I see the RBNZ has come out with the details of the LVR restrictions (loan-to-value limits on mortgages) they may well put in place soon. That is cool. I’m also a big fan of the “question and answer” style discussion of people’s submissions here. Brennan McDonald summarises the details here.
However, in the release about this, there were several quotes about LVRs that I had to admit I had issues interpreting. Either these quotes miscommunicate the justification the Bank is using for such policies, I have completely misinterpreted the quotes, or they communicate it perfectly and I fundamentally disagree with the association they are using. These ones are not about housing affordability, they seem to strike at something more fundamental.
As a result, I thought I should have a chat about the quotes in question – and why I think our understanding of them, and the causal mechanisms involved, is central to thinking about policy.
The quotes are:
“LVR restrictions on residential mortgage lending can help to dampen excessive house price growth in periods when credit growth is boosting housing demand beyond housing supply,” Mr Spencer said. “In so doing, they can reduce the risk of a rapid correction in house prices and the economic and financial instability that would ensue.
“In situations where house prices are overvalued, the further that house prices rise, the more likely it is that a disruptive downward correction will occur. Such a correction would be very damaging if combined with a significant deterioration in economic or financial conditions.”
Credit growth is boosting housing demand beyond supply
This is extremely misleading – credit growth doesn’t “cause” things, a lift in credit aggregates must be due to something fundamental (a “primitive” of the economy). We touched on this idea when discussing the Lucas Critique of DSGE models here. And we touched on it when discussing the related idea of monetary aggregates.
If I am wrong here, and there is some abstract credit monster wandering around that turns up pushing things in a policy relevant way (rather than the choices of a series of individuals) – I apologise.
Anyway, so unless we can say what the primitive is, we can’t articulate why policy makes any sense – this isn’t a matter of even saying “we need lots of evidence” (even though that is generally my preference), instead it is the point that we can make a number of different arguments to justify some set of data – and we need to make sure that the policy recommendation is actually consistent with the argument we are using!
Now don’t misread me here, I do not mean we should ignore credit figures in the slightest – instead I’m saying let’s make sure our story fits them. Since we have a bunch of things going on in the argument being made here (housing demand and credit growth) we can try to figure out why the RBNZ might want to restrict lending to highly leveraged borrowers in the housing market.
They may believe that credit growth is rising with house prices because of a generalised lift in “demand”. If this is the case there is no real need for these policies – just hike the OCR, this is straight monetary policy! As a result, I believe we can rule this one out as their justification.
They may instead believe that households are not appropriately categorising the risk associated with house prices. Furthermore, they may believe that retail banks will underplay the risk associated with house prices, due to the view they will be bailed out, or due to the view they are ignoring some systemic risk externality. In this case, the RBNZ could:
- Credit constrain households – think of it relative to the debate on sales bans,
- Ensure banks are holding sufficient equity/capital and allow private firms to price risk
The second solution makes more underlying sense to me, but the LVR restrictions are consistent with the first and will “work” in the very short term in that way.
Cool, so the Bank could say that credit availability has improved and is seeing housing demand accelerate more quickly than supply – an ‘imbalance’ that makes the financial system more fragile. I would NOT be sold on this as a first best solution, and I think it sounds a little bit too much like social planning and fine tuning – but it would have a structural, policy relevant interpretation. Furthermore, it could easily be justified in terms of this being a “risk management” process in financial markets – something society would buy into.
In this context, it is not the “high house prices” that are the concern in of themselves – it is the fact that the driver of house prices is based on a process, series of choices, institutional/expectations related issues, that leads to some market failure. In this context, the high credit growth is part of the perceived issue at hand – not a cause of it! The concern at hand is due to the view that credit creation is “excessive” and house price appreciation “too high” due to some underlying factor driving “housing demand” (and related to institutional arrangements in the regulated mortgage lending sector) – not the other way around!
Remember, people have to actually do the borrowing for “credit growth” to occur!
The risk of a rapid correction in house prices and the economic and financial instability that would ensue
Let us be a bit careful here. We appear to be thinking about a specific situation where people’s willingness to pay is out of line with the fundamental value of an asset – and then “changes” at an unpredictable point in time in the future. A bubble.
This is fine, and we know that sudden corrections can have an effect upon economic activity, financial stability, and the effectiveness of the financial system.
But what this means for policy is only clear when we have a framework for understanding what it means, and when we also include a monetary policy reaction to such an event!
