Land prices on the developable fringe of Auckland

Michael Reddell Housing

It is now pretty well-recognised that local authority zoning decisions can materially affect land values, creating an artificial scarcity in developable land and driving up the price of such land relative to the price land would otherwise command for alternative uses.    The best-known empirical study on this effect around Auckland (and the metropolitan urban limit in particular) was by Grimes and Aitken, summarised as follows:

We capture the impact of the MUL boundary on land prices by separately allowing for land which is: (i) well inside the MUL boundary,(ii) just within the boundary, (iii) sitting astride the boundary, (iv) sitting just outside the boundary, (v) sitting just a little further beyond the boundary, and (vi) sitting well beyond the boundary. We find a boundary land value ratio of between 7.9 and 13.2 (i.e. land just inside the MUL is worth around ten times more per hectare than land just outside it)

In a well-functioning liberal market, one might normally suppose that developable land on the periphery of an urban area would trade for around the value of that land in its best alternative use – typically agriculture.   If it went for much more than the agricultural use value, most farmers would be well-advised to sell, and they would do so until the prices in the alternative uses were more or less equalised.   The median sale price of dairy land is around $50000 per hectare.

Everyone knows that that is not remotely how things are in our highly distorted market.  But sometimes concrete examples bring home the point more starkly.

The other day a reader who knows something about property sent me a copy of a real estate agent’s newsletter on recent land sales in Dairy Flat, an –  as yet –  largely undeveloped area between Albany and Whangaparoa/Orewa, which is apparently classified as a “future urban zone”.    As my reader noted, the area does not yet have wastewater connections, so in his words “it is ages from development”.     Here were the sales in  July.

Total price ($) Parcel size (hectares)
1950000 1.557
1478000 1
2450000 2.493
2976000 3.189
1250000 0.303
1950000 0.9809

The average price of this land was $1.266m per hectare.

In our subsequent exchange, my reader noted that the value of this land for agricultural purposes might not be much more than $30000 per hectare.  He went on to point out that not that long ago 3800 hectares of forest land –  a little further inland than Dairy Flat, but similar terrain and a similar distance from central Auckland – had sold for $1700 per hectare.    In other words, the preferentially-zoned Dairy Flat land was selling as 750 times the price of the forest land.

Perhaps $1.266m per hectare doesn’t sound too bad.   But this is the unimproved value of the land –  none of any relevant earthworks have been done, no suburban streeets been formed, no development levies incorporated.  Even the holding costs for the few years until development actually occurs won’t be trivial (at, say, a low end estimate of a 10 per cent per annum cost of capital).  By the time tiny suburban sections are being sold to potential residents, they will have to be very expensive to cover the costs of someone now paying $1.266m per hectare.

And most of this “value” is simply added by politicians and bureaucrats drawing lines on a map.  It is obscene, and unnecessary.  It continues to skew the game against the young and those on relatively low incomes and/or limited access to credit, in favour of those who already have, or who can lobby councils to draw the lines in suitably limited places.

And, although I don’t have a time series of this sort of data, it doesn’t speak of any confidence among those actually buying and selling land right now that the next government –  of whatever political stripe – will make much difference in sorting out the shameful disgrace that is the New Zealand housing and urban land market.    I’ve long been sceptical, but these people are putting real money on such a call.  Perhaps they’ll be wrong and lose the lot.   But what reason is there to believe that is likely, when not one of our major political figures will even suggest that much lower house and land prices would be a desirable outcome towards which their party would be working?

Disagreeing with Don Brash on monetary policy

Michael Reddell labour party, Monetary policy

The Labour Party is campaigning on a couple of changes to the Reserve Bank Act.  One would make a statutory committee, rather than the Governor alone, legally responsble for monetary policy decisions, and would require the minutes of that committee to be published fairly shortly after the relevant meeting.   I don’t think that change goes far enough – and it doesn’t deal at all with the extensive (and much less constrained) decisionmaking powers the Bank has around financial institution regulation –  but if not everyone actively favours change, there aren’t now that many defenders of the (single decisionmaker, secretive) status quo.  Even Steven Joyce got The Treasury to commission some advice on possible changes, although his officials now refuse to release that report.

There is more dispute around the other limb of Labour’s proposed changes, in which they proposed to amend the statutory goal of monetary policy from “stability in the general level of prices” only “to also include a commitment to full employment”.

Earlier this week, so NBR reports, Grant Robertson and former longserving Governor Don Brash came head to head at BusinessNZ election conference.   Don thinks the proposed change is wrong and was reported as pointing to two reviews undertaken during the term of the previous Labour government, both of which saw no reason to change the statutory objective for monetary policy.

My initial reaction to the proposed Labour change was also sceptical, and I initially went as far as to describe it as “virtue signalling”.  I was discussant at an Victoria University event a few months ago where Robertson launched his policy, and this is how I summarised my view in a post written the following day.

I was (and am) much more sceptical, and nothing that was said in response to questions really clarified things much.    I get that full employment is an historical aspiration of the labour movement, and one that the Labour Party wants to make quite a lot of this year.  In many respects I applaud that.  I’m often surprised by how little outrage there is that one in 20 of our labour force, ready to start work straight away, is unemployed.  That is about two years per person over a 45 year working life.  Two years……     How many readers of this blog envisage anything like that for themselves or their kids?

But still the question is one of what the role of monetary policy is in all this, over and above what is already implied by inflation targeting (ie when core inflation is persistently  below target then even on its own current terms monetary policy hasn’t been well run, and a looser monetary policy would have brought the unemployment rate closer to the NAIRU (probably now not much above 4 per cent)).

I noted that I’m sceptical that the wording of section 8 of the RB Act is much to blame.  After all, for several years prior to the recession, our unemployment rate was not just one of the lowest in the OECD, it was also below any NAIRU estimates.  And when I checked this morning, I found that our unemployment rate this century has averaged lower than those of Australia, Canada, the US and the UK, and our legislation hasn’t changed in that times.  Robertson often cites Australia and the US.

The last few years haven’t been so good relatively speaking.  But if the legislation hasn’t changed and the (relative) outcomes have, that suggests it is the people in the institution who made a mistake –  they used the wrong mental model and were slow to recognise their error and respond to it.  Getting the right people, and a well-functioning organisation, is probably more important than tweaking section 8.

I stand by most of those individual comments.  But as I thought about things further, I’ve come to conclude that the direction Labour is wanting to go is the right one (although details matter, and there are few/no details).   If anything, one could mount an argument that defence of the current statutory formulation risks being “virtue signalling”.

Don Brash relies in part on the two enquiries undertaken in the term of the previous Labour government.  The second, conducted by Parliament’s Finance and Expenditure Committee, can largely be discounted.  It was set up in 2007 at time when there was quite a bit of caucus (and ministerial) discontent with the Reserve Bank –  the OCR had been raised again, and the exchange rate was again strong.   A lot of work went into the inquiry, and it reported in 2008, just weeks before the 2008 election.  But however much grumpiness there had been, a government-dominated committee was never going to come out a few weeks before an election their party looked like losing arguing that a key aspect of macroeconomic policy had been done badly throughout their term in office.

The earlier inquiry, conducted by Swedish economist, Lars Svensson at the request of the incoming Minister of Finance in 2000/01 would normally be a more potent argument.    Svensson was an academic expert in matters around inflation targeting and he was content to recommend retaining the statutory goal for monetary policy as it was.

So what has changed?   Robertson is quoted in the NBR article as saying that monetary policy has “enormously changed” since the international crises of 2008/09.  Here I simply disagree with him, and find myself (I think) strongly agreeing with the outgoing Governor of the Reserve Bank, who  notes that for all the talk it is remarkable how little change there has been in monetary policy anywhere.  Sure, interest rates are a lot lower, and various major central banks resorted to unconventional quantity-based measures to supplement their toolkit.  But there is no sign of any material change in any of those countries in how the goals of monetary policy have been specified (whether in statute or in more-operational documents).  As the Governor often notes, no one has abandoned inflation targeting, and no one has lowered (or raised) their inflation target.

Of course, if there was once in some circles a degree of hubris around quite how much good stuff central banks can deliver, much of that has now dissipated.  And the use of unconventional tools has raised questions about accountability, given that some of those tools can verge quite close to fiscal policy, for which legislatures are typically responsible.

But perhaps two relevant things have changed.  The first is Lars Svensson, who –  having had several years experience as a senior policymaker – now quite openly argues that flexible inflation targeting should involve a clear and explicit specification of an inflation target and  the identification of a sustainable long-run unemployment rate, with explicit weights assigned to deviations from these two variables.      I wrote at some length about Svensson’s view of these things in a post in April.   As I noted then

I don’t know specifically what Svensson would make of the current debate in New Zealand, or of what the Labour Party (at quite a high level of generality) is proposing.    What we do know is that Labour is proposing nothing nearly as specific or formal as Svensson argues for: there would be no numerical unemployment target or an official external assessment of the NAIRU (or LSRU).  My impression would be that his reaction would be along the lines of “well, of course the unemployment rate –  and short to medium term deviations from the long-run level, determined by non-monetary factors – should be a key consideration for monetary policymakers; in fact it is more or less intrinsic to what flexible inflation targeting is”.   He might suggest there are already elements of that in the PTA, but that making it a little more high profile, with an explicit reference to unemployment, might be helpful.

