The NZ Initiative – Op-eds

Why we’re walking the path to the next global financial crisis

Leonard HongLeave a comment

NZ Herald

The world’s major economies are walking into the next global financial crisis. Moreover, their authorities do not seem willing to change direction. They fear that raising interest rates or cutting government budget deficits risks precipitating the collapse they seek to avoid.

Those are the major conclusions of our report we released last Thursday.

In response to the Global Financial Crisis over a decade ago – and then again to Covid-19 – worldwide, major central banks have eased monetary policy settings to an extraordinary and potentially destabilising degree.

The Bank of England is the world’s oldest central bank. Never since 1697 has its control interest rate been as low as it is today (0.1% pa). Never has its balance sheet relative to gross domestic product (GDP) been as bloated from creating money as it is today. (See the following figure)

The US Federal Reserve, the European Central Bank, and the Bank of Japan have progressively also adopted historically extreme levels for monetary policy settings.

Simultaneously, many governments have pushed their public debt ratios up to an extraordinary degree. Federal public debt held by the public was a historic high relative to GDP at the end of World War II. Congress’s Office of Management and Budget now forecasts that this high will be exceeded in 2024 – a war-time like debt in peace time. This is unprecedented, and it is because of large ongoing budget deficits. The US Federal government’s projected fiscal deficit for 2021 is an astonishing 16.7% of GDP.

In September, US Treasury Secretary Janet Yellen warned the US was heading for sovereign default if the government’s debt ceiling was not lifted. Eventually, Congress agreed to increase the limit, but this merely kicks the debt can down the road – again.

In Europe, a condition set in 1992 for monetary union was that member countries’ gross public debt ratios should not exceed 60% of GDP. According to the latest official forecasts, only 7 of 22 countries will comply in 2021. All the largest economies now exceed 60%. The debt ratios for the seven worst cases exceed 100% – for Italy it is a crippling 166%.

Italy’s high debt ratio is a serious risk to the stability of the Euro currency block. This is because its economy looks to be too large for the rest of Europe to bail out.

Lower interest rates invite governments to borrow more. The utter perversity of the current situation is epitomised by the fact that the Eurozone’s overall government net financial indebtedness has never been higher and the net interest cost lower relative to GDP. 

China is also a potential source of instability. Serious debt problems have emerged in its housing market – which accounts for 29% of its economy. This makes it of potential global significance. The debt crisis at Evergrande – the second largest property developer illustrates the concern.

Globally, persistently low interest rates encourage firms and households to borrow excessively to buy assets that would otherwise be over-priced. That contains the seeds for that next crash.

Low interest rates also prolong the existence of “zombie” companies that should be wound up.  Healthy companies could use their resources more productively.

High public debt ratios not backed by assets of comparable value give governments a conflict of interest. As economic managers, government should be leaning against excessive borrowing rather than fuelling it by low interest rates and quantitative easing.

Being heavily indebted compromises government’s willingness to act.

This problem of excessive borrowing and over-priced assets has been made worse by the signal the major central banks have been sending to investors – that the authorities will ‘do whatever it takes’to prevent any major collapse.

Professor Arthur Grimes, former chair of the Reserve Bank’s board, wrote the foreword to the report. He succinctly identified that perverse incentive problem:

“Governments, central banks and private sector financial institutions have together created the seeds of the next crisis on the assumption that policy actions will protect borrowers and lenders from downside risks. The result has been a one-way bet for those positioned for asset price rises, while those who have acted prudently have been left behind.”

The perversity of the current situation is further illustrated by the US. In 2020, it recorded the greatest decline in economic activity (real GDP) in at least 60 years. Its unemployment rate more than doubled.

Yet US household wealth rose by a record amount (26%). In dollar terms, it rose by much more than if households had saved 100 percent of national income in 2020.

So, how could US households overall become far more prosperous amidst the biggest downturn in over 60 years? The answer is capital gains and more money in the bank because of the Federal Reserve’s credit creation and low interest rates. US sharemarkets have boomed along with property prices.

The Initiative’s report traces the path to the current government ‘debt trap’ situation, first under the gold standard and subsequently with fiat money.

There is an optimistic scenario. It requires continuing near zero interest rates; low inflation, strong growth that lifts tax revenues; and firm resolve to reduce government budget deficits.

One can hope, but each step in this scenario looks implausible. Consumer price inflation has emerged this year that can only put upwards pressure on interest rates; pressure that central banks have been resisting.

In the past, periods of excessive debt and money creation have tended to end badly. Our report considers two much less rosy, low growth, high unemployment scenarios and one disastrous one of ‘Great Depression’ dimensions.

We leave it for readers to decide what probabilities to put on these and other possible scenarios. Nor does the report speculate about the timing of the next global crisis.

