Interest rates, supply restrictions, and house prices

There was an interesting post from Peter Nunns on Transportblog the other day, attempting a bit of a back-of-the-envelope decomposition of how various factors, including land use restrictions, might have contributed to the rise in real Auckland house prices over the 15 years since the end of 2001.

Nunns starts his decomposition with the suggestion that:

One simple way to disentangle these factors is to look at the relationship between consumer prices, rents, and house prices:

  • When rents rise faster than general consumer prices, it indicates that housing supply is not keeping up with demand
  • When house prices rise faster than rents, it indicates that financial factors – eg mortgage interest rates and tax preferences for owning residential properties – are driving up prices.

and with this chart

nunns-1-auckland-real-house-prices-and-rents-2001-2016-chart-600x360

Disentangling the contribution of various factors isn’t easy.  A lot depends on what else one can reasonably hold constant.  Nunns seems to assume that holding real rents constant is a reasonable benchmark, and that we can then think about the change in net excess demand for accommodation by looking at deviations from that benchmark.   Thus, roughly, he suggests that a 31 per cent increase in house prices can be accounted for by supply shortfalls.

Over this period, I’m not at all convinced that is right.  Why?

Largely because of the big changes in long-term interest rates, which –  all else equal –  should have affected supply conditions in the rental market.  Specifically, when interest rates fall a long way it is a lot cheaper than previously to provide rental accommodation (the available returns on alternative assets having fallen so much).

And what has happened to interest rates over this period?  Well, here is a chart of the 10 year bond rate since the end of 2000.

10-year-rate

There is always a bit of noise in the series, but long-term nominal government bond yields are now about 350-400 basis points lower than they were in 2001.  A little bit of that is falling inflation expectations (around 50 basis points according to the Reserve Bank survey).  But fortunately in 2001 we also had a 14 year government inflation-indexed bond outstanding, and we do so now as well.  In late 2001, that indexed bond yielded about 4.6 per cent, and the current yield is around 1.6 per cent.  Real long-term bond yields look to fallen by at least 300 basis points (and around two-thirds of that fall has taken place in just the last five years or so).

Short-term real interest rate haven’t fallen that much.  Short-term rates are more volatile, so here I use a two year moving average.

1st mortgage rate 6mth term deposit rate
   Dec 2001 7.99 5.86
  Sept 2016 6.14 3.59

Even on these measures, real interest rates have fallen by perhaps 1.5 percentage points.

In a well-functioning housing supply market, those sorts of falls in real interest rates might reasonably have been expected to be reflected in lower real rents.

Quite how much a fall one might have expected in such a market will depend on a variety of assumptions one makes.  But if landlords had been looking for an 8 per cent annual real return on rental properties back in 2001, then even a 2 percentage point fall in real interest rates, might readily have been consistent with a 25 per cent fall in real rents –  in a well-functioning housing market.  If real risk-free rates have fallen by more like 300 basis points –  as the indexed bond market suggests –  that would be consistent with more like a 40 per cent fall in the rental cost of long-term assets.

These are all illustrative hypotheticals. They assume that new assets can readily be generated.  But in a well-functioning housing markets, new houses can be readily generated.  New unimproved land can’t be (there is a given stock, only what it is used for can be changed).  But in well-functioning housing markets, the unimproved land component of a typical new house+land package will be quite low.  Think of dairy land prices at perhaps $50000 a hectare and you start to get the drift.  All else equal, in well-functioning housing supply markets, when interest rates fall unimproved land values should be expected to increase, but the value of land improvements and houses shouldn’t be much affected at all.

But even that story is a cautious one (biased to the upside).  After all, interest rates typically fall for a reason –  big trend falls don’t occur in isolation.  One such factor is low expected future returns (eg lower expected rates of productivity growth).   And interest rates are not a trivial factor in the cost of land improvements, associated infrastructure, and house building itself.  Again, all else equal, lower interest rates should lower the real cost of bringing new houses onto the market –  reinforcing the expected fall in real rentals.

Of course, this is so detached from the reality of Auckland (or New Zealand more generally) housing markets that it is difficult to even envisage such a scenario.  We have land use restrictions  –  which tend to produce high land prices and high rents –  and when those restrictions run head on into severe population pressures (especially unanticipated ones), it is hardly surprising that house and land and rental prices rise.  But when that clash (between land use rules and rising population) occurs at time when real interest rates have been falling a lot, looking at trends in rents can badly confuse the issue.

