An issue with the idea that our debt stems from housing finance

Yes we have borrowed a lot to buy houses – but if people in New Zealand have been borrowing to buy houses off each other, why does that increase our net international debt position? Someone must have been paid a good sum for their properties – what has happened to them?

This fact makes me nervous about claims that our current account deficit stems from “borrowing to buy houses off each other”. I have heard this claim a lot – and I don’t think it makes much sense.

In the US they borrowed to build “too many” houses – but we didn’t even do that here in New Zealand. So what have we done with our borrowing:

  1. Invested in a lot of plant and machinery goods which increases our productive capacity,
  2. Purchased consumption imports which are tasty.

Ok, we can have opinions about those things and whether we believe they are good (I do, outside of the possibility that households mistook recent house price gains for wealth – which was unfortunate but impossible to prevent in an appropriate way). And the housing bubble could have contributed to higher consumption imports by making home owners feel wealthier, sure. But I don’t see how borrowing to pay other New Zealander’s for their existing houses increases our national debt level …

  • When the dutch bid tulip bulbs well above their intrinsic value the owners of those bulbs had a large amount of apparent wealth and (presumably) a large amount of debt. The value of tulips and NZ houses assets are nominal rather than intrinsic. It is not possible to earn economic income from the investment.

    It is not possible to turn all that nominal housing wealth into cash. The bubble relies on a bigger fool.

    If you and I both own houses valued at $100,000 and we both borrow another $50,000 and sell our houses to each other at $150,000 how have we done anything to increase intrinsic value. We have increased debt and increased our “wealth”, but only in illiquid bubble assets unrelated to incomes. Our incomes have not risen but the proportion we must allocate to servcing debt has.

    The private foriegn debt that spurred it will remain a burden.

  • Matt – I have to say your understanding points out a major flaw in measurement of inflation. We have had enormous asset price inflation in Western democracies that is not reflected in the CPI. That represents a flawed measure. The increase in price of housing had devalued the $ as it buys less of a house.

  • Bevanj

    as a quick example of how fast maney can disappear overseas with housing, a $300k mortgage at today’s good rates will see you hand over $75k in four years to a lender (possibly foreign)as interest.

    Talking very rough numbers that is two years of the average take home pay isn’t it.

  • “If you and I both own houses valued at $100,000 and we both borrow another $50,000 and sell our houses to each other at $150,000 how have we done anything to increase intrinsic value. We have increased debt and increased our “wealth”, but only in illiquid bubble assets unrelated to incomes”

    If we both paid each other $150k and borrowed $150k to do it then how is net debt higher?

    “I have to say your understanding points out a major flaw in measurement of inflation. We have had enormous asset price inflation in Western democracies that is not reflected in the CPI. That represents a flawed measure. The increase in price of housing had devalued the $ as it buys less of a house.”

    The CPI is trying to measure the increase in consumer prices – if we included house price growth in of itself we would not be stating consumer prices.

    Could the CPI be misused as a statistic, yes. However, it measures what it is supposed to measure.

    “as a quick example of how fast maney can disappear overseas with housing, a $300k mortgage at today’s good rates will see you hand over $75k in four years to a lender (possibly foreign)as interest.”

    This is the interest cost of debt over time. Some commentators have said that our large stock of debt is the result of borrowing to buy houses off each other – however, that ignores the fact that if you borrow $300k to buy a house off another New Zealander they have $300k. Sure you have to pay interest off it – but if that other New Zealander invested the money and earned the same return net debt would be unchanged.

    Fundamentally – we have to explain what New Zealander’s in general were doing.

    Hi guys,

    I am not disagreeing that there has been a bubble – and that the bubble will be painful for people. However, I am saying that the idea that our national debt has stemmed from “buying houses from each other” doesn’t really make sense.

  • Matt – you are missing the point. assume from above we both started off at no debt with 100% owned houses. After our transaction which has added no value and created no genuine wealth we have debts of $50,000 each. House price inflation has been 50%. Inflation being more money for the same utility. We have not built new houses from bare land, trees, iron ore, carbon and minerals. We have not created any wealth, simply debt. We have taken on a long term obligation to pay foriegn lenders interest without genuinely increasing the wealth of our economy.

    CPI is not “Misused” so much as being a flawed measure. It is intended to measure the price of a representative basket of goods that consumers consume. By missing out on the element of house price inflation it excludes a major part of human consumption.

    By building hew houses we are creating wealth. A better place for more people to live. If I live in your house and you live in mine we have not created any wealth, simply debt.

  • Your example is only step 1. By the time you and i have sold our houses back and forth to each other and we have reached $300,000 we will each have $200,000 of debt. We will be barely able to service the interest.

    The bubble happens over time, not simply one transaction at current value.

