The Reserve Bank, Debt and the Property Market

The issues of house price rises in Auckland and Christchurch is prompting comment that it may be time for the Governor of the Reserve Bank to raise interest rates.   It is noted in the media that an increase in interest rates will result in foreign money seeking higher returns to enter the domestic market and this will also increase the value of the already overvalued dollar. 

What hasn’t been commented on is that an increase in interest rates will also penalise every business and household in the country including everyone resident in Auckland and Christchurch who already have a mortgage and have no intention of buying or selling a home.  There will be no beneficial behaviour change within that wide group who are not seeking to get further into debt but it will impose hardship and constrain the rest of the economy.  The interest rate rise would be imposed simply as an attempt to limit price rises in response to artificial shortages of housing in two localised parts of the property market. 

The more sensible action would be to address the cause of these shortages rather than attempt to alter the market response by raising interest rates.

The Reserve Bank Act is not only completely ineffectual at slowing property prices it is the root cause of property price inflation.  Because the Reserve Bank Act obliges debtors to pay over the market price for debt, it also guarantees lenders greater than normal market returns on investments.  The result is that foreign cash looking for high and secure returns has flooded into the New Zealand property market.  The banks are incentivised to actively inflate the property market because of the high returns it provides (thanks to the Reserve Bank Act) and because of the flood of money that they have to invest.  As a result the more the Reserve Bank increases interests rates above the natural rate for the marketplace the more money that flows into the property market, the less risk averse lenders need to be because they receive higher margins on loans and this results in banks adopting laxer lending practices, this then leads to property price inflation which results in the rate of increase in capital value of the property (in the overheated parts of the market) to exceed the cost of debt - for a while at least – the negative real rate of interest in this small part of the property market consequently further incentivises borrowing.

The end result is that we are as a nation carrying far more debt than is necessary for the economy to function effectively, we have a ruinously over valued property market, we have a grossly overvalued exchange rate, we are bleeding our scarce foreign earnings on interest payments on all the debt and meanwhile our productive sector is crippled by both the cost of borrowing and by the over-valued and highly unstable exchange rate, Instead of suppressing inflation, the Reserve Bank act causes inflation.

The Reserve Bank Act is singularly the most stupid element of the reforms of the 1980’s.  It is utterly illogical in that it defies the simplest of precepts of economics.  The answer to the problem of inflation is simple.  If a government wishes to increase the cost to the consumer of any element of the economy without increasing the supply of that element it imposes a tax not a compulsory price increase – alcohol and tobacco are excellent examples of this concept in action.   The government also targets only those activities it wants to constrain.  So when it taxes alcohol it does that based on alcohol content – it doesn’t tax all liquids.

A tax also allows for redistribution and targeting by the government to occur so if the tax imposes on lower income households this can be resolved through social payments with the tax on debt as a source of funds.  Similarly the tax can be linked to the asset class or region causing the problem so there may be a lower tax on business debt.  This is not difficult; the banks already set interest rates by the manner in which the debt is secured, the tax could be similarly targeted.   This is only one possible mechanism as there are is a range of possible taxation responses to this problem which these need to be linked into a wider strategic review of the role of taxation in the economy.

At a more fundamental level any market failure or physical circumstances causing the price pressure also needs to be addressed.  Auckland prices are being driven by a range of other policy actions by government that put inflationary pressure into the market.  These include allowing uncontrolled foreign ownership of residential real estate, immigration – from both within New Zealand and from off-shore - and from a failure to fully price the true cost to the national economy of growth of the major cities and the cost of internal migration of business and residents.  Property in the larger cities but particularly in Auckland is being subsidised in a number of ways while the rest of the national market is in one form or another languishing with surplus housing and infrastructure.  In addition to fostering policy that actively inflates the cost of housing nationally and causes our international debt to be excessive and our currency to be over-valued we are not as a nation using our existing investment in infrastructure wisely. 