I’m not wedded to a story in which all the increase in real house prices in recent years is down to supply restrictions interacting with rapid population growth.  In his piece Nunns notes a couple of other possibilities

some other ‘financial’ explanations could include:

  • New Zealand’s tax treatment of residential property, and in particular investment properties – unlike many of the countries we ‘trade’ capital with, we don’t have any form of capital gains tax on property. All else equal, this means that we should expect structural inflows of cash into our housing market, driving up prices
  • The impact of ‘cashed-up’ buyers coming in without the need to borrow money to invest in properties – including, but not limited to, foreign buyers.

But….our tax treatment of investment properties has become less favourable not more favourable over the last few years  (reduced and then abolished depreciation provisions, the introduction of the PIE regime, lower maximum marginal tax rates.  If these arguments have force at all –  and they typically don’t when supply is responsive –  they should have worked in the direction of (modestly) lowering house prices over the last decade or so.

And while I suspect there is something to the “cashed-up foreign buyer” story, again any such demand only raises house prices when supply is unresponsive.  If supply is responsive –  which it would be without all the land use restrictions –  such demand would be just another export industry.

Of course, the common story is that lower interest rates have raised house prices.  And perhaps they have to some extent, but (a) recall that interest rates are lower for a reason, and real incomes now (ie the expected basis for servicing debt) are much lower than would probably have been expected a decade ago, and (b) lower real interest rates do not raise the equilibrium price of even a long-lived asset if that asset can be readily reproduced.  In well-functioning housing markets, houses can be, and unimproved land is a small part of the total cost.  If lower interest rates raise house prices, it is only to the extent that land use and building restrictions make it hard to bring new supply to market.  (As it happens, of course, in much of New Zealand real house prices are no higher than they were a decade ago when interest rates were near their peaks.)

To a first approximation, trend rises in real house prices are almost entirely due to supply constraints.  There can be all sorts of demand influences –  some government-driven, some not –  and it can be useful to identify them, but in well-functioning housing supply markets they don’t generate rising real house prices.

atlanta-2

As just one illustration, here is a chart of nominal house prices for Atlanta over the last decade. Atlanta has had rapid population growth, has experienced significant falls in real interest rates (like the rest of the US), is in a country with mortgage interest deductibility for owner occupiers, and is not obviously a worse safe-haven for Chinese money fleeing the weak property rights of China, and yet nominal house prices are no higher than they were in 2006.

 

 

 

 

What’s good for Australia is good for New Zealand

But that is not what the FTAlphaville blog would have its international readers believe.

It is always interesting when serious foreign media write about New Zealand.  Sometimes there are useful perspectives we just don’t see.  Then again, when they get things wrong about things you know about, it leaves me wondering about the coverage of things I don’t know so much about.

Yesterday, the Financial Times’s Alphaville blog ran a piece by Matthew Klein headed “What’s bad for Australia is good for New Zealand”.   Klein seems interested in New Zealand and has written a few other posts in recent months.  In this one he draws on a recent speech by Reserve Bank Assistant Governor, John McDermott, but what is wrong with this post is almost entirely the author’s own work.

He begins with this Reserve Bank chart of the Bank’s estimate of the rate of potential output growth for the last 15 years or so.

NZ-potential-output.png

Potential output estimates have changed quite a bit as we have moved through time (and actual past estimates have been revised to some extent).  The Bank published a useful paper on estimating potential output and the “output gap” a couple of years ago.   The biggest single factor explaining fluctuations in potential output growth over time has been swings in population growth –  very strong around 2003, very strong over the last year or two, and much more subdued in between.  Changes in trend productivity growth also matter, but they are harder to detect.   But that slowdown has been real –  population growth in the last year or two has been at least as fast as it was in the early 2000s and the Bank’s estimate of potential output growth is much lower than it was then.  And as Paul Krugman helpfully reminds if, if productivity isn’t everything, in the long run it is almost everything.

But Matthew Klein seems impressed by those 2.6 per cent potential output growth rates –  much stronger than they were a few years ago –  and seems unbothered whether that is the result of more people, or of more productive use of people (and other resources). The difference matters.

Klein’s story is that the Chinese (demand-driven) hard commodity boom was a terrible thing for New Zealand, and we are now reaping a windfall from the end of that boom.

