Treading the thin red line

I see that, due to concerns about systemic risk for the financial stemming from the housing market, the Reserve Bank of New Zealand has decided to increase capital requirements for high loan-value mortgages.  Fine, I think this can be fit inside our concept about why you want to deal with these types of issues, as we’ve noted here.

But it is a balancing act, and there are some comments I’m inherently uncomfortable with.  Namely the context of these two statements:

credit is now increasing faster than the rate of income growth (figure 2.1), after declining as a ratio to income over the past four years. …
While credit is growing more slowly than in most of the decade before the financial crisis, that growth is stretching household debt-to-income ratios, which are already elevated (figure 2.2). Rising house prices, combined with a greater willingness on the part of banks to lend against low deposits, suggests that many new borrowers will be acquiring homes with higher debt levels relative to both income and assets. Low  mortgage rates are helping to keep household debt burdens manageable in the short term, but the increase in underlying indebtedness leaves households vulnerable to a reduction in incomes or a rise in interest rates.
Factually true, indeed.  But how do we unpack this?
It doesn’t matter that people are highly indebted … unless this stems from a process that involves the increasing level of debt, and the distribution of the debt burden, in such a way that it creates an externality.  Where this risk is in turn thrust onto other people.  The very idea of systemic risk.
This is well and good, I have no doubt the RBNZ took policy actions with this in mind.  But I would another two points when we think about credit growth:
  1. We should compare credit growth to average expected income growth – not current income growth.  You borrow in the basis of future income, so the comparison they laid down was a bit dodge.  4% credit growth is lower than this.
  2. New Zealand is rebuilding its (arguably) second biggest city.  It will have to accumulate a higher level of debt (especially relative to current income) to do this.  We are going to have higher current account deficits etc as a result – the idea is that this investment in a new city will create a rate of return that covers it.  If we believe the rebuild leaves some areas streched this is still not a concern – it is just when those sectors in turn threaten to undermine the financial system.  Given this, the increase in investment, activity, employment, and debt are all pretty slow – this type of counterfactual is an important element to keep in mind.

We DON’T care about financial stability because we are worried about asset prices, or bubbles.  If people want to piss their money against the wall gambling on a bubble, no policy maker should try to help them.  It is if their actions have an impact on the broader economy – if we think that financial markets are underpricing risk due to systemic risk issues for example – that we care.  Bubbles and debt don’t magically stop people working and producing in of themselves, and we have to be careful that we interpret the data with the perceived externality in mind, rather than solely being focused a moral distaste for bubbles and debt … which is policy irrelevant.

  • rndtechnologies786

    Good blog.

  • boristhefrog

    Isn’t one of the issues with ‘bubbles’ is that you can only identify them after the fact?

    One could argue that there is a ‘bubble’ in Xero’s share price, however, it could be that the share price, while volatile, doesn’t plunge back down again – so is there really a bubble to be worried about?

    I’m not sure I see a lot of difference between a ‘bubble’ forming in a share vs the housing market – time frame are of course different, but lets say that prices rise for a period in Auckland then flatten out for a while before moving further up – where is the bubble?

    The RB wants to be sure that it is being seen as cautious, but not stuff the housing market, because its only Auckland and to a lesser extent Canterbury that are seeing sustained price increases… maybe they are talking out of both sides of their mouth because their real options are in fact quite limited

    • Matt Nolan

      The tough thing with bubbles is asking why we “give a frik”.

      In one sense, a bubble is just an income transfer between people. This doesn’t matter in either monetary policy or financial stability terms – but it is the main reason people get so wound up!

      The only reason we care is because we are worried about banks lending during a bubble and not taking into account systemic risk. As a result, we should act on the basis of that. Acting here involves pricing the systemic risk stemming from the asset class behind it … not monetary policy. And even here, the goal isn’t to “get rid of the bubble” which is in that sense psychological – it is to prevent spillover effects.

      A monetary policy “issue” may come from wealth effects, or the easing of a credit constraint. But that just tells us that “demand” will rise more quickly than we had anticipated … so its part of what they already do.

      This is all well and good, and in monetary policy terms we do not need to know whether something is a bubble or not. Even post crisis, bubbles are not a monetary policy issue.