At the time, I suggested they might find it useful to get in touch with Svensson, who retains an interest in New Zealand.    Should they form the government after the election next month, he would be someone that they would be wise to consult, both in making their proposed legislative change, and in articulating a social-democratic vision of what should be looked for from a central bank.

The other thing that has changed over the last 15 years or so is our own central bank.   It is striking how little public attention they ever pay to unemployment, even though it is the most tangible measure of excess capacity – and one directly involving people’s lives and livelihoods.  But perhaps more striking still is the way in which they have conducted monetary policy in a way that has left the unemployment rate above any reasonable estimates of the NAIRU for eight years.    That would have seemed staggering to us when we were looking at getting inflation under control in the late 1980s –  when we knew that temporarily higher unemployment was a price of getting inflation down.  It is pretty inexcusable in today’s climate –  which doesn’t stop people making excuses.

And so I come back to the point I made in the remarks quoted above.   Getting the right person –  and people –  into the senior positions responsible for the conduct of monetary policy probably matters more than changing the statutory objective.  At the moment, an incoming Minister of Finance has no way of putting his or her preferred types of people in those roles –  all that power rests with the Board (the company directors and the like appointed by the outgoing government, with almost no accountability).  That needs to be tackled directly, and quickly.

But the way the statutory goal is expressed should affect expectations on the new Governor (and any committee that is established as part of governance reforms).    Over recent years, fear of booms seems to have driven the Governor (and his staff)  – with no statutory mandate at all –  and there has been no pressure on them to focus on delivering low and sustainable rates of unemployment.    Changing the Act  –  in the generalised way Labour seems to be talking of  – and not changing the sort of people making the decisions won’t have much impact at all.  But changing the Act in this area, can be one part of an array of changes that lead the Reserve Bank in future to put much more emphasis on unemployment, in public and in private, in the way that many other advanced country central banks do.  Policy is, after all, supposed to be about people.

What array of changes should any new government make?

  • a move to a decisionmaking committee, appointed by the Minister, and subject to parliamentary hearings before taking up the appointment,
  • making a low sustainable rate of unemployment (“full employment” if you must) a part of the statutory goal of monetary policy,
  • require the Reserve Bank to publish estimates of the NAIRU and, in the Monetary Policy Statement,  require them to explain reasons for any material deviations from those NAIRU estimates,
  • require the timely publication of minutes of the decisionmaking committee and (with a longer lag) of the background analysis papers provided to the committee, and
  • in the immediate future, change the Act to allow the Minister and Cabinet to appoint the new Governor directly (this is the normal way such appointments are made in other countries).  Getting the right person to lead these reforms is vital and there is no reason to think people like the current Board would deliver that person.

And just briefly on the substantive issue: the reason we have active discretionary monetary policy is because people have judged, over decades, that, were we not to do so, output and employment would be much more variable, and in particular recessions –  and periods of high unemployment –  would be more more savage and sustained than they need to be.   That is not a novel proposition now, and it isn’t even a particular controversial one (although some free bankers will point out that, say, the worst US recessions have been since the central bank was set up) –  it is a standard insight of modern macroeconomics.  Greeece is a particularly nasty example of the alternative approach.   That’s why I’m uneasy about those defending a single price stability goal for monetary policy: it may well be the medium-term constraint on what else monetary policy can do, it is one of desired outcomes we want to preserve (I say preserve because sustained inflation is a phenomenon of the central banking era, whereas longer-term price stability was a feature of earlier centuries), but it isn’t the main reason why we have active discretionary central banks.  We have such institutions primarily because we care about minimising the bad times –  sustained periods of excess capacity and high unemployment.  We aren’t –  or shouldn’t be – averse to booms (except to the extent they portend busts) but we should be, and mostly are, very averse to significant deviations from “full employment”.  Keeping unemployment as low as the other labour market institutions (welfare systems, minimum wages etc) allow could reasonably be seen as the primary goal of monetary policy.     Rising inflation would then be an indicator that the central bank had overdone things, and thus price stability represents a useful constraint or check on over-optimism about how low the unemployment rate can be got at any particular point in time.   At present however, defenders of the current specification of the goal can almost come across as if it is a point of virtue not to care, let alone to mention, about those who are unemployed.

Things were a little different in 1989 when Parliament was first debating the Reserve Bank legislation. Arguably it made a lot of sense then to put in a single goal of price stability –  because having lost sight of the constraint (price stability) in earlier decades, it was important to establish confidence that inflation would in future be taken very seriously.    That isn’t the main message we, the markets, or the Reserve Bank need to hear after years of below-target inflation, and even more years of above-NAIRU unemployment rates.

So although I have a great deal of respect for Don Brash, and these days count him as a friend, on this occasion I think he’s wrong and Grant Robertson is much closer to right.

Wage inflation: surprisingly high

Michael Reddell New Zealand economic performance, Productivity

There is plenty of talk about weak wage inflation, here and abroad.

Mostly, I have tried not to put too much weight on New Zealand wages data.  I’m not always consistent, and higher nominal wage inflation is probably one of things we should normally be expecting to see if core inflation was really heading back to 2 per cent.    But, one can’t really bang on about how there has been no labour productivity growth (reported by SNZ) for almost five years now, and expect much in the way of wage inflation.   And I’m not one of those who thinks that immigration surprises tend to dampen wages (relative to GDP per capita, or productivity, that is): they may do so in certain specific occupational areas where there is a particular large presence of migrants, but generally –  as New Zealand economists have believed for decades –  immigration surprises add more to demand (including demand for labour) than they do to supply, at least over the first few years following a migration influx.    With the unemployment rate still somewhat above most estimates of the NAIRU, one probably shouldn’t really expect much acceleration of wage inflation, but there isn’t any obvious reason why workers should be doing particularly poorly relative to the rest of the economy.   Overall, of course, the economy isn’t doing that well; weak per capita GDP growth, and no productivity growth.

But listening to Steven Joyce talking about wages on Morning Report this morning  prompted me to dig out and play with some relevant data.

My preferred measure of wage inflation is taken from the Labour Cost Index.  The LCI series that get lots of coverage purport to adjust for changes in productivity etc.  I don’t have a great deal of confidence in the adjustment (mostly because it is a bit of a black box to outsiders), and so I prefer to use the Analytical Unadjusted Index of private sector wages (ie the data before the productivity adjustments).

analy unadj wages

It is a relatively smooth series.  Wage inflation picked up a lot during the 2000s boom, slumped in the recession and after an initial recovery seems to have been tailing off somewhat since then.

But this is a measure of nominal wages.  And inflation is a lot lower than it was.  Here is the same series adjusted for the Reserve Bank’s sectoral core factor model measure of inflation.

real wages

It is a noisier series (suggesting that perhaps parties bargain in nominal terms, rather than having reals in mind), although it is pretty unmistakeable that the average rate of real wage increases has been lower in recent years than in most of the earlier period.   I could have done that chart with some smoothed moving average of CPI inflation but (a) lots of the short-term fluctuations in the CPI aren’t things that should affect wages (eg changes in ACC levies or tobacco taxes) and (b) doing so would actually only make the gap shown in the next chart larger and more striking.

Over time, one might expect real wage inflation to roughly equal the rate of growth in labour productivity.   Productivity growth is, by and large, the way living standards improve, and for most people real wages rates are an important element in their potential living standards.

One wouldn’t expect those relationships to hold in the very short-term. There are measurement problems in each of the series (wages, inflation, and productivity).  There is also a great of short-term volat5ility in the published series that are used to generate the productivity estimates.   And if labour is particularly scarce, or abundant, bargaining outcomes can easily differ for a time from what a productivity growth benchmark might suggest.  Finally, a sustained lift in the terms of trade can also lead to real wages rising faster than real productivity measures.

In this chart I’ve shown real wages (same measure as above) and smoothed growth in labour productivity (real GDP per hour worked).  I’ve taken the quarterly observations for the last two years, compared them to the quarterly observations for the previous two years (and so on) and then converted the result back into an annualised growth rate.  There are plenty of other ways of smoothing the series, but none is going to change the fact that we have had no (reported) productivity growth for a number of years now.   My particular measure provides a reasonably smooth series for productivity growth, consistent with my prior that to the extent inflation and productivity affect wage bargaining they are likely to do so in a smoothed or trend sense.   Anyway, here is the resulting chart.

real wages and productivity growth

It hasn’t been a particularly close relationship over the (relatively short) history of the data.  On average, real wage inflation (on this measure, although it is also true using a smoothed CPI measure of inflation) has grown faster than measured productivity over much of the period, perhaps consistent with the step up in the terms of trade from around 2004. (The remaining small upward biases in the CPI work in the other direction, understating real wage growth).