China’s changing investment strategy has produced a windfall for New Zealand — through the unexpected channel of clobbering the Australian mining sector.

Now I suppose there could be some channels through which the end of that commodity boom might have helped New Zealand and New Zealanders.  We import some of those hard commodities too (although of course, we do export some and look what became of Solid Energy).  To the extent that slowing Chinese growth might have contributed to lower oil prices, we benefit from that.  But these aren’t at all the channels Klein has in mind.  On his telling, we have done well because Australia has done badly.  And that seems inherently unlikely given that Australia is the largest trading partner for New Zealand businesses, and the largest source of foreign investment in New Zealand.

But Klein’s story is one in which New Zealanders fled for greener pastures in Australia when commodity prices boomed, and stopped doing so when commodity prices fell.  He runs this chart.

nz-emigration-to-aus-vs-aus-usd-commod-prices

Note that (a) it shows only the flow of New Zealanders to Australia, not the net trans-Tasman flow, and (b) it shows only Australian commodity prices, not the relative Australia/New Zealand prices.

Here is a longer-term chart showing the relationship between the net trans-Tasman migration flow (NZ and Australian citizens) and the relative terms of trade (Australia’s divided by New Zealand’s).

transtasman-tot-and-migration

Over decades there have been big cyclical fluctuations in the net migration flow across the Tasman.    Allowing for the fact that our population is much larger now than it was, say, 25 years ago, the peaks and troughs don’t seem to have become larger than they were.   And most of the time, there haven’t been big changes in relative commodity prices to explain the migration fluctuations.

Generally, a better story explaining the trans-Tasman flows over recent decades would seem to be:

  • in typical years there is a fairly large net outflow from New Zealand to Australia (material living standards are simply higher there),
  • when unemployment rates in Australia are very low, the outflow is higher than usual, even if unemployment is low here (job search across the Tasman is easier than usual, and those wages are higher).  In 2007/08, for example, the unemployment rate in Australia was the lowest in decades, as it was in New Zealand, and New Zealanders still seized their opportunities,
  • when unemployment rates in Australia is very high that net flow dries up –  people are reluctant to leave existing jobs when the job search across the Tasman is likely to be longer and costlier (as we saw in 1991),
  • and when Australia’s unemployment rate is lower than New Zealand’s –  which doesn’t happen often – it again makes it very attractive for New Zealanders to go, especially if New Zealand’s unemployment rate is still on the high side.  The largest such gap in the last couple of decades was 2010 to 2012, which saw large scale outflows of New Zealanders resume.

Since then, of course, the unemployment rate in Australia has risen, and that in New Zealand has fallen. In both countries, unemployment is uncomfortably high, and above the respective estimated NAIRUs.  Perhaps it is a little surprising that the net outflow of New Zealanders has, for now, come back to around zero, but there has also been a lot more publicity in recent years about the relatively insecure position New Zealanders can find themselves in in Australia if things don’t go well.  But it would still be surprising if when both countries have unemployment rates are back at the respective NAIRUs there wasn’t typically a large net outflow of New Zealanders resuming.  After all, there has been no progress at all in closing the productivity gaps.

relative-u-rates

 

No doubt the hard commodity boom, and associated domestic investment boom, did contribute to the relatively low unemployment rate in Australia over 2010 to 2012.  But macro policy (especially monetary policy) also plays a big part in deviations of the unemployment rate from the level the underlying regulatory settings might deliver (the NAIRU).  In New Zealand, for example, the inflation outcomes quite clearly illustrate the monetary policy was tighter than it needed to be over that period.  Some of that was only clear in hindsight, and the earthquakes also muddied the water, but we didn’t simply have to live with such a high unemployment rate for so many years (which reinforced the incentive for New Zealanders to leave).

But, to stand back, perhaps the more important question to ask is why Klein thinks New Zealand is better off simply because the net outflow to Australia has temporarily ended.

After all, New Zealanders going to Australia presumably do so because they think the opportunities are better there (and most objective measures of material living standards suggest they are right).  If opportunities deteriorate in Australia –  cyclically or structurally –  that isn’t a gain for New Zealanders, but a loss.  Fewer of them are, for now, able to take advantage of the opportunities across the Tasman.  It would be different if there were New Zealand specific positive productivity or terms of trade shocks  that meant that prospects here were improving faster than they had been previously.  But there is just no sign of that: as just one indicator, there has been no growth at all in real GDP per hour worked in New Zealand for around four years.

