Brian Fallow: Smarter weapons or a damp squib?

Belaboured daily by headlines about job losses, Reserve Bank Governor Alan Bollard would love a smart bomb that could hit the housing market while avoiding the collateral damage his sole present weapon, the official cash rate (OCR), is inflicting on the economy.

In conjunction with the Treasury the bank began its search for one in November, with the Supplementary Stabilisation Instrument Project. The fruits of their quest are due next week.

Last week, Bollard repeated that the bank was "open to the idea that there may be supplementary instruments that can help cool domestic demand when it appears overheated relative to the traded sector and vice versa".

The frustration for the bank and the Government is that borrowers' preference for fixed-rate loans, which amount to 80 per cent of all mortgage debt, has created a longer lag between changes to the OCR and the average mortgage rate borrowers are paying.

Meanwhile, the fact that those fixed-rate loans are largely funded by overseas savers has created a strong demand for the kiwi dollar, hammering the export sector. Last year, the rest of the world needed about $31 billion of kiwi dollars to buy New Zealand exports, but another $25 billion was needed to buy eurobonds to finance our debt habit.

Despite this frustration, Bollard has been clear that his brakes have not failed, that the OCR still works (eventually) and that it will remain the primary instrument of monetary policy.

But it would be handy to have some additional means of dampening our collective enthusiasm to buy residential real estate, which has pushed up house prices and mortgage debt by about a third over the past two years.

The reason he would want to do that is the wealth effect. Homeowners see the value of their properties rise and happily borrow more. That has turbocharged consumer demand, driving inflation above 3 per cent and the balance of payments into the red.

Don't hold your breath that the search for an ancillary tool will come up with much, however.

The exercise's terms of reference rule out some of the big policy choices that influence people's attitudes to saving versus consumption and to housing versus other assets.

A capital gains tax remains politically radioactive and issues about the extent of social safety nets are too fundamental to be hostage to purely cyclical considerations.

A one-off measure that is under consideration is to scrap or restrict the use of structures like loss-attributing qualifying companies (LAQCs) that are being used by property investors as a means of reducing their overall tax liability.

If a property is heavily geared, it may be years before it is profitable, especially in an environment where house prices are rising about five times faster than rents. If the investment is held through a normal company, losses can only accumulate to offset future profits, but with a LAQC, they can be used to reduce the overall tax bill its shareholders face.

But, of course, there is no reason to hold the investment through a company structure at all. Owning it directly would also allow the investor to use the tax losses at once.

Such a change in the tax laws might have some effect on the property market at the margin, if prices have been bid up by unsophisticated investors thinking they were gaining some tax advantage that is largely illusory.

Also under consideration are changes to the rules governing banks "which could reduce the amplitude of housing credit cycles".

This might mean changing, either as a one-off or from time to time as a cyclical measure, the risk weighting given to mortgage lending when calculating how much capital a bank needs to support its loan book.

For many years, in line with international norms, the relatively low risk of mortgage debt has meant a bank only needs to have 50 per cent as much capital to support its mortgage book as for the same amount of lending to the corporate sector.

But the international rules on capital adequacy are changing, moving away from such rigid one-size-fits-all ratios in favour of a more finely graduated and dynamic approach.

A regulatory change that cut across or ran counter to that international trend, which the Reserve Bank says it supports, might harm its reputation.

It could also make it difficult to harmonise its approach to bank supervision with that of Australia, home of the parents of 85 per cent of New Zealand's banks.

The terms of reference make it clear that any changes have to be consistent with the Reserve Bank's longer-term objective of protecting the stability of the financial system. Surely prudential requirements need to be exclusively focused on the latter. So let's not go there.

Another possibility is to put a limit, which the Reserve Bank could raise and lower at will, on loan-to-value ratios, that is the proportion of the value of a property that a bank could lend on mortgage.

One problem with that is that it is likely to make it even harder for people to buy their first home because they would need a bigger deposit.

The bigger problem is that if demand for that extra credit is there people will find ways of making money by providing it.

Any regulatory intervention runs the risk of unintended consequences. In this case, damage might be done to the formation of new businesses, given how reliant they tend to be on loans secured by residential mortgages.

Muldoonist measures will not work in an open economy that has unimpeded access to international capital and which, has on balance, benefited mightily from that fact.

If we could only borrow what other New Zealanders are prepared to lend, interest rates would be a whole lot higher.

The other big structural shift that the central bank has to contend with is a permanently tighter labour market, driven by an ageing population and the income gap that has opened up between New Zealand and Australia.

That suggests less unemployment and more job security than might in the past have accompanied an economic downturn, and therefore more confidence about being able to pay the mortgage.

In the end, though, mortgages and rents have to be paid out of incomes rising at mid-single-digit rates, so house price inflation at double-digit rates cannot continue indefinitely.

It is entirely appropriate for officials to look for smarter ways of doing things. Announcing the fact they are doing so, however, may have raised false hopes.

With the news full of plant closures and job losses there may be a temptation to do something low-grade to be seen to do something.

It is the trap of the politician's syllogism: We have to do something. This is something. Therefore we have to do this.