities of the current state of the New Zealand housing market.


Of course a house can be more than a piece of paper in the way a share or a bond only is. It may provide direct benefits to its owner’s family as shelter and a home. That may be why we flinch from thinking about housing rigorously.


A particular house may also also confer status on its owner – it is a form of conspicuous consumption. It probably leads to houses larger than are necessary for shelter and so there is a kind of inefficiency from this source in the housing stock.


The other function of housing is that it is an investment, although we need to be careful with the notion. Certainly housing is a good place to put one’s savings by paying off the mortgage. Socially ownership housing seems to be a good investment insofar as owners look after their properties better than tenants; you fix it up yourself, rather than getting a builder, which lowers transaction costs.


However let’s focus on the capital appreciation side of the investment. Most home owners expect their price of their house to rise faster than the rate of consumer inflation. Is that a capital gain for the owner?


Compared to consumer prices the answer is ‘yes’ but, as a rule, home owners dont convert the cash they obtain from selling their house into consumption goods. Rather they buy another home. If they make a capital gain on selling their house, they make a capital loss on their next house purchase. That is why it is common not to tax the capital gain on the houses one lives in.


I’ll come back to second houses but before doing so I need to give a few examples where this analysis does not quite work. One is that if the owner dies, they will not be purchasing another house and so, arguably, their estate has made a capital gain. And what if they migrate, buying their next house overseas?


There is an argument that one should tax capital gains from expensive houses, say over a million dollars. However this is really arguing for a tax on conspicuous consumption; that is outside today’s topic.


The tricky issue is illustrated by supposing at retirement you sell down using the savings from the cheaper house to enhance your retirement spending. Yes, in that case you do get a capital gain (when house prices rise faster than consumer prices). On the other hand, suppose you move up in the market purchasing a bigger house. In effect you then make a capital loss. It would be a terribly complicated capital gains tax system to deal with such situations. My guess is that it would generate little revenue because the capital gains of moving up in the market and moving down would approximately net out. Given the administrative complications, let’s leave the possibility to a theoretical exercise.


What about those who dont own houses but want to become home owners? They have been making capital losses insofar as the return on their savings has not kept up with rising house prices. That is a problem which may need public policy attention which I shant deal with it here.


Rather, I want to analyse investment housing, typically involving someone buying a second house to rent out for the purpose of making a return on their savings. Usually it is a leveraged purchase and under the current tax regime any capital gains from the investment are hardly taxed. Given rapid increase in house prices and a lot of leveraging, the return can be quite high – exactly the circumstances required to generate a speculative bubble.


Only a month ago the OECD looked at relative housing prices across 16 economies. Compared to rents – and indeed also in comparison to wages – New Zealand house prices were the highest among the 16 rich countries – with Belgium, Canada and Norway closely behind.


Some have argued that means rents should rise, but economists tend to assume that rents are set by supply and demand, so that they may well be near equilibrium levels and difficult to jack up. The implication is that house prices are too high.


At face value the OECD relativity suggests that while investors could obtain an annual return of, say, 6 percent from company bonds they would be getting only 3.6 percent from property of which they were landlords. However, the OECD reported that house prices rose over 8.2 percent in the year. With that added in the return was a whacking 11.8 percent compared to the 6 percent on bonds. (If the landlord partly financed the purchase by a mortgage, the return would be even better.) The difference in after tax return is even better. Suppose the tax rate is a quarter then the annual return is 10.9 percent to the landlord, 4.5 percent to the bond holder.


Apparently landlords are calculating their return not just on what they are getting in rents but also from the capital appreciation. Is this a good thing? To forewarn you of my conclusion, I would not be too fussed except that some investments are taxed and some are not distorts investment decisions and probably leads to wasted investment and – as I shall argue in the case of housing – presents a potential threat to the stability of the economy.


But first, I want to illustrate how the housing market works by a few scenarios to illustrate the complexities of the housing market.


Number one scenario is to assume that the government sets a maximum price for each house. (How exactly, need not detain us.) Suppose, following the OECD, it set the maximum price at a 40 percent discount on the current price, so that today’s million dollar house would be valued at $600,000. Everyone would wake up the following morning, grumble about the damned government’s intervention, but hardly be affected. Even a person with a $800,000 mortgage would have exactly the same outgoings as the previous day. While their balance sheet would look different their income and expenditure would be exactly the same.


A price cap on housing might stop house buying and selling for speculative gain, but people would still need to change houses for practical reasons. Consider a person living in a million dollar house who had to change – perhaps go to another city. Faced with a price cap, they would sell their house for $600,000 and buy essentially the same house for $600,000, so they would be square. But what if they had a $800,000 mortgage? They would be expected to pay it off but of course they would be recovering only $600,000 from their house so they would be $200,000 adrift. Moreover the banks would advance them only $480,000, say, on their new house. A price reduction – or even just price stagnation – really stuffs up the housing market.


Without elaborating the scenario further I make but two simple points. The first is that it is not so much the price of housing that matters, but the debt on the house – Minsky would smile at this insight. Second, the price path matters a lot when people want to buy and sell houses.


The second scenario illustrates more facets of the housing market. Suppose the government were to announce that the Reserve Bank would target house prices so that they would not rise more in a year than 3 percent on average. That would certainly take the speculative heat out of the housing market, and people would stop purchasing for speculative purposes.


But they would still need to buy and sell for practical reasons – household size changes, job changes, changes in the household life cycle. They could still do that, but here’s the rub: there would be a dramatic drop in the number of house purchases as investors for capital gain withdrew from the market. The market would become much thinner and house owners would find it much harder to move when they needed to.