Of course, it might count as a gain if there was some sort of community goal to simply increase New Zealand’s population as fast as possible.  One sees those sorts of arguments in various countries from time to time –  there was a particularly daft Canadian example the other day  – but unless New Zealand is gearing up to defend itself from a military invasion from Antartica, the only good case for pursuing a larger population is if doing so makes us economically better off (higher productivity and all that).  And there is simply no evidence it has, or does –  whether in past decades, or in the latest population surge.

And all this is before reverting to the point that New Zealand firms trade more with Australian firms and households than they do with those in any other country. Australia is New Zealand’s biggest export market.  And so when Australian income growth tails off rapidly, as it has in the last few years, it isn’t very propitious for New Zealand firms hoping to increase their sales in Australia.  Weaker income growth in target markets is generally thought to be bad for the sellers (and their country) not good.

Here is a chart showing the net migration outflows for a longer period.

net-migration-charts

I’ve shown a variety of measures of trans-Tasman flows, and one of all NZ citizen flows everywhere.  They are all highly-correlated, as trans-Tasman flows almost always dominate the overall movements of New Zealand citizens.  There have been three times in the nearly 40 years for which the citizenship data have been available when the net outflow of New Zealanders has temporarily abated:

  • around 1983, when Australia was in recession and its unemployment rate was over 10 per cent,
  • in 1991, when both countries had a severe recession and both countries’ unemployment rates peaked around 11 per cent,
  • and in the last couple of years.  It is unusual in that neither country has been in recession, but both countries have had unemployment rates above the respective NAIRUs, in both countries income growth is much weaker than it was (particularly so in Australia) and in both countries (as in much of the advanced world) productivity growth has disappointed (most especially in New Zealand).

Not one of those occasions could be considered good news stories for New Zealand or New Zealanders.  Over the last 40 years, net outflows of New Zealanders to Australia have been something of a release valve –  Australia gave them opportunities New Zealand could no longer provide.  Unless and until New Zealand really begins to turn itself around structurally, anything that disrupts that outflow is more likely to be bad for New Zealanders than good.

Klein concludes his piece thus

As long as New Zealand is capable of boosting domestic spending without relying too much on household borrowing, admittedly a nontrivial challenge, this puts the country in an enviable position compared to much of the rest of the rich world. Policymakers should enjoy it while they can.

Given that household credit has been growing at almost 9 per cent in the last year, mostly reflecting very rapid increases in already high house prices, and that there has been no productivity growth for years, all while the unemployment rate has lingered above the NAIRU, I’m not at all sure what Klein thinks policymakers should be enjoying.  Perhaps write-ups like his – while they last –  but there doesn’t seem to have been much in the story for New Zealanders in recent years.

Here is the productivity growth comparison with Australia.  If anything, the latest relative deterioration seems to coincide with the end of the Australian commodities boom. I doubt that relationship is really causal, but it certainly doesn’t seem to help Klein’s story.

gdp-phw-nz-vs-aus

In general, what is good for the economy of our largest trade and investment partner will, almost always, be good for New Zealanders too.  That is how trade, and open markets, work.

NZ interest rates: why are they persistently higher than those abroad?

In my post yesterday, I noted (with illustrations) that looking back over at least the last 20 to 25 years:

…our interest rates (a) are and have been higher than those abroad, (b) this is so for short and long term interest rates, (c) is true even if we look just at small countries, and (d) is true in nominal or real interest rate terms.  And the gap(s) shows no sign of closing.

Not much about that is really controversial at all.  But quite why these gaps have been large and persistent is more contested.  It isn’t the sort of stuff the mainstream media focuses on –  they tend to be more interested in the historically low level of (New Zealand and foreign) interest rates –  but getting to the correct answer matters, not just analytically but in thinking about policy responses to New Zealand’s long-term economic underperformance.

In thinking about the issue, it is important to bear in mind a few things:

  • short and long term interest rates are related, and there can be information in the relationship between them,
  • short-term interest rates are set by the central bank in response to (perceived) domestic inflation pressures, and
  • interest rates in different countries are related at least in part, by expectations (implicit or explicit) about movements in the exchange rates between those two countries’ currencies.

Broadly speaking, I think there are three hypotheses that are canvassed when these issues are discussed in New Zealand (and there is a fourth, suggested by some recent literature, that a few commenters here have raised).