We need to be asking ourselves collectively why we, who as a nation have the highest natural capital per capita and arguably the best system of society in the world, are one of its debt basket cases.  We are only being prevented from being another Greece or Cyprus by the dairy industry.  We also need to ask why we are not so much better off as a nation when countries like China and Singapore are doing so much with so comparatively little.  The answer is quite simple and that comes down to the vision and courage of their political leadership, could I commend you to read George Monbiot’s recent post

http://www.monbiot.com/2013/04/22/the-self-hating-state/ as it very accurately describes the malaise that we have inflicted upon ourselves with our reforms and our reliance on “The Market”  to provide. 

Kiwisaver conned confirmed

The NZ Herald ran a story last weekend entitled Bigger KiwiSaver investment overseas predicted

Onepath predicts KiwiSaver will grow from about $12 billion now under management to $50b by 2020. At the same time it share of retail funds under management will increase from about 40 per cent to about 70 per cent, with total retail funds reaching about $70b, it says

This will mean that we have saved through Kiwi saver more than our share market is worth by 2020 and we will invest that money in the productivity of other countries – what losers we are!

Because our economy can’t absorb that level of savings under the current model the investment whizzo’s are going to put it into international share markets.  These while they have fallen back somewhat from their hysterical highs of the last decade are still horribly over valued and even the optimists expect no more than 2.5% return on capital from the Dow Jones for the next decade.  And that is if the money doesn’t disappear down the hole in the meantime either through business failure, skullduggery or inflation.  Remember that at the same time the EU, the USA and Britain are printing money like it was going out of fashion.  Your Kiwi saver will evapourate as this continues.

"The more money available [from KiwiSaver] the more money can come into the New Zealand capital markets and the more companies will use them," Body says.  "But the growth in the [KiwiSaver] industry will probably be too fast. That means more global exposure for a lot of fund managers.

So your savings are being used to help NZ’s capital markets grow fat- a bunch that even Stephen Joyce acknowledges as being less than honest over the past decade.  The investment advisors can’t see where in the NZ market they can invest so they are going to take it off-shore.  But BillE says that we need the money and the asset sales to build our capital markets.  The capital markets are saying that the asset sales wont make much difference.  And all that money pouring into the global capital markets is competing with all of the retirement funds of every other rich countries plus the money magic of the bank’s fractional lending and we will soon be wondering were our money has gone – a fool and his money – is an image that leaps to mind.

Body says state-owned asset sales will help. "But if you think about the raw numbers, we think KiwiSaver is going to grow $50b in the next 10 years and the [assets] float is about $6b in total.

Even if growing savings sees that triple by 2015, by that time the NZX may have a market cap of about $75b thanks to growth and proposed SOE privatisations, he says To date about $1b of KiwiSaver money is invested in the local share market from a NZX market cap of $58b

If the government wanted capital put into public assets why not just let KiwiSaver invest directly in our energy company through bonds.  Remember however that when all us old farts want our money out it wont matter whether it is through taxes or power bills - the next generation will cop the bill.

Why not use all this cash to get rid of the foreign banks that are bleeding us white and use the savings to fund our own internal borrowings – far safer and better returns than the share market, particularly the foreign share market.  Why not invest it in the rebuild of Christchurch?  Why not invest in energy self sufficiency? 

Do our leaders have no vision? No sense? No courage?

The current account deficit for the year to March 2011 was $7.2 billon, or 3.7 per cent of gross domestic product, Statistic New Zealand figures show.  Kiwi firms paid out $9.6b more to overseas investors than Kiwis received from other countries. On top of that we export another $4billion each year in Kiwisaver investments.  This is all stupid.

We are bleeding money and yet our leaders want to accelerate the bleeding.  Are they bleeding idiots or what?

Bigger KiwiSaver investment overseas predicted ELOISE GIBSON Business Day STUFF 23/07/2012

And Time magazine agrees with this current article...  Are Dividend Stocks the Next Bubble?

Dividend stocks are leading the market and some pundits believe the rally is a bubble about to end badly. But they may be underestimating the flood of income-starved retiree money heading this direction in a record low-yield environment

Read more: http://moneyland.time.com/2012/07/24/dividend-stocks-the-next-bubble/#ixzz21cYMw26T

The Reserve Bank Act

Or why we are broke.

The Reserve Bank Act defies the most basic logic in economics - the law of supply and demand.  It is also most profoundly contradictory that the most essential component of the market, the price of debt has to be determined by regulatory fiat – surely the market should be able to sort that out.