But the gap between the two lines at the end of the period is strikingly large and seems to have become quite persistent.  Real wage inflation –  although quite a bit slower than it was – still appears to be running much faster than productivity growth in recent years looks able to have supported.

If so, that represents a real exchange rate appreciation, representing a deterioration in the competitiveness of many of our producers.  Looking ahead, and since we can’t count on the terms of trade appreciating for ever (for all their ups and downs, over 100 years they’ve been basically flat)  we need to see some material acceleration in productivity growth or we are likely to see real wage growth falling away further still.   For all the talk of moderate wage inflation in countries such as the US, not many countries (and certainly not the US and Australia) have had no productivity growth at all in the last five years.  The puzzle in other countries may be why real wage inflation is so low, but here the focus should probably be on why it is still so high.

 

Capital gains tax: quite a few reasons for scepticism

Michael Reddell Housing, Taxation

Going through some old papers to refresh my memory on capital gains tax (CGT) debates, I found reference to a note I’d written back in 2011 headed “A Capital Gains Tax for New Zealand: Ten reasons to be sceptical”.  Unfortunately, I couldn’t find the note itself, so you won’t get all 10 reasons today.    But here are some of the reasons why I’m sceptical of the sort of real world CGTs that could follow from this year’s election.  Mostly, repeated calls for CGTs – whether from political parties, or from bodies like the IMF and OECD –  seem to be about some misplaced rhetorical sense of “fairness” or are cover for a failure to confront and deal directly with the real problems in the regulation of the housing and urban land markets.

Anyway, here are some of the points I make:

  • in a well-functioning efficient market, there are typically no real (ie inflation adjusted) expected capital gains.    An individual participant might expect an asset price to rise for some reason, but that participant will be balanced by others expecting it to fall.  If it were not so then, typically, the price would already have adjusted.  In well-functioning markets, there aren’t free lunches.    It also means that, on average, capital losses will be pretty common too, and thus a tax system that treated capital gains and losses symmetrically wouldn’t raise much money on average over time.   A CGT is no magic money tree.   And there is no strong efficiency argument for taxing windfalls.
  • if you thought, for some reason, that people were inefficiently reluctant to take risk, there might be some argument for a properly symmetrical CGT.  In such a system, the government would take, say, a third of your gains, but would also remit a third of your losses (the overall risks being pooled by the state).    The variance of an individual’s private after-tax returns would be reduced, and they might be more willing to take risk.   But, in fact, no CGT system I’m aware of is properly symmetrical –  there are typically tough restrictions on claiming refunds in respect of capital losses (one might only be able to do so by offsetting them against future gains).  There are some reasonable base-protection arguments for these restrictions, but they undermine the case for a CGT itself.
  • All real world CGTs are based on realised gains (and losses to an extent).   That makes it not a pure CGT, but in significant part a turnover tax –  if you never trade, you never pay (“never” isn’t literal, but tax deferred for decades discounts to a very small present value).    And that creates lock-in problems, where people are very reluctant to sell, even if their circumstances change or if a new potential owner could make much more of the asset, for fear of crystallising a CGT liability.  In other words, introducing a CGT introduces a new inefficiency to asset markets, making it less likely that over time assets will be owned by the parties best able to utilise them.
  • Basing a CGT on realised gains will also, over time, bias the ownership of assets subject to CGT to those most able to avoid realising the gains.  A long-lived pension fund, or even a very wealthy family, will typically be better able to  count on not having to sell than, say, an individual starting out with one or two rental properties, or some other small business, where changed circumstances (eg a recesssion or a divorce) might compel early liquidation.  Large funds are also typically better able to take advantage of loss-offsetting provisions.  The democratisation of finance and asset holding it certainly isn’t.
  • CGTs in many countries exclude “the family home” altogether.  In other countries, they provide “rollover relief”, enabling any tax liability to be deferred.  Most advocates of a CGT here seem to favour the exclusion of the family home, even though unleveraged owners of family homes already have the most favourable tax treatment in our system.  Again, a CGT applied to investment properties but not owner-occupied ones would simply trade one (possible) distortion for another.
  • In practice, most of the arguments made for a CGT in New Zealand have to do with the housing market.   But, on the one hand, all major (and minor?) parties claim that they have the fix for the housing market (various combinations of RMA reform, infrastructure reforms, changes to immigration, restrictions on foreign ownership, state building programmes or whatever).  If they are right, there is no reason to expect significant systematic real capital gains in houses.  If anything, real house prices should be falling –  a long way, for a long time.    Of course, prices in some localities might still rise at some point, if unexpected new opportunities appear.  But “unexpected” is the operative word.   Enthusiasm for a CGT, at least at a political level, seems to involve a concession that the parties don’t believe, or aren’t really serious about their housing reform policies.
  • Oh, and no one I’m aware of anywhere argues that a realisation-based CGT applied to (a minority of) housing has made any very material difference to the level of house prices, or indeed to cycles in house prices.
  • In general, capital gains taxes amount to double-taxation.    Think of a business or a farm.  If the owner makes a success of the business, or product selling prices improve, expected profits will increase.  If and when those profits are achieved, they would, in the normal course of affairs, be subject to income tax.  The value of the business is the discounted value of the expected future profits.  It will rise when the expected profits rise.  Tax that gain and you will be taxing twice the same increase in profits –  only with a CGT you tax it before it has even happened.   Of course, at least in principle, there is a double deduction for losses, but as noted above utilising losses (whether of income, or capital) is a lot more difficult.    If you think that New Zealand has had less business investment than might, in some sense, have been desirable,  you might want to be cautious about applauding a new tax that would fall heavily on those who took business risks and succeeded.
  • Perhaps double taxation of expected business profits doesn’t bother you.  But trying reasoning by analogy with wages.   If the market value of your particular skills has gone up, your wages would be expected to rise.  When they do you will pay taxes on those higher wages.  But by the logic of a CGT, we should capitalise the value of your expected future labour income and tax your on both that “capital gain” and on the later actual earnings.  Fortunately, we abolished slavery long ago, but in principle the two cases aren’t much different: if there is a case for a CGT on the value of a business, it isn’t obvious why one shouldn’t have one on the value of a person’s human capital.
  • (I should note here, for the purists, that there are other concepts of double-taxation often referred to in tax literature, none of which invalidate the point I’m making here.)
  • Real world CGTs also tend to complicate fiscal management?  Why?   Because CGT revenue tends to peak when asset markets and the economy are doing well, and when other government revenue sources are performing well.  CGT revenue doesn’t increase a little as the economy improves and asset markets increase, it increases multiplicatively.  And then dries up almost completely.  Think of a simple example in which real asset prices had been increasing at 1 per cent per annum, and then some shock boost asset prices by 10 per cent.  CGT revenue might easily rise by 100 per cent in that year (setting aside issues around the timing of realisations).  And then in a period of falling asset prices there will be almost no CGT revenue at all.   Strongly pro-cyclical revenue sources create serious fiscal management problems, because in the good times they create a pot of money that invites politicians to (compete to) spend it.  If asset booms run for several years, politicians start to treat the revenue gains as permanent, and increase spending accordingly. And if/when asset markets correct –  often associated with recession and downturns in other revenue sources-  the drying up of CGT revenue increases the pressure on the budget in already tough times.     It is easy to talk about ringfencing such revenue (mentally, if not legally) but such devices rarely seem to work.

None of this means that I think there is no case for changes in elements of our tax system as they affect housing.  The ability for business borrowers to deduct the full amount of nominal interest, even though a significant portion of that interest is simply compensation for inflation (rather than a real cost), is a systematic bias.  It doesn’t really benefit new buyers of investment properties (the benefit is, in principle, already priced into the market) but it is a systematic distortion for which there is no good economic justification   Inflation-indexing key elements of our tax system is highly desirable –  at least if we can’t prudently lower the medium-term inflation target –  and might be a good topic for a tax working group.  In the process, it would also ease the tax burden on people reliant on fixed interest earnings (much of which is also just inflation compensation, not a real income).

Of course, at the same time it would be desirable to look again at a couple of systematic distortions that work against owners of investment properties.  Houses are normal goods and (physically) depreciate.  And yet depreciation is no longer deductible.  Perhaps there was a half-defensible case for that when prices were rising seemingly inexorably –  but even then most of the increase was in land value, not in value of the structures on the land –  but there is no justification if land reform and (eg) new state building is going to fix the housing market.    Similarly, when the PIE system was introduced a decade or so ago, it gave systematic tax advantages to entities with 20 or more unrelated investors.  Most New Zealand rental properties historically haven’t been held in such entities.  There is no good economic justification for this distinction, which in practice both puts residential investment at a relative tax disadvantage as a saving option, and creates a bias towards institutional vehicles for holding such assets.  Institutional vehicles have their own fundamental advantages –  greater opportunities for diversification and liquidity –  but it isn’t obvious why the tax system should be skewing people towards such vehicles rather than self–managed options.  As noted above, any CGT will only reinforce that bias.  Funds managers, and associated lawyers and accountants, would welcome that. It isn’t obvious why New Zealand savers should do so.