But first, lets clear away some of other possible answers.

The explanation isn’t domestic monetary policy.  Sometimes people have argued that (a) our target was more demanding than those in other countries, or (b) that our Reserve Bank was excessively “hawkish”, inclined to see inflation under every stone, and so holding short-term interest rates persistently higher than they need to be.  In fact, our inflation target is very similar to those in most other advanced countries.  The Reserve Bank makes mistakes – sometimes they even persist for a couple of years –  and sometimes gaps between our interest rates and those abroad are affected by those mistakes. But other central banks make mistakes too (all of them are human, with much same limitations).  And taking a longer-term perspective, on average over time our Reserve Bank actually delivered inflation outcomes a bit higher than the target they’d been given.  Given the target, monetary policy (pre-2008/09 was typically a little loose  (since then it has probably been a little tight).   All in all, differences in monetary policy conduct or targets just can’t explain those persistent differences in real interest rates.

There is another possibility that be cleared away even more quickly.  If a country had very strong persistent productivity growth it would tend to have higher interest rates than would be seen in other countries.  There would be lots of profitable investment opportunities in that high productivity growth country, lots of (expected) income growth to consume in anticipation of, and so on.  And over time, that high-productivity growth country could expect to see its real exchange rate rise.  Unfortunately, high productivity growth isn’t the story of New Zealand in the last few decades.  Indeed, more often rather the reverse.

Here is a chart I haven’t shown for a while: total factor productivity for New Zealand and for a median of the large group of advanced countries for which the Conference Board has estimates back to 1989.

tfp-oct-16

Rapid productivity growth isn’t even close to a relevant story explaining New Zealand’s persistently high real interest rates.

There is another possible story which hasn’t really entered the mainstream of the New Zealand debate, but should be covered off for completeness.  It notes that New Zealand is a small country, with quite a volatile terms of trade, and that the currencies of such countries offer less good diversification opportunities, suggesting that anyone investing here would require a higher return than elsewhere.  It sounds initially plausible, but it has a number of problems.  The first is that our interest rates have been persistently higher than those in other not-large countries with their own currencies (I showed the chart against the median on Australia, Canada, Sweden, and Norway in the previous post).  And the second is that if this were an important channel, it would suggest that small countries face a higher cost of capital than large ones, which would limit the growth prospects of small countries.  But (badly as New Zealand specifically has done) there is no real sign that small countries typically grow (per capita, or per hour worked) more slowly than large ones.  At present, I don’t think it is a particularly strong candidate to explain New Zealand’s persistently high interest rates.  Apart from anything else, if this were the story, why would New Zealand have accumulated –  and maintained – such a large negative net international investment position (NIIP) (still among the largest of the OECD countries)?

Perhaps somewhat related, but from an older set of models, is the idea that New Zealand has some combination of persistently good investment opportunities, and modest national savings rates, and requiring foreign funding for such opportunities needs to pay a premium rate of return. It is nothing to do with specific New Zealand risks (small, volatile etc) simply that capital needs a premium to attract it away from home, no matter where home is.  Again, it sounds plausible, but runs into some problems.  Perhaps the most important is that this story cannot explain why the real exchange rate should also have been persistently high  (on a pure time series basis for at least the last decade, but relative to the growing productivity differentials for rather longer than that).   Typically, part of the way New Zealand might attract the foreign capital it needs is through some mix of a lower (than usual, or easily explainable) exchange rate, and higher interest rates: from a foreign investor’s perspective it is the total return that should matter, not just the interest rate.  Senior Reserve Bank people have, at times, sought to invoke this explanation as at least part of the story.

A more prominent explanation for New Zealand’s persistently high interest rates points to the large negative NIIP position and asserts that the explanation for high interest rates is pretty straightforward: lots of debt means lots of risk, and hence the need for a substantial risk premium on New Zealand interest rates.  Taken in isolation –  if someone told you only that a country had a large negative NIIP position this year –  it might sound plausible.  Once you think a bit more richly about the New Zealand experience it no longer works as a story.

