Friday, May 12, 2017

The evidence-based New Zealand housing price policies

Last week I reported some estimates of the long-run magnitudes of the effects of demand and supply measures on the New Zealand house price index. The question is what to do with this evidence.
It seems obvious from the data that the most effective way to dampen the house price increase is to increase the supply of housing.

Demand management is less effective and could be even damaging. It is rather silly to argue that a recession, caused by tight monetary policy (i.e., higher interest rate) or contractionary fiscal policy (i.e., new taxes), is needed to reduce housing prices and resolve the affordability problem.

Specific taxes may reduce speculative excesses. The Treasury knows all about the size, the efficacy, etc. but this is an election year and politicians would be reluctant to introduce new taxes.

Higher real house prices (i.e., adjusted for inflation) imply higher wealth for Kiwis. Wealth is not a bad thing, or is it? Recall that the main concerns about high house prices are about affordability and financial instability. Just as many Kiwis will benefit from having affordable housing many middle class Kiwis will lose from lower housing prices. Policy errors could send the whole economy into a deep recession because most of the assets held by New Zealanders are housing’s.

Also on the demand management side, restricting immigration has a small effect on housing prices as the data show, unless we have a huge reduction or shutting down the immigration program completely. In addition to immigration, there could be corporations, banks, or even nonresidents in additional to people buying houses in New Zealand. 

The price and the quantity (the number) of housing are determined (simultaneously) by the intersection of demand and supply. These curves shift up and down because of shocks. In absence of interventions, restrictions and regulations both the price and the quantity adjust until they settle at a new equilibrium.

That is not the case in reality. We have two independent regulations affecting the quantity and the price of housing.

First, we know that there have been increasing building regulations, requirements, and land restrictions among other regulations that affect the quantity of housing. These regulations (interventions) increased the cost, and essentially altered the slope of the supply curve of housing. When the demand for housing increases because of the increase in income, population, immigration etc. most of the adjustment to the shock, under such regulations, has to be in the price, naturally, because the quantity is restricted by regulations. Thus, more demand means higher prices.

Second, the RBNZ intervenes with different regulations to deal with the house price increase under the new, widely followed, international arrangements of maintaining financial stability.[1]  Central banks regulate credit flow. They essentially try to manage demand for housing.  However, the problem is initially on the supply side really.

So what we have is two different regulators regulating the price and the quantity in the housing market, independently and fully discretionary, making it impossible for prices and quantities to adjust to shocks. The natural mechanism of adjustment in the housing market is impaired and it has no chance of working under these sorts of regulations.

To resolve the housing problem we have to allow the quantity of housing to vary by increasing the supply of housing (i.e., relaxing restrictions on the quantity of housing). This will bring the housing price down. One hundred thousand new building consents reduce the price house index by about 7000 index points. However, we should also allow the price of housing to vary (i.e., by relaxing the restrictions on credit and the banking system). Otherwise, we will continue to have adjustment problems in the housing market.

New Zealand banking system is good by international standards. Credit rating is Aaa. The global financial crisis did not affect us because the banking standards are high. Banks know best how to lend, to whom, and at what price, under the RBNZ’s banking supervision guidelines. These guidelines have been in place for some time; they are well tested. Therefore, to bring the housing market back to normal by removing restrictions on the supply side, discretionary intervention in the credit market needs reexamination. 

[1] Macro-prudential policy is a discretionary regulatory intervention aims, in this case, at restricting credit in housing market when the central bank thinks there are “bubbles” or “speculative excesses” in order to prevent “systemic risk” and financial instability. Read Lars P. Hansen “Challenges in identifying and measuring systemic risk,” CEMFI working paper No. 1305 I have written about this before (see older blogs) and I still believe that it is quite murky area in economic policy.