Earlier this year I was teaching my students about the circular flow model of an economy. It is a picture of how a market economy fits together. I told them that savings flow from households to the banking sector. The banks then lend these funds to businesses to invest in new capital such as factories, IT and machinery.

I proudly exclaimed that this is why a market system is sometimes called capitalism. It is based on firms using borrowed funds for new capital to increase output. This generates more jobs and incomes in a steady march towards a prosperous nirvana.

Antony's hand shot up. "But Sir, everyone knows that banks mainly lend for mortgages for houses."

This trend towards critical thinking by students is a worry. I blame over-enthusiastic social studies teachers with their new-fangled approaches to teaching. Critical thinkers make it very difficult to drill students with the correct answers for their Cambridge exams. I told the class to copy down the circular flow model and memorise it for homework. I quietly sidled over to Antony and told him to tuck his shirt in or I would give him a detention.

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The Reserve Bank has recently started publishing broken-down figures on bank lending. In September the banks lent $4.2 billion for mortgages. About 10 per cent went to first-home buyers. More than 25 per cent went to property investors. Direct business lending was $67 million.

Antony had an excellent point.

New Zealand's version of capitalism largely involves borrowing to bid up the prices of our existing houses, particularly in Auckland. The rest of the country looks on bemused. It creates few new jobs and little extra output or income. It is not a sustainable route to economic prosperity.

The Reserve Bank recognises the risk to our financial sector of this distorted approach to economic prosperity. The Loan to Value Ratio (LVR) that it introduced was due to its concerns about future financial stability if this trend continues. The Reserve Bank governor has indicated he is looking at measures to rein in investor demand for mortgages.

The Reserve Bank is aware that banks can get it horribly wrong in their overall lending practices. The global financial crisis provided ample evidence of this.

To understand how banks can get it so wrong, it is necessary to understand how they operate. If a customer applies for a mortgage of $500,000, the bank does not check how many deposits it received that week before providing the loan. Banks are only interested in the value of the collateral and the ability of the borrower to service the loan. If it grants the loan this results in a simple debit and credit entry in its computer system. If the money ends up in another bank, this will involve further debits and credits to settle up. The bank has effectively created $500,000 of new money.

During good times banking is a very profitable enterprise. But during the credit crunch the system almost collapsed in many countries where banks were wary of other banks because they were unsure of the extent of their bad debts from poor lending practices. This is what our Reserve Bank is worried about in managing financial stability.

The financial sector has always been the Achilles' heel of a market economy. If banks compete to gain lending market share, this can lead to massive bubbles in assets such as shares or property. Eventually the prices of these assets become divorced from their earnings streams. In the case of property this means house prices become exorbitant compared with the rents they generate.

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Rents are more constrained by incomes. Yet people keep borrowing and buying based on the assumption that capital gains will never end. This is very profitable for the banks, while it lasts. The LVR policy and possible moves to quell lending to landlords are a recognition that banks don't always get it right.

Before the financial crisis, central bankers enjoyed immense prestige. They saw their primary role as controlling inflation. The financial stability of the entire economy was not a problem because competitive markets were always efficient, according to theory. Borrowing and lending was driven by rational independent people unaffected by others' decisions. Herd behaviour and asset bubbles were historical anomalies. The crisis exposed how wrong they were. Since then central banks have paid more attention to overall financial stability.

If the Reserve Bank moves to control lending to landlords, it will meet staunch opposition from vested interests, including politicians who prefer the illusion of prosperity. It is a lone voice of reason.