The Reserve Bank of New Zealand (RBNZ) last week lodged a fascinating submission with the New Zealand Productivity Commission’s Housing Affordability Inquiry which, given the strong similarities between the Australian and New Zealand housing markets (explained in these earlier articles), is highly relevant to Australia.
The RBNZ submission is provided below. At only 10 pages long, I highly recommend that you read it yourself. But for those of you that are time poor, the key extracts are provided below.
Executive Summary
Changes in house prices matter for the Reserve Bank of New Zealand (the Bank), both through their cyclical implications for monetary policy and the longer‐term implications of the level of house prices for macroeconomic and financial stability.
Demand for housing can change, at times quite quickly, and, as in any market, it is important that the supply of houses quickly responds to changes in demand. Supply response moderates potentially damaging swings in house prices. Policy can have an influence on housing market outcomes through a variety of channels, in particular over the longer‐term, by helping ensure that the regulatory regime facilitates the ready adjustment of supply to demand…
The right policy framework should probably be focused on supply conditions in the housing market, although a sensible tax structure is also likely to matter…
Supply constraints matter a lot for determining housing market outcomes… This is particularly so for countries or regions with fast growing populations, like New Zealand. In the long‐run, evidence suggests that significant supply constraints lead both to bigger house price booms and eventually to nastier house price corrections.
Many other factors have influenced house price cycles in New Zealand. Big swings in migration (by OECD standards) have been an important factor. At the margins, changes in relevant tax parameters, as well as the stance of monetary policy, will have been important at times. With housing supply slow to adjust, these were among the factors that helped trigger initial increases in house prices. Higher prices in turn fuelled expectations of further appreciation, which served to reinforce demand for housing at even higher prices.
As the Reserve Bank has acknowledged previously, with the benefit of hindsight, monetary policy may have been too slow to tighten in the early stages of previous business cycles. Rapid growth in fiscal transfers late in the cycle probably also provided a boost to income that sustained the house price boom a little longer than otherwise might have been possible. Both these mattered more than they should have because of the way demand shocks and supply constraints interacted to trigger the house price boom in the first place.
Policy should focus on regulation that gets supply conditions in the housing market right and removes barriers that impede productivity gains in the construction sector. Such a policy framework should produce lower, and perhaps most importantly from the Bank’s perspective, less variable house prices over the long‐run.
Taxation regimes can affect house price movements and house price cycles, but our judgement is that they have not been of decisive importance compared to supply factors, migration factors or fiscal and monetary policy. At times, tax provisions, in conjunction with other shocks, may have served to amplify or extend a housing boom that had initially been triggered by quite unrelated factors. Our reading of the international literature suggests that the presence or absence of a capital gains tax is not a decisive factor explaining house price behaviour here or in other countries.
The liberalisation of access to finance since the 1980s will have had a significant impact on debt levels, as well as the distribution of debt. Of course, the typical interest rate in New Zealand has been relatively high compared to international standards. Over the longer‐term, changes in access to finance should not have a large or sustained effect on house prices. The ability to use additional land for housing (or use existing land more intensively) and the value of that land in alternative uses, probably matter most. Over long periods, and allowing for productivity growth, the prices of other inputs to housing construction like wood, steel and of course unit labour costs, should probably not grow much differently than the general level of prices in the economy…
House prices and the RBNZ:
Large swings in house prices over the cycle matter primarily to the extent that they change consumption behaviour, by easing collateral constraints or leading households to think that their real wealth has increased. The associated wealth effects can bring forward consumption…, residential investment decisions and drive up inflation (as firms increase their output price in response to stronger demand)…
House prices swings can often be costly. They can distort the allocation of resources, detract from economic efficiency and, at times, threaten financial stability…
Large rises in the level of house prices are also often associated with increased household leverage. If those higher prices prove unsustainable, the resulting fall in house prices can generate financial stability risks (as recently happened in the United States and Ireland) or, at least, act as a sustained drag on private demand and economic activity (as appears to be the case in a number of other advanced economies at present)…
Appropriate focus for the inquiry:
Turning to the inquiry into housing affordability, we think the focus should be on the long‐term structural issues…
When supply is relatively constrained in the short‐term, swings in demand matter a lot for the determination of house prices. Lots of factors influence changes in the demand for housing but factors such as migration and demography appear to have been particularly important in New Zealand…
Another demand‐side factor in the latest cycle was rapid growth in fiscal transfers late in the cycle, targeted at groups who were probably among those purchasing houses with large mortgages. These transfers probably provided the income to sustain the house price boom a bit longer than would have otherwise been possible. Generally, we think less pro‐cyclicality in fiscal policy helps.