  • Hi Phil,

    If I borrow $150,000 and give it to you for a house you own, and you do the same for me, we both have $150,000 of cash as well as $150,000 of debt – we could use the $150,000 to pay off the debt and we are square. All we have done is transfered houses.

    “CPI is not “Misused” so much as being a flawed measure. It is intended to measure the price of a representative basket of goods that consumers consume”

    In a house you “consume” its rental yield, as that is the implied price of having somewhere to live. That is in the CPI measure. The asset price part of the increase in house prices is not – as that is not part of “consumption”.

    The “wealth effect” which you rightly point out stems from households expectations of future house prices – which were off whack during the bubble.

  • Andrew Coleman

    Hi Matt

    You are largely correct. The initial act of a foreign lender (architypically, a Japanese investor) exchanging foreign currency for a NZ borrower’s IOU does not change the net international liability position. A foreign person gets a NZ IOU, and a New Zealander gets yen, which are exchanged into NZ dollars and then used to a purchase a house.

    It is what happens to the yen next that matters. There are 3 (not 2) options:

    (1) They are spent on imports of capital equipment (Toyotas for businesses)
    (2) They are spent on consumer goods (Toyotas for consumers)
    (3) They are spent purchasing financial assets (Toyota shares; or the yen are simply held as cash or as a deposit with a (Japanese)bank.

    Ultimately the exchange rate changes (normally appreciates) until the yen are all spent in one of these three ways. If there is little NZ demand for additional capital expenditure or for more foreign financial assets, the exchange rate will appreciate until more consumer goods are imported. In this case, the Japanese loan will result in NZ having a higher net international liability (net debt) position. My hunch is that in practice an exchange rate appreciation and higher consumer imports do occur when foreign people lend en masse to NZ borrowers.

    It is worth noting that even if the yen loan is used entirely to purchase foreign financial assets, under our current measurement practices such a loan could worsen the measured net liability and current account positions. First, Statistics NZ does not measure private holdings by NZ residents of foreign shares (unless they are held through an institution such as a managed fund): so if the seller of a house bought Toyota shares directly, this would lead to an increase in the measured net foreign liability position. Secondly, the current account accounts don’t recognize that the inflation component of interest income is not really income but merely a capital transfer. Thus if a NZ resident pays NZ dollar interest to a foreign party, part of the interest they pay is improperly recorded and suggests that the current account deficit is higher than it really is.

  • Miguel Sanchez

    “If I borrow $150,000 and give it to you for a house you own, and you do the same for me, we both have $150,000 of cash as well as $150,000 of debt – we could use the $150,000 to pay off the debt and we are square. All we have done is transfered houses.”

    The point being that we haven’t used the cash to pay off the debt – instead we’ve bought cars, plasma TVs, etc, leaving no cash and $150,000 of debt.

    The more interesting point out of this is that it doesn’t explain the rise in house prices at all. If we borrow more and trade our houses amongst ourselves then we’re simply choosing to hold more debt against the same houses. In fact we could get the same result without trading our houses at all – just withdraw some of the equity in your house by topping up the loan. We’d have more debt but house prices would be unchanged. (Miller-Modigliani: the value of an asset has nothing to do with how it’s financed.) To explain the house price boom you still have to resort to some other rational (supply and demand) or irrational (greed and myopia) reasons.

  • Hi Andrew,

    “It is what happens to the yen next that matters. There are 3 (not 2) options:”

    Good point – initially I had meant to put, invest or consume as the two options, but then I messed it up 😛

    “My hunch is that in practice an exchange rate appreciation and higher consumer imports do occur when foreign people lend en masse to NZ borrowers”

    Undoubtedly. However, interest rates would need to fall in order to get the New Zealander’s to borrow in the first place – something that did happen internationally at the turn of the century.

    “It is worth noting that even if the yen loan is used entirely to purchase foreign financial assets, under our current measurement practices such a loan could worsen the measured net liability and current account positions”

    That is very interesting. Thanks for the discussion on how that works.

  • Hi Miguel,

    “The point being that we haven’t used the cash to pay off the debt – instead we’ve bought cars, plasma TVs, etc, leaving no cash and $150,000 of debt”

    If that is what we have done, then thats cool – but was there a problem with that.

    I would also note that plant and machinery investment has been really really high relative to GDP – obviously we have used some of the funds to invest in capital.

    “To explain the house price boom you still have to resort to some other rational (supply and demand) or irrational (greed and myopia) reasons”

    Indeed, good point.

  • Miguel Sanchez

    Actually, to correct my earlier comment: the source of funding does affect the value of an asset if there’s a tax advantage to debt, as is the case in NZ. But the point still holds – it’s the tax law itself that pushes up house prices, not the act of borrowing more money against them.