I see that there are more than 10 bullet points in the list above.  I’m not sure it covers all the issues I raised in my paper a few years ago, but it is enough to be going on with.

And in all this in a country where we systematically over-tax capital income already.  I commend to readers a comment on yesterday’s tax post by Andrew Coleman, of Otago University (and formerly Treasury).  As Andrew noted:

Somehow, New Zealand’s policy advising community decided it would restrict most of its attention to the ways income tax could be perfected rather than question whether income taxes (which are particularly distortionary when applied to capital incomes) should be replaced by other taxes. It is almost as if we have the Stockholm Tax Syndrome – fallen in love with a system that abuses us.

A broad-based capital gains tax would just reinforce that problem.

 

Treasury not convinced about the economic strategy?

Michael Reddell Exports, Treasury

Or so it would seem from looking at the forecast tables accompanying today’s PREFU.

Recall that the government has long had a goal of materially increasing the share of New Zealand’s GDP accounted for by exports (with, presumably, a more or less matching increase in imports).  As I’ve highlighted on various occasions –  yesterday most recently – if anything the actual export share of GDP has been shrinking.

Here is the share of exports in GDP, showing actuals for the last decade or so, and Treasury’s projections for the next few years.

x to gdp

By the end of that forecast period, there will only be four more years until the goal of a much-increased export share of GDP was to be met.  On these numbers, exports as a share of GDP would by then be at their lowest since 1989, 32 years earlier.  So much for a more open globalising economy.

(The government actually specifies their target as the ratio of real exports to real GDP, while this chart is nominal exports to nominal GDP.    Statisticians generally advise against using the real formulation.  But on this occasion, it doesn’t make much difference either way.    Over the five forecast years, the volume of exports is forecast to rise by 10.8 per cent, and real GDP is forecast to rise by 15.6 per cent.   Whichever way you look at it, The Treasury expects the export share of the economy to carry on shrinking over the next few years.)

In many respects that isn’t very surprising.  Treasury expects no fall in the exchange rate at all over the period, and they expect rapid increases in the OCR from around the end of next year.  And they expect continued rapid population growth.

It is a non-tradables skewed economy, and while there is nothing intrinsically wrong with non-tradables, it isn’t usually a successful path for countries seeking to achieve higher productivity and sustained national prosperity.    (Although Treasury does forecast that six years of zero productivity growth will finally come to an end, and we’ll have respectable productivity growth from 2019 onwards.  What this is based on, who knows.  We can hope I suppose.)

 

 

Taxing business

Michael Reddell Taxation

One subject that seems destined to get little attention in the current election campaign is the appropriate tax rate to be applied to business income.  As I’ve noted previously, our company tax rate is now in the upper third of those in OECD countries.  And if there is any discussion at all in this campaign, it seems more likely to centre on plans to raise more money from companies –  foreign companies anyway.   The government has just announced measures designed to have that effect, and parties on the left seem keen on doing even more, under the cover of OECD-coordinated moves in that direction.

I was talking to some tax people yesterday, which prompted me to dig out the OECD data on company tax rates and company tax revenue.  Both matter.  A country can have quite a high statutory headline company tax rate but also have so many exemptions, deductions etc, that the company tax doesn’t actually raise that much money.  The United States is a good example –  the general government corporate tax rate is 38.9 per cent, the highest in any OECD country, and yet corporate income tax receipts are only 2.2 per cent of GDP, well below the median OECD country.  Corporate tax reform is well overdue in the United States (although my money is on nothing very fundamental happening in the current presidential term).

What about New Zealand?

Here is a chart, using OECD data, showing company tax receipts as a share of GDP for New Zealand (blue) and for the median OECD country (orange), all the way back to 1965.

corporate tax revenue

We take a much larger share of GDP in company tax revenue than most OECD countries do.  In fact, in recent years, the only countries that have taken a larger share have been Australia, Chile, Norway, and Luxembourg.   Given the importance of minerals in the first three of those countries, the company tax receipts may include a large chunk of what might be better described as resource rentals  (and in addition production processes in those extractive sectors tend to be quite capital intensive).

But several other things struck me:

  • the rising trend in company tax receipts as a share of GDP over the last 30+ years.  It probably isn’t the impression most people have when you hear all the talk about taxing (or not taxing) multinationals.    Presumably part of the increase will have been accounted for by the larger share in overall national income now accounted for by returns to capital in many countries.
  • just how large the gap was between the New Zealand line and the OECD line at the start of the period (and, hence, how much of a convergence happened during the period when Sir Robert Muldoon was our Minister of Finance –  most of the time from 1967 to 1984).
  • and the substantial rewidening of the gap since the reforms of the late 1980s.  The broad-base low(er) rate strategy seems to have raised a great deal of revenue.

But it does leave me with at least two questions:

  • why has New Zealand typically raised so much more (per cent of GDP) in company tax revenue than most other OECD countries?
  • is this a sensible approach to tax policy, particularly in the context of our long-term structural economic underperformance.

In the earlier decades, a heavily protected economy probably meant a business sector that was ripe for the (headlines of) plucking.    Between the non-tradable service sectors and the highly-protected manufacturing sector, there was plenty of scope to pass increased business costs, in the form of high headline business taxes, on to domestic consumers.  The export sector was mostly based around family farms –  and probably didn’t pay much company tax.  But bear in mind that exports as a share of GDP were shrinking through this period – high internal domestic costs (including business taxes) also help to erode competitiveness.

These days the economy is much less protected, but we are still back to taking a much larger share of GDP in company tax than most other countries do.  Many of our biggest tax paying firms are foreign-owned  (apparently around 40 per cent of all company tax revenue is paid by foreign-controlled firms), which command little public sympathy or support.  The Australian banks are perhaps the most prominent example.   Perhaps it looks like a “free lunch” to tax heavily such operations?

(In principle, our dividend imputation system  –  also adopted in Australia –  may act to make people more relaxed about conducting business through a corporate vehicle, since for domestic shareholders there is no double-taxation of dividends.  I don’t know whether this will be part of the explanation, although I’d be surprised if it explained much, given the other advantages of limited liability.)

And our large share of company tax revenue as a share of GDP isn’t just because New Zealand taxes everyone heavily –  in fact, our tax revenue as a share of GDP doesn’t stand out as being high.  Here is the chart showing company tax revenue as a share of total tax revenue (NZ in blue, OECD median in orange).

coy tax revenue

Our heavy reliance on company tax revenue looks to be a deliberate choice to favour that soource of revenue.

Whatever the reason for why we take such a large share in company tax, it seems unlikely to be a sensible element of a successful economic strategy.    It is well-known that business investment as a share of GDP has been quite low in New Zealand for many decades.  It is one of the more obvious symptoms of our economic underperformance.  We also now have a quite moderate level of inward foreign investment.  It seems at least plausible that the tax regime might be one part of the explanation –  after all, particularly for foreign investors, the choice to operate here (or not) is purely an economic one, influenced largely by the expected after-tax returns, and the risk around those returns.   For foreign investors (who can’t take advantage of imputation credits) the New Zealand company tax rate should matter a lot.    Partly for that reason, the estimated deadweight costs of business taxation are far higher than those for most other taxes. You get less of what you tax, and foreign investment is likely to be particularly sensitive to taxes.

The OECD data on company tax rates does not go back as far.  But here is how our rates have compared to those of:

  • the median OECD country, and
  • the median “poor” OECD country (ie those who’ve had consistently lower GDP per capita or productivity than New Zealand).

corporate tax rates Of the “poor” OECD countries, only Mexico and Portugal now have higher company tax rates than we do.  Whereas most of the “poor” countries are closing the income/productivity gaps to the richer OECD countries, Mexico and Portugal (and New Zealand) aren’t.  I’m not suggesting it is the only factor by any means, just highlighting the choice that the more successful converging countries have been making.

In much of the debate around these issues, all the focus is one who writes the cheque, not on who actually bears the burden of the tax (the incidence).  Foreign investors, for example, will have target after-tax rates of return.  Higher tax rates discourage reinvestment in the business, discourage new investment, and in time result in lower average productivity and lower wage rates.    By contrast, lowering business taxation is a pro-growth, pro working people, policy.

