House prices in Auckland have been rising well ahead of rents. This suggests that there is a significant degree of speculation at play, not simply a shortage of places to live. When house prices are increasing at an annualised rate in excess of 25 per cent, such behaviour becomes very difficult to explain on the basis of inadequate supply. A more convincing explanation is "irrational exuberance" on the part of buyers who are betting on a continued upwards trend in prices. It also becomes difficult to see how any short-term increases in housing construction could effectively counteract this degree of optimism.
Those who suggest that land-use regulations are the primary culprit of high house prices should consider the cases of Ireland and Spain before 2008. In these countries, residential construction did respond to increasing house prices. The result was simply a construction boom alongside an even larger housing boom. Furthermore, when the bubble burst these countries ended up with an oversupply of housing and an over-correction of prices.
A key factor in explaining the sky-rocketing asset prices in the past few decades is the liberalisation of finance. Low global interest rates and fewer regulations around mortgage lending have enabled housing booms of greater regularity and magnitude across various advanced capitalist economies. In New Zealand, this increased access to large quantities of credit has intersected with our ingrained cultural obsession with real estate investment as a way to get ahead. That this is quite obviously a zero-sum game has done little to dampen investor enthusiasm.
A sharp house price correction might sound appealing to prospective buyers. However, all it would do is expose the real source of risk - the unsustainable build-up of household debt, which has now reached 163 per cent of household income. Homeowners who see rapidly rising house prices tend to increase their consumption accordingly, which is known as the "wealth effect". The reverse is true in the context of plummeting house prices.
Grimes may be correct in his view that the banks could survive a housing crash. Nonetheless, the prospect of homeowners across the country simultaneously trying to reduce their debt levels would put New Zealand at real risk of an economic downturn.
There is a growing appreciation among economists of the role of household debt in explaining the continuing economic weakness of major economies in the wake of the global financial crisis. We need to consider what happens to the balance sheet of households, not just those of the banks.
The prevailing debate around increasing the supply of housing is necessary, but this is a long-term solution. Further measures to relieve pressure on the demand side ought to be the more immediate priority. This includes a more comprehensive capital gains tax. Complementing the Reserve Bank's existing macro-prudential restrictions with debt to income ratios would also help to slow the build-up of household debt.
Managing the slow deflation of the bubble is easier said than done. However, a market crash is not in anyone's interests - no matter how well-intentioned.
