Westpac had a note out the other day under the heading “Household debt levels now higher than before the financial crisis”. Using December data for household and consumer debt (including debt used to finance residential rental businesses) and comparing it with household disposable income, they calculated that household debt was 162 per cent of income, compared to 159 per cent at the previous peak in September 2009.
Using slightly different numerators or denominators alters the picture only a little. Debt to income ratios fell back during and after the 08/09 recession, and have been increasing quite a bit in the last couple of years. Credit growth has picked up and income growth has slowed. I prefer to focus on debt to GDP measures, and here is my version of the chart.
The ratios haven’t yet reached the previous peaks, but aren’t that far away, and may well go past the previous peak this year. One gets much the same picture looking at broader credit aggregates relative to GDP.
One could look at these trends in a variety of ways. I’d tend to emphasise the fact that over the last 7.5 years there has been no growth at all in the ratio of household debt to GDP, whereas over the previous 15 years that ratio had increased by around 60 percentage points. Westpac seems much more worried than that.
But there are a couple of important things we know (or know we don’t know):
- that we have no idea what any sort of “equilibrium” ratio of household debt to income is.
- that when household debt levels were first at these sorts of levels, around the time of the 08/09 recession, it didn’t lead to any serious stresses on the financial system – we had a pretty serious recession, mostly reflecting global developments, and yet there was never any question about the soundness of the New Zealand financial system.
- that vanilla household debt has very rarely been at the heart of serious financial system problems in this or other countries – the Reserve Bank drew our attention to that in an article only a couple of years ago. Lending on speculative commercial (and residential) developments, and other (typically unsecured) business lending, has usually been the presenting source of financial system problems.
But I’m also puzzled by two points about the Westpac piece – one presence, and one absence.
Westpac talks of high house prices boosting consumption.
But household consumption as a share of GDP is currently just slightly below the average ratio for the last 30 years or so. This shouldn’t be very surprising – higher house prices don’t make New Zealanders as a whole any better off. A longer discussion of this issue is contained in this Reserve Bank Bulletin article from a few years ago.
The “absence” is any sense that changes in household debt to GDP (or income) ratios are not mostly some exogenous phenomenon of reckless banks and households taking on new debt with gay abandon. I discussed this issue a couple of weeks ago. If there are shocks to the population, and land supply restrictions exist, then house prices will rise. New purchasers will typically (and probably rather reluctantly) need to take on more debt than their predecessors did. As a result, debt to income ratios will rise. Since the housing stock turns over only quite slowly, an initial shock boosting house prices will go on boosting debt to income ratios for many years.
In the chart below I’ve done a very simple exercise. I’ve assumed that at the start of the exercise, housing debt is 50 per cent of income, house prices and incomes are flat, and people repay mortgages evenly over 25 years. Only a minority of houses is traded each year, but each year the new purchasers take on new debt just enough to balance the repayments across the entire mortgage book.
And then a shock happens – call it tighter land use regulation – the impact of which is instantly recognized, and house prices double as a result. Following that shock, house purchasers also double the amount of debt they take on with each purchase, while the (now rising) stock of debt continues to be repaid in equal installments over 25 years.
In this scenario remember, house prices rose only in year 1. There is no subsequent increase in house prices or incomes. But this is what happens to the debt to income ratio:
In this particular scenario, 100 years after the initial doubling in house prices, the debt to income ratio is still rising, solely as a result of the initial shock, converging (ever so slowly by then) to the new steady-state level of 1. One could play around with the parameters, but a permanently higher level of real house prices will, in almost any of them, produce a permanently higher level of gross housing debt, and it will take many years to get to that new level. The flipside, which I could also show, is the deposit balances of the other parts of the household sectors – the young who have to save for a higher deposit (even for a constant LVR) and the older cohorts who extract more money from the housing market when they downsize or exit the market. Higher house prices do not, of themselves, require banks to raise more funding offshore.
This is deliberately highly-stylized, but it is designed to illustrate just two main points: higher debt ratios can be primarily a symptom of higher house prices (rather than any sort of cause) and the adjustment upwards in debt levels following an upward house price movement can take many years to work through.
Given the huge population pressures, especially in Auckland, and the lack of much material progress in easing land use constraints, it is hardly surprising that real house prices have increased quite a lot further in some places. If anything, it might be a little surprising that debt to income ratios have not increased more. But these things take time – the point of the chart above.
Westpac has long been of the view that low interest rates have been a major factor explaining rising house prices. I’ve never found that story particularly persuasive. We’ve had a 600 point cut in the nominal OCR since 2008 (and a bit more in real terms). If all else was equal and the Reserve Bank had not cut the OCR as much no doubt house prices would be lower (and quite a lot of other aspects of the economy would be doing even less well). But the OCR cuts have been done for a reason: the economy hasn’t been performing that well, and inflation has persistently surprised on the downside. In Wicksellian terms, it looks a lot as though the natural interest rate has fallen quite a bit. Westpac worries about what happens when (if) interest rates rise, but they are only likely to rise much if the economy is performing much better, and is generating much stronger income growth (which would support the existing debt).
There is a still a strong sense around that, when it comes to housing, what goes up must come down. But when a market is so heavily influenced by regulatory factors, there is no such natural adjustment. As a loose parallel, we have plenty of people who find it hard to get a job, but the minimum wage keeps on being increased. Urban residential property prices, especially in Auckland, are a disgrace – the responsibility of the choices (active and passive) of a succession of central (and local) government politicians. They are hard to defend under any conception of justice or fairness. But there is little sign that they are any sort of macroeconomic risk. Debt to income is little higher than it was a decade ago, consumption to GDP has not gone crazy, there is nothing of the sort of debt fuelled speculative construction boom seen in, say, Ireland, and there is no sign of reckless behaviour by lenders. And the banks are very well-capitalized. It is awful for the many adversely affected, but there is no reason why things should necessarily change much for the better any time soon,
Finally, one of the points of the Westpac note seemed to be to foreshadow the risk of new layers of regulatory controls (so-called “macro-prudential” measures) being imposed on the banking system by the Reserve Bank. Perhaps they are right about what might be coming. But there would be no good (financial system soundness) basis for further intrusions on the ability of borrowers and lenders to freely arrange finance. There is simply no evidence that the soundness of the financial system is at risk – or would be even if, say, the population pressures reversed and land use restrictions were freed up. Then again, the last two sets of LVR restrictions, undermining the efficiency of the financial system and the wider economy in the process were unwarranted, but that didn’t stop the Reserve Bank charging ahead then.