And expectations dynamics in housing markets matter. While supply was initially slow to respond sufficiently strongly to increased demand, total residential investment as a percentage of GDP ended up being quite similar to that in other countries with similar population growth (including the United States) across the boom period as a whole. But faced with large demand shocks supply appears to have been slow to respond. This allowed prices to rise quite materially, which appeared to fuel expectations of ongoing future house price rises. It is reasonably well accepted that expectations of future house prices are weakly anchored and hence quite easily displaced. The prevalence of publications touting the attractiveness of rental property as an investment option increased as the boom went on, not decreased.
Monetary policy can also play a role. If interest rates are set too low for too long, that will affect demand for housing and house prices… with hindsight we may have been too slow to tighten monetary policy against a backdrop of a relatively strong economic performance. In terms of cyclical demand, we can certainly lean against the wind regarding asset prices, and leaning early is better than leaning late… That said, pre‐emptive moves to try to manage house price booms using monetary policy risk exacerbating stresses on the tradable sector of the economy. Raising interest rates in this context will increase demand for New Zealand dollar‐denominated assets, increasing the exchange rate and putting pressure on the bottom line of both exporters and import‐competing manufacturers. It would be preferable to have the sort of housing market that was less prone to exaggerated price fluctuations in the first place…
The Reserve Bank’s work suggests that macroprudential instruments could possibly have a role to play in helping manage the credit cycle, although their influence is likely to be ‘at the margin’ and to date remains largely untested. While the international research is continuing, such tools are generally seen as best directed toward bolstering financial system resilience in the face of credit growth being used rather than to directly influence the growth in credit or asset prices. The possibility of using such instruments in the future should not replace a continued focus on the underlying drivers of house prices, particularly housing supply constraints…
The supply side:
It is now well‐established in the international literature that different housing supply regimes go a long way to explaining differences in cyclical house price behaviour… These effects are particularly important in countries or regions where populations are growing comparatively rapidly. There is strong evidence of this in the United States at both the state and county level… When demand for any product is prone to significant changes, it is especially important that supply can respond relatively quickly…
Overall, [New Zealand’s] housing supply has not been very responsive when there have been big swings in housing demand. As a result, on international metrics, our house prices look high, and have increased very substantially in the last decade. Supply constraints are therefore a key area warranting policy attention…
The key supply factors appear to be the availability and price of land for residential purposes and construction costs. The Resource Management Act, and the way it is applied by local councils, may be playing a role. One solution that is often advanced regarding land prices is for metropolitan planning agencies to ease their urban limits and, more generally, to ensure that residential zoning practices are more directly responsive to market price signals. This will help ensure that land is used for the most economically valuable purposes, as revealed by prices. Issues have also been raised around the most appropriate way for local council to cover the infrastructure costs around new housing, and whether the move to greater lump‐sum development levies may have played a role in inadvertently exaggerating house price fluctuations…
Demand-side issues:
The tax treatment of housing and savings products varies widely across countries. Tax regimes can be shown to influence both the level and volatility of house prices…, especially when supply responses are sluggish. But countries with a variety of tax regimes experienced similar housing booms in the mid to late 2000s. Moreover, it is not clear that, in aggregate, housing is more tax favoured in New Zealand than in other countries. For example, householders in the US can deduct owner‐occupier interest payments for tax purposes and in most cases face no capital gains tax. In addition, relatively high local government rates in New Zealand compared to other countries, act as a tax on property ownership.