New Zealanders can only take precautionary measures. Being a small and globally integrated economy, New Zealand cannot prevent the next financial crisis.

Reducing debt to prudent levels is important both for governments and households. A fiscal council could help Parliament to hold government to account for the quality of its spending.

Firms and households should avoid borrowing to excess to buy over-priced assets. A narrower and more prudent focus for the Reserve Bank is desirable.

The temptation in the face of such extremes in the major economies is to hope that somehow this global episode will not end in tears – that “this time really is different”. That is mere wishful thinking.

Dr Bryce Wilkinson and Leonard Hong of The New Zealand Initiative co-wrote Walking the Path to the Next Global Financial Crisis.

Housing crisis? You ain’t seen nothing yet

Leonard HongLeave a comment

NZ Herald

Against the predictions of most economists early last year, the housing market has boomed through Covid-19. Since March last year, house prices have risen by 20%, rents by 12%. During the period, the economy suffered its worst-ever quarterly fall in GDP, and net migration has been virtually zero. Low-interest rates and limited land supply make a powerful combination.

But there is even more trouble on the horizon for housing. An ageing population results in declining average household sizes – this will add fuel to the housing fire. These demographic changes will be with us for decades, long after the Bitcoin becomes the primary global currency.

If you think the current housing circumstances are dire, wait till you see the potential long-run implications – you ain’t seen anything yet.

The housing crisis is a core supply problem. For decades, housing construction has not kept up with the growing population, which means house prices have gone through the roof.

Analysis by Infometrics shows more construction in a region slows down the rate of housing inflation. Auckland and Wellington’s stagnant building resulted in rapid inflation of 20% for the last decade. In comparison, Christchurch and Hamilton’s construction building surge resulted in prices increasing by only 13%. 

Gross construction rates across New Zealand have increased substantially in recent times. According to Statistics New Zealand, residential completion numbers peaked at 38,624 in November 2020, the highest number since the 1970s.

This is great news, except that the population in the 1970s was 3 million and today it is 5.1 million. On a per-capita basis, we are nowhere near historical peaks. There were 13.2 new builds per thousand people in 1973, but only 7.6 per thousand people in 2020.

New Zealand’s housing construction rate is nowhere near adequate in proportion to population, let alone the long run effects of an ageing population.

The Initiative’s new report, ‘The Need to Build’, shows that long-term housing demand in New Zealand is set to rise as New Zealand’s population becomes larger and older, adding fuel to the ‘housing crisis’ fire.

An older population results in fewer people living per dwelling and a larger population further increases housing needs. Across all the OECD countries, including New Zealand, the average household size has declined, which means more houses are needed per capita regardless of net migration levels.

In the report, we consider a range of housing for the period 2038 to 2060.

Under all the six most realistic scenarios, from 2019, we will need between 26,246 and 34,556 per year by 2038, and we will need between 15,319 and 29,052 additional dwellings per year by 2060.

The point is that cutting migration entirely would stop new housing demand – it does not because we still have an ageing population.

Even in extreme scenarios where net migration is zero for the next few decades, it does not stop new housing demand. By 2038, New Zealand would still need between 20,933 and 24,665 per year under medium life expectancy.

The report’s figures exclude the annual housing replacement rate, and the ongoing undersupply of 40,000 – estimated by Infometrics – adds to the chronic housing shortage.

What does all this mean for the outlook for housing in New Zealand?

The projected figures in the reports are well above the average annual construction rate of 21,445 since 1992. The implication is that house prices will rise a lot more unless house construction is much greater.

Fortunately, New Zealand is relatively young, with a median age of 37 years. Older countries across the OECD provide a window to the future. Kiwi policymakers have a unique opportunity to prepare what we can do now regarding housing policy.

In countries like Germany, the country is ageing, and the average household size has already been decreasing. Germany’s median age went from 37.6 in 1990 to 45.9 in 2020 and the average household size dropped from 2.3 to 2.0.

Since 1990, Germany’s population has been roughly stable at just above 80 million, but the household numbers went from 35 million in 1990 to 42 million in 2020 – 7 million more households in 30 years.

New Zealand is on a similar trajectory. New Zealand’s median age is currently close to 37 and is expected to increase to around 43 by 2038 and 50 by 2060. Our household size is also likely to drop from 2.6 to 2.4 by 2038 and even lower afterwards. The German illustration shows a potential image of New Zealand’s future, albeit with a far smaller total population size.

Even if annual construction increased closer to the 1970s, it would likely struggle to meet a more extensive and older population’s housing demand.

And estimating housing demand just on population growth is insufficient. On our projections, the dwelling stock in 2060 will be between 64% (‘low’ migration and ‘low’ fertility) and 26% (‘high’ migration and ‘high’ fertility), below what is needed to cater for the projected population need.