Again, there is a tendency to discount this point with a response along the lines of “look at all the existing investment; cut taxes on the profits on those businesses and it is just a windfall transfer to existing owners”.     That often seems particularly unappealing if the owners are foreign –  as if it was a pure welfare loss to New Zealanders.     The banks are good example of what bothers people –  mostly owned by big Australian operations.  But actually, the banks are a sector where lower tax rates offer the prospect of genuine savings across the board, for all users of financial services in New Zealand, even if the size of the banking sector itself doesn’t change much.   Cut taxes on banks’ profits and, over time, you’ll find fees and interest margins falling.  Not from the goodness of a bank’s heart, but from the competitive process at work, as each competes for market share and finds they can discount their pricing a bit more and still deliver on Sydney or Melbourne’s after-tax return expectations.

I don’t think we should be making tax policy specifically to favour foreign investors over domestic ones –  which would be the effect of simply cutting the company tax rate – but I do think there is a good case for materially lower taxes on business income.  I’ve argued prevously for a Nordic system, in which capital income is taxed at a lower rate than labour income.  A more ambitious approach still would be to work towards the development of a progressive consumption tax.   Whatever the precise solution, the current arrangements –  high rates of company tax, high shares of GDP taken in company tax – don’t look like the right answer if we serious about lifting economic performance in New Zealand, and with it raising the capital intensity of production in New Zealand.

(Commenters on previous posts have asked whether I’m being consistent, in calling for lower business tax rates and at the same time noting the serious limitations of our remoteness.   I certainly accept that if we were adopt the Irish company tax policy it would not have the scale of benefits for us it has had for Ireland.  But an integrated economic strategy for New Zealand would also involve lower real interest rates and a lower real exchange rate, and in conjunction with lower business tax rates, that would be likely to bring forth quite a range of new business investment –  in some cases in new sectors (or retaining firms in New Zealand that might otherwise relocate), and in other cases, adopting more capital intensive (ie higher labour productivity) modes of production in existing sectors, including agriculture.)

The Labour Party is campaigning on establishing a tax working group if it forms the next government.  I hope they envisage something more than just a tidy-up and a recommendation for a capital gains tax, and that in thinking now about the possible terms of reference for the proposed tax working group –  which they will presumably want to move quickly on once in office –  they are willing to cast the net rather wider, and invite the proposed group to consider connnections between the design and balance of our tax system and our overall economic performance.   Higher taxes on business – especially the dreaded multinationals – might be some sort of “progressive” shibboleth, but in fact lower business taxes should be an option that any seriously progressive government, concerned to lift living standards for all, takes very seriously.

 

Economic performance

Michael Reddell Exports, New Zealand economic performance, Productivity

The second half of the Grant Robertson/Steven Joyce debate on Sunday was around things to do with overall economic performance and management.

On one thing they agreed: Winston Peters’ proposal that New Zealand should adopt a Singapore-style approach to monetary policy and the exchange rate isn’t an option for New Zealand.  I agree with them, and explained why in a post a few months ago.

Grant Robertson reminded viewers that John Key had promised to close the gaps between New Zealand incomes and productivity and those in Australia, noting that no progress has actually been made.   Steven Joyce likes to push-back by citing numbers that suggest that after-tax real wages have been rising faster here than in Australia.    When I’ve looked at that claim previously, a lot appeared to depend on which exchange rate one used to convert wages in the two countries into a common currency.  Using PPP exchange rates, the gap has actually widened a bit further.    Comparing wage series across countries isn’t that easy –  countries measure things differently, and things that are effectively part of remuneration (eg employer superannuation contributions) often aren’t included.

Personally, I prefer to focus on economywide measures, which are compiled in a consistent manner across countries.   Here is real GDP per capita for the two countries, indexed to 2007q4, just before the global downturn/recession began.

real gdp pc nz and aus

I could have started the chart a few quarters later, to coincide with the change of government.  Either way, no progress at all has been made in closing the gap to Australia.

Things look worse if we focus on labour productivity (real GDP per hour worked).

real gdp phw nz and aus aug 16

Best summary?  We haven’t lost much ground against Australia when we focus on GDP per capita, but since relative productivity has dropped away badly we’ve only maintained even that mediocre real GDP per capita record by working even longer hours on average.

But if the government’s record is pretty poor, it isn’t clear that the Labour Party is offering anything much different.   It is all very well to criticise the current government for making no progress in closing the gaps, but Labour doesn’t even seem to be talking about doing so.    Robertson did highlight the four or five years now of zero productivity growth, and talked of needing a plan for something different.  But it wasn’t obvious from anything he said, or anything I’ve read, quite what the plan is, that might be equal to the challenge.   There is plenty of talk of lifting skills –  but the OECD data already suggest New Zealand skills levels are among the very highest among advanced countries.    There is talk of a tax working group, with an apparent presumption that that is likely to lead to a capital gains tax.  And there is talk of R&D tax credits.  But I doubt anyone –  even those who support such measures – believes that they are remotely enough to make the sort of difference closing the gaps to Australia might involve.

Of course, the National Party’s position seems no better.  The Minister’s rhetoric is that people are voting with their feet and realising that the jobs and incomes are now here.  Sure, the annual outflow of New Zealanders to Australia has dropped, but it is still an outflow each and every year.   And no one seriously thinks other than that average incomes in Australia remain much higher than those here.  But it is tougher to get established in Australia at present –  that’s a bad thing for New Zealanders, not a good one.

Steven Joyce was touting the success of certain subsets of firms exporting from New Zealand.  It is perhaps easy to forget that the government has long had a goal of substantially increasing the export share of GDP (and, presumably, the import share, since we export to import –  sell stuff to other people so that we can consume ourselves).

Here are exports as a share of GDP.

exports joyce It is easy for one’s eye to go to those peaks in 2000 –  at a time when the exchange rate had fallen sharply – but even much more recently the trends haven’t been favourable.  Even the vaunted services exports are lower now as a share of GDP than they were 10 years ago, or than when the government came to power.   The Minister talked of “high-tech value-added manufacturing” as the future, but then overall goods exports are lower as a share of GDP now than at any time in the last 30 years.

Mr Joyce talked of a slump in global trade, as if our experience was just something like everyone else had experienced.  But even that isn’t true.     The share of exports in GDP for the median OECD country has increased by around 5 percentage points in the last decade.  In that decade before that, it increased by about 6 percentage points.

And for all the talk of services exports, here are exports of services as a per cent of GDP for New Zealand and the other small OECD countries.

services x small countries

Grant Robertson was prepared to go as far as to say that the exchange rate is “too high”.  Artificially lowering it wasn’t, we were told, the answer (and I’d agree, if by that he meant eg a Singapore-style monetary policy).  But there was no hint of how Labour thought a lower exchange rate might be brought about in a more sustainable manner.

New Zealand has faced some obstacles to growing the tradables sector of our economy in the last decade.  The earthquakes meant that real resources had to be used for other things –  repair and rebuild –  and other activities had to make room.  Policymakers have known this since the very days after the earthquakes occurrred.  The substantial amount of offshore reinsurance just reinforced the way in which the earthquakes represented a large shock skewing the economy for a time more towards the non-tradables sectors.

But what was extraordinary is that the same policymakers allowed, and cheered on, another even bigger non-tradables-skewing shock.

Here is a chart showing cumulative population growth since National took office, and the cumulative inflow of non-citizens (the PLT data, with all their pitfalls).

popn and immigration

We’ve had a 510000 increase in population over the term of this government, 421000 of which is accounted for by the net inflow of non-citizens.    The fertility and migration choices of New Zealanders would, all else equal, have given us only around 2 per cent population growth over the eight and half years, putting a great deal less pressure on

  • housing markets
  • other infrastructure
  • the physical environment, and
  • the tradables sector as a whole.

Remember that each new arrival need a lot more physical capital stock than is accounted for by the labour those people supply early on.   Policy has been deliberately skewing our economy away from the tradables sector.    We’ve had a net non-citizen migration inflow of almost exactly 300000 people in just the last five years.   With no productivity growth at all in that time, and an export (and import) sector shrinking as a share of GDP, and business investment pretty subdued too, one might reasonably ask ‘to what end?’ for New Zealanders.

We should be left wondering why, if we vote for them, either main party expects anything different than the mediocre economic performance of the last few years.   Gareth Morgan criticised Labour’s apparent lack of much policy substance  as “putting lipstick on a pig”.  It isn’t obvious that the National Party is even offering the lipstick.

And all this is without even repeating for the umpteenth time that the unemployment rate now is still higher than it was at any time in the last five years of the previous Labour government, at a time when demographics appear to be lowering the natural rate of unemployment.  Or the underutilisation rate of almost 12 per cent.      We should be able to do a great deal better for New Zealanders.

 

Submission on the DTI proposals

Michael Reddell Financial stability, Housing

Submissions close today on the Reserve Bank’s consultation on its proposal to add a debt to income limit tool to the approved list of possible direct controls on bank housing lending.