This illustrates one of the acknowledged roles of speculation in financial markets. More participants deepen the market adding to its liquidity, so ordinary participants find it easier to get in and out of the market when they need to.


An ordinary financial market is far more liquid than a housing market; its products are more uniform and the transaction costs for buying and selling much lower. One guesses that a reduction in liquidity in the housing market would be even more damaging.


Moreover, investors supply housing for tenants. Suppose their investment becomes less profitable. It seems likely that there would be a reduction in the supply of additional rental housing. Would it be necessary to make an alternative supply?


My third scenario involves an external shock. Suppose, for illustration, that the Chinese financial system implodes. It seems likely some of the house purchases in Auckland (and Sydney and Vancouver) are financed directly or indirectly from the offshore financial system. In the stress some of the investors would want to reduce their exposure in New Zealand and would start selling houses. That would certainly put a dampener on rising house prices – especially in Auckland. The bubble would pop. Distressed selling, would cause prices to fall a bit (and then stagnate) so we would be back to a version first scenario.


I would not expect a dramatic drop in house prices, say of 40 percent similar to the collapse when a share market bubble pops. Typically New Zealand house prices do not fall sharply because people hold on as long as they can, rather than sell down. (It is different in America because of the different way their mortgages are organised.) House prices may fall a little but generally they stagnate, their real value being deflated by inflation. That could mean, as some regions are already experiencing, a long period of stagnation – literarily years or even a decade or more.


My fourth scenario, about which I shall be more elaborate, is the imposition of a capital gains tax. I shall assume a mild version, not too unlike the Labour proposal of 15 percent on second houses only and prospective, so it would only be on capital gains after the tax was implemented – say from April 1, 2015.


The Minister of Revenue, Todd McLay, has said that New Zealand already has a capital gains tax on property speculators. He said

‘When people say New Zealand doesn’t have a capital gains tax on property it’s not true – we do have a capital gains tax, and it applies to speculators.… if their intention is to make a gain from the capital, their normal income tax rules apply …’


If the OECD is right and most landlords are relying on capital appreciation to justify their investments in rental housing, then if the government enforces the law as set out by the minister, virtually every landlord should be taxed on the increment of the value of their rental properties when they sell it. Such a capital gains tax would be retrospective. My illustration will stick to the milder Labour proposal.


Under it we can expect there to be less investment interest in property and so house prices would not rise as quickly – all house prices, not just rental properties. The slower rise in housing prices may also discourage households from buying and selling their homes. So there will be a reduction in activity in the housing market generally. We are now very close to the outcome of my second scenario in which the Reserve Bank is charged with targeting house prices. There will be a reduction in liquidity of the housing market and fewer transactions, although the relatively lower house prices might encourage first home owners to enter the market.


What happens when the numbers of houses bought and sold are reduced? I shall get to the obvious, but do so slowly by putting in the steps of the analysis.


It is generally accepted that our bubbling is partly caused by overseas borrowing. It is not immediately obvious why. Suppose I buy a house for a million dollars, borrowing it (on the margin) from overseas via a bank. The vendor will bank the million, which will be used to pay off overseas debt so New Zealand is quits.


But whatever happens to the mortgage debt story, there are also considerable transactions costs in house selling and purchase. It is not just the real estate agent’s fees, lawyer’s fees, valuer’s fees, bank fees and building inspector’s fees plus removal costs. The purchaser may upgrade some of the furnishings and durables and make some alterations to the new house or do some maintenance preparing the old house for sale. Friends of mine doing this have spent over $35,000 all up.


That would, in effect, be borrowed overseas as a consequence of either running down the bank balance or taking out an increased mortgage. Since we trade about 80,000 already built houses a year, this amounts to borrowing about $2.5 billion annually to cover, say, an  average transaction costs of $30,000. That amounts to about 1 percent of GDP.


Suppose that amount would halve following the discouragement of property purchase for capital appreciation. That is over a $1 billion less offshore borrowing. It is also a $I billion odd less spent on transaction costs. The economics gets a bit complicated here, but to simplify, the exchange rate would fall while exports would increase. In principle the real estate agents and all who become unemployed would switch into working in the tradeable sector.


That production changes would take time is one of the reasons I think it wise to squeeze property speculation based on capital gains rather than slam down on it or wait for the bubble to pop.


The government might argue that it is doing something about the unstable housing market by making it easier to build new houses. Supply measures often have a role in managing a market, but the feasible additions to the stock of housing are small compared to overall demand. It is a bit like trying to cool soup by marginal increases in the size of the pot, while the flame of demand blazes merrily away.


Focussing on the supply side and ignoring the demand side comes from the same intellectual stable as the now discredited real business cycle theory. It is like going into a boxing match with one hand tied behind your back. You are bound to lose.


So what should we do about the demand side? I join our Treasury, our Reserve Bank, the IMF and the OECD who think that it is good economic policy to treat the return on all investment the same for tax purposes, thereby avoiding the distortions which discriminatory tax regimes engender. Not all of these have actually advocated a capital gains tax, but it is a way of implementing their policy principle.


I’d go for Labour proposal of starting afresh rather than the National (McLay) proposal of broadening the tax base to cover virtually all landlords retrospectively.


Of course, many would argue that this is all a counsel of perfection which can be delayed indefinitely. But if we do not try to squeeze a bubble caused by tax distortions, then it will pop with far more serious consequences. That was the point of my third scenario – to show how it could happen. There are many other ways it could.


And it will happen. Stein’s law is fundamental – irrefutable. The issue before us is whether we think fast and do nothing until the bubble pops followed by considerable pain, or whether we think slow and take action to ameliorate the pop – as soon as we can.