First, our NIIP has been large (and negative) for a very long time now –  for at least the last 25 years, and over that time there has been no persistent tendency for the NIIP position to get better or worse.  By contrast, 20 years earlier than that New Zealand had almost no net foreign debt.  The heavy government borrowing of the 70s and 80s had markedly worsened the position.  It is quite plausible that foreign lenders might then have got very nervous and wanted a premium ex ante return to cover the risk. In fact, we know some (agents of) foreign investors got very nervous –  there was the threat of a double credit rating downgrade in early 1991.  But when lenders get very nervous, borrowers tend to change their behavior, voluntarily or otherwise, working off the debt and restoring their creditworthiness.   And in New Zealand, the government did exactly that –  running more than a decade of surpluses and restoring a pretty respectable government balance sheet.  But the large interest rate differential has persisted –  in a way that it did in no other advanced country (including those that went through much worse crises and threats or crises than anything New Zealand has seen in the last 25 years).

We also know that short-term interest rates are set by the Reserve Bank, in response to domestic inflation pressures. But long-term interest rates are set in the markets.  If investors had really been persistently uneasy about New Zealand’s NIIP position, we might not have seen it much in short-term interest rates, but should certainly have expected to see it in the longer-term interest rates. (That, after all, is what we see in various euro countries that have lapsed in and out of near-crisis conditions).   But one of the other features of the New Zealand experience is that over the last 25 years is that New Zealand’s long-term interest rates have been a bit lower relative to New Zealand’s short-term interest rates, than is typically seen in other countries.   In one obvious place one might look for direct evidence of such a risk premium, it just isn’t there.

yield-gap-2016In fact, on this measure we look a lot more like Norway –  which has a huge positive NIIP position (net foreign assets) and very little government debt.

And remember, too, the point I made earlier about the exchange rate.  When risk concerns about a country/currency rise, one of the first things one typically sees –  at least in a floating exchange rate country –  is a fall in the exchange rate.  It is a bit like how things work in equity markets.  When investors get uneasy about a company, or indeed a whole market, they only rarely succeed in getting higher dividends out of the company(ies) concerned.  If the companies were sufficiently profitable to support higher dividends the concerns probably wouldn’t have arisen in the first place.  Instead, what tends to happen is that share prices fall –  and they fall to the point where expected dividends, and the expected future price appreciations of the share(s) concerned, in combination leaves investors happy to hold those shares. In that process, an increased equity risk premium is built into the pricing.

At an economywide level,  if investors had had such concerns about the New Zealand economy and the accumulated net debt position, the most natural places to have seen it would have been in (a) higher long-term bond yields, and (b) a fall in the exchange rate (and perhaps a persistence of a surprisingly weak exchange rate). But we’ve seen neither in New Zealand.  Had we done so, presumably domestic demand would have weakened, and net exports would have increased.  The combined effects of those two shifts would have been to have reduced the negative NIIP position, and reduced whatever basis there had been for investors’ concerns.  Nothing in the New Zealand experience over the last 20 years or more squares with that sort of story.

And that is the really the problem with the most common stories used to explain New Zealand’s persistently high interest rates. They simply cannot explain the co-existence of high interest rates and a high exchange rate over long periods.

My alternative approach seeks to do so.

It involves looking at the stylized facts and suggesting that perhaps they point in the direction of an abundant supply of credit from abroad (perhaps something almost like the horizontal supply curve of the textbooks), combined with some factors that give rise to persistently strong demand for scarce domestic resources.  That in itself shouldn’t really be terribly controversial.  There are pleasing stories which, if true for New Zealand, would produce that sort of combination.  If New Zealand individuals and firms were generating a world-beating stream of new ideas and business opportunities, business investment would be strong, productivity growth would be strong, and a “strong demand meets ready supply” story would have everyone nodding approvingly.    But….we know that productivity growth has been persistently weak (there are good years and bad ones, but the trend story is pretty disappointing) and business investment has also been weak (in long-term cross-country comparisons).  And with that disappointing productivity growth, households also wouldn’t have been rationally consuming in expectation of even stronger future income growth than we see in most countries.

So I’ve suggested looking at “demand shocks” instead, and particularly those that might arise from outside the system (the private economy), focusing on activities/choices/initiatives of government.   Governments are not as responsive to market prices as the rest of us.