Despite the Prime Minister’s comments the other day, I don’t regard this as a “dead duck” at all.  The Reserve Bank won’t be coming back to the Minister of Finance with its recommendation, in light of the consultation, until after the election, and who knows what the political or housing market climate will be like by then.  Graeme Wheeler will be gone by then, and so the Reserve Bank’s decision will be in the hands of the (illegally appointed) acting Governor, Grant Spencer, and new Head of Financial Stability (and presumed Governor-aspirant) Geoff Bascand.  Perhaps they will have less appetite for controls than Wheeler has had –  both come from backgrounds that were not particularly keen on direct interventions –  but for now we have to assume that the proposal will continue to move ahead.

As I noted earlier in the week, there is a lot of useful and detailed material in Ian Harrison’s paper on the DTIs, which I gather he is putting in as a submission.

I ummed and aahed about whether to make a submission.  In one sense, it is a pure waste of time, since the Bank is unlikely to grapple very seriously with any points I make.  But, on other hand, it is good to have alternative perspectives, and questions, on the issue out there, and just possibly it might provide some angles for people with a bit more influence than I have.

So I did write a fairly brief submission.  My overview and summary is here

Overview

I am firmly against adding any sort of serviceability restriction (henceforward “DTI”) to the list of possible controls.  The Reserve Bank has failed to mount a convincing case, and has not demonstrated that it (or anyone) has the level of knowledge required for such restrictions to operate in a way likely to make New Zealanders as a whole better off.  Such restrictions would appear to go well beyond the Reserve Bank’s statutory mandate (contributing little or nothing to soundness and eroding the efficiency of the financial system), and a better cost-benefit analysis would in any case suggest that such controls would probably be welfare-detracting.   Other instruments (such as capital requirements and associated risk weights) that do not impinge directly on the borrowing and lending options open to individuals and firms remain a superior way to manage any future risks to the soundness of the financial system.  Serious microeconomic reform remains the best route to fix the serious housing affordability/land price problems.

As a reminder, the Reserve Bank has no statutory mandate to target house prices or the level (or growth rates) of credit in the New Zealand economy.   It also has no “house purchaser or borrower protection” mandate.  Restrictions of the sort proposed in the consultative document would represent serious regulatory over-reach.

The fact that a handful of advanced economies have deployed somewhat similar tools is little comfort or basis for support for the Reserve Bank’s own proposals.  Bad policy elsewhere isn’t a good reason to adopt bad policy here.  But more specifically, the interests of regulators themselves and of citizens are not necessarily, or naturally, well-aligned, a point that Reserve Bank material rarely if ever addresses.  For example, the Reserve Bank makes much of the British and Irish DTI limits (which do not apply to investment properties, where the consultative document says the Reserve Bank would want to focus), but never addresses the institutional incentives facing regulators in those countries following the financial crises each experienced in 2008/09 (the typical regulator incentive in the wake of a crisis to overdo caution –  and “to be seen to be doing something”, in the regulator’s own bureau-protection interests).     On the flip side, neither in the current consultative document nor in past Reserve Bank material has the Bank seriously engaged with the experience of housing loan portfolios in floating exchange rate countries during the 2008/09 crisis.  In countries like ours –  including Australia, Canada, the UK, Norway, Sweden, as well as New Zealand –  residential loan books emerged largely unscathed, despite big credit and housing booms in the prior years, and the subsequent nasty recession and, in most of these countries, a sustained period of surprisingly low income growth.

There has also been no evidence presented that banks have been systematically poor at making and managing portfolios of loans secured by residential mortgage, let alone that citizens should have any confidence in the ability of (and incentives on) regulators to do the job better.    Anyone can suppress overall credit creation with tough enough controls, but to what end, at what cost, to whom?     Controls of the sort now proposed, and the sorts of LVR restrictions already extensively used, seem to represent ill-targeted measures, based on an inadequate model of house and land prices.  They temporarily paper over symptoms –  house prices driven high by the failures of regulation elsewhere require high levels of credit – rather than address the structural causes of the housing market problems.     And because they seem to be premised on a model that wrongly treats credit as a leading factor in the housing market problems, they also do little to address any (limited) financial stability risks.  And in the process, they systematically favour some groups in society over others –  the sorts of distributional choices that, if made at all, should be made only by elected politicians, not by an unelected official.

A reasonable starting proposition would be that in the 25 years prior to the imposition of LVR restrictions the New Zealand housing finance market had been efficient and well-functioning.  Lenders lost little money, more borrowers could get better access to credit than in the earlier regulated decades, borrowers had no need to concern themselves with the changing details of Reserve Bank regulatory restrictions, there were no rewards to special interest group lobbying and rent-seeking, and competitive neutrality among different classes of lending institutions prevailed.  Perhaps the Reserve Bank would disagree with that characterisation of the market, but if so then, in proposing still further extensions of its regulatory intervention powers, surely the onus should be on you to make your case, not simply to ignore the past, apparently successful, experience?

Anyone interested can read the whole document here

Submission to RBNZ consultation on DTI proposal Aug 2017

The DTI proposal is a tool to address, inefficiently, a problem that isn’t there (threats to the soundness of the financial system), while appearing to try to do something about an actual serious problem (house and urban land prices), of successive governments’ making, about which the DTI tool can do little or nothing useful.  It won’t help, and if anything it distracts attention from the real issues, and from those really responsible, for the disaster that is the New Zealand housing “market”.

Misconceived and deeply flawed

Michael Reddell Financial stabilty, Housing

Later this week submissions close on the Reserve Bank Governor’s attempt to get the some sort of debt to income restriction added to the list of possible direct controls on banks upon which the government has bestowed its favour.  (I write it in that slightly awkward way because, by law, the Governor does not need the Minister’s permission at all –  Parliament, somewhat recklessly, appears to have given all those powers to the Governor personally, but a few years ago the Governor committed to only using restrictive tools that the government had approved of.)

This would be the latest in the series of direct interventions by which the Reserve Bank has been undermining the effectiveness and efficiency of the housing finance market.  For now, the (outgoing) Governor says he wouldn’t apply a debt to income restriction even if he had the Minister’s imprimatur.  But all it will need will be another rebound in the property market and Wheeler would no doubt be keen.  Whether his permanent successor next year shares that enthusiasm is, I would hope, something the Board and the (next) Minister turn their minds to in considering possible candidates for Governor.

I probably will put in a submission, but if so it will overlap in many areas with the paper just published by my former colleague (now Tailrisk Economics) Ian Harrison.    Ian spent many years in the prudential supervisory wing of the Reserve Bank and led the work on risk modelling that has underpinned the Bank’s positions on capital, risk weights etc.  He has previously written and published his critical analysis on the Reserve Bank’s decision to treat residential mortgage loans owed by investors as riskier than the same loan on the same security when owed by owner-occupiers.  It was published under the somewhat provocative title House of Cards – and I wrote about it here.

His new paper on the proposal to have a debt to income instrument available doesn’t have a provocative title.   But it is no less forceful in its conclusions.  Here is the bulk of Ian’s press release

A report by Tailrisk Economics on the Reserve Bank’s justifications for possibly imposing debt to income (DTI) limits on housing lending, shows that that they are deeply flawed.

The main problem is that the DTI is a crude tool that does not adequately assess borrowers’ debt servicing capacities, and which will perversely target better quality loans.

“The Reserve Bank has presented no substantive evidence that higher DTI loans are ‘excessively’ risky, or that a DTI ratio of 5 is a sensible cut-off,” said Ian Harrison, Principal of Tailrisk Economics, “but there is significant evidence that DTIs do not predict loan defaults, or reduce the likelihood or severity of crises”. The European Systemic Risk Board found, in a recent assessment of GFC performance, that DTI levels did not have any “relevant effect either on the prediction of the crisis or on the depth of the crisis” .

The application of the DTI limit to investor loans, which are the primary focus of the policy, is particularly misconceived, because DTI limits are only intended to apply to owner occupier borrowers. The DTI measure assumes that when investor purchases a new property their living expenses increase. “This simply does not make sense”, Harrison commented.

The effect of the policy could be to impose an effective LVR limit as low as 30 percent on professional investors.  No other country has imposed DTI restrictions on investor loans.

“Higher future interest rates do not pose a material systemic risk, providing the conduct of monetary policy is competent”  Harrison added. “Further, the Bank’s assessment that the restrictions would have a net welfare benefit, is very optimistic. Our assessment is that they will have  a welfare cost, like most misconceived quantitative interventions.”

Much of the case the Reserve Bank seeks to make for having the ability to use a debt to income limit rests on the assumption that banks don’t do risk management and credit assessment well and that, inevitably crude, central bank interventions will do better.  The Bank’s consultation paper makes little or no effort to engage on that point at all.  It provides no evidence, for example, that the Reserve Bank has looked carefully at banks’ loan origination and management standards, and identified specific –  empirically validated –  failings in those standards.  Neither has it attempted to demonstrate that over time it and its staff have an –  empirically validated –  superior ability to identify and manage risks appropriately.