Some have also argued that the increase in the maximum marginal tax rate in 2000 (perhaps in combination with the change in the inflation target in 2002) played a major role in the last cycle. We are sceptical for a variety of reasons outlined in our 2007 work. At most, we believe it was an exacerbating and amplifying factor. At the time, the underlying regulatory model made new housing supply relatively slow to respond and expectations of persistent future price increases became entrenched for a time. We also doubt that loss‐offsetting in and of itself, was more than an amplifying factor, because rental yields at the start of the housing boom were high enough (and interest rates relatively low) that large losses were limited. More generally, however, correcting the tax treatment of interest to assess or deduct only real interest would remove the distortion in this area…
The liberalisation of access to finance since the 1980s has allowed a rise in aggregate debt levels, and affected the distribution of debt. As in many other similar developed countries, it is likely that financial deregulation affected the savings and housing finance decisions of New Zealanders…Together with lower inflation and lower nominal interest rates since the early 1990s, deregulation allowed householders to service more debt with a fixed proportion of their income. With housing supply slow to adjust, easier access to finance, especially in the presence of other demand shocks, resulted in large increases in house prices. Higher prices fuelled expectations of further appreciation, which served to reinforce higher housing demand.
Over the long‐term, changes in access to finance should not have a large or sustained effect on house prices. In much of the United States, for example, with historically relatively liberal access to housing finance and similar debt‐to‐income ratios as in New Zealand and Australia, real house prices (and house price‐to‐income ratios) are materially lower than those in New Zealand…The more important factors are probably the ability to use additional land for housing (or to use existing land more intensively), and the value of that land in alternative uses.
What does this mean for the appropriate focus for policy? Policy should focus on the first‐best solution – providing a regulatory environment that gets the underlying supply conditions right. New Zealand needs to ensure that land use can change relatively readily towards the most valuable use for that land, especially if its population is to continue to grow relatively rapidly. New Zealand also needs a regulatory environment that enables a highly productive residential construction sector. In combination, such changes to the supply conditions would help limit the risk of large future swings in house prices when demand shifts occur. House price swings of the sort that we have seen recently are damaging to New Zealand’s overall economic performance. At times, house price cycles can also unnecessarily complicate macroeconomic policy and pose avoidable risks for individual and system‐wide financial stability.
Meanwhile, ACT Party leader, Don Brash, who served from 1988 to 2002 as the Governor of the RBNZ, last week gave a speech in which he also noted the role played by regulatory constraints on land/housing supply in making New Zealand’s housing unaffordable:
It is impossible to avoid the conclusion that the interaction of the RMA, the Local Government Act and local government staff all over the country has produced a major obstacle to improved living standards.
One of the ways this has happened is through the way in which this interaction has pushed the price of housing well beyond the reach of far too many New Zealanders – or more accurately, has pushed the price of residential land well beyond the reach of far too many New Zealanders.
We know, from the annual surveys undertaken by the Demographia organisation, that housing in our major cities is now among the most expensive in the world, relative to household incomes. And why? In large part because too many local governments have quite deliberately limited the supply of residential land.
Arthur Grimes, now chairman of the Reserve Bank, found that the effect of the Metropolitan Urban Limit [urban growth boundary] imposed by the Auckland Regional Council had increased the price of land just inside that Limit by some 10 times compared with the price of land just outside the Limit.
This is absolutely nuts, in a situation where New Zealand is one of the most under-populated countries in the world, and where Auckland is one of the most densely populated cities in the world – in terms of people per square kilometre, Auckland is more densely populated than Vancouver, Melbourne, Portland, Adelaide, Perth or Brisbane.
I’m delighted that one of the first projects of the newly-established Productivity Commission is to look into the affordability of housing.
