Peter Lyons: Big spenders at risk of bursting bubble

Reserve Bank Governor Allan Bollard must feel as though he is yelling "fire" in a crowded cinema but is ignored because everyone is too busy enjoying the movie.

Speaking "bollards" may come to mean talking good sense but being completely disregarded because everyone is having a good time.

Bollard is in a difficult position in having to keep the inflation rate below 3 per cent. He is very aware of the debt mountain Kiwis are sitting on and the possible risk of toppling this mountain.

Financial markets seem to have anticipated that his next interest rate move will be upwards because of current inflationary pressures.

High interest rates and the resulting high exchange rate are throttling our export sector. It is no coincidence that the same day Bollard made dire warnings about the state of the economy, exporters Scott Technology and CWF Hamilton both announced very poor trading results attributable to the high New Zealand dollar.

Bollard's warnings about a hard landing and possible falling house prices were an attempt to reduce inflationary pressure without the harsh medicine of further interest rate rises.

So far his attempts have been ineffective and the consumer borrowing and spending spree has continued unabated. The party is in full swing and tomorrow's hangover is a blurry, distant threat, possibly avoidable with more drink.

New Zealand was a pioneer in introducing a monetary policy operated independently by the Reserve Bank. Unlike health or education, controlling inflation was regarded as too important to leave to politicians.

Tough monetary policy and the resulting high interest rates were very effective in squeezing inflation and, more importantly, inflationary expectations, out of the economy in the early to mid 1990s.

Currently the Reserve Bank's main tool in the fight against inflation is the official cash rate (OCR).

By setting this base interest rate the bank is able to influence all other interest rates in the economy. If the Reserve Bank increases the OCR other interest rates rise, which should dampen demand and reduce the pressure on price levels to rise. This means of controlling inflation is a very blunt tool.

The rise in the interest rates attracts demand for the New Zealand dollar in foreign exchange markets. Overseas investors buy the dollar to receive the higher interest rates on offer here.

This causes the exchange rate of the New Zealand dollar to rise, reducing import prices, which should further dampen inflationary pressures. It also makes our exports less competitive in overseas markets, reducing exporters' profit margins.

This process was very effective throughout much of the 1990s. Unfortunately, market participants adjust their behaviour and several phenomena have developed in recent years that have served to undermine this process for controlling inflation and may actually make it counter-productive.

Here's how it works. Most of the developed world is awash with savings as the baby boomers are flush with cash and seeking investments that offer higher returns.

New Zealand's high interest rates due to our tight monetary policy make us a very attractive country to lend to. Banks and finance companies are borrowing New Zealand dollars from overseas and then lending this money in New Zealand.

This is done by selling Uridashi and Euro kiwi bonds in Japan and Europe. These bonds are in New Zealand dollars and offer very attractive interest rates to overseas lenders.

The overseas lenders need New Zealand dollars to buy these bonds and their demand pushes up the exchange rate for the New Zealand dollar.

The banks and other financial institutions then lend these New Zealand dollars to us to buy houses, cars and household appliances in a massive shopping spree funded by overseas lenders.

Borrowing New Zealand dollars cheaply overseas and lending at higher rates in New Zealand is hugely profitable for financial institutions. They also have little exchange rate risk because they are paying overseas lenders back in New Zealand dollars.

The only constraints are overseas savers' willingness to lend to us and our willingness to borrow. So far we have shown an enormous tolerance for debt. This has largely fuelled the property boom that Bollard is now publicly calling an asset bubble.

The bubble is being inflated by the availability of funds for lending and extremely effective marketing by the banking and real estate sectors.

There is nothing sinister in this. Both sectors are making the most of a very profitable situation that is largely the result of a mixture of group psychology and favourable policy settings.

Group psychology is the hallmark of any speculative bubble. Everyone seems to be making big money so everyone wants to get in on the action.

New Zealand's small size probably makes us more susceptible to speculative activity because we all know someone who made a fortune buying and selling property.

Bollard now finds himself in an ironic situation. If he raises interest rates he may continue to fuel this borrowing and lending process.

Expect an onslaught of home loan advertising from banks should interest rates rise. The current account deficit will continue to grow as will our debt mountain. The slow strangulation of our export sector will also continue.

* Peter Lyons teaches economics at Foundation Studies at the University of Otago.