A run up in house prices, out of nowhere, would imply a transfer of resources between those who decide to buy and sell. Similarly, a sudden collapse in house prices implies a transfer of resource between people. Fair enough – the RBNZ shouldn’t care.
But the impact of the change in house prices on “demand” or on the “stability of the financial system” is something the Bank is concerned about. In terms of “demand” they dance around with monetary policy (although with the view that they don’t want instability in demand created by shifts in the financial or government sectors). In terms of “distribution” in terms of housing resources we have government dancing around. And in terms of the stability of the financial system, and the implicit insurance view we have of it given government regulation we have the Bank with financial stability policy.
Sidenote: It is important to mention here that we have these three government bodies – but we also, always, have the inherent willingness to pay and ability to supply associated with the private sector. The underlying value placed on things, and choices made, are indeed by individuals – individuals making choices given views about broader social variables. Also zoning laws etc fit within the “distribution” mention above.
So this is cool, the Bank is looking at a set of tools because they have a specific view around how the current increase in house prices is influencing financial stability – this quote is fine in that context. But then …
Such a correction would be very damaging if combined with a significant deterioration in economic or financial conditions
Hmmm. Such a correction is damaging IF IT CAUSES a significant deterioration in economic conditions (if the Bank cannot respond quickly enough – or we believe the Bank’s response will inherently take longer to have an impact than the mechanism that links asset prices to the real economy) or financial conditions.
The “transfer” associated with the correction is irrelevant for central bank policy – the drop in house prices transfers from those with houses to those without. But the associated impact of the sudden change on economic and financial conditions, whatever that is, is what we view as policy relevant.
The RBNZ cannot include a transfer in their objective function, and importantly they shouldn’t be communicating that it is a transfer they are concerned about. House prices should be able to do whatever the hell they want (in terms of the Bank’s mandate – not the government’s potentially) but the Bank does need to respond to their impact on demand and associated view of economic utilization (monetary policy) and the impact on the stability of the financial system (financial regulation, microprudential and macroprudential policy).
Now we need to also think about these channels in clearly complementarily, but separate, ways. What exactly has happened with this exogenous shift in house prices? There has been a wealth transfer between people. Ok, that’s nice. Remember, we are not trying to stop people hurting themselves – we are trying to avoid a situation where people hurting themselves hurts others.
Retail banks know there is a risk of increased default given that the market value of these housing assets have dropped – and if people default, then the banks end up facing the loss between the value of the mortgage and the value of the asset. In this environment, there is a risk that given the tiny amount of equity they hold they could fail – this is a genuine concern of course.
“Read it the other way around Matt!”
Instead the RBNZ may be saying that such a situation creates vulnerabilities – so that if there is some other shock (eg collapse in dairy prices) the high levels of leverage in the financial system combined with asset prices that have a long way to fall (implying redistribution that may in turn worsen credit constraints) would lead to a hellish situation.
Given this, we are looking at it in terms of a public “insurance” against a nasty shock which would be exacerbated by these vulnerabilities!
That’s cool. I’d probably make the argument like that though. Such as “a sharp correction is likely to coincide with a broader deterioration in financial and economic conditions, which implies accepting some restraint in the housing market now in order to insure against a systemic episode”.
The idea around having “social insurance” for a systemic episode has to be that individuals in society can’t insure themselves against this, or that certain expectations of private agents are inconsistent with a believe that they are not socially insured. This is why such a view makes sense – and provides a policy basis for this style of regulation.
I initially just wanted to point out that the Bank had announced these things. But after spending a bit of time looking at these quotes and trying to justify them, I felt it would be dishonest of me not to comment about the fact I fundamentally disagree with what they directly imply.
Let us remember that the RBNZ is working along two complementary roles – one is the use of monetary policy to “manage demand” through their inflation target (which is really just a way of helping to co-ordinate expectations), the other is to regulate the financial system.
They recognise, and have articulated clearly before many others, that financial instability undercuts their ability to manage demand. This is fine.
Furthermore, both my views and those of the Bank appear to lead to similar policy conclusions, so in some regard this may seem trivial.
But I have a specific understanding of “why” they intervene in these ways, and the quotes appeared to be at odds with this. And given the “why” justifies policy, scope, how these matters are communicated, and how we view value I find this issue far from trivial.
As I said, this could be that I read the quotes in a way that they implied something the Bank didn’t mean – or it could be that the Bank and its team of economists fundamentally disagrees with my interpretation of what is going on.
And if I wasn’t that I was talking to myself here, I would actually just listen to them 😉