One of the Reserve Bank’s bugbears is that while the current lending practices may look broadly okay at current interest rates, those same loans will look rather less sound if interest rates rise considerably.  Of course, banks already take into account the resilience of each borrower, including their ability to cope with unexpected changes in servicing costs.    I wrote about this in my post on the most recent FSR.

… there was something a little odd in the box the Bank included on “Vulnerability of owner-occupiers to higher mortgage rates“, clearly softening us up for the consultation paper on debt to income ratios.  They argue that

New Zealand is particularly vulnerable to a sharp rise in mortgage rates as the banking system funds a large proportion of its mortgage credit from offshore wholesale markets. The cost of this funding can increase sharply if there is an unexpected increase in global interest rates or a change in investor risk appetite, and banks are likely to pass on the higher funding costs to customers through higher mortgage rates.

But mostly this is just untrue.  The Reserve Bank sets the OCR in New Zealand based on overall inflation pressures in New Zealand.  If funding spreads rise –  as they did in 2008/09 –  and domestic inflation pressures don’t the Reserve Bank can easily offset most or all of the potential impact on retail interest rates by lowering the OCR.    That is what happened in 2008/09.

Of course, retail interest rates can rise, quite materially.  As the Bank points out, new floating mortgages rose from “around 7 per cent to over 10 per cent between early 2004 and 2007”.  Of course, as we used to stress at the time, fixed mortgage rates rose nowhere near that much.  But, more importantly, interest rates here didn’t rise because foreign rates were rising, but because the economy was cyclically strong, unemployment was low and falling, and wage and price inflation were increasing.  Wages rose roughly 20 per cent in that period.

It is fine and good for the Reserve Bank to do these sorts of stress-testing exercises, looking at what happens if interest rates rise to 7 per cent, or 9 per cent.  But in any realistic assessment, those sorts of substantial increases are only remotely likely if the economy is doing really cyclically well.  If jobs are readily available and wages are rising, not many people will be under that much stress even if interest rates rise quite a lot.  And those that are should quite readily be able to sell their house and move on.  It might be painful for them, but it simply isn’t a financial stability event.

Ian makes many of the same points, including

Financial  stability  will  only  be  threatened  if  there  is  a  large  number  of  borrowers   who  can  not  service  their  loans,  and  if  there  is  a  material  fall  in  house  prices.      If   house  prices  hold  up  through  the  interest  rate  cycle  then  borrowers  who  come   under  servicing  pressure  will  generally  be  able  to  resolve  their  problem  by  selling  the   house.  A  systemic  problem  only  starts  to  arises  if  the  interest  rate  increases  cause  a   large  fall  in  house  prices.    However,  if  this  did  occur  then  RBNZ  could  readily  respond   by  reducing  the  OCR.  It  is  almost  inconceivable  that  a  large  house  price  shock  would   not  feed  through  into  broader  economic  activity,  and  into  the  inflation  rate,  which   would  naturally  require  a  monetary  policy  response.    Mortgage  interest  rate  would   fall  and  the  pressure  on  borrowers’  servicing  capacity  would  be  relieved.

He also rightly highlights how unusual it is to propose including investor loans in a debt to income limit.  The Reserve Bank likes to highlight the debt to income limits adopted by the United Kingdom and Ireland, but simply hasn’t engaged with the fact that neither country includes investor loans in its limits.   Of the Bank of England Ian notes

The  Bank  of   England  has  the  legal  capacity  to  apply  DTI  limits  to  investor  lending,  but  has  not  done  so,   because  the  retail  DTI  limits  do  not  readily  translate  to  investor  lending.  Instead  the  Bank   requires  banks  to  meet  minimum  qualitative  standards  in  their  affordability  assessments.  In   addition,  banks  are  required  to  apply  a  2  percentage  point  stress  test  to  the  interest  cost   assessment,  and  the  test  rate  must  be  at  least  5.5  percent.  Where  buy-­‐to-­‐let  borrowers  rely   on  other  income  to  support  the  loan,  account  must  be  taken  of  taxation  and  living  costs.  This   is  basically  the  methodology  that  New  Zealand  banks  apply  to  retail  investment  lending.   There  are  no  further  quantitative  restrictions  such  as  times  interest  cover.  This  is  left  to   individual  bank’s  assessments.

In its assessment of submissions, the Reserve Bank should really be expected to provide rather more justification for the inclusion of investment loans than it has done to date.

Ian concludes his press release this way

“There are simpler, and less distortionary, ways of targeting ‘excessive’ house price rises, which appears to be the Bank’s primary motivation for DTI restrictions,” Harrison said. “Banks could be required to apply a prescribed higher test interest rate to affordibilty assessments.  This would provide the Reserve Bank with an interest rate policy tool that can be directed to imbalances in the housing market.”

His is a pragmatic response.   Mine is perhaps more hardnosed –  and perhaps less “realistic”.  It is no business of the Reserve Bank to be targeting house prices, targeting whether investors or owner-occupiers are buying, or even targeting levels of household debt.  Apart from anything else, they have no robust model of the housing market, or of the incidence of financial crises, and without those all they appear to have is gubernatorial whim, or the shifting winds of political preferences.  That is no basis for sound public policy.     The Bank –  and its political masters –  needs to be reminded of its mandate in this area: to promote the soundness and the efficiency of the financial system.  Direct controls that apply to one set of lenders and not others, to one set of loans and not others, to one class of borrowers but not others, are quite simply inferior on both limbs of that mandate to reliance on indirect instrument, such as capital standards, stress tests, and a deeply informed understanding of how banks are measuring, monitoring and managing risk.   To their credit, banks in countries like ours appear to have done a good job in recent decades of managing housing loan books.  It is a shame that the same cannot be said of the central and local government politicians and officials who have regulated urban land markets to the point where a house purchase is an increasingly impossible dream for too many of our fellow citizens.    How did we allow such disastrous outcomes?

Anyway, for anyone interested in the DTI proposal I’d commend Ian’s paper.  I don’t agree with everything in it, but is a detailed review of many of the relevant issues, and of the “evidence” the Reserve Bank seeks to rely on.  I hope that, for example, the Treasury will pay careful attention when they formulate their advice on the Reserve Bank inevitable (regardless of this “consultative process”) bid for approval to add debt to income limits to their toolkit of direct controls.

 

Doomed to repeat history…..or not

Michael Reddell Financial stability, Monetary policy, New Zealand economic performance

Last week marked 10 years since the pressures that were to culminate in the so-called “global financial crisis” burst into the headlines .

Local economist Shamubeel Eaqub marked the anniversary in his Sunday Star-Times column yesterday.  It grabbed my attention with the headlines “Ten years on from the GFC” and “We appear dooomed to repeat history” .  

Frankly, it all seemed a bit overwrought.

It seems inevitable that there will be yet another crisis in the global financial system in the coming decade.

There have been few lessons from the GFC. There is more debt now than ever before and asset prices are super expensive. The next crisis will hopefully lead to much tighter regulation of the financial sector, that will force it to change from its current cancerous form, to one that does what it’s meant to.

The first half of the column is about the rest of the world.  But what really caught my attention was the second half, where he excoriates both the Reserve Bank and the government for their handling of the last decade or so.    This time, I’m defending both institutions.

There are some weird claims.

We were well into a recession when the GFC hit. So, when global money supplies dried up, it didn’t matter too much, because there was so little demand to borrow money in New Zealand anyway.

Here he can’t make his mind as to whether he wants to date the crisis to, say, August 2007 (10 years ago, when liquidity pressures started to flare up) or to the really intense phase from, say, September 2008 to early 2009.

Our recession dates from the March quarter of 2008 (while the US recession is dated from December 2007), but quite where he gets the idea that when funding markets froze it didn’t matter here, I do not know.  Banks had big balance sheets that needed to be continuously funded, whether or not they were still expecting any growth in those balance sheets. And they had a great deal of short-term foreign funding.  Frozen foreign funding markets, which made it difficult for banks to rollover any such funding for more than extremely short terms, made a huge impression on local banks.  For months I was in the thick of our (Treasury and Reserve Bank) efforts to use Crown guarantees to enable banks to re-enter term wholesale funding markets.  Banks were telling us that their boards wouldn’t allow them to maintain outstanding credit if they were simply reliant on temporary Reserve Bank liquidity as a form of life support.

Despite what he says I doubt Eaqub really believes the global liquidity crunch was irrelevant to New Zealand, because his next argument is that the Reserve Bank mishandled the crisis.

The GFC highlighted that our central bank is slow to recognise big international challenges. They were too slow to cut rates aggressively. They were not part of the large economies that clubbed together to co-ordinate rate cuts and share understanding of the crisis.

