Money and House Prices
The average price of a house in Auckland reached $1 million last week. The largest city in New Zealand is experiencing a property boom. The average price of a house in Auckland is double what it was back in 2008.
The property boom is partly driven by a couple factors.
Immigration – New Zealanders returning from Australia and other places where economic prospects are not as good as here have increased the demand for housing.
Scarcity of Land – Zoning laws have limited the availability of land for housing.
In the past, capital controls and fixed exchange rates allowed central banks to control the supply of money. However, in a modern economy, banks have the power to create money by making loans. They can now create as much money as they like.
The Reserve Bank has given up trying to control the money supply and has adopted a policy of inflation targeting by controlling the overnight cash rate at which banks can borrow from the Reserve Bank. The cash rate is currently set at 2.0 percent.
The measure for the inflation target is the Consumers Price Index, which only measures the prices of household consumption goods and services. Unfortunately, inflation can also affect capital goods and government consumption goods and services. These are not covered by the Consumers Price Index, so the inflation target can be met, while the price of capital goods is rocketing up. (In the United States, inflation has hit the government consumption goods produced by the Military Industrial Complex, costing the government billions of dollars).
In a small open economy like New Zealand, the power of the banks to create money is amplified by their ability to import money from overseas. As long as the central banks of the US, Japan and the EU keep their cash rates close to zero, banks will be able to make a good profit by borrowing at zero interest rate and lending the money in New Zealand for 4%.
The Reserve Bank of NZ’s cannot control the money supply, so we face an infinite supply of money at very low interest rates. This would normally flow into inflation of the prices of household goods and services, but imports of cheap goods from China mean that the CPI has not increased much. That does not mean that there has been no inflation. Instead, the rampant supply of money has flown into house prices in Auckland.
In a normal market, prices adjust to eliminate excess demand. Basic economics explains that during a period of excess demand, buyers will bid up prices. However, when the price of a good rises, producing and importing it becomes more profitable, which increases the supply of the good.
At the same time, the increase in price of the good means that some people who wanted to buy it, can no longer afford it, so they spend their money on something else that is cheaper.
A rising price generally increases supply and reduces demand. Combined together these effects of the rise in prices eliminate the excess demand. Sometimes, producers and importers will supply too much and the price will fall back a little.
In a housing market with unlimited money creation by banks and low interest rates, the market mechanism no longer functions. When house prices rise, no one is priced out of the market, because banks are willing to lend more, because the value of the asset used as security has increased too. Even if they have to take on greater debt, the purchaser does not worry, because they can count on an even bigger capital gain, as long as house prices keep rising.
The supply of houses changes slowly, because developing new suburbs and building new houses takes time.
Prices go up an up, and banks lend more and more, without the restraint of the normal market mechanism. While interest rates are low, the capital gain from rising prices more than compensates for the extra repayment burden.
Of course, this cannot go on forever. Eventually the whole thing gets out of kilter and the grossly inflated housing market will collapse. That is what happened in the United States in 2008.
Various things could cause the house price spiral to collapse here.
A shock to the NZ economy that destroys confidence.
A sharp increase in interest rates (unlikely while central banks around the world are clinging desperately to zero rates.
An increase in unemployment that affects the ability of people to make house repayments.
A shock from the international economy that causes a flight of capital back to the safety of the US and Europe.