At a conceptual level the Reserve Bank Act and the mediaeval practice of bloodletting have the same basic premise, that draining the essential life fluids from the fevered body will make the patient well.    All it achieves is to weaken the body further.  Deathly pallor is mistaken for a fever cured.

The most basic failure is that when some element of the economy is over-heating the cost of debt is increased indiscriminately draining economic energy from the innocent and the guilty.  The RBA slows the economy by transferring wealth from the productive sector of the economy to the banking sector.

Unfortunately it drains money from the productive sector and from households far more effectively than it drains money from the speculative sector.  The speculative sector of the economy is driven by higher returns and higher risk and often the risk is displaced onto the lender through default when things go wrong.  The mortgaged businessman or householder cannot escape so easily.

Fundamentally the Governor of the Reserve Bank raises the cost of borrowing to reduce demand for new debt to reduce inflationary pressure in the economy.  This is perverse for while it is targeted at reducing the creation of additional debt it also punishes those who already are in debt.  The indebted cannot immediately reduce their indebtedness so must pay the imposed cost of borrowing.  Their demand for debt is highly inelastic. 

This is where the true perversity of the Reserve Bank becomes apparent.  At the same time that the Governor increases the cost of debt to existing and new borrowers he also increases the rewards to lenders.  It is at this point that the basic illogicality of the Reserve Bank Act becomes clearly apparent, the Reserve Bank Act incentivizes the introduction of additional debt into the economy. 

The higher interest rates draw in new lenders with a higher resistance to risk, along with the careless and the greedy.  These new lenders draw in their equivalents among the borrowers.  So putting the price of money up makes the problem much worse by increasing the riskiness of all debt funded activity.  It also drains resources from productive activity by increasing the cost of debt while fuelling speculative activity by increasing the supply of less risk averse lending.  The past decade is testimony to that.

A deeper fact is that this whole artifice is a substitute for the fact that the government has relinquished its right to issue currency to the banks and uses the Reserve Bank Act to moderate the rate at which the banks create it.  This doesn’t work. 

The foreign banks have also abused the process to inflate parts of our economy, principally property and shares, so that they can push more debt into our economy and in doing so expropriate our Nation’s wealth creating ability.  We have been stupid enough to think that this is a good thing.  

The difference between the overnight cash rate in Australia and New Zealand over the past decade meant that Banks could borrow in Australia at a low interest rate and lend in New Zealand at a higher rate.  They would be stupid not to.  We are stupid to encourage them to.

In the past several decades it has only been a limited range of economic activity that has been inflationary.  To illustrate this, the decade 2000 to 2010 saw property values treble yet government figures indicated that the Consumer Price Index was never above 3%.  So interest rates stayed relatively low while the returns on speculative investment soared.  The real rate of interest on debt against property was in the order of -10% annually.  This meant that anyone with a mortgage was getting 10% growth in asset value after the cost of debt.  Everyone else was paying interest at about 2-3% more than the underlying economic activity warranted.

We are now in a position as a result of the Reserve Bank Act that the entire gross export earnings of the dairy industry is consumed by paying the interest on all of the debt this country has accumulated over the past two decades.  


And we wonder why we are selling our land and our national assets to ;pay the bills.  It is because we are governed by the stupid and the greedy and the doctrinaire.

The Answer is simple

The simple fact is that if the Governor wants to increase the cost of money but not increase the price of money then the Governor should be able to impose a tax on borrowing.  If the governor wants interest rates to provide a 4% return to the lender but impose a 6% cost to the borrower to dampen both supply and demand for debt then the only logical way to do it is to impose a tax equivalent to an annual interest of 2% to establish the difference between price and cost.

That resulting tax income could be put to all sorts of good uses within the economy and it would achieve exactly what the government intends to achieve.

To be really subtle the tax would need to be variable according to the target sector of the economy.  This might sound complex but it isn’t.  Banks achieve this level of differentiation simply through the nature of the security against which the loan is raised.

But again it is not that simple.  


It is not that simple because the Reserve Bank Act is not the only fundamental flaw in our monetary and fiscal world.  But more on that some other time!