Tinkering the edges of demand will do little to address the chronic shortage in housing supply. Once the border opens, housing demand will continue to escalate, and the problem could become even worse.

All of this is fuel to the house fire, especially considering the revival of an open international economy after the global pandemic ends.

The housing crisis affects all Kiwis, but especially the millennials and Generation Z. There has been a growing intergenerational inequality preventing younger Kiwis from fulfilling their Kiwi Dream. The younger generation’s homeownership prospects are close to nil unless their parents are homeowners. Housing supply must expand substantially to give the younger generations a chance. 

The housing shortage is worse than you’d thought

Leonard HongLeave a comment

NZ Herald,

According to the OECD’s Building for a Better Tomorrow report, New Zealand now has the least affordable housing market for the poorest families. We have left more Kiwis with a slimmer chance of achieving the Kiwi Dream and exacerbated social inequality.

New Zealand’s housing is a national catastrophe. House prices have gone up by 37% nationally since 2015, according to ANZ. Shortages drive rising prices. And the problem will only worsen as an aging population means even more housing will be needed.

At a press conference last week, Prime Minister Ardern too called the housing market “unsustainable,” a U-turn from last year’s position of “sustained moderation” of housing inflation.

But the Prime Minister’s proposed solutions, thus far, have addressed the symptoms of the housing shortage rather than its root causes.

The Prime Minister re-launched the Public Housing Plan to build up to 18,000 social houses by 2024. Social housing is important, but would there be nearly as much need for it if a surplus of housing overall made for affordable rents? The barriers faced by private developers are also faced by government-led building initiatives, as Labour discovered with KiwiBuild.

Making it easier to build more housing in places where people want to live is the only thing that can solve a housing supply shortage.

While demand-side measures, like banning foreign buyers, can be tempting, they do not address the problem. The pandemic has done far more than any foreign buyer ban to curb housing pressure arising from overseas. International students and international visitors, each of whom needs a place to live while here, have largely gone away. Net migration has dropped to zero. But rents and housing costs are sharply up regardless.

Hopefully, vaccination programmes in 2021 can restore normality to the border. But even if the border remained closed forever, migration is only one part of growing demand for housing.  Demographic change and an aging population, all on their own, will also worsen the shortage.

An aging population, all else equal, requires more dwellings. And while those kinds of changes are incorporated in household projections by Statistics New Zealand, and consequently into Council forecasts of future housing demand, they are underappreciated in popular discussion of housing pressure.

Long-run demographic changes in household composition (such as from nuclear families to single-person households) and population ageing affect overall housing demand and require flexibility about the kinds of housing that can be built.

In New Zealand, average household size has dropped from 3.2 in the 1970s to 2.6 in 2020 (similar to OECD countries as seen in the figure below). It could drop to 2.4 in the next two decades or less, according to Statistics New Zealand’s projections. 

As family sizes reduce, median age increases along with demand for housing.

When the typical group of a hundred people consists of 20 couples, each with two young kids, and ten retired couples, those hundred people fall into thirty households. Thirty homes might be needed. When the hundred instead are 15 couples with two kids each, and 20 retired couples, 35 homes might instead be needed.

Aging populations require more homes for the same number of people.

The causes of the housing shortage have been reasonably well canvassed. Over decades, councils have borne the costs of accommodating more housing while central government enjoys the tax revenues that flow from growing cities – higher income tax, company tax, and GST revenues. Making it harder to build more housing has been one way that councils have sought to contain the costs of growth.

Years and years of restrictions on development have resulted in a construction sector scaled to the amount and types of building that have been allowed, rather than the amount and types of building that might be demanded by a growing and changing population.

The effects are stark. Housing shortages and high resulting housing costs undermine social cohesion. Families are forced to live in less pleasant and overcrowded dwellings, leading to deprivation, adverse health and social outcomes, and unstable environments for young children to grow and learn.

As of 2018, one in nine Kiwis were living in crowded housing, with Maori and Pasifika families most affected.

It will be impossible for the government to achieve promised increases in wellbeing without changing the fundamental direction of housing policy. But whatever your view on the best way of enabling more supply, the extent of the shortfall is larger when an aging population all on its own will increase the number of homes that are needed.

The government will soon be announcing its plans for remedying the problem. When thinking about the government’s proposals, ask yourself whether they enable more housing to be built, or whether they provide more tinkering around the demand side. Reform of the Resource Management Act will also be coming, but unless it improves the incentives facing Councils to enable more housing, it will not be as effective as it should be.

The housing shortage is bad enough already, even without considering the effects of demographic change that will only worsen the problem. Let’s hope that the government’s proposed policy responses strike to the root.