I have a little bit of sympathy here –  but only a little.  I well remember through late 2007 and the first half of 2008 our international economics people patting me on the head and telling me to go away whenever I suggested that perhaps events in the US might lead to something very bad (and I’m not claiming any great foresight into just how bad things would actually get).  And I still have a copy of an email from (incoming acting Governor) Grant Spencer in August 2007 suggesting that it was very unlikely the international events would come to much and that contingency planning wasn’t worth investing in.

And, with hindsight, of course every central bank should have cut harder and earlier.  I recall going to an international central banking meeting in June 2007 when a very senior Fed official commented along the lines of “some in the market are talking about the prospect of rate cuts, but if anything we are thinking we might have to tighten again”.

As for international coordination, well the Reserve Bank was part of the BIS –  something initiated in Alan Bollard’s term.  Then again, we were tiny.   So it was hardly likely than when various central banks did coordinate a cut in October 2008 they would invite New Zealand to join in.  Of its own accord, the Reserve Bank of New Zealand cut by 100 basis points only two weeks later (having already cut a few weeks earlier).

But what did the Reserve Bank of New Zealand actually do, and how did it compare with other advanced country central banks?

The OECD has data on (a proxy for) policy rates for 19 OECD countries/regions with their own currencies, and a few other major emerging markets.   Here is the change in the policy rates between August 2007 (when the liquidity pressures first became very evident) and August 2008, just before the Lehmans/AIG/ agencies dramatic intensification of the crisis.

policy rate to aug 08

The Reserve Bank had cut only once by this time.  But most of these countries had done nothing to ease monetary policy.  It wasn’t enough, but it wasn’t exactly at the back of the field, especially when one recalls that at the time core inflation was outside the top of the target range, and oil prices had recently been hitting new record highs.

That was the record to the brink of the intense phase of the crisis.  Here is the same chart showing the total interest rate adjustment between August 2007 and August 2009 –  a few months after the crisis phase had ended.

policy rate to aug 09

Only Iceland (having had its own crisis, and increased interest rates, in the midst of this all) and Turkey cut policy rates more than our Reserve Bank did.   In many cases, the other central banks might like to have cut by more but they got to around the zero bound.  Nonetheless, the Reserve Bank cut very aggressively, to the credit of the then Governor.  It was hardly as if by then the Reserve Bank was sitting to one side oblivious.

Obviously I’m not going to defend the Reserve Bank when, as Eaqub does, he criticises them for the mistaken 2010 and 2014 tightening cycles.  And the overall Reserve Bank record over several decades isn’t that good (as I touched on in a post on Friday), but their monetary policy performance during the crisis itself doesn’t look out of the international mainstream.   Neither, for that matter, did their handling of domestic liquidity issues during that period.

Eaqub also takes the government to task

The government bizarrely embarked on two terms of fiscal contraction. This contraction was at a time of historically low cost of money, and a long list of worthy infrastructure projects in housing and transport.

Projects that would have created long term economic growth and made our future economy much more productive, tax revenue higher, and debt position better.

Our fiscal policy is economically illiterate: choosing fiscal tightening at a time when the economy needed spending and that spending made financially made sense.

To which I’d make several points in response:

  • our interest rates, while historically low, remain very high relative to those in other countries,
  • in fact, our real interest rates remain materially higher than our rate of productivity growth (ie no productivity growth in the last four or five years),
  • we had a very large fiscal stimulus in place at the time the 2008/09 recession hit, and
  • we had another material fiscal stimulus resulting from the Canterbury earthquakes.

Actually, I’d agree with Eaqub that the economy needed more spending (per capita) over most of the last decade –  the best indicator of that is the lingering high unemployment rate – but monetary policy is the natural, and typical, tool for cyclical management.

And, in any case, here is what has happened to gross government debt as a share of GDP over the last 20 years.

gross govt debt

Not a trivial increase in the government’s debt.   Not necessarily an inappropriate response either, given the combination of shocks, but it is a bit hard to see why it counts as “economically illiterate”.  Much appears to rest on Eaqub’s confidence that there are lots of thing governments could have spent money on that would have returned more than the cost of government capital.  In some respects I’d like to share his confidence.  But I don’t.   Not far from here, for example, one of the bigger infrastructure projects is being built –  Transmission Gully –  for which the expected returns are very poor.

Eaqub isn’t just concerned about how the Reserve Bank handled the crisis period.

Our central bank needs to own up to regulate our banks much better: they have allowed mortgage borrowing to reach new and more dangerous highs.

I’d certainly agree they could do better –  taking off LVR controls for a start.  But bank capital requirements, and liquidity requirements, are materially more onerous than they were a decade ago.  And our banking system came through the last global crisis largely unscathed –  a serious liquidity scare, but no material or system-threatening credit losses.  Their own stress tests suggest the system is resilient today.  If Eaqub disagrees, that is fine but surely there is some onus on him to advance some arguments or evidence as to why our system is now in such a perilous position.

Macro-based crisis prediction models seem to have gone rather out of fashion since the last crisis.  In a way, that isn’t so surprising as those models didn’t do very well.     Countries with big increases in credit (as a share of GDP), big increases in asset prices, and big increases in the real exchange rate were supposed to be particularly vulnerable.  Countries like New Zealand.   The intuitive logic behind those models remained sound, but many countries had those sorts of experiences and had banks that proved able to make decent credit decisions.  And we know that historically loan losses on housing mortgage books have rarely been a key part in any subsequent crisis.     Thus, the domestic loan books of countries like New Zealand, Australia, Canada, the UK, Norway and Sweden all came through the last boom, and subsequent recession, pretty much unscathed.

One of the key indicators that used to worry people (it was the centrepiece of BIS concerns) was the ratio of credit to GDP.  Here is private sector credit as a per cent of GDP, annually, back to when the Reserve Bank data start in 1988.

psc to gdp

Private sector credit to GDP was trending up over the two decades leading up to the 2008/09 recession.   There was a particularly sharp increase from around 2002 to 2008 –  I recall once getting someone to dig out the numbers suggesting that over this period credit to GDP had increased more in New Zealand than it had increased in the late 1980s in Japan.  It wasn’t just housing credit.  Dairy debt was increasing even more rapidly, and business credit was also growing strongly.   There was good reason for analysts and central bankers to be a bit concerned during that period.  But what actually happened?  Loan losses picked up, especially in dairy, but despite this huge increase in credit –  to levels not seen as a share of GDP since the 1920s and 30s – there was nothing that represented a systemic threat.

And what has happened since?  Private sector credit to GDP has barely changed from the 2008 peak.  In other words, overall credit to the private sector has increased at around the same rate as nominal GDP itself.  It doesn’t look very concerning on the face of it.  Of course, total credit in the economy has increased as a share of GDP, but that reflects the growth in government debt (see earlier chart), and Eaqub apparently thinks that debt stock should have been increased even more rapidly.

It is certainly true that household debt, taken in isolation, has increased a little relative to household income.  But even there (a) the increase has been mild compared to the run-up in the years prior to 2008, and (b) higher house prices –  driven by the interaction of population pressure and regulatory land scarcity – typically require more gross credit (if “young” people are to purchase houses from “old” people).

If anything, what is striking is how little new net indebtedness there has been in the New Zealand economy in recent years.  Despite unexpectedly rapid population growth and despite big earthquake shocks, our net indebtedness to the rest of the world has been shrinking (as a share of GDP) not increasing.  Again, big increases in the adverse NIIP position has often been associated with the build up of risks that culminated in a crisis –  see Spain, Ireland, Greece, and to some extent even the US.   I can’t readily think of cases where crisis risk has been associated with flat or falling net indebtedness to the rest of the world.

There is plenty wrong with the performance of the New Zealand economy, issues that warrant debate and intense scrutiny leading up to next month’s election.  In his previous week’s column, Eaqub foreshadowed the possibility of a domestic recession here in the next year or two: that seems a real possibility and our policymakers don’t seem remotely well-positioned to cope with such a downturn.     But there seems little basis for “GFC redux” concerns, especially here:

  • for a start, we didn’t have a domestic financial crisis last time round, even at the culmination of two decades of rapid credit expansion,
  • private sector credit as a share of GDP has been roughly flat for a decade,
  • our net indebtedness to the rest of the world has been flat or falling for a decade,
  • there is little sign of much domestic financial innovation such that risks are ending up in strange and unrecognised places, and
  • whereas misplaced and over-optimistic investment plans are often at the heart of brutal economic and financial adjustments, investment here has been pretty subdued (especially once one looks at capital stock growth per capita).

In other words, we have almost none of the makings of any sort of financial crisis, “GFC” like, or otherwise.

House prices are a disgrace. We seem to have no politicians willing to call for, or commit to, seeking lower house prices.  But markets distorted by flawed regulation can stay out of line with more structural fundamentals for decades.  If house prices are distorted that way, it means a need for lots of gross credit.  But it tells you nothing about the risks of financial crisis, or the ability of banks to manage and price the associated risks.