Again, there is nothing overly controversial about this idea in principle.  A big increase in domestic government spending on goods and services, for example, will tend to push up the real exchange rate, and quite possibly push up domestic interest rates as well. My favourite example is prisons.  Relative to a no-crime hypothetical, a government that finds itself needing to build more prisons, needs to get command of the resources to build those prisons, and then staff them.  Doing so will tend to bid up the price of domestic goods and services (including labour) –  and raising the price of non-tradables relative to tradables is one of the definitions of the real exchange rate.  Resources used for building and staffing prisons (and actually, the people imprisoned and no longer in the labour market) can no longer be available for generating tradable products.  The higher real exchange rate squeezes some of that production out.

But my specific version of the demand story looks at our immigration policy.  Government decisions on how many non-New Zealanders too admit each year –  themselves largely reached independently of the state of the New Zealand business cycle – can be presented, quite reasonably as a “demand shock”.   The net impact of additions to the population from outside the system –  births are conceptually a little different –  tends to boost demand more than it does supply in the first couple of years after the migrant arrives.  And if there was simply one wave of migrants –  as in some of the events studied in the literature –  the effects would wash through fairly quickly.  But in fact, we have a new large wave each year, and have had really ever year since around 1990 (immigration was being liberalized over several years around that time).    Each new migrant needs –  just as they did at time Belshaw was writing – quite a lot of new physical capital (houses, roads, schools, offices, factories etc) and they bring almost none of it with them.  Additional demand for those real resources has to be met by squeezing out other forms of demand –  and that is what persistently higher real interest rates and exchange rate tend to do.  The fuller version of my story was in a paper I wrote a few years ago for a Reserve Bank and Treasury forum on exchange rate issues.

Some people worry that I must be assuming some irrationality or market failure (crutches which, quite rightly, economists are wary of relying on).  But I’m not.  Recall that the active agent here is mostly a body outside the market: the government, which for whatever reason decided that it wanted to bring in 45000 to 50000 non-citizens per annum.  The people who come are presumably being quite rational.  The people whose firms respond to new fixed capital demands (and other requirements of a growing population) are being quite rational.  There is quite real new demand in front of them.  The central bank which raises interest rates, and the markets which push up longer-term interest rates, are also presumably being quite rational.  There is more demand pressure in the New Zealand economy. Perhaps the one area in the story that is a bit of a surprise is that long-term interest rates haven’t stayed up as high, relative to short-term interest rates, as we might expect.  I’m not sure why that is –  but it is a hard observable fact, present in the data without any need to torture it first.

My own hypothesis –  and it is pretty tentative –  is that few people in international markets really realise the importance of persistently high immigration in boosting demand.  And most of them –  quite rightly – operate with a mental model that envisages convergence with world real interest rates in the long haul.  If immigration policy were overhauled and drastically cut back, exactly that sort of long-term interest rate convergence would occur.  In a way, it might be just as well that many investors haven’t quite realized –  over many years –  how persistently large the gap between New Zealand and world interest rates would remain.  If they had (or even did today), the rational response would have been to bid the exchange rate quite a lot higher than it has actually been.  Investors  –  and international agency experts –  have often expected New Zealand’s exchange rate to come down, partly because they kept, mistakenly, expecting the interest rate convergence that never happened (yet).  Expectations drive pricing, and if people think the interest rate gap will remain larger for longer, relative expected returns on different assets are only roughly equalized if the exchange rate goes still higher now, so that it can fall further some time in the future.

Is my story the correct one?  I don’t know, but I’ve been running it now for six or seven years, and as the ideas have had more exposure I’ve not been presented with any counter-arguments or evidence that would undermine my sense that “repeated demand shocks” (largely resulting from our immigration policy) are a material part of the story for why our interest rates have remained so persistently high relative to those in the rest of the world.  It is a difficult story to test in a formal empirical way –  something that probably frustrates me as much as it does some of the sceptics –  partly because it isn’t some generalized global story about all immigration everywhere, but about how events and policy interventions have unfolded in his specific economy, with its own specific set of other stylized facts (including, for example, the modest national savings rate).

Like all hypotheses, mine is put out in part to prompt reactions, to identify holes in other stories, and to help prompt alternative, perhaps richer, stories. For now, however, I’m pretty confident that mine is the only one of the stories on offer that can reasonably account for the combination of:

  • persistently high (relative to other countries) real interest rates,
  • a persistently high real exchange rate,
  • long-term interest rates lower relative to short-term rates than is typically seen,
  • a high (almost entirely private) negative NIIP position,
  • all over a period where productivity growth has continued to lag behind that seen in most other advanced countries.

It might not be the whole story, but it feels a lot like a significant step towards such a story.